Financial Accounting: Tools for Business Decision Making - Chapter 1 Flashcards

Forms of Business Organization

• Types of Business Organizations

  • Sole Proprietorship

    • Owned by one person.

    • Simple to establish.

    • More difficult to obtain financing.

    • Personal liability.

    • Unfavorable tax treatment.

  • Partnership

    • Owned by two or more persons.

    • Simple to establish.

    • More difficult to transfer ownership.

    • Personal liability.

    • Unfavorable tax treatment.

  • Corporation

    • Separate legal entity owned by stockholders.

    • Easier to raise funds.

    • Easier to transfer ownership.

    • No personal legal liability.

    • Tax advantages.

• Hybrid Forms of Organization

  • Combine tax advantages of partnerships with limited liability of corporations.

  • Examples

    • Limited Liability Companies (LLCs)

    • Subchapter S corporations

Users and Uses of Financial Information

• Internal Users

  • Marketing managers.

  • Production supervisors.

  • Finance directors.

  • Company officers.

• External Users

  • Investors.

  • Creditors.

  • Taxing authorities (e.g., IRS).

  • Regulatory agencies (e.g., SEC, PCAOB).

  • Customers.

  • Labor unions.

  • Economic planners.

Ethics in Financial Reporting: Fraud

• Fraud: A dishonest act by an employee resulting in personal benefit at a cost to the employer

• Fraud Triangle:

  • Opportunity.

  • Financial Pressure.

  • Rationalization.

• Sarbanes-Oxley Act (SOX)

  • Passed to reduce unethical corporate behavior and financial scandals.

  • Applies to publicly traded U.S. corporations.

  • Requires system of internal control.

  • Corporate executives and boards of directors must ensure controls are reliable and effective.

  • Independent outside auditors must attest to adequacy of internal control system.

  • Created the Public Company Accounting Oversight Board (PCAOB).

Business Activities

• Three Principal Types of Business Activity

  • Financing.

  • Investing.

  • Operating.

• Financing Activities

  • Borrowing money (debt financing)

    • Amounts owed are called liabilities.

    • Party to whom amounts are owed are creditors.

    • Notes payable and bonds payable are different types of liabilities.

  • Issuing (selling) shares of stock for cash (equity financing).

    • Common stock is the term used to describe the amount paid by stockholders for shares they purchase.

    • Payments to stockholders are called dividends.

• Investing Activities

  • Purchase of resources a company needs to operate.

  • Resources owned by a business are called assets.

  • Examples:

    • Acquisition or disposition of land, buildings, and equipment (long-term resources/assets).

    • Investments in another company.

    • Assets must have future value.

• Operating Activities

  • Involve day-to-day actions to produce and sell a product, or provide a service.

  • Occur after a business obtains financing and invests in assets required for operation.

  • Result in:

    • Revenue: Amounts generated from the sale of goods or performance of services.

    • Expenses: Costs consumed or services used in the process of generating revenue.

    • Revenues are generated.

      • Amounts earned from the sale of products or providing services and other sources.

      • Sales revenue, service revenue, interest revenue

      • We recognize revenue when we deliver products or provide service, not when we receive cash!

      • Revenue ≠ Cash Received!

    • Assets that commonly increase from operations

      • Supplies are assets used in day-to-day operations.

      • Inventory is an asset that consists of goods available for sale to customers.

      • Accounts receivable are the right to receive money from a customer as the result of a sale (because when sale is made, cash is not paid right away)

Financial Statements

• Four Financial Statements

  • Income Statement.

  • Retained Earnings Statement.

  • Balance Sheet.

  • Statement of Cash Flows.

• Income Statement

  • Reports revenues and expenses for a specific period of time.

  • Net income – revenues exceed expenses.

  • Net loss – expenses exceed revenues.

  • Past net income provides information for predicting future net income.

  • Income statement measures operating success or failure OVER TIME

• Retained Earnings Statement

  • Statement shows amounts and causes of changes (current period net income and dividends paid out) in retained earnings during the period.

  • Time period is the same as that covered by the income statement.

  • Users can evaluate dividend payment practices.

  • Dividend is not an expense (NOT used in daily operations).

  • Dividends are payments to stockholders IF there is enough cash to cover what’s owned to creditors

• Balance Sheet

  • Reports assets and claims to assets (liabilities and stockholders’ equity) at a specific point in time.

  • Assets = Liabilities + Stockholders’ Equity.

  • Lists assets first, followed by liabilities and stockholders’ equity.

• Statement of Cash Flows

  • Provides answers to:

    • Where did cash come from during the period?

    • How was cash used during the period?

    • What was the change in the cash balance during the period?

    • A company cannot survive without cash!!!

Other Elements of an Annual Report

• U.S. companies that are publicly traded must provide shareholders with an annual report. The annual report always includes:

  • Financial statements.

  • Management discussion and analysis.

  • Notes to the financial statements.

  • Auditor's report.

• Management Discussion and Analysis (MD&A)

  • Presents management’s view on the company’s ability to (1) pay near-term obligations, (2) its ability to fund operations and expansion, and (3) its results of operations.

  • Management must highlight (1) favorable or unfavorable trends, and (2) identify significant events and uncertainties that affect these three factors

• Notes to the Financial Statements

  • More detail to clarify the financial statements

  • Provide additional details about accounting policies

  • assumptions, estimates, measurement procedures, and details behind the summary numbers

  • Companies have choices!!!

  • Notes are essential to understanding a company’s operating performance and financial position

  • Uncertainties and contingencies

• Auditor’s Report

  • Only certified public accountants (CPA) may sign off on audits.

  • CPA conduct independent examination of financial reports

  • Auditor’s opinion as to the fairness of the presentation of the financial position and results of operations and their conformance with GAAP or IFRS.

A Look at IFRS – Key Points

• International standards are referred to as International Financial Reporting Standards (IFRS)

  • IFRS tends to be simpler in its accounting and disclosure requirements; some people say it is more “principles-based.”

• Accounting standards in the United States are referred to as generally accepted accounting principles (GAAP)

  • GAAP is more detailed; some people say it is more “rules-based.”

  • The internal control standards applicable to Sarbanes-Oxley (SOX) apply only to large public companies listed on U.S. exchanges.