Chapter 1

Accounting as a Form of Communication Key Concepts: n What is accounting? n Who uses financial information? n Why do users need accounting information? n What information is communicated through the Balance Sheet, Income Statement, and Statement of Retained Earnings?

n What are the primary assumptions made in preparing financial statements? n What opportunities will be available to you as an accounting major?

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Chapter Outline LO 1

Users of Accounting Information and Their Needs Internal users are the managers and employees of a company

n Have easier access to information than external users n Management accounting provides company's managers with information needed to plan and control their areas of responsibility External users are anyone outside the company

n Limited access to information n Financial accounting prepares information primarily for outside users

• • •

LO 2

stockholders (or potential ones) creditors government agencies (IRS, SEC, ICC, FTC) ♦ often require specialized reporting ♦ suppliers, unions, trade associations, brokers

www.irs.gov www.sec.gov www.ftc.gov

Financial Statements: How Accountants Communicate Accounting equation: Assets = Liabilities + Owners' Equity

n Left side, assets, are resources n Right side indicates who has claim to these resources, in other words, who provided the assets

• •

liabilities from creditors owners' equity from stockholders (stockholders' equity) ♦ investments by stockholders (capital stock) ♦ earnings retained in the business, called retained earnings, have not been paid to stockholders as dividends

Balance sheet is the statement that summarizes assets, liabilities and equity at a specific point in time, usually the end of a month, quarter, or year

n The entity's status at that point in time Income statement summarizes the period's revenues and expenses

n Flow rather than status—whole period's activities n Revenues less expenses Statement of retained earnings links the income statement to the balance sheet

n Income increases retained earnings n Dividends, distributions of income, reduce retained earnings; thus Beginning retained earnings + Net income – Dividends = Ending retained earnings Statement of cash flows is the fourth major financial statement. It is introduced in Chapter 2.

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The Conceptual Framework: Foundation for Financial Statements

LO3

Conceptual framework: foundation for standards, assumptions for preparation of published information

n Economic entity concept: one identifiable, specific entity should be the subject of the statements

•

personal transactions and business transactions kept separate

n Cost principle says to record assets at their acquisition cost, even if that is not a very recent cost

• •

historical cost equals original cost objective, or verifiable by an outside observer

n Going concern principle assumes the business will continue indefinitely n Monetary unit used in preparing statements is the recognized medium of exchange in the country in which the business is located, for example, U.S. dollars

n Time period assumption says that although we cannot know how successful a business is until the end of its life, we need information before then, so we report at even intervals of time, for example, annually

n GAAP, Generally Accepted Accounting Principles, are the rules, which are the organized group of principles, and assumptions under which financial statements are prepared. Accounting as a Social Science Accounting is a service activity. Its purpose is to provide financial information to decisionmakers.

n It is a social science as opposed to a physical science. Who Determines the Rules of the Game? Joint effort:

n Securities and Exchange Commission (SEC): publicly traded companies ("listed stocks") www.sec.gov

n Financial Accounting Standards Board (FASB): public reporting www.rutgers.edu/Accounting/raw/fasb

n American Institute of Certified Public Accountants (AICPA): advisory body to FASB; auditing standards www.aicpa.org

n International Accounting Standards Committee: development of worldwide accounting standards www.iasc.org.uk

The Accounting Profession

LO 4

Private business:

n Controller is chief accounting officer n Treasurer is responsible for cash management n Internal audit oversees accounting and administrative control

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Non-business entities are similar to private business Public accounting:

n Audit records assure fair reporting to stockholders and other outside users

• •

opinions, not statements of fact unable to verify every transaction

n Tax return preparation, tax planning n Management consulting Education Accounting as a career:

n Traditional roles include auditing n Emerging specialty roles include tax accounting, environmental accounting, forensic accounting, software development, accounting in entertainment and telecommunications, etc. Accountants and Ethical Judgments: § Judgments necessary about what to present and how to present it § Great trust placed in accountants by statement users

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Lecture Suggestions Who are the internal users of financial information? Ask students to name as many as they can. How does management accounting information help them? Who are the external users of accounting information? Why is the information they need different from what internal users need?

LO 1

Focus on the word balance in the balance sheet and the accounting equation. The balance sheet must balance: assets equal the total of liabilities plus owners' equity.

LO 2

Summarize Uno’s financial statements to show how the income statement and the statement of retained earnings bridge the gap between the balance sheet of one period and that of the following period: IN THOUSANDS

OCT 1, 2000

DURING 2000 FY

Assets Liabilities Equity stock retained earnings 2000 RE balance

168.5 86.7

=

25.7 56.0

Revenues Expenses Income Dividends Retained Income

56.0

2000 income retained

OCT 3, 1999

213.2 209.2 4.0 None 4.0 4.0

Assets Liabilities Equity stock retained earnings + 1999 RE balance

149.6 68.6 29.0 52.0 52.0

The reader can find many pieces of desired financial information (net income, dividends paid, cash balance) in more than one place in the statements. Students should learn to "read" the statements, to become familiar with what is in them, and where it is located. This familiarity will help them keep the more complicated detailed topics in perspective as you progress through the book. Students think they "know" what an auditor does, but do not have a clear conception of the specifics. Conduct a brief discussion in class of how an auditor really "audits" the books. What specifically do they do? You get some wide-ranging answers, and can shed a lot of light on the subject by leading the class around to some real facts to replace ill-formed notions.

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Projects and Activities LO 1

Users of Accounting Information and Their Needs Outside assignment: The competition In this chapter of your textbook, many examples are drawn from the financial statements of Uno’s. How do they compare to other similar businesses? To answer this, you obviously need to know who the competition is. In an interview, someone asked Peter Lynch, the now-famous former manager of Fidelity Investments' successful Magellan Fund, where he got his ideas about which companies to invest in. One of his sources, he said, was the supermarket! He was not trivializing the question. We all spend a great deal of time shopping, so our first exposure to a company is frequently its product. A good product comes from what may turn out to be an interesting company. The place to learn about products is where they are sold. For students with a Pizzeria Uno’s in the local area: With several classmates make a survey of pizzerias in your area. Visit a Pizzeria Uno and several of its competitors. Ask your server for the most popular pizza in the restaurant and ask several questions about the pizza. Compare the friendliness, knowledge, and courtesy of your server. Evaluate the ambiance of the restaurants. Are you greeted upon arrival? Time how long it takes to get a seat, to have your order is taken, until salad or antipasto is delivered, until the pizza arrives? Is the pizza presented in an appetizing way? Is it hot and fresh from the oven? And now the ultimate test – the first bite. Try to determine ownership if the restaurant is local or part of a chain, is it a franchise. Have you seen ads for the restaurant and where? Is there a customer survey form available? For students without a local Pizzeria Uno: Visit a local supermarket. Do they sell Uno’s products? If not, have they ever heard of them? Why don't they sell them? What do they sell? Examine the frozen pizzas to see which brands the store sells in place of, or in addition to, Uno’s. Can you find the name(s) and address(es) of the manufacturer(s)? What immediate comparisons between products can you make? Where should you go next if you want to find out more about these companies? Solution

There is, of course, no "right" answer to this question, or, countless right answers could be given. Students begin to learn where to find information. The sources are everywhere. Comparisons can begin in the store. Students see how many brands are available, in-store advertising, relative prices, and packaging. Of course, this consumer research is the perfect excuse for some sampling, too. Once they've read the pizza labels, and tried the products, they will probably go off in a number of directions. Many of the packages nowadays contain "800 numbers, or internet web addresses," which can be a treasure trove of information. Of course the library, and helpful reference librarians, will supply material for this assignment. Students do not necessarily need sophisticated electronic databases to continue their research, although these are certainly useful and great to have. But your school's resources may be limited, and the students need to open their minds to various means of inquiry, available in "hard copy," including books, newspapers, magazines, and journals. The quickest way to research is by using the internet. Students can go to a company's web site and find financial information. They can access information by using sites such as Reportgallery.com or Marketguide.com. Students enjoy searching for information on the web. Encourage students to share current events and good reference sites with the class throughout the semester. Each student (or a group of students) can be responsible for a specific company during the semester. It is very interesting to have the class choose an industry to follow during the semester. Each student (or group) could follow a specific retailer, restaurant, computer manufacturer, internet company, etc. 1-6

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Outside assignment: Annual report treasure hunt Read through the Uno’s Annual Report and find the answers to the following questions. The answers to all these questions are in the report. You will have to read most of the report to find them all. A quick "skim" probably won't do it. 1.

Who is the Chairperson of the Board of Directors?

2.

Who is the President and Chief Executive Officer of the Company?

3.

Where is the Company headquartered?

4.

What is the Company’s web address?

5.

What was the highest closing price of Uno’s common stock during 2000?

6.

How many holders of common stock are there?

7.

On which exchange are shares of Uno’s traded?

8.

Who are the Company's independent auditors?

9.

How many full service Pizzeria Uno… Chicago Bar and Grills were owned by the Uno Corporation in 2000 and what was their average sales?

10. How many franchised Pizzeria Uno… Chicago Bar and Grills were there in 2000 and what was their average sales? 11. What is revenue? How much has total revenue increased from 1998 to 2000 (both in absolute dollars, and as a percent)? 12. What is net income? How much has net income increased or decreased from 1998 to 2000 (both in absolute dollars, and as a percent)? 13. How much was the diluted earnings per common share for 2000? How much was it in 1998? 14. Pizzeria Uno…. Chicago Bar and Grill is Chicago institution. Does it have restaurants outside of Chicago? The United States? Is it only a bar and grill? 15. What was the last day of the Company's 1999 and 2000 fiscal years? 16. Which airline is a customer of the Uno Corporation? 17. Using a search engine on the internet, try to find a new article about the Uno Restaurant Corporation. Solution

This annual report exercise can be used as a term project in Financial Accounting sections with favorable student responses. It is not enough to tell students to read an annual report, even if they have it right in front of them. They are busy, and will skim through it with no outside incentive. A list of questions provides incentive. No matter whose annual report they read, students are always surprised at how much information it contains, and at how readable it generally turns out to be. The above is not by any means a comprehensive list, but rather a starting point to which you can add your own questions. There is so much to be found between the covers of the report. If you want more “academic content,” you could very easily add more questions related to the financial statements. Some terms introduced in these questions have not yet been covered. Exposure to the terms keeps the students interested and may encourage them to read ahead. The exercise could also be delayed to Chapter 2 or even farther along in the term, when the students will have learned more and you can ask more analytical questions, or more technical accounting questions. It is good to include a question that requires some writing. For #17 in this case, you might substitute one of the questions below. Tell the students, as a guideline, that the answer to the essay question should be 1 to 1 ½typed pages.

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"What is your impression of this company based on their Annual Report? Would you invest in this company? Would you lend them money? Would you like to work for them?" "Describe what in your opinion are the three most important issues the company faces in the coming year, and what they are doing to deal with them." “Find an article that discusses the company’s current financial status and their prospects for the future, either as a competitor in their chosen business, or as an investment.” “Try one or more of the company’s products. Discuss how successfully the product reflects the company’s corporate mission and personality as conveyed in their annual report.” Answers to the questions (other than opinion essays): 1.

Aaron D. Spencer

2.

Craig S. Miller

3.

100 Charles Park Rd., Boston, MA 02132

4.

www.unos.com

5.

The stock reached a high of $12.65 during the fourth quarter 2000

6.

Approximately 2200 as of October 1, 2000.

7.

NYSE (symbol UNO )

8.

Ernst & Young LLP

9.

110 company owned stores with average sales of $2,052M

10. 55 franchises with average sales of $2,071M. 11. Total revenue is total inflow of assets from operations from all sources. Uno’s has three sources of revenue: restaurant sales, consumer product sales and franchise income. In 1998 total revenues were $191,276M and 2000 revenues were $231,170M. The percentage growth was 20.85%. 12. Net income for 1998 was $5,387 and for 2000 was $4,035M, which is an absolute decrease of $1,352M!! This is a percentage drop of 25%. 13. The Diluted Earnings per share for 2000 was $ .34 and for 1998 was $ .45. 14. Pizzeria Uno’s are located in 30 states, and in Puerto Rico, Mexico, and the United Arab Emirates. It has a consumer products division that sells to an airline, supermarkets and movie theaters. 15. The last day of the Company's 1999 fiscal year was October 3 and the 2000 fiscal year was October 1. 16. American Airlines 17. Students may present a variety of articles. However depending on the search engine, many articles are likely to be about the same news item.

LO 2

Financial Statements: How Accountants Communicate Outside assignment: Prepare your own balance sheet Do you have your own personal balance sheet? Before you say, “No, I'm not a business, so I don't have accounts or anything,” think about the question. Financial records, and the statements that result from them, are a way of recording formally what already exists physically. Don't you already have

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some assets, like a bank account, a car, a stereo and TV, perhaps furniture? How about liabilities? Do you owe anyone money? Set up a balance sheet form similar to the one in your textbook in the review problem (Greenway Corporation). Instead of using the accounts for Greenway Corporation, fill in your own name, and your own “accounts.” Approximate the costs of your assets if you do not know their exact cost, in accordance with the principles you are learning. Are you going to list any of them at market value? Why or why not? What is the difference between the total of your assets, and your total liabilities? Solution

Your students may need a bit of guidance to get started, mainly because they do not think of their possessions as “assets.” Begin by reviewing the definition of an asset. They will see that a balance sheet is not an abstraction created from nowhere, but a way of writing down what physically exists. Students may be asked to prepare a personal balance sheet when they fill out a loan application. They are asked, essentially, for a balance sheet, although not in so many words. The historical cost concept is introduced here, in the question of cost versus market value. Students may debate what their assets are “worth.” They finish by calculating their own “equity” or “net worth” (using the old phrase), that is, what they own outright with no outside claims or liens. Doing this in personal terms makes the concepts more “real” than doing it for some abstract company whose “equity” means nothing to a student. In-class discussion: Why do we need so many statements? The balance sheet gives the company's status at the end of a chosen accounting period. It includes the results of all the operations that took place during this period. Why do we need to have an income statement and statement of retained earnings, which simply expand upon the retained earnings account? If we wanted detail, couldn't we just include it as part of the retained earnings section of the balance sheet? Solution

Many students, when they begin to prepare financial statements, mix up the statements. A very common error is that students will include all the revenues and expenses in the retained earnings section, come up with a net, subtract dividends, and show, then, the ending retained earnings. In other words, they include the income statement and statement of retained earnings in the balance sheet. Then they repeat them again when asked for the individual statements (and probably grumble to themselves that this sure is a lot of extra work). It is useful to review the intent, and different purposes, of the statements so that students see them as individual pieces of information. In-class discussion: Dividends Dividends, you have learned, are a distribution of income, not an expense. What is the difference? Why can't the corporation list them as an expense, since dividends are just another amount of money paid out to somebody? This concept is important in other business courses (i.e. finance). Therefore, students need to become comfortable with the concept as quickly as possible. Solution

The key concepts here are

• • •

To whom are the dividends paid? Is the company required to pay dividends? Are dividends paid in the process of earning revenue?

Expenses are incurred to earn revenues. Dividends are not a part of the revenue process. Expenses imply an obligation, whereas no requirement to pay dividends exists. The company may (or may not) feel that they should pay dividends, but are not required to do so. Finally, expenses involve payments to outside parties: suppliers, employees, banks. Dividends are paid to the owners of the company. In Harcourt, Inc.

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FINANCIAL ACCOUNTING INSTRUCTOR’S MANUAL

other words, they are withdrawals by the owners. Return to simple proprietorships or partnerships to reinforce the difference between an expense and a withdrawal from Getting Started in Business. In-class discussion: GAAP Although regulations promulgated by the SEC and the IRS, for example, carry legally prescribed penalties, the standards used by the accounting profession, under which published statements are prepared, carry no such penalties. If nothing will happen to a company that does not follow generally accepted accounting principles, why do so? What prevents a company from deviating from these conventions if it sees an advantage to doing so? Solution

Here is a question of peer pressure, which students understand very well. If the principles are indeed “generally accepted,” then they are also generally used, and the company that does not use them will stand out. Since corporations are dependent upon outside parties for their revenues (customers) and for major financing (lenders and stockholders, as well as short-term creditors), they want to maintain the trust of these parties. They cast a shadow on this trust if they do not adhere to accepted professional practice, and thus decrease the comparability of their published statements to those of other similar companies. Students will point out that the company will get a bad audit report. This may be an acceptable consequence if the company has already decided to deviate from accepted practice. But they do have some concern for the opinion of those outside the company. An unfavorable audit report will erode credibility as a company. Further, even though the FASB has no legal authority, other bodies do, as mentioned, and they require statements prepared in accordance with generally accepted accounting principles, and impose some of their own rules. GAAP is difficult to escape for a public company. On the other hand, private companies are less subject to these rules, because they are not required to publish financial statements. Few of these private entities can go very far without buying on account, or borrowing money from banks, and creditors generally require audited statements, which again have to conform to GAAP.

LO 3

Who Determines the Rules of the Game? Food for thought: How does FASB make the rules? Visit the web site for the Financial Accounting Standards Board (www.rutgers.edu/Accounting/raw/fasb). Access the on-line publication, "Facts about the FASB". What is its mission? Who are the members? What are their qualifications? Are they no more than rule-makers (don’t we have enough already?) How does the process of developing a new standard begin? What process does the Board goes through before the standard becomes a part of accepted practice. What are the latest developments? Solution

This independent board has seven members, appointed for five-year terms, from business, public accounting, and academe. They are paid substantial salaries for their full-time service. Members of the Board are required to sever all connections with their previous firms or institutions. They monitor the profession and, as they become aware of the need for a change in current practice, they thoroughly investigate the situation, using the services of FASB’s large research staff, and draft position papers. Comments from members of the profession are solicited and carefully considered, and a number of successive modifications to the original position may be made, before a standard is finally adopted. The process may take two or more years and is referred to as due process. Comments about the latest developments will vary.

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The Accounting Profession

LO 4

Food for thought: What are auditors responsible for? Re-read the auditors' opinion on Uno’s financial statements. Describe in your own words what this statement means. Use the following questions as guidelines:

• • •

Did the auditors prepare the financial statements for the company? What do the auditors mean by “reasonable assurance about whether the financial statements are free of material misstatement?” How would you define, specifically, the word misstatement? Does this mean that they are sure everything is correct? We encounter the word material more than once. What does this mean? Be specific.

Solution

The auditors indicate that the statements, and by implication their preparation, are the responsibility of the company. The auditors' job is to check selectively, based upon a set of prescribed auditing procedures generally used in their profession, the data that backs up these statements. Auditors can only be reasonably assured because time and expense prevent their checking each and every transaction that occurred, and in the opinion of many writers even that extensive a check might not uncover every error or misstatement. Thus the auditors do not say that the statements are absolutely correct, they only say that as far as they can ascertain, the statements are free of material errors, and prepared in accordance with generally accepted methods. A material item is one that a reasonably informed reader would consider to have a significant influence on the results as published. In other words, it, too, is a relative term, subject to interpretation. Ethics: What does it mean to you? The topic of ethics concludes this chapter. It is a recurring theme throughout the book because it is a critical item in accounting as it is in any profession. Take a few minutes to ask yourself what ethics means to you. In a brief paragraph, give your own definition of ethics (please do not simply quote something out of a dictionary, but rather give your own personal meaning). Now describe how you see ethics applied to business in general, and to accounting in particular as far as you have been introduced to it. Why is it important? What do you hope to learn as this course continues that will help you solve the ethical dilemmas that you will inevitably meet in your continued schooling, and in your professional life? This last is a difficult question. You have defined what ethics means to you, your own standards, and what you wish to learn. Do you live by the rules you define? Think carefully. Are there instances where your actual performance falls short of what you say is correct? Solution

There are several ways to approach a discussion of this assignment. One approach is to ask several volunteers to read their responses in class and to solicit feedback from other students to their answers. This can kick off a lively discussion. Another approach is to divide the class into small groups and ask the groups to develop a group response to the questions, which will then be presented to the class. This method has the advantage of providing more opportunities for more students to participate. Accounting Careers The financial accounting course can be an opportunity for a business major to choose accounting as a career. It is a great time to encourage students to explore career opportunities. Have students interview accountants about their careers and share their findings with the class. Students can research the web to obtain salary information. Also, have student visit the web site of the AICPA (www.aicpa.org). The site includes a link "Just for Students".

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Secure a copy of Room Zoom from the AICPA and make it available to interested students. This CDROM provides exciting information about CPA careers. Encourage students to get involved with your school's student accounting organizations.

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