Chapter 1 – Financial Accounting and Business Decisions

CH 1

Chapter 1 – Financial Accounting and Business Decisions

Business Organization

Sole Proprietorship

• Definition: Business owned and operated by one individual.

• Characteristics:

  • Most common form of business.

  • Complete owner control.

  • Business income reported on personal tax return.

• Advantages:

  • Easy to form, minimal regulation.

  • Taxed once at the owner’s rate.

• Limitations:

  • Limited life (ends at owner’s death/withdrawal).

  • Not a separate legal entity.

Partnership

• Definition: Voluntary association of two or more people conducting business together.

• Characteristics:

  • Range from two partners to large firms.

  • Partnership agreement needed to prevent disputes.

• Advantages:

  • Broader skill set/resources.

  • Pass-through taxation (not taxed at entity level).

• Limitations:

  • Limited life (dissolves if a partner withdraws/dies).

  • Not a separate legal entity.

Corporation

• Definition: Legal entity under state/federal law, distinct from owners (shareholders).

• Characteristics:

  • Owned by one or many shareholders.

  • Ownership represented by stock.

• Advantages:

  • Unlimited life.

  • Limited liability for shareholders.

• Limitations:

  • Double taxation (corporate profits + shareholder dividends).

  • More complex/costly to establish.

Business Activities

Every business engages in financing, investing, and operating.

Financing Activities

• Definition: Obtaining funds for operations.

• Types:

  • Debt Financing: Borrowing (loans, bonds). Requires repayment with interest.

  • Equity Financing: Selling stock. Investors expect returns (dividends or stock growth).

Investing Activities

• Definition: Acquiring/disposing of long-term assets (PP&E).

• Examples: Factories, vehicles, computers, office furniture, land.

Operating Activities

• Definition: Day-to-day activities of producing and selling goods/services.

• Importance: Primary source of income; failure leads to loss of investor/creditor confidence.

Accounting Information and Its Use

Importance

• Provides systematic data for decision-making.

• Serves both external and internal users.

Users

• External Users: Investors, creditors, regulatory agencies. Rely on financial statements for decisions.

• Internal Users: Management and employees. Use accounting for operations and planning.

Audits

• Independent auditors review statements to ensure GAAP compliance.

• Public companies are required to publish audited annual and quarterly reports.

Ethics in Accounting

• Importance: Builds trust in financial reporting.

• Unethical Practices: Price gouging, insider trading, bribery, misleading reports, ignoring safety/environmental rules.

• Scandals: Wirecard, Wells Fargo, Luckin Coffee.

• Professional Standards:

  • AICPA (code of ethics for CPAs).

  • IMA (standards for management accountants).

• Legislation: Sarbanes-Oxley Act (2002) increased regulation and governance.

Accounting Process

• Definition: Measuring and reporting economic activity in monetary terms.

• Steps:

  1. Identification

  2. Quantification

  3. Recording

• Forensic Accounting: Helps detect/prevent fraud and errors.

Accounting Standards

GAAP

• Definition: U.S. standard rules for financial reporting.

• Nature: Evolving with economic/business changes.

Regulatory Bodies

• FASB: Sets U.S. GAAP.

• AICPA: Contributes to standards.

• SEC: Requires audited reports; delegates rule-making to FASB.

• PCAOB: Oversees auditing standards (GAAS).

• GASB: Sets GAAP for state/local governments.

• IASB/IFRS: International accounting standards.

Financial Statements

1. Balance Sheet (Statement of Financial Position)

• Purpose: Snapshot of assets, liabilities, and equity.

• Equation: Assets = Liabilities + Stockholders’ Equity.

• Components:

  • Assets (cash, receivables, inventory, supplies, PP&E).

  • Liabilities (notes payable, accounts payable, wages payable).

  • Stockholders’ Equity (residual claim after debts).

2. Income Statement

• Purpose: Reports revenues and expenses for a period.

• Key Parts:

  • Revenues (sales).

  • Expenses (COGS, marketing, admin, interest, taxes).

  • Net Income (revenues > expenses) or Net Loss.

3. Statement of Stockholders’ Equity

• Components:

  • Contributed Capital (common stock).

  • Earned Capital (retained earnings).

• Shows: How much income is distributed as dividends vs retained.

4. Statement of Cash Flows

• Sections:

  • Operating (cash from operations).

  • Investing (asset purchases/sales).

  • Financing (loans, stock issuance).

• Goal: Identify major cash sources and uses.

Relationships Among Financial Statements

• Interconnected: income affects equity, equity affects balance sheet, balance sheet connects to cash flows.

• Period-of-Time Statements: Income statement, stockholders’ equity, cash flows.

• Point-in-Time Statement: Balance sheet.

Annual Reports

Public companies must file Form 10-K (SEC). Includes:

• Financial statements.

• Notes to financial statements.

• Auditor’s report.

• Management’s Discussion and Analysis (MD&A).

Notes

• Provide details and accounting methods.

• Example: Allowance for doubtful accounts (adjusts receivables).

Auditor’s Report

• Confirms whether statements follow GAAP.

• Discusses Critical Audit Matters (CAMs).

MD&A

• Management explains performance, risks, and strategy.

• Not audited but required by SEC.

📘 Vocabulary List (Ch. 1)

• Sole Proprietorship – business owned by one person.

• Partnership – business owned by two or more individuals.

• Corporation – separate legal entity owned by shareholders.

• Stockholders’ Equity – owners’ claim after liabilities are settled.

• Assets – resources owned by a company (cash, inventory, PP&E).

• Liabilities – obligations owed (loans, payables).

• Debt Financing – raising funds by borrowing.

• Equity Financing – raising funds by selling stock.

• Operating Activities – daily business functions (sales, services).

• Investing Activities – acquiring/disposing of long-term resources.

• Financing Activities – obtaining/repaying funds from creditors/owners.

• GAAP – U.S. financial reporting standards.

• IFRS – international financial reporting standards.

• FASB – Financial Accounting Standards Board.

• SEC – Securities and Exchange Commission.

• PCAOB – Public Company Accounting Oversight Board.

• GASB – Governmental Accounting Standards Board.

• Auditor’s Report – independent evaluation of financial statements.

• MD&A – management’s narrative on performance and outlook.

• Net Income – revenues minus expenses (profit).

• Net Loss – expenses greater than revenues.

• Contributed Capital – stockholder investments.

• Retained Earnings – profits kept in the business.

• Accounting Equation – Assets = Liabilities + Equity.

• Forensic Accounting – using accounting to prevent/detect fraud.