Week 1 · Chapter

Chapter 1 — Accounting and the Business Environment

Financial Accounting Free sample edition

The module's primary reading · ~40–50 minutes · Objective 1 · Read it first this week, before the lecture and the slide deck.

In plain language

This week is about what accounting is for and who it is for. Accounting is the way a business keeps track of what happens to it and tells people about it. Some of those people run the business, and some stand outside it, such as a bank or an investor. You will meet the three common ways to set up a business, the groups that write the rules for business reports, and the ethics that make those reports worth trusting. You will also meet the running case — a made-up bicycle shop the course follows all term.

Why you already care about this

Picture a food truck parked outside a hospital at lunch. The owner takes card payments all day, buys tortillas and propane, and pays a helper on the weekends. At the end of the month the owner asks one question: did this month make money? Nobody else is in the truck. The owner still needs records to answer it.

Now picture a loan officer at a community bank. A two-partner landscaping company wants a loan to buy a second mower and a trailer. The loan officer has never seen the company's crews at work. What the officer can see is a set of reports about the company's past year. The question is different, but it is the same kind of question: can these numbers be trusted, and what do they say?

Both people need accounting. One runs the business. The other stands outside it and decides whether to lend to it. This course teaches you to produce numbers that both of them could rely on.

By the end of this chapter you will be able to: define accounting and tell financial accounting from managerial accounting; sort the users of a business's numbers into internal and external users and name the question each one asks; describe the sole proprietorship, the partnership, and the corporation; apply the economic entity assumption to keep an owner's personal spending out of a business's records; explain who sets GAAP and what the FASB and the SEC each do; compare IFRS and GAAP without ranking them; name the six principles of the AICPA Code of Professional Conduct; name the four financial statements; and read the running case's plan for its form and its users.

Hook to keep: the numbers are for someone — ask who before you ask how.

Where we are

This week: what accounting is, who uses it, the three forms of business organization, the economic entity assumption, GAAP and who sets it, IFRS, the AICPA's six principles, the four financial statements, and the running case.
How they connect: this chapter is the foundation; every later week records events for the users you meet here, under the rules you meet here.
Where we're going next: Week 2, The Accounting Equation and Transaction Analysis, starts recording the bicycle shop's first month, one event at a time.

Week 1 has no earlier weeks behind it. If you have never taken an accounting course, you are in the right place. You need arithmetic and a willingness to ask "who is going to read this?" Debits, credits, and the accounting equation come later, so none of them appear here.

1. Define accounting: measure, record, report

Think about a household with a shared fridge and three roommates. One person buys groceries, another pays the internet bill, and a third covers the electric bill. Without a running list, nobody knows who owes whom. A list on the fridge solves it. It measures what each person spent, it keeps a record, and it reports the result at the end of the month.

A business does the same three things on a larger scale. Here is the definition this course uses:

Accounting is the system a business uses to measure its economic events, keep a record of them, and report them to the people who need the information.

Each verb matters. Measure means putting a dollar amount on what happened. Record means writing it down in an organized way, so nothing is lost or counted twice. Report means turning those records into a summary that someone can read and act on.

This course also teaches a way of working, and you will use it every week. Analyze what happened. Record it so the books stay in balance. Put it in the right period. Check every total before anyone relies on it.

Worked example — measure, record, or report? A food truck owner does four things in one month. Sort each one.

The owner counts the cash box and the card receipts after a lunch rush and finds $640 in sales. That is measuring.
The owner writes that $640 into a sales log with the day's number beside it. That is recording.
The owner adds the month's sales log and tells a business partner the total. That is reporting.
The owner checks the log's total a second time before sending it. That is the habit of checking every total before anyone relies on it.

All four steps belong to accounting. The reading in one sentence: accounting is not only adding numbers; it is measuring, recording, and reporting them so someone else can use them.

Misconception check. Students often think accounting is the same as doing the math. That is tempting, because accounting is full of numbers. But the arithmetic is the easy part. The harder part is deciding what to measure, recording it the same way every time, and reporting it so a reader can trust it. The cure is to keep all three verbs in mind: measure, record, report.

2. Split the users: financial versus managerial accounting

Go back to the food truck. The owner wants to know which menu item earns the most, so they can decide what to make more of. A bank deciding on a loan wants something else: a summary of the whole business that follows rules the bank already understands. Same truck, two kinds of readers.

Accounting splits its readers into two groups.

Internal users are the people who run a business from inside and use its numbers to make decisions, such as managers and owner-operators.
External users are the people outside a business who rely on its reports, such as investors, lenders, suppliers, customers, tax authorities, and regulators.

Each group gets its own branch of accounting.

Financial accounting produces general-purpose financial statements for external users such as investors and lenders.
Managerial accounting produces information for internal decision-makers, such as a manager deciding what to stock or how to schedule staff.

"General-purpose" is a key phrase. An outside reader cannot ask the business to build a custom report, so financial statements are built to serve many outside readers at once. That is also why they follow shared rules, which you meet in Section 5.

Worked example — internal or external? A small dog-grooming service has five people who care about its numbers. Sort them.

Five illustrative readers of a dog-grooming service's numbers, sorted by user group
Reader	What they want to know	User group
The owner, who also grooms dogs	Which services earn the most per hour	Internal
A supplier of shampoo, selling on credit	Will the service pay its bill on time?	External
A bank considering a loan for a new van	Can the service repay the loan?	External
The tax authority	How much tax does the service owe?	External
A shift manager	How many groomers to schedule on busy days	Internal

So 2 readers are internal and 3 are external, which makes 5 in all. The reading in one sentence: whether a reader is inside or outside the business decides which branch of accounting serves them.

Misconception check. Students often think financial and managerial accounting are the same thing with two names. That is tempting, because both use the same events and the same dollars. But they serve different readers. Financial accounting reports to people outside the business, under shared rules. Managerial accounting serves people inside, in whatever form helps them decide. The cure is to ask one question: who is reading this?

3. Name the three forms of business organization

Picture three businesses on one street. A food truck is owned by one person. A landscaping company is owned by two partners who split the work and the profits. A bicycle shop is owned by two founders who set it up as a separate legal company. The law treats each one differently, and so does accounting.

Here are the three common forms of business organization:

A sole proprietorship is a business owned by one person, with no legal separation between the business and its owner.
A partnership is a business owned by two or more people who share its ownership.
A corporation is a legal entity separate from its owners, the shareholders, who have limited liability for its debts.

Limited liability means the corporation's shareholders do not owe the corporation's debts beyond what they invested. If a corporation cannot pay a bill, the creditor's claim is against the corporation, not against each shareholder's home or savings.

Which form is most common? The IRS's Statistics of Income program counted returns for tax year 2022. It reported about 31.0 million nonfarm sole proprietorship returns, over 4.5 million partnership returns, and about 6.8 million active corporate returns. You do not need to memorize those counts. Keep the one point they make: the sole proprietorship is the most common form of business in the United States.

Worked example — which form is it? Read three illustrative businesses.

One person runs a food truck alone, and nobody else owns any part of it. One owner and no separate legal entity: a sole proprietorship.
Two people share ownership of a landscaping company and split its profits. Two owners and no corporation formed: a partnership.
Two founders set up a bicycle shop as a separate legal company and receive shares of its stock. A separate legal entity owned by shareholders: a corporation.

The reading in one sentence: the form depends on how many owners there are and whether the business is a legal entity separate from them.

Misconception check. Students often think a big business must be a corporation and a small business must be a sole proprietorship. That is tempting, because many large companies are corporations. But size does not decide the form; the owners' legal choice does. The illustrative bicycle shop in this course is small, and it is still a corporation. The cure is to look at ownership and legal separation, not at size.

4. Separate the business from its owners: the economic entity assumption

Picture the food truck owner at a grocery store. Into the cart go tortillas and cheese for the truck. Then, at the same checkout, cereal and diapers for home. One person paid for both. Should both go into the truck's records?

Accounting says no. Here is the rule:

The economic entity assumption is the rule that a business's records are kept separate from its owners' personal records, even when the business is a sole proprietorship.

This matters most for a sole proprietorship, because the law does not separate the owner from the business. Accounting separates them anyway. The truck's records hold the truck's events. The family's cereal belongs in the owner's personal budget, not in the truck's expenses.

Worked example — business or personal? The food truck owner pays for four things in one week. Sort each one.

$120 of propane for the truck's grill: a business event, because the truck uses it to serve customers.
$35 of cereal and milk for the family: personal, because the truck does not use it.
$60 for the weekend helper's pay: a business event, because the helper works on the truck.
$90 for the owner's concert tickets: personal, even if the owner pays from the truck's card.

Add the business items: $120 + $60 = $180. Add the personal items: $35 + $90 = $125. Only the $180 belongs in the truck's records. The reading in one sentence: who paid does not decide where an item goes; what the item was for does.

Misconception check. Students often think an owner's personal spending counts as a business expense when the owner is the business. That is tempting, because in a sole proprietorship one person signs for both. But mixing them makes the business look less profitable than it is, and it hides what the business really costs to run. The cure is the economic entity assumption: the business is its own entity on paper, even when the law does not separate it.

5. Find who sets the rules: GAAP, the FASB, and the SEC

Imagine every restaurant in town wrote its menu prices in a different currency. Comparing them would take forever. Financial statements have the same problem. If every business picked its own rules, an outside reader could not compare one company with another.

The United States solves that with shared rules.

Generally accepted accounting principles (GAAP) are the standards U.S. companies follow in preparing financial statements for external users.

Two bodies matter most for GAAP, and they are easy to confuse.

The Financial Accounting Standards Board (FASB), established in 1973, is an independent, private-sector, not-for-profit organization that sets GAAP for public and private companies and not-for-profit organizations. It is not a government agency.
The Securities and Exchange Commission (SEC) is the federal agency created by the Securities Exchange Act of 1934. It has legal authority over the financial reporting of U.S. public companies, and it recognizes the FASB as its designated accounting standard setter.

So the SEC holds the legal power over public-company reporting, and it relies on the FASB to write the standards. A public company is one whose shares anyone can buy, such as on a stock exchange.

Where do the rules live? The FASB's Accounting Standards Codification is the source of authoritative GAAP recognized by the FASB for nongovernmental entities. It took on that role in 2009. For companies registered with the SEC, the SEC's own rules and interpretive releases are also authoritative.

Worked example — which body is it? Match each statement to the FASB or the SEC.

"A federal agency with legal authority over public-company reporting." That is the SEC.
"A private-sector, not-for-profit standard setter, established in 1973." That is the FASB.
"Created by the Securities Exchange Act of 1934." That is the SEC.
"Recognized as the designated accounting standard setter for public companies." That is the FASB, recognized by the SEC.

The reading in one sentence: the FASB writes GAAP, and the SEC holds the legal authority over public-company reporting and recognizes the FASB's role.

Misconception check. Students often think the FASB is a government agency, and that the SEC was created by the Securities Act of 1933. Both are tempting. The FASB's rules carry real weight, so it sounds official. And the 1933 Act is a famous securities law from the same period. But the FASB is private-sector and not-for-profit, and the SEC was created by the Securities Exchange Act of 1934. The cure: FASB writes, SEC oversees, and 1934 is the SEC's year.

A caveat: the bicycle shop you meet in Section 9 is a small private corporation, not a public company. Its outside readers still expect statements that follow GAAP, but the SEC's legal authority covers public-company reporting.

6. Compare IFRS with GAAP, without a verdict

Picture two board games that use the same pieces but slightly different rules. A player who knows one can learn the other, but cannot assume every rule matches. Accounting has two big rule books like that.

International Financial Reporting Standards (IFRS) are the accounting standards set by the International Accounting Standards Board (IASB) and used for public company reporting in many countries.

GAAP and IFRS share most of their big ideas, and they differ in some specific rules. This course describes each difference by its effect on the numbers. It never calls one framework better or worse, and it never calls them the same. When a later week meets a place where the two differ, you will see what each one does and how the reported figures change.

Worked example — fair or unfair comparison? Read three sentences about the two frameworks.

"IFRS is set by the IASB, and GAAP in the United States is set by the FASB." Fair: it describes who sets each one.
"IFRS is the better system, so every country should switch." Unfair: it ranks them, and the course does not.
"IFRS and GAAP are identical, so it does not matter which one a company uses." Unfair: it erases real differences.

One out of three is fair. The reading in one sentence: compare the two frameworks by who sets them and what each rule does, never by a verdict.

Misconception check. Students often think IFRS is "the same as GAAP," or that one is "better" or "worse." That is tempting, because people like a simple rule or a simple ranking. But the two frameworks differ in specific places, and a difference is an effect to describe, not a contest to settle. The cure is to say what each one does and stop there.

7. Add the ethics: the AICPA's six principles

Think about a referee in a youth soccer game. The rulebook says what counts as a foul. But the game only works if the referee is honest, pays attention, and does not favor one side. Rules need people who follow them in good faith.

Accounting has the same need. The American Institute of CPAs publishes the AICPA Code of Professional Conduct, which sets out six principles for its members:

Responsibilities
The Public Interest
Integrity
Objectivity and Independence
Due Care
Scope and Nature of Services

The rules tell an accountant what to record. The principles describe how to behave while recording it. Integrity is honesty. Objectivity and independence mean not letting a personal interest bend the numbers. Due care means doing the work with skill and attention.

Misconception check. Students often think ethics is a separate topic that has nothing to do with the numbers. That is tempting, because the six principles contain no arithmetic. But a statement that balances perfectly can still mislead if the person who prepared it bent the facts. The cure is to see the principles as part of what makes a number trustworthy.

Pause and choose one. Pick one option and write two or three sentences.

(a) Think of a time you relied on someone else's count, such as a team's score, a receipt, or a shared bill. Which of the six principles did you count on that person to follow?
(b) Imagine you keep the books for a friend's small business, and the friend asks you to leave out one sale. Which of the six principles would that request test, and why?

8. Name the four financial statements

Think about how you might describe a month of your own money. You could say what came in and what went out. You could say what you own and what you owe today. You could say where your cash went. Each answer is a different view of the same month.

Financial statements give outside users those views. There are four:

The income statement reports a business's revenues and expenses for a period and the net income or net loss that results.
The statement of retained earnings shows how the earnings a corporation has kept in the business changed during a period.
The balance sheet reports what a business has, what it owes, and the owners' claim at one moment in time.
The statement of cash flows reports where a business's cash came from and where it went during a period.

Notice the time words. Three of the statements cover a period, such as a month. The balance sheet is a snapshot of one moment, such as the end of the month. You will prepare the first three from the running case's records in Week 5, and the statement of cash flows in Week 15.

Misconception check. Students often think the income statement shows how much cash the business has. That is tempting, because "income" sounds like money in your pocket. But the income statement reports revenues and expenses, and the statement of cash flows is the one that follows cash. The cure is to match each statement to its question: earned, kept, owned and owed, or cash in and out.

9. Meet the running case: read the bicycle shop's plan

Here is the business you will follow all term. It is an illustrative, unnamed bicycle repair and sales shop, organized as a corporation by two founders. It does not exist. It describes no real business, and it has no name; the course calls it "the bicycle shop."

This week you read the shop's plan only for two things: its form of organization and its likely users. You record no transaction yet. Week 2 starts that.

Worked example — the bicycle shop's plan (illustrative). Read the plan the way an outside user would.

The form. Two founders organize the shop as a corporation. They plan to invest $30,000 cash in exchange for 30,000 shares of $1-par common stock. So each share costs $30,000 ÷ 30,000 = $1. That makes the founders shareholders with limited liability, and it makes the shop a legal entity of its own, separate from them.

The entity. Once invested, the $30,000 belongs to the shop, not to either founder. Anything a founder spends on personal life stays out of the shop's books; that is the economic entity assumption at work.

The plan's events. The shop plans 12 transactions for Month 1. Sort them by who stands on the other side of each one.

The bicycle shop's 12 planned Month 1 transactions, tallied by the party on the other side (illustrative)
Party on the other side	Planned transactions	Count
Shareholders	The founders' $30,000 investment; a $500 cash dividend	2
Customers	A cycling club pays $1,200 in advance for tune-ups; walk-in customers pay $3,500 cash for repairs; a delivery company is billed $1,800 on account; that company pays $1,000 of it	4
Vendors	The $12,000 equipment purchase; $900 of supplies bought on account; the $2,400 insurance policy; the $1,500 rent; a $600 payment to the supplier	5
The employee	The part-time mechanic's $1,600 wages	1

Add the counts: 2 + 4 + 5 + 1 = 12.

The users. The two founders run the shop, so they are internal users; they use managerial accounting to decide what to stock and how to schedule the mechanic. The outside readers each have a question:

The founders, as shareholders, ask whether their investment is earning.
The supplier that sold $900 of supplies on account asks whether the shop will pay.
The cycling club that paid $1,200 in advance asks whether the shop will still be open to do the tune-ups.
A bank asked for a future loan would ask whether the shop can repay it.
The IRS, the tax authority, asks what the shop owes.

The rules. The shop's statements for outside users follow GAAP, set by the FASB. The shop is a small private corporation, and the SEC's legal authority is over public-company reporting, so the shop's outside users get its statements directly from the shop.

The reading in one sentence: the bicycle shop is a corporation that is separate from its two founders, so its records start with the shop's own $30,000, and the people outside it who will read its statements are its shareholders, its supplier, its customers, a future lender, and the IRS.

Misconception check. Students often think the founders are only internal users. That is tempting, because they run the shop every day. But a founder wears two hats. As a manager, a founder is an internal user. As a shareholder, the same founder is an investor reading the shop's financial statements. The cure is to name the role, not the person.

An honesty note: the shop's numbers are illustrative, written so the arithmetic works out cleanly. A real shop's first month would be messier. The point is the habit of asking who reads the numbers, not the size of any one figure.

Key terms

Accounting — the system a business uses to measure its economic events, keep a record of them, and report them to the people who need the information. (first used: 1. Define accounting: measure, record, report)
Internal users — the people who run a business from inside and use its accounting information to make decisions, such as managers and owner-operators. (first used: 2. Split the users: financial versus managerial accounting)
External users — the people outside a business who rely on its financial statements, such as investors, lenders, suppliers, customers, tax authorities, and regulators. (first used: 2. Split the users: financial versus managerial accounting)
Financial accounting — the branch of accounting that produces general-purpose financial statements for external users such as investors and lenders. (first used: 2. Split the users: financial versus managerial accounting)
Managerial accounting — the branch of accounting that produces information for internal decision-makers, such as managers deciding what to stock or how to schedule staff. (first used: 2. Split the users: financial versus managerial accounting)
Sole proprietorship — a business owned by one person, with no legal separation between the business and its owner. (first used: 3. Name the three forms of business organization)
Partnership — a business owned by two or more people who share its ownership. (first used: 3. Name the three forms of business organization)
Corporation — a legal entity separate from its owners, the shareholders, who have limited liability for its debts. (first used: 3. Name the three forms of business organization)
Shareholders — the owners of a corporation, who hold its shares of stock; also called stockholders. (first used: 3. Name the three forms of business organization)
Limited liability — the protection that keeps a corporation's shareholders from owing the corporation's debts beyond what they invested. (first used: 3. Name the three forms of business organization)
Economic entity assumption — the rule that a business's records are kept separate from its owners' personal records, even when the business is a sole proprietorship. (first used: 4. Separate the business from its owners: the economic entity assumption)
Generally accepted accounting principles (GAAP) — the standards U.S. companies follow in preparing financial statements for external users. (first used: 5. Find who sets the rules: GAAP, the FASB, and the SEC)
Financial Accounting Standards Board (FASB) — the independent, private-sector, not-for-profit organization, established in 1973, that sets GAAP; it is not a government agency. (first used: 5. Find who sets the rules: GAAP, the FASB, and the SEC)
Securities and Exchange Commission (SEC) — the federal agency, created by the Securities Exchange Act of 1934, that has legal authority over U.S. public-company reporting and recognizes the FASB as its standard setter. (first used: 5. Find who sets the rules: GAAP, the FASB, and the SEC)
Accounting Standards Codification — the FASB's organized collection of standards that is the source of authoritative GAAP recognized by the FASB for nongovernmental entities. (first used: 5. Find who sets the rules: GAAP, the FASB, and the SEC)
International Financial Reporting Standards (IFRS) — the accounting standards set by the International Accounting Standards Board and used for public company reporting in many countries. (first used: 6. Compare IFRS with GAAP, without a verdict)
International Accounting Standards Board (IASB) — the body that sets International Financial Reporting Standards. (first used: 6. Compare IFRS with GAAP, without a verdict)
AICPA Code of Professional Conduct — the American Institute of CPAs' code of ethics, which sets out six principles: Responsibilities, The Public Interest, Integrity, Objectivity and Independence, Due Care, and Scope and Nature of Services. (first used: 7. Add the ethics: the AICPA's six principles)
Income statement — the financial statement that reports a business's revenues and expenses for a period and the net income or net loss that results. (first used: 8. Name the four financial statements)
Statement of retained earnings — the financial statement that shows how the earnings a corporation has kept in the business changed during a period. (first used: 8. Name the four financial statements)
Balance sheet — the financial statement that reports what a business has, what it owes, and the owners' claim at one moment in time. (first used: 8. Name the four financial statements)
Statement of cash flows — the financial statement that reports where a business's cash came from and where it went during a period. (first used: 8. Name the four financial statements)
The running case — the course's illustrative, unnamed bicycle repair and sales shop, organized as a corporation by two founders. (first used: 9. Meet the running case: read the bicycle shop's plan)

Summary

Accounting measures, records, and reports a business's economic events.
Financial accounting serves outside users; managerial accounting serves inside users.
The three forms are the sole proprietorship, the partnership, and the corporation.
The sole proprietorship is the most common form in the United States.
The economic entity assumption keeps an owner's personal spending out of the business's records.
The FASB writes GAAP; the SEC, created in 1934, oversees public-company reporting.
IFRS and GAAP are compared by their effects, never ranked.
The AICPA's six principles describe how accountants behave while they record.
The four statements: income statement, statement of retained earnings, balance sheet, statement of cash flows.
The bicycle shop is an illustrative corporation with 12 planned Month 1 transactions.

Check your understanding

Work these before looking at the answers — they are ungraded, and the answers (with reasoning) are at the bottom of the page.

An illustrative phone-repair kiosk is owned by one person. In one week the owner pays $45 for replacement screens, $80 for a personal gym membership, $25 for the kiosk's card-reader fee, and $30 for a family dinner. How much belongs in the kiosk's records, and which rule decides it?
An illustrative tutoring business has six readers: its owner, an office manager, a bank considering a loan, a landlord who rents it space on a lease, the tax authority, and a parent deciding whether to prepay a term of sessions. How many are internal users, and how many are external?
Three illustrative founders set up a small software firm as a corporation. They invest $45,000 for 45,000 shares of $1-par common stock. What does each share cost, and what does limited liability mean for the founders?
A classmate writes: "The SEC sets GAAP, and it was created by the Securities Act of 1933." Name both errors and correct them.

Answers (worked reasoning — read after attempting)

Only the kiosk's own costs belong in its records: $45 + $25 = $70. The gym membership and the family dinner, $80 + $30 = $110, are personal. The economic entity assumption decides it: the kiosk's records stay separate from the owner's, even though the kiosk is a sole proprietorship.
The owner and the office manager run the business from inside, so 2 are internal users. The bank, the landlord, the tax authority, and the parent stand outside it, so 4 are external users. Check the total: 2 + 4 = 6.
Divide the cash by the shares: $45,000 ÷ 45,000 = $1 a share. Limited liability means the founders do not owe the firm's debts beyond what they invested; a creditor's claim is against the corporation.
First, the FASB sets GAAP; the SEC holds legal authority over public-company reporting and recognizes the FASB as its standard setter. Second, the SEC was created by the Securities Exchange Act of 1934, not the Securities Act of 1933.

Next up in this module: the Readings & Resources page, the lecture tutorial, the practice set, the quiz, and the discussion — and next week the accounting equation, the rule every transaction keeps in balance, puts the bicycle shop's first month to work.

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