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C H A P T E R 1 Accounting: The Key to Success Accounting Leads the Way Wynne Powell is an accounting professional. He is also president and CEO of London Drugs, a business that has millions of dollars in revenues annually and a staff of approximately 6,000. It’s a highly stressful position, he admits, but Wynne finds it stimulating. The excitement is in making things happen: taking money and making it grow, providing a return to the owners. “It’s like a chess game; somebody makes a move and you carefully develop and adjust your strategy, positioning yourself for the win. It’s fun!” How do you make sure you win in business? According to Wynne, it’s pretty basic: you need a thorough understanding of accounting figures; that’s what allows a company to fail or flourish. The management team must fully understand how financial information is created; it’s only then that they can use it to their advantage. In Wynne’s opinion, businesses begin to fail because of inappropriate or late financial figures. Advances in technology have ensured that accounting information can be available on a real-time basis. Technology has also triggered the evolution of a new breed of accountant whose focus has expanded to every aspect of the business in every corner of the world. “Accounting knowledge is the key,” says Wynne Powell. “It is the ‘language of business’ and as such is fundamental to your success in the business world.” Accounting leads the way. Learning Objectives LO1 Describe accounting and its goals and uses. LO2 Describe forms of business organizations. LO3 Identify users and uses of accounting. LO4 Explain why ethics and social responsibility are crucial to accounting. LO5 Describe how technology is changing accounting. LO6 Identify opportunities in accounting and related fields. *APPENDIX 1A *LO7 Describe the codes of ethics and professional conduct for accountants. * An asterisk (*) identifies appendix material. 4 Chapter 1 Accounting: The Key to Success Chapter Preview A Chapter Preview introduces the importance and relevance of the material, and also links these materials to the opening article to motivate you, the reader. Accounting is at the heart of business: accounting information pulsates throughout an organization, feeding decision makers with details needed to give them an edge over competitors. Because of new technologies, the increasing speed and quantity of information available makes the task for accountants like Wynne Powell an ever-increasing challenge. Decision makers like Wynne cannot rely on hunches and guesses. Decision makers depend on their knowledge of accounting principles and practices to help identify and take advantage of opportunities discovered from reviewing large volumes of information. Through your studies of this book, you will learn about many of the accounting concepts, procedures, and analyses common to both small and large businesses. This knowledge will provide you with the basics necessary to make better business decisions. This first chapter serves a dual role. First, it introduces the subject of accounting. It describes accounting, the users and uses of accounting information, the importance of ethics and social responsibility, and opportunities in accounting. This chapter provides a foundation for those students who have little or no understanding of business or the role of accounting in business. Chapter 2 will build on this foundation by focusing on transactions and financial statements. Chapter 1 also introduces you to each of the learning features found in most chapters. For example, immediately to the left of the first paragraph above is an explanation of purpose regarding the Chapter Preview, and two additional features are described in the lower left margin. Some of the features refer to the “OLC,” the Online Learning Centre, located on the Web at www.mcgrawhill.ca/college/larson. Take the time in this chapter to explore and learn the value of these additional resources. What is Accounting? Boldfaced words or phrases represent new terminology that is explained here and defined in the glossary at the end of the chapter. Accounting knowledge is a powerful tool; it is your key to success, according to Wynne Powell. How does accounting knowledge give you power? What exactly is the focus of accounting? This section answers these fundamental questions. Power of Accounting LO1 Describe accounting and its goals and uses. Each chapter is separated into chunks of information called learning objectives (LO). Each LO tells you what needs to be mastered in that section of reading. Accounting is an information system that identifies, measures, records and communicates relevant, reliable, consistent and comparable information about an organization’s economic activities, as shown in Exhibit 1.1. Its objective is to help people make better decisions. It also helps people better assess opportunities, products, investments, and social and community responsibilities. In addition to reporting on the performance of a business, what the business owns, and what it owes, accounting opens our eyes to new and exciting possibilities. Chapter 1 Accounting: The Key to Success Identifying and measuring 5 Exhibit 1.1 Accounting Activities Exhibits aid in visual learning of key accounting and business topics. Recording Communicating This feature relates the theory to a real-life situation. Power of Accounting Information in Small Business Pete Seerden, owner of ECOF, used to pay thousands of dollars annually in renting warehouse space for his cabinet-making business. “Rent payments were eating into my profits big time. I looked at alternatives and crunched some numbers. I ended up buying my own warehouse. I knew that I was increasing my risk but the upside was that the money I used to pay for rent was now paying for my building. Now, I’ve expanded my warehouse and am renting a part of it to somebody else.” Pete Seerden is not an accountant but was able to use his knowledge of accounting information to make a successful business decision. Power of Accounting Information in Big Business The Toronto-Dominion (TD) Bank teamed up with Starbucks to create an innovative customer experience. The TD Bank became the first major Canadian bank to combine banking with the services of a retailer in one of its branches. In the TD Bank branch at Queen and Bay Streets in downtown Toronto, you can purchase Starbucks products while doing your banking. This innovative decision was made through an analysis of information from a variety of sources including the accounting information system. By increasing customer exposure for both parties, profits should be positively affected. D i d Yo u K n o w ? ? 6 Chapter 1 Accounting: The Key to Success Accounting can provide you with important and interesting learning experiences. You will acquire knowledge and skills that will help you in both business and everyday life. For example, you can use accounting knowledge to make better investment decisions or to help you get a loan for a house. Focus of Accounting A series of Flashback questions in the chapter reinforces the immediately preceding materials. It gives you feedback on your comprehension before going on to new topics. back Accounting affects many parts of life. Some examples of common contacts with accounting are through credit approvals, chequing accounts, tax forms, and payroll. These experiences are limited and tend to focus on the recordkeeping (or bookkeeping) parts of accounting. Recordkeeping, or bookkeeping, is the recording of financial transactions and events, either manually or electronically, for the purpose of creating a reliable bank of data. Accounting involves the recordkeeping process but is much more. Accounting also involves designing information systems to provide useful reports to monitor and control an organization’s activities. In order to use the reports effectively, decision makers must be able to interpret the information. The skills needed to understand and interpret accounting information come from an insight into each aspect of accounting, including recordkeeping. Because accounting is part of so much that we do in business and our everyday lives, you can enjoy greater opportunities if you understand and are able to use accounting information effectively. 1. What is the major objective of accounting? 2. Distinguish between accounting and recordkeeping. Answers—p. 20 Forms of Organization LO2 Describe forms of business organizations. A business is one or more individuals selling products or services for profit. Products like athletic apparel (CCM, Bauer, NIKE, Reebok), computers (Dell, Hewlett-Packard, Apple) and clothing (Tilley, Levis, GAP) are part of our daily lives. Services like information communication (Sympatico, AOL Canada, CompuServe, Microsoft), dining (Tim Hortons, Harvey’s, McDonald’s, Burger King) and car rental (Tilden, Hertz, Budget) make our lives easier. A business can be as small as an in-home childcare service or as large as the Hudson’s Bay Company. Nearly 100,000 new businesses are started in Canada each year, with most of them being founded by people who want freedom from ordinary jobs, a new challenge in life, or the advantage of earning extra money. Most organizations engage in economic activities, such as the business activities of purchasing materials and labour, and selling products and services. They can also involve activities for non-business organizations, more commonly referred to as not-for-profit organizations, such as government, schools, and churches. A common feature in all organizations, both business and nonbusiness, is the power and use of accounting. Business Organizations Businesses take one of three forms: sole proprietorship, partnership, or corporation. For some of the characteristics of each business form, see Exhibit 1.2. Chapter 1 Business entity Legal entity Limited liability Unlimited life Business taxed One owner allowed Accounting: The Key to Success Sole Proprietorship Partnership Corporation yes no no no no yes yes no no no no no yes yes yes yes yes yes Sole Proprietorship A sole proprietorship, or single proprietorship, is a business owned by one person. No special legal requirements must be met in order to start this form of business, other than to file for a business licence and register the business name. While it is a separate entity1 for accounting purposes, it is not a separate legal entity from its owner. This means, for example, that a court can order an owner to sell personal belongings to pay a proprietorship’s debt. An owner is even responsible for debts that are greater than the resources of the proprietorship; this is known as unlimited liability, and is an obvious disadvantage of a sole proprietorship. Because tax authorities do not separate a proprietorship from its owner, the profits of the business are reported and taxed on the owner’s personal income tax return. Small retail stores and service businesses often are organized as proprietorships. Partnership A partnership is owned by two or more persons called partners. Like a proprietorship, no special legal requirements must be met in order to start a partnership, other than to register the business name and obtain a business licence. To run the business together, the partners need an oral or written agreement that usually indicates how profits and losses are to be shared. A partnership, like a proprietorship, is not legally separate from its owners, therefore each partner’s share of profits is reported and taxed on that partner’s tax return. Partners are usually subject to unlimited liability. There are two types of partnerships that limit liability. A limited partnership includes a general partner(s) with unlimited liability and a limited partner(s) with liability restricted to the amount invested. A limited liability partnership restricts partners’ liabilities to their own acts and the acts of individuals under their control. This protects an innocent partner from the negligence of another partner, yet all partners remain responsible for partnership debts. Corporation A corporation is a business that is a separate legal entity chartered (or incorporated) under provincial or federal laws. A corporation is responsible for its own acts and its own debts. It can enter into its own contracts, and it can buy, own, and sell property. It can also sue and be sued. Not only does separate legal status give a corporation an unlimited life, but it also entitles the corporation to conduct business with the rights, duties, and responsibilities of a person. As a result, a corporation files a tax return and pays tax on its profits. A corporation acts through its 1 The business entity principle, is one of a group of accounting rules, the Generally Accepted Accounting Principles (GAAP), which are discussed in detail in Chapter 2. This principle states that each economic entity or business of the owner must keep accounting records and reports separate from the owner and any other economic entity of the owner. 7 Exhibit 1.2 Characteristics of Business Organizations 8 Chapter 1 Accounting: The Key to Success managers, who are its legal agents. Separate legal status also means that the shareholders are not personally liable for corporate acts and debts. Shareholders are legally distinct from the business and their loss is limited to what they invested. This limited liability is a key to why corporations can raise resources from shareholders who are not active in managing the business. Ownership, or equity, of all corporations is divided into units called shares. Owners of shares are called shareholders (the American term for shares is stock and for shareholders, stockholders). A shareholder can sell or transfer shares to another person without affecting the operations of a corporation. When a corporation issues (or sells) only one class of shares, we call them common shares. Air Canada is an example of a Canadian corporation. As of December 31, 2002, Air Canada had issued a total of 79 million common shares to the public. This means that Air Canada’s ownership is divided into 79 million units. A shareholder who owns 790,000 shares of Air Canada owns 1% of the company. Non-Business Organizations Non-business organizations plan and operate not for profit but rather for other goals such as health, education, religious services, and cultural and social activities. Examples are public schools meeting the needs of citizens, and community care groups meeting the needs of the poor. Non-business organizations do not have an identifiable owner. Still, the demand for accounting information in these organizations is high since they are accountable to their sponsors. These organizations are accountable to taxpayers, donors, lenders, legislators, regulators and other constituents. Exhibit 1.3 lists a wide range of government and not-forprofit organizations that are affected by the power of accounting. This list is but a sampling of the roughly one-third of Canadian economic activity done by this type of organization. In all of these organizations, accounting captures key information about their activities and makes it available to users both internal and external to the organization. Exhibit 1.3 Transit Partial List of Government and Not-for-Profit Organizations Schools Parks Health Hospitals Shelters Legislatures Mail Police Colleges Military Judicial Parliament Churches Museums Airports Prisons Highways Treasury Utilities Cities Theatres Universities Libraries Charities Chapter 1 Accounting: The Key to Success Entrepreneur You and a friend have developed a new design for mountain bikes that improves speed and performance by a remarkable 25% to 40%. You are planning to form a small business to manufacture and market these bikes. You and your friend are concerned about potential lawsuits from individuals who may become injured because of using the speed feature of the bikes with reckless abandon. What form of organization do you set up? 9 Judgement Call Answer—p. 19 The Judgement Call feature requires you to make accounting and business decisions. It uses role-playing to show the interaction of judgement, the need for business awareness, and the impact of decisions. 3. What are the three common forms of business organizations? 4. Identify examples of non-business organizations. back Answers—p. 20 All chapters have a mid-chapter and end-of-chapter demonstration problem to illustrate and reinforce important topics. Mid-Chapter Demonstration Problem For each of the following independent situations, identify which type of business organization is being described (sole proprietorship, partnership, or corporation). a. The owners of JenStar can sell or transfer their ownership to another person without affecting the operations of the business. b. The 28 owners of InterIsland Tours each have 15,000 shares. c. Jan Wallace and Roth Winters are subject to unlimited liability in their business. d. Willis Corsairs is responsible for debts that are greater than the resources of his business. e. The profits of Perth’s Financial Consulting are reported and taxed on the personal tax return of Wyette Perth, the owner. S O L U T I O N a. b. c. d. e. Corporation Corporation Partnership Sole proprietorship Sole proprietorship T O Mid-Chapter Demonstration Problem 10 Chapter 1 Accounting: The Key to Success Users of Accounting Information LO3 Identify users and uses of accounting. Accounting is a service activity that serves the decision-making needs of external and internal users. External Information Users External users of accounting information are not directly involved in running the organization. They include shareholders, lenders, directors, customers, suppliers, regulators, lawyers, brokers, and the press. Each external user has special information needs that depend on the kind of decision to be made. To make a decision, key questions need to be answered; this is often done using information available in accounting reports. The following table identifies several external users and decisions that require accounting information. External User Group Examples of Decisions to be Made Questions That Require Accounting Information Lenders (creditors) lend money or other resources to an organization To lend money or not Can current loans be repaid? Can additional loans be repaid? What is the future profit outlook? Shareholders are the owners of a corporation To invest or not What is net income for current and past periods? Do loans seem large or unusual? Do expenses fit the level and type of revenues? External auditors examine financial statements and provide assurance that they are prepared according to GAAP To determine the reasonableness of a client’s statements Have all expenses been recorded? Do revenues include only those for the current period? Employees of an organization, or their union representatives To determine if wages are fair Is net income large enough to support a request for increased pay? Regulators, such as Canada Customs and Revenue Agency (CCRA)* To determine if payroll deductions are calculated properly Are all employees being paid through the payroll system? Others • Contributors to not-forprofit organizations • Suppliers To continue financial support of the organization Are funds being spent in an appropriate manner? To determine if goods should be supplied on credit Is the purchaser able to pay for goods purchased? *CCRA was formerly known as Revenue Canada. External Reporting Financial accounting is the area of accounting aimed at serving external users. Its primary objective is to provide external reports called financial statements to help users analyze an organization’s activities. Because external users have limited access to an organization’s information, their own success depends on getting external reports that are reliable, relevant, consistent, and comparable. Some governmental and regulatory agencies have the power to get reports in specific forms, but most external users must rely on general-purpose financial statements. The term general-purpose refers to the broad range of purposes for which external Chapter 1 Accounting: The Key to Success 11 users rely on these statements. Generally Accepted Accounting Principles (GAAP) are important in increasing the usefulness of financial statements to users. We discuss these principles along with the financial statements in Chapter 2. Accounting Information at Work The Multiple Sclerosis (MS) Society of Canada provides assistance and support to individuals with MS, in addition to funding research aimed at finding a cure. Accounting makes it possible for not-for-profit organizations like the MS Society of Canada to present to external users information like the following: How funds are spent How funds are raised Memberships 1% Investments 4% Services 39% Grants 4% Management 14% United Way 5% Research 21% Fund Raising 6% MS Clinics 6% Other Public Education Chapter Development 7% 1% 4% Social Action Donations 86% 2% SOURCE: w w w. m s s o c . c a . Internal Information Users Internal users of accounting information are those individuals directly involved in managing and operating an organization. The internal role of accounting is to provide information to help internal users improve the efficiency and effectiveness of an organization in delivering products or services. For example, Kathy Silver, HR Manager Recruitment, Training, and Policy of Shell Canada, says about the role of accounting in the human resources area: “As an HR person, I am often involved in developing proposals for HR initiatives in order to positively affect the company’s profitability. In order to get management to support these proposals, I have to be able to clearly demonstrate in financial accounting terms how the proposed HR activities will impact the bottom line and contribute to business success. In today’s tough competitive business environment, it is critical that HR professionals have an understanding of financial accounting and are able to speak intelligently about financial issues. Otherwise, they have very little credibility with internal business clients and will have difficulty making a valuable contribution. In addition, HR functions must be managed like any other business and this requires a knowledge of financial accounting; the training department must account for all its expenses and revenues; the payroll department must book all the accounting entries for salaries and tax deductions; the pension and benefits department must be able to book accounting entries for benefits and pensions; the recruitment department must account for their recruitment expenses. And all HR departments must manage to a budget and explain variances. HR is not just about people. It is about business and finance and how people can contribute towards business goals. Those who grasp this concept will be much more marketable in the workplace.” D i d Yo u K n o w ? ?