Chapter 1: Business Decisions and Financial Accounting

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.

  

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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

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