Introduction to Accounting and Business

Nature of Business and Accounting

Categories of Businesses

Three categories of businesses are service, merchandising, and manufacturing.

There are three common categories of businesses—service, merchandising, and manufacturing. A service business generates revenue by providing services, which are intangible products. Instead of delivering a tangible product, a service business delivers expertise, offers advice, or employs a professional skill set to the consumer. Law firms, accounting firms, repair shops, salons, and restaurants are considered service businesses. Some well-known service businesses include Uber (transportation service), Red Lobster (food service), American Airlines (transportation service), and Beauty Bars (expertise in makeup artistry).

A merchandising business buys products from other businesses and sells them to consumers. Commonly referred to as a retail business, a merchandising business purchases goods from a wholesaler and resells them to the consumer. Some examples of merchandising businesses include Target, Macy's, Best Buy, and TJ Maxx. The cost associated with the goods purchased for resale is called cost of merchandise sold, or cost of goods sold. Using the cost principle, the good must be purchased for resale and recorded at the price paid to the wholesaler. The goods to be sold are considered merchandise inventory. The merchandise inventory is marked up to a retail selling price, which is the price paid by the consumers. To calculate net income, a merchandising business must first determine its gross profit, or the difference between revenue and cost of merchandise sold.

A manufacturing business converts basic inputs, such as raw materials or parts, to make a final product that is sold to consumers. Finished products can be sold to consumers directly, through a merchandising business or to other manufacturing businesses. Manufacturing businesses will have at least three types of inventories: raw materials (inputs), work in process (in process but not complete), and finished goods (finished products). Some examples of products created by manufacturing businesses are computers, cell phones, clothing, and beverages. Examples of manufacturing businesses include Toyota (cars, trucks, vans), Coca-Cola (beverages), HP Inc. (computers), and Beats Electronics (headphones).

Business Entities

Four types of business entities are proprietorships, partnerships, limited liability companies (LLCs), and corporations. Each business entity has associated pros and cons that vary based on how the entity is established.

Of the four types of business entities—proprietorships, partnerships, limited liability companies, and corporations—proprietorships are the simplest business entity to establish. They have one owner and do not require any legal documents to get started. In addition to the ease of formation, proprietorships are not subject to business income taxes. The income is only taxed as personal income of the owner. Most small businesses are organized as proprietorships. For example, many doctors, lawyers, and stylists form their businesses as proprietorships. The downside to establishing a proprietorship is the challenge associated with raising capital. Another downside is that the sole proprietor can be held personally liable if something happens to the business.

Partnerships are formed by two or more individuals. Like proprietorships, starting up is fairly uncomplicated. Partnerships have limited life and unlimited liability. Additionally, partnerships themselves are not taxed, but the income of their partners is taxed as personal income. Examples of partnerships include accounting firms, law firms, medical groups, and real estate ventures. Often viewed as a partnership alternative, limited liability companies (LLCs) have the tax benefits of a partnership and the limited liability of a corporation.

A corporation may have numerous owners, known as stockholders. Corporate ownership is documented with shares of stock. Corporations have transferable ownership, giving them unlimited life while also limiting their liability. Corporations are subject to double taxation. That is, the income of the business is taxed, and distributions, such as dividends, to the corporation's owners, are taxed on the owners' personal tax returns.

Pros and Cons of Types of Business Entities

Proprietorships Partnerships Limited Liability Companies Corporations
Pros
  • Easy to establish
  • Popular business form
  • Limited resources
  • Easy to establish
  • Limited liability
  • Transferable ownership
  • Limited liability
  • Unlimited life
Cons
  • Difficult to raise capital
  • Unlimited liability
  • Limited life
  • Limited life
  • Income taxed at ownership level
  • Income taxed at ownership level
  • Double taxation

What Is Accounting?

Preparing financial information in financial accounting involves external reporting and is governed by Generally Accepted Accounting Principles (GAAP). However, managerial accounting involves internal reporting and is not governed by GAAP.

The primary differences between financial accounting and managerial accounting focus on users and reporting authorities. Both types of accounting are essential for business entities.

Applied to financial accounting, the Generally Accepted Accounting Principles (GAAP) are a combination of accounting principles, standards, and procedures that govern the preparation of financial statements. Financial accounting involves reporting for a business's external users, such as potential investors, creditors, customers, and taxing and regulatory authorities, who rely on financial accounting and accurate statements for decision-making.

The goal of financial accounting is to ensure the financial information provided is timely and relevant. For example, lenders use the financial information to determine if an entity is creditworthy. Taxing authorities need to verify that companies are reporting accurate information and paying the appropriate amount of tax. Businesses should prepare financial accounting records in accordance with GAAP.

Managerial accounting, however, is not governed by GAAP reporting rules as is financial accounting. The reports or statements by managerial accountants are created internally for internal users of financial information, such as owners, managers, and employees. Internal users also rely on the information prepared by managerial accountants to help managers plan for the future and to make good decisions specifically for the business.

Managerial accountants can prepare their financial reports specifically for a company's purposes and needs, such as to monitor the business’s performance. They might have company reports by region, product, brand, or demographics. They also use the accounting information to check if management's plans and decisions were correct, for controlling purposes. For managerial accounting, timeliness may be necessary to deliver data to internal users (management) for decisions.

While financial accounting and managerial accounting information are most often utilized by different users with different goals and applications, both types are essential to the success of businesses and organizations.

Users of Accounting Information

Financial accounting information is used by various external users, and managerial accounting information is used by internal users.

Business and Accounting Ethics

Ethical standards for financial professionals are necessary to ensure the information provided is trustworthy and useful for decision-making.

The application of ethics in accounting is essential to the usefulness of the accounting information provided. Defined as what one considers morally right or wrong, ethics can vary from employee to employee. While not always illegal, an unethical action or decision can damage a business as well as customers or clients. As a result, it is imperative that the accounting professional adheres to an established set of ethical standards.

The public's confidence in the accounting profession and the securities markets was shaken during the wave of accounting scandals throughout 2001 and 2002. Several prominent business entities engaged in fraud and unethical accounting practices. The impact of the accounting scandals was far reaching, affecting business entities beyond the United States. More than 85,000 jobs were lost, along with the public's trust. Scandals were to blame for the demise of Enron, WorldCom, Tyco International, Adelphia, Parmalat and HIH Insurance, and Arthur Andersen. The scandals sent shock waves throughout the world financial markets and the accounting profession. The unethical actions of a few companies cost investors, creditors, and employees billions of dollars.

To restore the tarnished image of the accounting profession, a code of ethics for professional accountants was established by the International Federation of Accountants (IFAC). The code of ethics addresses the fundamental principles of integrity, objectivity, competence, confidentiality, and behavior of individual accountants. For public accounting firms, the code of ethics addresses issues such as conflicts of interest, second opinions, appropriate fees charged, ethical marketing and advertising, gifts and hospitality, custody of clients' records and privacy, and other issues.

Fraudulent Actions of Companies 2001–2002

Company Fraudulent Actions
Bristol-Myers Squibb Inflated revenues and income
Enron Inflated income, left critical items such as debt off financial statements, bribed officials
Fannie Mae Inflated income
Tyco Left critical items such as debt off financial statements and taxes evaded by the CEO and CFO
WorldCom Understated expenses, inflated income, left critical items such as debt off financial statements
Xerox Inflated income

Once ongoing ethical problems in the accounting profession were disclosed, two members of Congress, Senator Paul Sarbanes and Representative Michael G. Oxley, sponsored the Sarbanes-Oxley Act (SOX), which is legislation passed in 2002 to restore the public's trust in the financial information provided by publicly traded entities by establishing auditing and financial regulations. The Public Company Accounting Oversight Board (PCAOB) was set up by this legislation to oversee auditing services and independently established standards for public accounting firms. For example, corporations are required to enhance disclosure when reporting financial transactions and must disclose conflicts of interest. The PCAOB expanded the authority of the Securities and Exchange Commission (SEC), which can bar or censure professionals from practice. The board established criminal penalties for destroying or changing financial records and committing other white-collar crimes, such as bribery. Public companies must have whistleblower protection, and the chief executive officer must sign corporate tax returns. Implementation of SOX has encountered some issues, such as insufficient funding by the SEC and rising compliance costs for business entities.