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- 1. Financial Accounting: ABusiness Process Approach Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 1 - 1
- 2. Chapter 1 Business:What’s It All About? Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 1 - 2
- 3. Chapter 1 LearningObjectives When you are finished studying Chapter 1, you should be able to: 1. Describe what a business does and the various ways a business can be organized. 2. Classify business transactions as operating, investing, or financing activities. 3. Describe who uses accounting information and why accounting information is important to them. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 1 - 3
- 4. Chapter 1 LearningObjectives 4. Identify the elements of the four basic financial statements—the income statement, the statement of changes in shareholders’ equity, the balance sheet, and the statement of cash flows, explain the purpose of each, and be able to use basic transaction analysis to prepare each statement. 5. Identify the elements of a real company’s financial statements. 6. Describe the risks associated with being in business and the part that ethics plays in business. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 1 - 4
- 5. Ethics Matters 1.Is it legal? 2. Will it harm anyone? 3. Would you mind reading about your decision in the morning newspaper? Should Bernie Madoff have asked himself these questions? Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 1 - 5
- 6. Learning Purpose ofa Business Objective 1 Obtain the resources needed to 1. Obtain capital start and run a business 2. Add value 3. Sell to customers Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 1 - 6
- 7. Purpose and Organizationof a Business For-profit firms . . . Make profits for investors. Not-for-profit organizations . . . provide goods and services to people and use profits to provide more goods and services to people. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 1 - 7
- 8. Simple Business Model INPUTS Cash from Capital, Financing, Property, Plant, Equipment, Raw Materials, Labor, Inventory, Goods & Services OUTPUTS Product Service Value-added conversion Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 1 - 8
- 9. Nature of BusinessOperations Types of Companies: Service : Provide services for customers Financial Services deal in services related to money. Sales Merchandising—buys goods and resells them to other businesses (wholesale) or to final customers (retail) Manufacturing—makes a product and sells it to other businesses (wholesale) or to final consumers (retail) Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 1 - 9
- 10. Your Turn 1-1 The What main is purpose the main of purpose a business of a is business? to make a profit, increasing the value of the company for the owners. What are the four general types of businesses? Service company Merchandising company Manufacturing company Financial services company Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 1 - 10
- 11. Ownership Structure ofBusinesses More Sole Proprietorship--than 2/3 of U. S. a single businesses are owner sole business proprietorships. Only partnerships, Partnership--2.5% of U. S. businesses are and a multiple-they earn owner less than business 10% of all U. S. firms’ profits. Corporation-a business whose ownership is divided into "shares" and may be owned by a large number of people. More than 2/3 of U. S. companies’ profits are earned by corporations. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 1 - 11
- 12. Characteristics of DifferentForms of Business Personal liability Taxation Transfer of ownership Ability to raise capital Government regulation 1Liability 2 Taxation 3 Ownership 4 Capital 5 Regulation Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 1 - 12
- 13. Sole Proprietorship Personalresponsibility and liability Income reported on individual’s tax return Owned by one individual Difficult to acquire capital Minimal government regulation Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 1 - 13
- 14. Partnerships Partners share personal responsibility and liability Partners usually create an agreement that describes how much work each will do and how the profit and loss will be divided. Income IS reported on each partner’s individual tax return Difficult to acquire capital Minimal government regulation Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 1 - 14
- 15. Corporations A corporationis a popular form of business because . . . Individuals can purchase small amounts of stock. Provides stockholders with limited liability. Allows for easy transfer of ownership. More than two-thirds of U.S. firm’s profits are made by corporations. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 1 - 15
- 16. Corporations Once thestate issues a charter, the stockholders elect a board of directors. A corporation is a separate legal entity that can . . . Enter into contracts Own assets Incur liabilities Sue and be sued Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 1 - 16
- 17. New Hybrid Formsof Business Have characteristics of both corporations and partnerships Limited Liability of a corporation Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 1 - 17 LLP Limited Liability Partnership LLC Limited Liability Corporation Tax advantages of a partnership Mostly used by law, medical, and accounting profession
- 18. Your Turn 1-2 The three major forms of ownership are: (1) sole proprietorships (single owner) What are the three major forms of business ownership? (2) partnerships (multiple owners) (3) corporations (widespread ownership) Disadvantages: Advantages: Sole Proprietorship and Partnership: Liability, Difficulty to raise capital From the owners’ point of view, what are the advantages Sole Proprietorship and disadvantages and Partnership: of each form of Owner control, single taxation Corporation: ownership? Corporation: Conflict of interest between management and owners, Limited Liability, Ease of raising capital Double taxation Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 1 - 18
- 19. Business Transactions Operating Activities Investing Activities Financing Activities Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 1 - 19 Learning Objective 2 Business transactions are economic exchanges classified as: Transactions related to the general operations of the firm Transactions related to buying and selling items the firm will use for more than a year Transactions that deal with how a business gets it funding
- 20. How a BusinessWorks Transactions for Team Shirts’ First Month of Business Sara contributes $5,000 of her own money to start her business. Team Shirts borrows $500 from Sara’s sister to help finance the business. Team Shirts purchases 100 T-shirts from a T-shirt maker. Team Shirts decides to advertise the new business. Team Shirts the loan plus interest to Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 1 - 20 repays Sara’s Sister. Team Shirts sells 90 T-shirts.
- 21. Information Needs ofDecision Makers • Revenue from sales • Expenses incurred • Net income • Inventory • Reliability of Vendors Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 1 - 21 Learning Objective 3
- 22. Operating Cycle Endwith more Start with cash Purchase inventory Collect cash cash Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 1 - 22 from customers Make sales to customers
- 23. Who Needs Accounting Information? Management Those with direct financial interest Current or potential investors Current or potential creditors Employees Those with an indirect financial interest Tax Authorities Regulatory Agencies Economic Planners Labor unions, financial advisors, others. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 1 - 23
- 24. Your Turn 1-4 Revenues are the amounts a company earns from providing goods or services to its customers. Expenses are the costs to earn those revenues. What are revenues and expenses? The four statements include the income statement, balance sheet, statement of changes in shareholders’ equity, and the statement of cash flows. What are the four basic financial statements? Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 1 - 24
- 25. Who Sets theGuidelines? Securities and Exchange Commission (SEC): Created by the U.S. Congress in 1934 to set the rules for corporations that trade on the public stock exchanges. Mandated by the Sarbanes- Oxley Act. Created by the SEC in response to 2001- 2002 accounting scandals to oversee audits of public companies. Public Company Oversight Board (PCAOB) The SEC delegates much of the Accounting standard-setting responsibility to the FASB. SEC retains and sometimes exercises its rights to set standards. Financial Accounting Standards Board (FASB) Generally Accepted Accounting Principles Auditing Standards Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 1 - 25
- 26. International Financial Reporting Standards International guidelines for financial reporting, used in many places around the world. International Accounting Standards Board (IASB) sets international financial reporting standards. The SEC plans implementation of IFRS in the United States by 2014 so that one global set of standards is used by all major economies. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 1 - 26
- 27. Four Basic FinancialStatements Accountants communicate financial information in the form of four basic financial statements. Balance Sheet Assets = Liabilities + Equity Statement of Changes in Owner’s Equity Beginning equity + Contributions +/- Net income/loss - Dividends = Ending equity Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 1 - 27 Income Statement Revenues - Expenses = Net income Statement of Cash Flows Cash inflow - Cash outflow = Net cash flow Learning Objective 4
- 28. Financial Statements Datesof Financial Statements are Important! The Balance Sheet is prepared “AS OF…” or “AT” a particular date, a “snapshot” in time. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 1 - 28
- 29. Financial Statements 1.The Income Statement 2. Statement of Changes in Owner’s Equity 3. Statement of Cash Flows cover a period of time: “FOR THE PERIOD ENDING” Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 1 - 29
- 30. Balance Sheet Assets= Claims Assets = Liabilities + Equity Things of Something owed value Obligations/debt Economic (creditors’ share of the assets) resources of the assets) owned Net Assets (owner’s share Contributed Capital Retained Earnings Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 1 - 30
- 31. Your Turn 1-5 TheW twhaot p aarret st hoef stwhaor ephaortlsd eorfs S’ heqarueithyo aldreer cso’ nEtqruibituyt?ed capital and retained earnings (earned capital). A fiscal year is a year in the life of a business for What is a fiscal year? financial reporting purposes. It may begin at any time and ends a year later. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 1 - 31
- 32. Accounting Equation TeamShirts Shareholders' Equty Contributed Capital Retained Assets All Liabilities + Event Cash All other assets Account Account Common Stock Earnings 1 5000 5000 2 500 500 Note Payable 3 (400) 400 Inventory 4 (50) (50) Expense 5 900 900 Revenue (360) Inventory (360) Expense 6 (505) (500) Note Payable (5) Expense 7 (100) (100) Dividends Balances 5345 40 5000 385 --Income Statement, --Statement of Changes in Shareholders’ Equity, --Balance Sheet, --Statement of Cash Flows Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 1 - 32
- 33. Income Statement .. .describes the activity of a company The amount earned from providing goods or services to customers Costs incurred to generate revenue Difference between revenues and expenses Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 1 - 33 during a period Also called: Statement of earnings, statement of operations, profit and loss statement Revenue – Expenses = Net Income
- 34. Your Turn 1-6 The income statement contains revenues and expenses. The balance sheet contains assets, What is included on the income statement? What is included on the balance sheet? liabilities, and shareholders’ equity. The time period captured by the income statement is an accounting period, often a fiscal year. The statement covers a period of time. On the other hand, the balance sheet describes the financial position of a company at a given point in time. Describe the difference in the time periods captured by the income statement and the balance sheet. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 1 - 34
- 35. Statement of Changesin Owners’ Equity Beginning balance +/- changes in contributed capital +/- changes in retained earnings = Ending balance Contributed Capital: Contribution by investors to obtain ownership in a corporation. Ownership is divided into shares of stock. Retained Earnings: Total of all net income earned by the business Minus Dividends Paid to owners (Distributions to owners) Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 1 - 35
- 36. Statement of CashFlows Cash from Operating Activities Cash from Investing Activities Cash from Financing Activities From customers’ purchases, interest or dividend income From sale of property and equipment Cash Inflow From issuing long-term debt or issuing stock Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 1 - 36
- 37. Statement of CashFlows Cash from Investing Activities Cash Outflow Cash from Operating Activities Cash from Financing Activities To suppliers for inventory, For employees’ Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 1 - 37 salaries To purchase plant and equipment, Investments in other firms To repay long-term debt principal, To pay dividends to owners
- 38. Your Turn 1- 7 The income statement gives the revenues and expenses for the period. The net amount, net income, is added to retained earnings. So the income statement number How is the income statement related to the balance sheet? In other words, how does the amount of net income affect the balance sheet? becomes part of the retained earnings total on the year-end balance sheet. The Why income is it necessary statement to have shows both all revenues an income and statement expenses and for a a period statement of time—of cash all the flows? revenues that have been earned Look at and the statements expenses incurred for Team to Shirts earn those and explain revenues. why The they statement are different. of cash flows simply lists the cash inflows and outflows during the period. Also, any transactions with owners (contributions and dividends) are not included on the income statement. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 1 - 38
- 39. Revenue s -Expense s Net income Multi-step: Calculates net income in steps Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 1 - 39 Learning Objective 5 Real Company’s Financial Statements Single-step: Groups all revenues together and deducts all expenses from total revenues Revenues - Cost of Goods Gross Margin + Other Revenue - Other Expenses Operating Income - Income Taxes Net Income Income Statements
- 40. Real Company’s Financial Statements Classified Balance Sheet Shows a subtotal for various classes of assets and liabilities, including current and long-term assets and liabilities, and shareholders’ equity Assets: Current Assets Property, Plant, and Equipment Other Assets Shareholders’ Equity: Contributed Capital, Retained Earnings, Other Comprehensive Income Liabilities: Current Liabilities Long-term Liabilities Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 1 - 40
- 41. Risk: Anything thatexposes us to potential injury or loss. Can turn into significant losses, scandals, or total company failure. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 1 - 41 Learning Objective 6 Business Risk, Control, and Ethics Product Failure Theft of Assets Purchase/sale of poor quality inventory Strategic Risks Operating Risks Financial Risks Information Risks
- 42. Business Risk, Control,and Ethics Every risk brings a potential reward. Firms’ managers want to minimize risks. A manager must always put good ethical behavior above putting a good face on the firm’s financial position or performance. Control: An activity performed to minimize or eliminate risk. A firm must establish and maintain control over its operations, assets, and information systems. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 1 - 42
- 43. All rights reserved.No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in the United States of America. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 1 - 43
Editor's Notes
- #4 1. Describe what a business does and the various ways a business can be organized. 2. Classify business transactions as operating, investing, or financing activities. 3. Describe who uses accounting information and why accounting information is important to them. 4. Identify the elements of the four basic financial statements—the income statement, the statement of changes in shareholders’ equity, the balance sheet, and the statement of cash flows, explain the purpose of each, and be able to use basic transaction analysis to prepare each statement. 5. Identify the elements of a real company’s financial statements. 6. Describe the risks associated with being in business and the part that ethics plays in business.
- #5 1. Describe what a business does and the various ways a business can be organized. 2. Classify business transactions as operating, investing, or financing activities. 3. Describe who uses accounting information and why accounting information is important to them. 4. Identify the elements of the four basic financial statements—the income statement, the statement of changes in shareholders’ equity, the balance sheet, and the statement of cash flows, explain the purpose of each, and be able to use basic transaction analysis to prepare each statement. 5. Identify the elements of a real company’s financial statements. 6. Describe the risks associated with being in business and the part that ethics plays in business.
- #6 In 2009, Bernie Madoff pleaded guilty to 11 felony charges associated with a $50 billion Ponzi scheme that lasted for decades. In his own words, Madoff does a pretty good job of explaining what a Ponzi scheme involves: The essence of my scheme was that I represented to clients and prospective clients who wished to open investment advisory and individual trading accounts with me that I would invest their money in shares of common stock, options and other securities of large well-known corporations, and upon request, would return to them their profits and principal. Those representations were false because for many years up until I was arrested on December 11, 2008, I never invested those funds in the securities, as I had promised. Instead, those funds were deposited in a bank account at Chase Manhattan Bank. When clients wished to receive the profits they believed they had earned with me or to redeem their principal, I used the money in the Chase Manhattan Bank account that belonged to them or other clients to pay the requested funds. (Source: Document #09-Cr-213(DC) filed with the United States District Court Southern District of New York on March 12, 2009.) Madoff’s auditing firm, Friehling & Horowitz, CPAs, has been charged with failing to conduct meaningful, independent audits of Madoff’s firm while falsely certifying that it had done so. As you will read later in this chapter, investors depend on auditors to provide an unbiased evaluation of a firm’s financial position and performance. As in the big scandals of the early 2000s, such as Enron and WorldCom, people are asking why the auditors didn’t find the problems. Madoff’s failure to address our initial three questions, combined with the auditor’s failure to do a competent audit, resulted in thousands of people losing their life savings. Madoff’s sentence of 150 years in prison will keep him in jail for the rest of his life.
- #7 Generally, the purpose of a business is to provide goods and services to make a profit. It’s that simple. A company must obtain financing. The best way to do that is to add value to a product and sell it to a customer or provide a service of value to a customer. If a business is not providing something of value to its customers, it won’t make a profit for very long. That means it will be out of business! The moral to this story: a business must add value.
- #8 A for-profit firm makes a profit for its investors. A not-for-profit organization provides goods and services to people and uses its profit to provide more goods and services to people.
- #9 A firm acquires goods and services (inputs), does something to the inputs that adds value, and then provides the products or services (outputs) to its customers. A firm (also called a company, a business enterprise, or an entity) must acquire and pay for the inputs. Information about these activities are recorded in the company’s information system. Both internal (owners and employees) and external decision makers (creditors, governmental agencies, and potential investors) use the information. Each activity can be thought of as part of this cycle. After converting the inputs, the outputs are then sold to the customers and payment is collected. The major inputs that a firm must acquire to do business are, first, capital – the money needed to start the business. That is usually either money the owner(s) invests in the business or loans. People or companies who provide loans to a business are called creditors. Money that owners invest in the firm are called owners’ contributions. Even though they are an investment in the business from any owner’s point of view, they are contributions (also called contributed capital) from the firm’s point of view. From this point on, we will refer to them as contributions. The term investments, from the firm’s point of view, will refer to things the business has bought. For example, a firm may “invest” in a new piece of equipment; or a firm may make “investments” in the stock market by using its extra cash to buy shares of stock. Firms also acquire property, plant, equipment, material, inventory, and employees to work for the company. The output of a company is the product it sells or the service it provides to its customers. A business must successfully plan, control, and evaluate its activities. If it does these activities well, the business will survive.
- #10 There are two major types of businesses: those that provide services to their customers and those that sell products to their customers. A service company provides a service—it does something for you, rather than sells something to you. Services range from activities you cannot see, such as the advice provided by lawyers or tax consultants, to activities you can see, such as house cleaning or car washing. During the past two decades, our economy has been producing more services than goods. Financial services companies do not make tangible products, and they do not sell products made by another company. They deal in services related to money. Banks are one kind of financial services company; they lend money to borrowers to pay for cars, houses, and furniture. Another type of financial services company is an insurance company, which provides some financial protection in the case of loss of life or property. A company that sells products to customers may sell merchandise they buy from others or may sell merchandise they have manufactured. Often, we refer to the first as merchandising companies. Examples are the shops in our malls. They sell merchandise they’ve bought from their suppliers. Companies that make their own products are called manufacturing companies. They often sell their products to other companies, rather than to the final consumers.
- #11 Your Turn 1-1 1. The main purpose of a business is to make a profit, increasing the value of the company for the owners. 2. The four general types of businesses are as follows: a. Service company: provides a service—it does something for its customers rather than selling them a tangible product. b. Merchandising company: buys goods, adds value to them, and then sells them with the added value. c. Manufacturing company: makes products and sells them to other companies and sometimes to the final consumers. d. Financial services company: provides services related to money—insurance, banking, etc.
- #12 Businesses can be classified in another way—by who owns the company. A company owned by one person is called a sole proprietorship. A partnership is owned by more than one person. A corporation is a very special form of business organization that involves ownership by a potentially large number of people. A corporation is a separate legal entity, whereas a sole proprietorship and partnerships are not legally separate from their owners.
- #13 A sole proprietor or a partner is personally responsible for the company’s debt. However, this type of business owner only pays tax once by including the business profit in their personal income for taxes. These forms of business are subject to few governmental regulations. Investors (owners) of a corporation are only liable for the company’s debt up to the amount invested in the company. With respect to taxes, a corporation pays income taxes just like an individual does. The rules aren’t exactly the same, but a profitable company may pay a very significant amount of taxes. Then, when earnings are distributed to the corporation’s owners, the individual owners must pay individual income tax on that income. Distributions to the owners are called dividends. Corporations are required to file many forms with the SEC and the IRS! If a corporation wants to be traded on one of the stock exchanges--publicly traded—there are a huge number of reports and forms that must be filed each quarter.
- #14 A company owned by one person is called a sole proprietorship. In the course of running the business, a sole proprietorship accumulates financial information—such as the cost of materials, equipment, rent, electricity, and income from sales—but is not required by law to make any of that financial information available to the public. As a sole proprietor, you are responsible for all the decision making in the company, and you are liable for all of your company’s debts.
- #15 A company owned by two or more people is called a partnership. The partners should create a Partnership Agreement in writing to share workloads, profit, and loss because they share the responsibility of operating the firm. The company’s assets are the partners’ assets, and the company’s debts are the partners’ debts. Even so, as with a sole proprietorship, the financial records of a partnership should be separate from the partners’ personal financial records.
- #16 In most business courses, the corporation is the business organization usually studied. The corporate form of business has many advantages for the owners. I am an owner of AT&T. Are you impressed? Don’t be. Because AT&T is a corporation and its stock is publicly traded; I own a share or two. I also own a share or two of Sprint, Coca Cola, PepsiCo, and many other corporations as part the investments of my retirement funds. If you are the sole proprietor or a partner in a company, you are responsible for the actions of the company. If the company is sued, you may have to use your own assets to pay any fines or penalties. With a corporation, that is not the case. Even though I own stock in McDonald’s, I am not personally responsible for the damages that McDonald’s had to pay the woman who spilled the extra hot coffee on her lap. That’s the idea of limited legal liability for the owners of a corporation.
- #17 This idea of a corporation being a “separate legal entity” gives the company rights that otherwise are restricted to individuals. You may think that a sole proprietorship may own assets, but legally the assets of a sole proprietorship belong to the sole proprietor—the owner. A corporation may itself own assets. Again, the liabilities of a sole proprietorship are the obligation of the owner—the sole proprietor. A corporation may incur its own liabilities. When someone sues AT&T, I don’t lose any sleep, even though I may be an owner (albeit a small owner). The corporation is a legal entity that may be sued without my being sued. When a sole proprietorship is sued, it is just like the owner being sued. Stockholders give managers of the corporation the responsibility for doing the company’s business—and entering into contracts is one of those responsibilities. Not only can a person own a very, very small share of a large corporation, a person can own a small share of lots of different corporations. This allows a person to diversify some of the risk of owning stock. Because I can own a little stock in some soft drink companies and a little stock in some coffee and tea companies, I am reducing the risk I face if something happens to make people switch from soft drinks to coffee as their primary drink.
- #18 In the past 10 years, new business forms with some characteristics of a partnership and some characteristics of a corporation have become commonplace. Both LLPs and LLCs have the tax advantages of a partnership and the legal liability advantages of a corporation. An LLP is a business form mostly of interest to partners in professions such as law, medicine, and accounting. An LLP’s owners—who are the partners—are not personally liable for the malpractice of the other partners. They are personally liable for many types of obligations owed to the LLP’s creditors, lenders, and landlords. Owners of an LLP report their share of profit or loss on their personal tax returns. The LLP form of business organization is not available in all states, and it is often limited to a short list of professions—usually attorneys and accountants. You will notice that the four largest international accounting firms have all taken this organizational form. The letters LLP will appear after the firm’s name. An LLC is a corporation that has characteristics of a partnership. It has the advantage of limited liability like a regular corporation with the tax advantage of a partnership. It generally requires less paperwork and documentation than a regular corporation.
- #19 The three general forms of business ownership are (1) sole proprietorships (single owner), (2) partnerships (multiple owners), and (3) corporations (potential for widespread ownership often with separation of ownership and management). 2. Some advantages and disadvantages of each business form are as follows: Sole Proprietorship and Partnerships Taxes flow to proprietor’s income Owners control Taxes flow to partners’ income Corporations Limited liability for owners Often easier to raise capital For owners, they may diversify their investments across many different companies, often for a very small investment Disadvantages: Sole Proprietorship and Partnership Owner is liable for all business decisions Partners are liable for all business decisions Often difficult to raise capital Corporations Often, management and owners are separate, creating a conflict of interest Corporation pays taxes and then owners pay taxes again on the dividends they receive (unless the tax law provides special treatment for dividends)
- #20 In accounting, we often classify transactions as operating activities, investing activities, or financing activities. Operating activities are transactions related to the general operations of a firm—what the firm is in business to do. Investing activities are transactions related to buying and selling items that the firm will use for longer than a year. Financing activities are those that deal with how a business gets its funding—how it obtains the capital needed to finance the business.
- #21 The first exchange starts the business—Sara invests her own $5,000 in the business. From the perspective of the business, this is called a contribution. It is often called contributed capital. As with all transactions, we look at this from the point of view of the business entity. This transaction is the exchange of cash for ownership in the business. Because this transaction deals with the way Team Shirts is financed, it is classified as a financing transaction. The second transaction is between Team Shirts and Sara’s sister. The business borrows $500 from Sara’s sister. Team Shirts gets an economic resource—cash—and in exchange Team Shirts gives an I-owe-you (IOU). From the perspective of Team Shirts, this transaction involves a cash receipt. Borrowing money to finance a business is the get side of the exchange. The next transaction is the company’s purchase of 100 T-shirts with unique logos on them. The get part of the exchange is when Team Shirts gets the shirts for the inventory. The give part of the exchange is when Team Shirts gives cash to the T-shirt manufacturer. The next transaction is the acquisition of a service. The economic resources exchanged in this transaction are advertising and cash. The get part is the acquisition or purchase of advertising brochures. The give part is a cash disbursement transaction. Team Shirts now sells the T-shirts, exchanging T-shirts for cash. Once again, the activity is an operating activity, precisely what Team Shirts is in business to do—sell T-shirts. Team Shirts repays the $500 loan from Sara’s sister plus interest. The company gives the economic resource of cash (amount of the loan, called the principal, plus interest, a cost of borrowing the money) to Sara’s sister.
- #22 What was the revenue from sales during the accounting period? An accounting period is any length of time that a company uses to evaluate its operating performance. It can be a month, a quarter, or a year. • What expenses were incurred so those sales could be made? • What was net income—the difference between revenues and expenses? • What goods does Team Shirts have left at the end of the period? • Should Sara increase or lower the price of the T-shirts she sells? In addition to this kind of financial information, there is other information that can help Sara make decisions about her business. For example, Sara would want information on the reliability of different vendors and the quality of their merchandise to decide which vendor to use next time.
- #23 The operating cycle of Team Shirts begins with cash, converting cash to inventory, selling the inventory, and turning inventory sales back into cash—Sara has more decisions to make. Should she buy T-shirts and do the whole thing again? If so, should she buy more T-shirts than she bought the first time and from the same vendor? To make these decisions, Sara must have information. The kind of information usually provided by accountants will provide the basis for getting a good picture of the performance of her business.
- #24 Every business major has to take this introductory financial accounting course. That’s because accounting information is crucial to so many aspects of a business. The first group of people who need accounting information is management. Both investors and creditors need accounting information to evaluate the financial condition of a company. If you were interested in investing money in a company as an owner (e.g., you want to buy some stock in a company), you would want to see a company’s financial statements. The same is true if you were to consider loaning a company some money. You’d want to evaluate the company’s potential to repay your loan. As you know, there are lots of other interested parties. YOU are one of them. Even employees are interested in the financial condition of a company.
- #25 1. Revenues are the amounts a company earns from providing goods or services to its customers. Expenses are the costs to earn those revenues. 2. The four statements include the income statement, balance sheet, statement of changes in shareholders’ equity, and the statement of cash flows.
- #26 The U.S. Congress established the Securities and Exchange Commission (SEC) in 1934. Auditing standards are set by the Public Company Accounting Oversight Board (PCAOB), and accounting standards (GAAP) are set by the Financial Accounting Standards Board (FASB).
- #27 The International Financial Reporting Standards (IFRS) are international guidelines for financial reporting, used in many places around the world. The International Accounting Standards Board (IASB) is the group that sets international financial reporting standards. Although U.S. GAAP are currently the set of standards used by U.S. firms, there is another widely used set of accounting standards called the International Financial Reporting Standards (IFRS). These standards, similar in many ways to GAAP, are used in many other places around the world. They are set by a group called the International Accounting Standards Board (IASB), similar to the FASB. As a matter of fact, there is a member of FASB who also sits on the IASB. In 2008, the SEC published a “roadmap to IFRS” that details how and when U.S. GAAP should converge with IFRS so that one global set of standards is used by all major economies. The SEC plan calls for implementation of IFRS in the United States by 2014.
- #28 These are the four basic financial statements that we will focus on throughout this course. The balance sheet is just a summary of the accounting equation. The income statement shows all revenues minus all expenses to give net income. This statement gives the details of the earnings part of the change in owners’ equity for the accounting period (often a year). The statement of changes in owners’ equity tells how all parts of owners’ equity have changed during the year. That includes both contributed capital and retained earnings. The statement of cash flows shows all the cash inflows and all the cash outflows during the accounting period. The cash flows are classified as operating, financing, or investing cash flows.
- #29 Only the balance sheet has a specific point in time as its date. The income statement shows all revenue and all expenses over a period of time. A balance sheet is a list of every asset the company has and details of the related claims at a specific point in time. It makes sense for a company to list its assets at a certain time. If I asked you how much cash you have in your pocket, it would be for a specific point in time. If I asked you how much money you earned at your job, it would have to be for some period of time. That’s like the income statement. It describes the change in the earned part of owners’ equity for a specific period of time, usually a year. The statement of changes in owners’ equity and the statement of cash flows are both statements that describe changes over a period of time.
- #30 Only the balance sheet has a specific point in time as its date. The income statement shows all revenue and all expenses over a period of time. A balance sheet is a list of every asset the company has and details of the related claims at a specific point in time. It makes sense for a company to list its assets at a certain time. If I asked you how much cash you have in your pocket, it would be for a specific point in time. If I asked you how much money you earned at your job, it would have to be for some period of time. That’s like the income statement. It describes the change in the earned part of owners’ equity for a specific period of time, usually a year. The statement of changes in owners’ equity and the statement of cash flows are both statements that describe changes over a period of time.
- #31 The balance sheet equation: Assets = Liabilities + Owners’ Equity. It is also known as the accounting equation which is one of the most important things for you to learn in an introductory accounting course. MEMORIZE IT! Assets—economic resources owned or controlled by the business. Liabilities—obligations of the business; amounts owed to creditors. Shareholders’ equity—the owners’ claims to the assets of the company. There are two types: contributed capital and retained earnings.
- #32 The two parts of shareholders’ equity are contributed capital and retained earnings (earned capital). A fiscal year is a year in the life of a business for financial reporting purposes. It may begin at any time and ends a year later.
- #33 All of a firm’s transactions can be shown in the accounting equation worksheet. The income statement is made up of the transactions in the red box—everything that is in the retained earnings column EXCEPT dividends. The income statement transactions (revenues and expenses) are then condensed into one number (net income), which becomes part of the statement of changes in shareholder’s equity, indicated by the yellow box. Then, the information from the statement of changes in shareholder’s equity is summarized as part of the balance sheet, shown in blue. All of the transactions have directly or indirectly affected the balance sheet. The balance sheet reports the condensed and summarized information from the transactions, indicated by the amounts in the last row (balances at 1/31/2010). The fourth statement, the statement of cash flows, indicated by the green box, shows how the company got its cash and how it spent its cash during the accounting period.
- #34 The income statement shows all revenues minus all expenses to give net income. This statement gives the details of the earnings part of the change in owners’ equity for the accounting period (often a year known as a fiscal year).
- #35 The income statement contains revenues and expenses. The balance sheet contains assets, liabilities, and shareholders’ equity. The time period captured by the income statement is an accounting period, often a fiscal year. The statement covers a period of time. On the other hand, the balance sheet describes the financial position of a company at a given point in time.
- #36 The statement of changes in owners’ equity tells how all parts of owners’ equity have changed during the year. That includes both contributed capital and retained earnings.
- #37 The statement of cash flows is needed to form a complete picture of a company’s financial health. This statement is, in theory, the easiest to understand, and many people consider it the most important. It is a list of all the cash that has come into a business (its cash receipts) and all the cash that has gone out of the business (its cash disbursements) during a specific period. In other words, it shows all the cash inflows and all the cash outflows for a fiscal period.
- #38 The statement of cash flows is needed to form a complete picture of a company’s financial health. This statement is, in theory, the easiest to understand, and many people consider it the most important. It is a list of all the cash that has come into a business (its cash receipts) and all the cash that has gone out of the business (its cash disbursements) during a specific period. In other words, it shows all the cash inflows and all the cash outflows for a fiscal period.
- #39 The income statement gives the revenues and expenses for the period. The net amount, net income, is added to retained earnings. So the income statement number becomes part of the retained earnings total on the year-end balance sheet. The income statement shows all revenues and expenses for a period of time—all the revenues that have been earned and expenses incurred to earn those revenues. The statement of cash flows simply lists the cash inflows and outflows during the period. The income statement and the statement of cash flows for Team Shirts are different because Team Shirts paid cash for some inventory that was not sold, so the cost of that inventory is not included in the income statement’s cost of goods sold. Also, any transactions with owners (contributions and dividends) are not included on the income statement.
- #40 All publicly-traded corporations—ones that sell their stock in the public stock exchanges such as the New York Stock Exchange (NYSE)—must prepare the four basic financial statements every year. A complete set of annual financial statements includes the four basic statements—balance sheet, income statement, statement of changes in shareholders’ equity, and the statement of cash flows—as well as the Notes to the Financial Statements. Accompanying the annual financial statements in a public company's 10-K is an audit opinion. Independent auditors play a crucial role in making sure the financial statements provide data that investors can rely on. A single-step income statement summarizes all the revenues (from sales or services) a company earns minus all the expenses (costs incurred in the earning process) associated with earning that revenue for an accounting period—a month, a quarter, or a year. A multistep income statement lists revenue first and then subtracts expenses related to earning the revenue, cost of revenue (also known as cost of goods sold), which gives a subtotal called gross margin. Then operating and other expenses are subtracted from gross margin to calculate net income. Net income is always the same no matter how the revenues and expenses are grouped on the statement.
- #41 A classified balance sheet shows a subtotal for various classes of assets and liabilities, including current and long-term assets and liabilities, and shareholders’ equity.
- #42 A risk may be generally defined as anything that exposes us to potential injury or loss. In business, risks can turn into significant losses, scandals, or total company failure. There are hundreds of risks that any business faces. Some examples are: • the risk of product failure that might result in the death of consumers • the risk that someone will steal assets from the company • the risk that poor-quality inventory will be purchased and sold
- #43 Risks relate to all aspects of the business, including the following: • General strategic risks • Operating risks • Financial risks • Information risks The potential losses from taking on business risks may be the loss of reputation, loss of customers, loss of needed information, or loss of assets. All the losses translate into monetary losses that can put the company at risk for total failure. It is difficult to think of business risk without considering the relationship of risks to ethics. When the risks of business result in losses or legal exposure, a firm’s managers want to minimize the damage to the firm. In such cases, the ethical standards of the firm and its managers become paramount. A manager must always put good ethical behavior above putting a good face on the firm’s financial position or performance. Failure to do this has resulted in huge losses for employees and investors. For the potential of developing a successful business. To deal with the risks and increase the chances to reap the rewards, a firm must establish and maintain control over its operations, assets, and information system. A control is an activity performed to minimize or eliminate a risk. As we study the business processes that Team Shirts will be engaged in during its first year in business, we will look at how the firm can control the risk involved in each process.