Objective 1.1: Describe various organizational forms and business decision makers.

The Three Types of Businesses

• 1.) Sole Proprietorship

  • Business that is owned by one individual.

  • The owner is liable for the debts of the business.

  • It is the easiest form of business to start.

  • No special legal maneuvers are required.

  • The profits or losses from the business become a part of the owner’s tax return/income.

• 2.) Partnership

  • Business owned by 2 or more individuals.

  • Each partner is personally liable for the debts of their business.

  • It is slightly more expense to create and needs a lawyer to come up with a partnership agreement.

  • The profits or losses are split between the owners.

• 3.) Corporation

  • Considered a separate legal entity and is formed by documents filed with a state.

  • A lawyer is required and legal fees are high.

  • The owners of the corporations, stockholders, are not personally liable for the debts.

  • Income taxes are paid by the corporation and the owners (dividends).

  • Can be a public or private company:

    • Public company: Your stock is readily available for people to buy

    • Private company: The stock is owned by individuals and privately conducts the process of buying and selling to others

  • Corporations commonly start as a private company, but can “go public” if needed.

    • Initial Public Offering (IPO) - “Going public”. This is the very first day that stock is traded on an established stock market.

Limited Liability Companies

• Limited Liability Companies (LLC) - A company that is a combination of a corporation and a sole proprietorship or a partnership.

• It can have characteristics from the three types of business, depending on the number of owners.

• You must file with the state to become a LLC.

• Primary characteristics:

  • Has limited liability like a corporation.

  • Has access to pass through income taxation like a partnership or sole proprietorship.

  • If there are two owners, it can be taxed as a partnership.

The Accounting System

• In accounting, you are analyzing, recording, and summarizing financial information and reporting the outcome of business activity.

• There are two types of reports that can be produced:

  • 1.) Managerial Reports

    • For internal users

    • Reports on the operating activities of a business

    • Includes financial plans

  • 2.) Financial Statements

    • For external users (those who are not employed at the company)

    • Periodic statements

• There are four types of external users:

  • 1.) creditors (ex: banks)

  • 2.) investors (the stockholders)

  • 3.) directors ( aka the board of directors)

  • 4.) government (ex: IRS, SEC)

• Different types of business activities can be reported:

  • Operating activities generate profit and involve short term expenses. These are the simple actions of running a business (buying supplies, paying employees).

  • Investing activities involve the process of buying and selling assets that are considered long term (ex: equipment, land, buildings).

  • Financing activities are more formal actions (not day to day) such as borrowing money from the bank, paying loans, receiving cash, or paying dividends.

Objective 1.2: Describe the purpose, structure, and content of the four basic financial statements.

The Basic Accounting Equation

• The Basic Accounting Equation:

  • Assets = Liabilities + Stockholders’ Equity

  • Must always be balanced.

• Separate Entity Assumption- The financial reports of a business are assumed to include the results of only that business’s activities**.**

Assets

• Resources the company owns and will benefit from in the future.

• Examples:

  • Cash

  • Supplies

  • Equipment

  • Accounts Receivable

  • Software

  • Buildings

Liabilities

• Measurable amounts a company owes to creditors.

• If you see the word “payable”, it is a liability.

• Examples:

  • Notes Payable - This is when you borrow money from a bank. Considered a formal agreement (legal document, aka promissory note, is required).

  • Accounts Payable - Less formal agreement. You are paying for something “on account”, no legal document is required.

Stockholders’ Equity

• What stockholders (owners) are entitled to.

• Stockholders is interchangeable with shareholders.

• An owner’s claims to the business can arise from 2 sources:

  • Common Stock - This is equity PAID by stockholders to get stock.

  • Retained Earnings - This is equity EARNED by the company. It represents cumulative profit or loss of the company.

Revenues, Expenses, and Net Income

• Revenues are the amounts we earn from selling goods or services:

  • They are recorded when earned (after doing a sale or service).

• Expenses are considered to be day to day operations:

  • They are the cost of what is needed to earn revenue, such as paying employees, paying bills, paying for space/land, etc.

  • They are recorded when they are incurred (to become liable or subject to).

• Equation for calculating net income:

  • Revenues - Expenses = Net Income

• If Revenues > Expenses, it is Net Income and increases equity (Good)

• If Revenues are < Expenses, it is Net Loss and decreases equity (Bad)

• Example of Net Income:

  • $6,000 (R) - $2,000 (E) = $4,000 (N/I)

• Example of Net Loss:

  • $2,000 (R) - $6,000 (E) = -$4,000 (N/L)

Dividends

• Dividends are considered a financing activity that involves using the profits of the company to “repay” (usually in cash) shareholders as a return on their investments towards the business.

• Dividends are a component of Retained Earnings.

• They help reduce Retained Earnings.

• Dividends are not considered to be an expense.

Using the Basic Accounting Equation:

• Example: Use the following information to plug into the basic accounting equation:

  • Assets = 168

  • Liabilities = 75

  • Stockholders’ Equity = 93

  • 75 + 93 adds up to 168, so the equation is balanced.

  • 168 = 168

Financial Statements

• There are four types of financial statements and they are prepared in the following order:

  • Income Statement

  • Statements of Retained Earnings

  • Balance Sheet

  • Statement of Cash Flows

• They can be prepared monthly, quarterly, and annually.

• If they are annual reports, they can either be based on a calendar year or fiscal year:

  • Both are reported in a 12 month period

  • A calendar year ends on December 31

  • A fiscal year ends on a day that is not December first (can be anytime during the year)

The Structure of Financial Statements

• Financial statements have headings that address who, what, and when.

• They include the name of the company, what type of report is being presented, and the accounting period for the report.

The Income Statement

• This report provides information regarding profitability for a specific period.

• The structure of the Income Statement:

  • Heading (who, what, when)

    • Company name

    • Income Statement

    • For the Month Ended

  • Revenue

    • Ex: Sales/Service Revenue

    • Total Revenues

  • Expense

    • Ex: Rent Expense, Utilities Expense

    • Total Expenses

  • Net Income/Loss

• Expenses are listed from biggest to smallest.

• Income Tax Expense is always listed last.

• You want Revenues to be higher than Expenses to get Net Income.

• Unit of measurement assumption - the proper monetary unit must be used to report business activities (ex: United States = Dollar).

• The amount of Net Income/Loss with carry over into the next Financial Statements.

The Statement of Retained Earnings

• This report provides information regarding the company’s dividends and how their distribution affects the company’s financial position.

• The structure of the Statement of Retained Earnings:

  • Heading (who, what, when)

    • Company name

    • Statement of Retained Earnings

    • For the Month Ended

  • Retained Earnings (beginning)

    • Add/Subtract: Net Income/Loss

    • Subtract: Dividends

  • Retained Earnings (ending)

• Retained Earnings (beginning) is the balance of the last period. If it is a new business, it will be $0.

The Balance Sheet

• In regards to source of financing, this sheet reports:

  • Assets - What the business owns.

  • Liabilities - Money borrowed and whats owed to creditors.

  • Stockholders’ Equity - Money leftover to go to company’s shareholders.

• Balance sheets are considered to be a “snapshot” of a business’s resources on a specific date.

• The structure of the Balance Sheet:

  • Heading (who, what, when)

    • Company name

    • Balance Sheet

    • “At” a specific date

  • Assets

    • Ex: Cash, Supplies, Equipment

    • Total Assets

  • Liabilities and Stockholders’ Equity

    • Ex: Payables

    • Total Liabilities (to creditors)

  • Stockholders’ Equity

    • Only 2: Common Stock and Retained Earnings

    • Total Stockholder’s Equity (to stockholders)

  • Total Liabilities and Stockholders’ Equity

• Assets must = liabilities + stockholders’ equity (it “balances”)

• Cost principle - Assets are recorded based on what we negotiated to pay for them.

The Statement of Cash Flows

• Reports the effects on cash balance based on operating, financing, and investing activities.

• The structure of the Statement of Cash Flows:

  • Heading (who, what, when “For the Month Ended”)

    • Company name

    • Statement of Cash Flows

    • For the Month Ended

  • Cash Flows from Operating Activities

    • Cash received from customers

    • Cash paid to employees and suppliers

      • Cash Provided by Operating Activities

  • Cash Flows from Investing Activities

    • Cash used to buy equipment and software

      • Cash from Investing Activities

  • Cash Flows from Financing Activities

    • Cash received for stock issuance

    • Cash dividends paid to stockholders

    • Cash borrowed from the bank

      • Cash Provided by Financing Activities

  • Change in Cash

    • Beginning Cash Balance (beginning of the month)

    • Ending Cash Balance (end of the month)

• Cash from Statement of Cash Flows must be equal to the cash reported on the Balance Sheet

How These Statements Connect

• (1.) Net Income/Loss from the Income Statement carries over onto the Statement of Retained Earnings.

• (2.) On the Statement of Retained Earnings, the ending Retained Earnings moves to the “Stockholders’ Equity” section on the Balance Sheet.

• (3.) Cash amount reported under the “Assets” section of the Balance Sheet must be equal to the “Ending Cash Balance” on the Statement of Cash Flows.

Objective 1.3: Explain how financial statements are used by decision makers.

What Does Each Statement Do For Creditors and Stockholders?

• The Income Statement provides the stockholders with what the long term return is.

• The Statement of Retained Earnings shows the returns through dividends that are to be distributed to investors.

• The Balance Sheet allows creditors to see if the business’s assets will cover their liabilities.

• The Statement of Cash Flows shows if a business is making enough money to pay the amounts it owes.

Objective 1.4: Describe factors that contribute to useful financial information.

External Financial Reporting

• External users review and utilize the information of different financial statements.

• In order for decision makers to use these statements, it is important for the statements to be:

  • Verifiable

  • Timely

  • Comparable

  • Understandable

Accounting Standards

• FASB - Financial Accounting Standards Board (United States)

• GAAP - Generally Accepted Accounting Principles (United States)

• IASB - International Accounting Standards Board

• IFRS - International Financial Reporting Standard