Unit 1: Accounting Environment, Decision-Making, and Theory

1a. Define the basic accounting equation

  • What is the basic accounting equation?
  • What is the definition of assets, liabilities, and owners' equity?
The basic accounting equation is what underpins financial accounting. It illustrates the relationship between a company's assets, liabilities, and owners' equity. The equation is assets = liabilities + owners' equity. Assets are items that have value to the company, or what they own. Liabilities are promises to pay, or what a company owes. Owners' equity is the owners' claim on the assets of the company. For example, assume you own a house. The house is an asset worth $200,000. If you have a $150,000 mortgage (a liability), then your equity is the difference: $50,000.
 

 

1b. Apply the accounting equation to illustrate the impact of business transactions

  • How can you use the accounting equation to analyze business transactions?
  • What is the impact on the accounting equation of common business activities?
  • How can the activities of a business impact the owners' equity?
The basic accounting equation will show the balance that must be achieved in the company's accounting system. When recording business transactions, this basic equation has to hold. If an asset account is increased, then the other part of the transaction must allow the equation to remain in balance. So if you buy assets for $100,000, then either you decrease another asset (cash) for $100,000 to remain in balance, or you increase a liability to stay in balance.
 
Knowing the basic accounting equation also allows you to understand better the rules of debits and credits. If a company increases its assets without increasing liabilities, the owners' equity will increase. If a company increases liabilities without increasing asset value, then owners' equity will decrease. Financial managers can project the impact on the accounting equation of various business strategies and make financial decisions that will lead to the maximization of shareholder wealth.
 
To review, see Accounting and its Use in Business Decisions.
 

1c. Compare and contrast the basic forms of business organizations

  • What are the main forms of business organization?
  • What are the advantages and disadvantages of a sole proprietorship?
  • What are the advantages and disadvantages of a partnership?
  • What are the advantages and disadvantages of a corporation?
The three main forms of business organization in the United States are sole proprietorship, partnership, and corporation. A sole proprietorship is a business owned by one person. The owner is solely responsible for all the decisions of the company. They are easy to set up, and the owner gets the profits of the business, which are subject to only single taxation at the rate of the business. The disadvantages include unlimited liability and limited access to capital. With a partnership, two or more owners share the decision-making and profits but still face unlimited liability. Earnings are taxed only at the owners' level. Corporations are legal entities by themselves, owned by shareholders. They have the advantage of limited liability and better access to capital. The disadvantages include double taxation and more reporting requirements.
 
To review, see Accounting and its Use in Business Decisions.
 

1d. Explain GAAP rules and their importance in the study of accounting

  • What does GAAP stand for?
  • What organization oversees the creation of GAAP rules?
  • Why is it important to study GAAP rules?
GAAP stands for Generally Accepted Accounting Principles. These standards allow for comparison across companies and allow readers of financial statements to be confident that the same rules and definitions are followed by all publicly traded companies. The Financial Accounting Standards Board (FASB) oversees the creation of GAAP rules. FASB is a private sector organization, but it works with government agencies to develop and implement the standards that American companies must follow.
 
Companies are required to follow GAAP rules, so understanding them and their implementation is a critical component of financial management. Understanding GAAP rules also helps the manager understand how their company is judged and measured against other companies.
 
To review, see GAAP Principles and Concepts.
 

1e. Explain the difference between financial and managerial accounting

  • What is the difference between financial and managerial accounting?
  • Do managers have to use both financial and managerial accounting?
  • Why is it important for managers to understand both?
Financial accounting focuses on reporting to outside constituents, while managerial accounting focuses on reporting to internal users. The other differences between managerial and financial accounting are detailed in this chart.
 
Managerial Accounting Financial Accounting
Users Inside the organization Outside the organization
Accounting rules None U.S. Generally Accepted Accounting Principles (U.S. GAAP)
Time horizon Future projections (sometimes historical if in detail) Historical information
Level of detail Often presents segments of an organization (e.g., products, divisions, departments) Presents overall company information in accordance with U.S. GAAP
Performance measures Financial and nonfinancial Primarily financial

Financial accounting provides historical financial information for external users that conforms to GAAP rules. It is required for financial reporting. Managerial accounting provides detailed financial and non-financial information for internal users. It is important for managers to use managerial accounting data to make good decisions, plan for the future, and control their operations.
 
To review, see Financial vs. Managerial Accounting.
 

1f. Summarize the foundational principles of accounting used in analyzing transactions

  • What are the major underlying assumptions that guide the system of accounting?
  • Do you understand how the fundamental accounting principles govern the reporting that companies in the U.S. must do?
  • What are the basic principles that govern how accounting information is reported?
There are five major underlying assumptions of accounting:
 
  1. business entity
  2. going concern
  3. money measurement
  4. stable dollar
  5. periodicity
Review how each of these assumptions creates the foundation for how accounting information is gathered. GAAP has many rules, which are developed by following the following five major principles:
 
  1. cost principle
  2. revenue recognition principle
  3. matching principle
  4. gain and loss recognition principle
  5. full disclosure principle
It is important that you review and understand how these standards help standardize the reporting and presentation of financial data and allow for comparisons across companies.
 
To review, see Accounting Theory.
 

1g. Explain how to detect fraud risk in the accounting function

  • What is the fraud triangle, and how is it used to detect fraud risk?
  • How does perceived opportunity create the potential for fraud?
  • How can rationalization lead to fraud?
  • What pressures might create incentives for someone to commit fraud?
The fraud triangle consists of three elements: incentive, opportunity, and rationalization. The three elements of the triangle must all be present for workplace fraud to occur.

The fraud triangle consists of three elements: incentive, opportunity, and rationalization. The three elements of the triangl

Perceived opportunity exists when the potential perpetrator believes that internal controls are weak or sees a way to override them. Rationalization is when the fraudster justifies their behavior. Incentive or pressure is when there is something in the fraudster's life that causes them to think about committing fraud, such as gambling, drug use, work issues, living beyond means, need to appear successful, etc.
 
To review, see Fraud, Internal Controls, and Cash.
 

1h. Discuss management responsibilities for monitoring the effectiveness of internal control systems in an organization

  • How does SOX govern management responsibility for internal controls?
  • What is the responsibility of management in ensuring the integrity of financial reports?
SOX refers to the Sarbanes Oxley Act. This act strengthens the oversight and controls for public companies to ensure the integrity of their financial statements. The act makes it clear that management is responsible for ensuring the effectiveness and integrity of their internal control systems. The act makes the CEO and CFO personally responsible for financial reporting and the internal control structure. These officers must certify that they reviewed the internal control reports, verified their accuracy, and that the financial reports accurately reflect the economic activity of the company.
 

 

Unit 1 Vocabulary

This vocabulary list includes terms you will need to know to successfully complete the final exam.

  • assets
  • basic accounting equation
  • corporation
  • FASB
  • financial accounting
  • fraud triangle
  • GAAP
  • incentive
  • internal control
  • liabilities
  • managerial accounting
  • owners' equity
  • partnership
  • perceived opportunity
  • rationalization
  • Sarbanes Oxley Act
  • sole proprietorship