Untitled Flashcards Set

Chapter 10 – The Role of Accounting in Business

10.1 Rent a Room or a House

o   Airbnb and how accounting is needed to manage and record money in the business.

10.2 The Role of Accounting

o   Accounting is often called the language of business because it communicates so much information that owners, managers, and investors need to evaluate a company’s financial performance.

o   Purpose of accounting is to help stakeholders make better business decisions by providing them with financial information.

o   Accounting – system for measuring and summarizing business activities, interpreting financial information, and communicating the results to management and other decision makers.

o   Two major fields in accounting; management accountants (provide information and analysis to decision makers inside the organization in order to help them run it) and financial accountants (furnish information to individuals and groups both inside and outside the organization in order to help them assess its financial performance).

o   In other words, management accounting helps you keep your business running while financial accounting tells you how well you’re running it.

o   Management accounting - Branch of accounting that provides information and analysis to decision makers inside the organization to help them operate the business.

o   Financial accounting - Branch of accounting that furnishes information to individuals and groups both inside and outside the organization to help them assess the firm’s financial performance.

o   Financial accountants adhere to a set of rules called generally accepted accounting principles (GAAP).

o   GAAP is issued by Financial Accounting Standards Board (FASB).

o   Companies outside US follow International Financial Reporting Standards (IFRS).

o   IFRS is issued by the International Accounting Standards Board (IASB).

o   IFRS is stricter about the ways you can calculate the costs of inventory than GAAP.

10.3 Understanding Financial Statements

o   Parts of a financial statement: income statement, balance sheet, statement of owner’s equity, and statement of cash flows.

o   Income s – financial statement summarizing a business’ revenues, expenses, and net income.

o   Revenues – amount of money earned by selling products to customers.

o   Expenses – costs incurred by selling products to customers.

o   Divide expenses into two categories: costs of goods sold and operating expenses.

o   The positive difference between sales and cost of goods sold is your gross profit or gross margin.

o   The positive difference between gross profit and operating expenses is your net income or profit (if difference is negative then took a loss instead of profit).

o   Breakeven analysis – Method determining the level of sales at which the company will break even (have no profit or loss).

o   Fixed costs – costs that don’t change the amount of goods sold changes

o   Variable costs – costs that vary as quantity of goods sold changes but stay constant on a per-unit basis.

o   Contribution margin per unit – excess of revenue per unit/variable cost per unit.

o   $10 selling price – $6 variable cost per unit = $4

o   Breakeven point in units – number of sales units at which net income is zero.

o   $300 fixed costs/$4 contribution margin per unit = 75 units

o   Balance sheet – report on a company’s assets, liabilities, and owner’s equity at a specific point in time.

o   Assets – resources from which it expects to gain some future benefit.

o   Liabilities – the debts that it owes to outside individuals or organizations.

o   Owner’s equity – your investment in your business.

o   Fiscal year – company’s designated business year

o   The accounting equation – assets = liabilities + owner’s equity

o   Statement of owner’s equity – a financial statement that details changes in owner’s equity for a specified period of time.

10.4 Accrual Accounting

o   Accounts receivable – record of cash that will be received from a customer whom a business has sold products on credit (receive later).

o   Accounts payable – record of cash owed to sellers from whom a business has purchased products on credit (pay later).

o   inventory – goods that a business has made or bought and expects to sell in the process of normal operations.

o   Accrual accounting – a system that records transactions when they occur, regardless of when cash is paid or received.

o   Depreciation expense – costs of a long-term or fixed asset spread over its useful life.

o   Classified balance sheet – balance sheet that totals assets and liabilities into separate categories.

o   Types of assets: current assets and long-term assets.

o   Liquidity – speed with which an asset can be converted into cash.

o   Current assets – assets that you intend to convert into cash within a year.

o   Long-term assets – assets that you intend to hold for more than a year.

o   Types of liabilities

o   Current liabilities – liabilities that you’ll pay off within one year.

o   Long-term liabilities – liabilities that don’t become due for more than a year.

o   Statement of cash flows – financial reporting on cash inflows and outflows resulting form operating, investing, and financing activities.

o   Three categories of cash flows:

o   Operating activities- activity that created cash inflows or outflows through day-to-day operations.

o   Investing activities – activity that creates cash inflows and outflows through the selling or buying of long-term assets.

o   Financing activities – activity that creates cash inflows and outflows through obtaining or repaying of borrowed or invested funds.

10.5 Financial Statement Analysis

o   Comparative income statement – financial statement showing income for more than one year.

o   Vertical percentage analysis – analysis of an income statement treating the relationship of each item as a percentage of a base (usually sales).

o   Ratio analysis – a technique for financial analysis that shows the relationship between two numbers.

o   Profit margin ratios - tell you how much of each sales dollar is left after certain costs are covered.

o   Management efficiency ratios - tell you how efficiently your assets are being managed.

o   Management effectiveness ratios - tell you how effective management is at running the business and measure overall company performance.

o   Financial condition ratios - help you assess a firm’s financial strength.

o   Inventory turnover ratio – financial ratio that shows how effectively a company turns over it inventory.

o   Current ratio - financial ratio showing relationship between a company’s current assets and current liabilities.

o   Debt-to-equity ratio - financial ratio showing relationship between debt and equity.

o   Capital structure – relationship between a company’s debt and its equity.

o   Interest coverage ratio – financial ratio showing a company’s ability to pay interest on its debts from its operating income.

10.6 The Profession: Ethics and Opportunities

o   Sarbanes-Oxley Act (SOX) – A federal law enacted to encourage ethical corporate behavior and discourage fraud and other wrongdoing.

Here is a comprehensive summary of the key takeaways, points, and equations from the provided sources, organised by section numbers for easy reference.

## 10.2 The Role of Accounting

   Accounting is crucial for providing financial information to stakeholders, enabling informed business decisions. It acts as the "language of business".

   Two branches of accounting:

       Managerial Accounting:  Focuses on information for internal users like managers, helping them plan, control, and make decisions about the organisation.

       Financial Accounting: Prepares financial statements (income statement, balance sheet, statement of owner's equity, and statement of cash flows) for both internal and external users.  It follows Generally Accepted Accounting Principles (GAAP) to ensure accuracy and comparability.

   GAAP is essential for accurate financial reporting, enabling stakeholders to compare statements from different companies.

   Users of financial information:

       Internal: Managers, employees.

       External: Investors, creditors, government agencies (e.g., SEC, IRS), suppliers, and others interested in the company's performance.

   International Financial Reporting Standards (IFRS): An alternative accounting standard used by many companies outside the US, aiming for global consistency in financial reporting.

10.3 Understanding Financial Statements

   Financial Statements: Summaries of a company's financial activities over a specific period, including:

       Income Statement: Reports revenues, expenses, and net income (profit or loss).

       Balance Sheet: Shows assets, liabilities, and owner's equity at a point in time.

       Statement of Owner's Equity: Tracks changes in owner's equity over time.

       Statement of Cash Flows: Details cash inflows and outflows from operating, investing, and financing activities (discussed in Section 10.4).

   Accounting Equation:  Highlights the relationship between assets, liabilities, and owner's equity:

    Assets = Liabilities + Owner's Equity

    This equation underlies the balance sheet, where assets must equal the sum of liabilities and owner's equity.

   Preparation order of financial statements: Income Statement, Statement of Owner's Equity, Balance Sheet. This is because net income from the income statement is needed for the statement of owner's equity, and ending owner's equity is reported on the balance sheet.

   Breakeven Analysis: Determines the sales level required to cover all costs and avoid losses.

       Breakeven Point (in units) = Fixed Costs / Contribution Margin per Unit

       Contribution Margin per Unit = Sales Price per Unit - Variable Cost per Unit

## 10.4 Accrual Accounting

   Accrual Accounting: Recognises revenue when earned and  when incurred, regardless of when cash changes hands. This method provides a more accurate view of financial performance compared to cash-basis accounting, which records transactions only when cash is received or paid.

   Key Concepts:

       Inventory:  Represents goods purchased for resale and is reported as an asset on the balance sheet.

       Cost of Goods Sold: Represents the expense of goods sold during a period and appears on the income statement.

       Depreciation:  Allocates the cost of long-term assets (like equipment) over their useful life, appearing as an expense on the income statement.

   Classified Balance Sheet: Categorises assets and liabilities into current and long-term:

       Current Assets:  Expected to be converted into cash within one year (e.g., cash, accounts receivable, inventory).

       Long-Term Assets: Held for more than one year (e.g., property, plant, equipment).

       Current Liabilities: Due within one year (e.g., accounts payable, short-term loans).

       Long-Term Liabilities: Due in more than one year (e.g., long-term loans, mortgages).

   Statement of Cash Flows: Reports the movement of cash from operating, investing, and financing activities, providing insights into the company's cash management practices.

## 11.2 The Functions of Money

   Functions of Money:

       Medium of Exchange: Facilitates transactions by being widely accepted for goods and services.

       Measure of Value: Provides a common unit to express prices and compare values.

       Store of Value: Allows wealth to be held and used later, assuming money retains its value.

   Measures of Money Supply:

       M-1: Includes the most liquid forms of money: cash, checking account balances, and traveller's cheques.

       M-2:  Includes M-1 plus less liquid, near-cash items like savings accounts, time deposits, and money market mutual funds.

## 11.3 Financial Institutions

   Financial Institutions: Act as intermediaries, channelling funds from savers to borrowers, thereby facilitating financial transactions.

   Types of Financial Institutions:

       Depository Institutions: Accept deposits from customers:

           Commercial Banks: Offer various banking services, including checking and savings accounts, loans, and credit cards.

           Savings Banks:  Focus primarily on savings accounts and mortgage loans.

           Credit Unions: Member-owned institutions providing banking services similar to commercial banks but often with better rates and lower fees.

       Nondepository Institutions: Don't accept deposits but provide financial services:

           Finance Companies: Make loans to individuals and businesses, often specialising in higher-risk lending.

           Insurance Companies:  Provide protection against financial losses.

           Brokerage Firms:  Facilitate the buying and selling of securities (stocks, bonds, etc.).

           Pension Funds:  Manage retirement savings plans.

## 11.5 The Role of the Financial Manager

   Financial Plan: Outlines a company's capital needs, acquisition strategies, and repayment plans.

   Common Funding Sources:

       Personal Assets:  Investing personal savings or assets into the business.

       Loans from Family and Friends:  Borrowing from personal connections.

       Bank Loans:  Securing loans from financial institutions.

       Crowdfunding: Raising funds from a large number of individuals, often online, through platforms like Kickstarter and Indiegogo.

   Managing Accounts Payable: Efficiently handling payments to suppliers to maintain good relationships and optimise cash flow.

   Budgeting: Creating financial plans for specific periods, typically a year, to project revenues, expenses, and cash flow, helping in financial control and decision-making.Chapter 10 – The Role of Accounting in Business

10.1 Rent a Room or a House

o   Airbnb and how accounting is needed to manage and record money in the business.

10.2 The Role of Accounting

o   Accounting is often called the language of business because it communicates so much information that owners, managers, and investors need to evaluate a company’s financial performance.

o   Purpose of accounting is to help stakeholders make better business decisions by providing them with financial information.

o   Accounting – system for measuring and summarizing business activities, interpreting financial information, and communicating the results to management and other decision makers.

o   Two major fields in accounting; management accountants (provide information and analysis to decision makers inside the organization in order to help them run it) and financial accountants (furnish information to individuals and groups both inside and outside the organization in order to help them assess its financial performance).

o   In other words, management accounting helps you keep your business running while financial accounting tells you how well you’re running it.

o   Management accounting - Branch of accounting that provides information and analysis to decision makers inside the organization to help them operate the business.

o   Financial accounting - Branch of accounting that furnishes information to individuals and groups both inside and outside the organization to help them assess the firm’s financial performance.

o   Financial accountants adhere to a set of rules called generally accepted accounting principles (GAAP).

o   GAAP is issued by Financial Accounting Standards Board (FASB).

o   Companies outside US follow International Financial Reporting Standards (IFRS).

o   IFRS is issued by the International Accounting Standards Board (IASB).

o   IFRS is stricter about the ways you can calculate the costs of inventory than GAAP.

10.3 Understanding Financial Statements

o   Parts of a financial statement: income statement, balance sheet, statement of owner’s equity, and statement of cash flows.

o   Income s – financial statement summarizing a business’ revenues, expenses, and net income.

o   Revenues – amount of money earned by selling products to customers.

o   Expenses – costs incurred by selling products to customers.

o   Divide expenses into two categories: costs of goods sold and operating expenses.

o   The positive difference between sales and cost of goods sold is your gross profit or gross margin.

o   The positive difference between gross profit and operating expenses is your net income or profit (if difference is negative then took a loss instead of profit).

o   Breakeven analysis – Method determining the level of sales at which the company will break even (have no profit or loss).

o   Fixed costs – costs that don’t change the amount of goods sold changes

o   Variable costs – costs that vary as quantity of goods sold changes but stay constant on a per-unit basis.

o   Contribution margin per unit – excess of revenue per unit/variable cost per unit.

o   $10 selling price – $6 variable cost per unit = $4

o   Breakeven point in units – number of sales units at which net income is zero.

o   $300 fixed costs/$4 contribution margin per unit = 75 units

o   Balance sheet – report on a company’s assets, liabilities, and owner’s equity at a specific point in time.

o   Assets – resources from which it expects to gain some future benefit.

o   Liabilities – the debts that it owes to outside individuals or organizations.

o   Owner’s equity – your investment in your business.

o   Fiscal year – company’s designated business year

o   The accounting equation – assets = liabilities + owner’s equity

o   Statement of owner’s equity – a financial statement that details changes in owner’s equity for a specified period of time.

10.4 Accrual Accounting

o   Accounts receivable – record of cash that will be received from a customer whom a business has sold products on credit (receive later).

o   Accounts payable – record of cash owed to sellers from whom a business has purchased products on credit (pay later).

o   inventory – goods that a business has made or bought and expects to sell in the process of normal operations.

o   Accrual accounting – a system that records transactions when they occur, regardless of when cash is paid or received.

o   Depreciation expense – costs of a long-term or fixed asset spread over its useful life.

o   Classified balance sheet – balance sheet that totals assets and liabilities into separate categories.

o   Types of assets: current assets and long-term assets.

o   Liquidity – speed with which an asset can be converted into cash.

o   Current assets – assets that you intend to convert into cash within a year.

o   Long-term assets – assets that you intend to hold for more than a year.

o   Types of liabilities

o   Current liabilities – liabilities that you’ll pay off within one year.

o   Long-term liabilities – liabilities that don’t become due for more than a year.

o   Statement of cash flows – financial reporting on cash inflows and outflows resulting form operating, investing, and financing activities.

o   Three categories of cash flows:

o   Operating activities- activity that created cash inflows or outflows through day-to-day operations.

o   Investing activities – activity that creates cash inflows and outflows through the selling or buying of long-term assets.

o   Financing activities – activity that creates cash inflows and outflows through obtaining or repaying of borrowed or invested funds.

10.5 Financial Statement Analysis

o   Comparative income statement – financial statement showing income for more than one year.

o   Vertical percentage analysis – analysis of an income statement treating the relationship of each item as a percentage of a base (usually sales).

o   Ratio analysis – a technique for financial analysis that shows the relationship between two numbers.

o   Profit margin ratios - tell you how much of each sales dollar is left after certain costs are covered.

o   Management efficiency ratios - tell you how efficiently your assets are being managed.

o   Management effectiveness ratios - tell you how effective management is at running the business and measure overall company performance.

o   Financial condition ratios - help you assess a firm’s financial strength.

o   Inventory turnover ratio – financial ratio that shows how effectively a company turns over it inventory.

o   Current ratio - financial ratio showing relationship between a company’s current assets and current liabilities.

o   Debt-to-equity ratio - financial ratio showing relationship between debt and equity.

o   Capital structure – relationship between a company’s debt and its equity.

o   Interest coverage ratio – financial ratio showing a company’s ability to pay interest on its debts from its operating income.

10.6 The Profession: Ethics and Opportunities

o   Sarbanes-Oxley Act (SOX) – A federal law enacted to encourage ethical corporate behavior and discourage fraud and other wrongdoing.

Here is a comprehensive summary of the key takeaways, points, and equations from the provided sources, organised by section numbers for easy reference.

## 10.2 The Role of Accounting

   Accounting is crucial for providing financial information to stakeholders, enabling informed business decisions. It acts as the "language of business".

   Two branches of accounting:

       Managerial Accounting:  Focuses on information for internal users like managers, helping them plan, control, and make decisions about the organisation.

       Financial Accounting: Prepares financial statements (income statement, balance sheet, statement of owner's equity, and statement of cash flows) for both internal and external users.  It follows Generally Accepted Accounting Principles (GAAP) to ensure accuracy and comparability.

   GAAP is essential for accurate financial reporting, enabling stakeholders to compare statements from different companies.

   Users of financial information:

       Internal: Managers, employees.

       External: Investors, creditors, government agencies (e.g., SEC, IRS), suppliers, and others interested in the company's performance.

   International Financial Reporting Standards (IFRS): An alternative accounting standard used by many companies outside the US, aiming for global consistency in financial reporting.

10.3 Understanding Financial Statements

   Financial Statements: Summaries of a company's financial activities over a specific period, including:

       Income Statement: Reports revenues, expenses, and net income (profit or loss).

       Balance Sheet: Shows assets, liabilities, and owner's equity at a point in time.

       Statement of Owner's Equity: Tracks changes in owner's equity over time.

       Statement of Cash Flows: Details cash inflows and outflows from operating, investing, and financing activities (discussed in Section 10.4).

   Accounting Equation:  Highlights the relationship between assets, liabilities, and owner's equity:

    Assets = Liabilities + Owner's Equity

    This equation underlies the balance sheet, where assets must equal the sum of liabilities and owner's equity.

   Preparation order of financial statements: Income Statement, Statement of Owner's Equity, Balance Sheet. This is because net income from the income statement is needed for the statement of owner's equity, and ending owner's equity is reported on the balance sheet.

   Breakeven Analysis: Determines the sales level required to cover all costs and avoid losses.

       Breakeven Point (in units) = Fixed Costs / Contribution Margin per Unit

       Contribution Margin per Unit = Sales Price per Unit - Variable Cost per Unit

## 10.4 Accrual Accounting

   Accrual Accounting: Recognises revenue when earned and  when incurred, regardless of when cash changes hands. This method provides a more accurate view of financial performance compared to cash-basis accounting, which records transactions only when cash is received or paid.

   Key Concepts:

       Inventory:  Represents goods purchased for resale and is reported as an asset on the balance sheet.

       Cost of Goods Sold: Represents the expense of goods sold during a period and appears on the income statement.

       Depreciation:  Allocates the cost of long-term assets (like equipment) over their useful life, appearing as an expense on the income statement.

   Classified Balance Sheet: Categorises assets and liabilities into current and long-term:

       Current Assets:  Expected to be converted into cash within one year (e.g., cash, accounts receivable, inventory).

       Long-Term Assets: Held for more than one year (e.g., property, plant, equipment).

       Current Liabilities: Due within one year (e.g., accounts payable, short-term loans).

       Long-Term Liabilities: Due in more than one year (e.g., long-term loans, mortgages).

   Statement of Cash Flows: Reports the movement of cash from operating, investing, and financing activities, providing insights into the company's cash management practices.

## 11.2 The Functions of Money

   Functions of Money:

       Medium of Exchange: Facilitates transactions by being widely accepted for goods and services.

       Measure of Value: Provides a common unit to express prices and compare values.

       Store of Value: Allows wealth to be held and used later, assuming money retains its value.

   Measures of Money Supply:

       M-1: Includes the most liquid forms of money: cash, checking account balances, and traveller's cheques.

       M-2:  Includes M-1 plus less liquid, near-cash items like savings accounts, time deposits, and money market mutual funds.

## 11.3 Financial Institutions

   Financial Institutions: Act as intermediaries, channelling funds from savers to borrowers, thereby facilitating financial transactions.

   Types of Financial Institutions:

       Depository Institutions: Accept deposits from customers:

           Commercial Banks: Offer various banking services, including checking and savings accounts, loans, and credit cards.

           Savings Banks:  Focus primarily on savings accounts and mortgage loans.

           Credit Unions: Member-owned institutions providing banking services similar to commercial banks but often with better rates and lower fees.

       Nondepository Institutions: Don't accept deposits but provide financial services:

           Finance Companies: Make loans to individuals and businesses, often specialising in higher-risk lending.

           Insurance Companies:  Provide protection against financial losses.

           Brokerage Firms:  Facilitate the buying and selling of securities (stocks, bonds, etc.).

           Pension Funds:  Manage retirement savings plans.

## 11.5 The Role of the Financial Manager

   Financial Plan: Outlines a company's capital needs, acquisition strategies, and repayment plans.

   Common Funding Sources:

       Personal Assets:  Investing personal savings or assets into the business.

       Loans from Family and Friends:  Borrowing from personal connections.

       Bank Loans:  Securing loans from financial institutions.

       Crowdfunding: Raising funds from a large number of individuals, often online, through platforms like Kickstarter and Indiegogo.

   Managing Accounts Payable: Efficiently handling payments to suppliers to maintain good relationships and optimise cash flow.

   Budgeting: Creating financial plans for specific periods, typically a year, to project revenues, expenses, and cash flow, helping in financial control and decision-making.