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- 1. Chapter 1 The Role of Accounting in Business
- 2. Learning Objectives After studying this chapter, you should be able to… Describe the types and forms of businesses, how businesses make money, and business stakeholders Describe the three business activities of financing, investing, and operating. Define accounting and describe its role in business. Describe and illustrate the basic financial statements and how they interrelate. Describe eight accounting concepts underlying financial reporting.
- 3. Learning Objective 1 Describe the types and forms of businesses, how businesses make money, and business stakeholders
- 4. Types of Businesses? Service Business Manufacturing Business Merchandising Business
- 5. Forms of Business • Proprietorship • Partnership • Corporation • Limited Liability Company Considerations in Choosing a Form of Business Organization • Ease of formation • Ability to raise capital • Legal liability • Taxation • Limitation on life
- 6. Differences in Forms of Business Organization Legal Limited Capital Form Ease Liability Taxation Life Access Proprietorship Simple No limit Nontaxable Yes Limited Partnership Simple No limit Nontaxable Yes Average Corporation Complex Limited Taxable No Extensive Limited Liability Co. Moderate Limited Nontaxable Yes Average
- 7. How Do Businesses Make Money? By providing goods and services to customers so that they can make a Profit. To maximize their profits, by using one of the following two strategies: Low Cost Strategy Premium Price Strategy
- 9. Learning Objective 2 Describe the three business activities of financing, investing, and operating
- 10. Business Activities • Use business assets to acquire more assets: tangible (machinery, buildings, computers, etc.) and intangible (patents and • Borrowing goodwill) from a 3rd party • Investing in the business • Use assets to earn revenues and profits (Revenues < expenses = net loss; Revenues > expenses = net income
- 11. Learning Objective 3 Define accounting and describe its role in business
- 12. Objectives of Financial Accounting Sometimes called the “language of business”, Accounting is an information system that provides reports to stakeholders about the economic activities and condition of a business. Essentially, it summarizes the financial performance of the firm for external users.
- 13. Financial Condition Financial Condition FinancialCondition POINT IN As of aa POINT IN As of TIME TIME Financial Condition Financial Condition Financial Condition Over a PERIOD OF Over a PERIOD OF TIME TIME Two Major Objectives of Financial Accounting
- 14. Learning Objective 4 Describe and illustrate the basic financial statements and how they interrelate.
- 15. Financial Statements • Income Statement • Retained Earnings Statement • Balance Sheet • Statement of Cash Flows
- 16. Income Statement • Summary of revenue and expenses for a specific period of time (e.g., month, quarter, or year) • Reports the change in financial condition due to the operations of a business • Uses the Matching Concept • Expenses for the period are matched against revenues for the same period Revenue – Expenses = Net Income
- 17. Retained Earnings • Reports changes in financial condition due to changes in retained earnings during a period • Retained earnings is the portion of net income retained by the business
- 18. Balance Sheet • Reports financial condition at a point in time. • Measured by total assets and claims to those assets: Assets = Liabilities + Stockholders’ Equity
- 19. Balance Sheet - Preparation • Step 1: Each asset is listed and added to arrive at total assets • Step 2: Each liability is listed and added to arrive at total liabilities • Step 3: Each stockholders’ equity item is listed and added to arrive at total stockholders’ equity • Step 4: Total liabilities and total stockholder’s equity are added together • Step 5: Total assets must equal total liabilities and stockholders’ equity
- 20. Statement of Cash Flows • Reports the change in financial condition due to the changes in cash during a period – Net change in operating cash flows – Net change in investing cash flows – Net change in financing cash flows
- 21. Statement of Cash Flows – Operating Activities • Net cash flows from operating activities is reported first. • Cash flow from operating activities is a focus of creditors, employees, managers, suppliers and customers. • Operating activities are transactions that involve the acquisition or production of products and services and the sale of those products or services to customers
- 22. Statement of Cash Flows – Investing Activities • Net cash flows from investing activities is reported second. • Cash receipts from selling property, plant, and equipment are reported in this section. • Cash used to purchase property, plant, and equipment is also reported in this section. • Negative cash flow from investing activities is normal for an expanding company.
- 23. Statement of Cash Flows – Financing Activities • Net cash flows from financing activities is reported third. • Any cash receipts from issuing debt or stock are reported in the section. • Cash payments on debt and dividends is also reported in this section.
- 24. Integrated Financial Statements • Statement of cash flows is linked to cash on the balance sheet. • Net income from the income statement is linked to the retained earnings statement. • Retained earnings is linked to the balance sheet in stockholders’ equity.
- 25. Learning Objective 5 Describe eight accounting concepts underlying financial reporting
- 26. The Accounting “Rules” Generally accepted accounting principles (GAAP)
- 27. Eight Concepts BUSINESS COST ENTITY CONCEPT ACCOUNTING PERIOD GOING CONCERN ADEQUATE DISCLOSURE MATCHING CONCEPT UNIT OF OBJECTIVITY MEASURE CONCEPT
- 28. End of Chapter 1
Notas del editor
- Business come in all sizes- from your local hardware store to Lowes Home Improvement centers. The objective of most businesses is to earn a profit- or, to receive more value for the goods or services provided than the cost to make or provide those goods and services.
- Forms of Business: Setting up a business can follow several different formats. A proprietorship is owned by one individual and is the easiest form of business to establish. Over 70% of the businesses in the United States are organized as proprietorships. A partnership is similar to a proprietorship, but is owned by two or more individuals. About 10% of the businesses in the United States are organized as partnerships. Some proprietorships can grown to have many owner/partners. About 20% of businesses in the United States are organized as corporations. A corporation operates as a legal entity separate from its owners, called stockholders. The ownership of a corporation is divided into shares of stock which each stockholder purchases as an ownership interest in the corporation. Limited Liability companies combine the ownership attributes of a partnership and corporation. This format operates mainly like a partnership but owners have limited liability, which is an advantage of a corporate structure. Considerations in Choosing a Form of Business Organization: A proprietorship is the easiest business to form, however, a proprietorship has the disadvantages of unlimited liability for the proprietor and an organizational life that could be limited by the life of the owner. Proprietorships and partnerships also have a more difficult time than corporations raising capital – however, a corporation usually pays a much higher tax burden than a proprietorship or partnership.
- This table summarizes the similarities and differences among formats of organization discussed. While a manufacturing business, merchandising business, or service business can be organized under any of these formats, business that require a large amount of resources, such as a large manufacturer or merchandiser, usually are organized as corporations.
- Companies try to maximize profits by earning high revenues while maintaining low costs. Increasing a company’s profits can be achieved by either increasing revenues, decreasing costs, or both. However, competitors are usually try to do the same thing. Two general strategies are used to gain advantage over competitors. A low-cost strategy is employed by an airline like Southwest which offers no-frill airline services and has minimized costs by employing standard aircraft and buying fuel futures. Starbucks is an example of a premium-price strategy; customers in the past have been willing to pay more for a cup of coffee or purchase a specialized coffee under this model. Companies often struggle to find a competitive advantage- sometimes being caught between a low-cost competitor while not providing a unique product or service that would allow competition as a premium-price business.
- Business stakeholders can come from several areas. Stakeholders can be generally classified into one of four categories: Capital Market - Capital market stakeholders provide financing for a company to start up, expand, or continue business. Banks and creditors expect to recover the original amount loaned plus interest. Stockholders want to maximize the value of their investment in a business. Product or Service Market - Product or service market shareholders purchase the company’s products and services or sell their products and services to the company. A customer has a stake in the continued health of a company in order to be assured they will receive their product or service. Likewise, a supplier has financial interest in the company; A supplier expects to be paid for the goods or services they provide to the company. Government - Government stakeholders can be federal, state, county, city, or other regulatory bodies. The more successful a company, the more it will pay in taxes. Internal - Finally, internal stakeholders include managers and employees who depend on the continued success of a company in order to remain employed.
- All companies engage in three basic business activities: Financing activities - Often times, the very first activity of a business is a financing activity- when an owner deposits some of their own money to start up the business. Financing activities of a business include borrowing transactions and owner investments into the company. Borrowing creates liabilities- a liability represents a legal obligation to repay a creditor at a point in the future based upon terms set by the creditor. A business can also be financed by its owners making investments in the organization. An owners’ investment differs from a liability in that future repayment from the company is not expected. Operating activities - Operating activities are the activities a business enters into in order to earn revenues and generate profits. Costs or expenses need to be incurred by a business in order to sell their product or service – these costs or expenses also represent operating activities. Investing activities - Investing activities involve using funds provided from either financing operations, operating activities or other investing activities to start, expand or operate a business. Depending on the nature of business, a variety of different assets may be needed.
- The role of accounting is to provide information about the financing, investing and operating activities of a company to its stakeholders. Depending on the stakeholder, different information will provide different value. For example, a creditor will be interested in information related to the economic performance of the company and its ability to repay its obligations in the future. Accounting is a language because it is the primary way a business can communicate information to its stakeholders. This information is communicated usually through the use of financial statements and reports. Financial statements and reports can provide information to internal users, which is called managerial accounting. Financial accounting is associated with preparing financial statements and reports for external users.
- The objectives of accounting are achieved by recording the events affecting a business and then summarizing the impact of these events on the business in the financial reports and statements of the company. The first objective of financial condition, reporting the financial condition of a business AS OF A POINT IN TIME, can be thought of as a still picture or snapshot of the company’s financial condition at a specific moment in time. The second objective , reporting the financial condition of a business OVER A PERIOD OF TIME, can be thought of as a moving picture of activities and performance of a company over a period of time.
- Financial statements report the financial condition of a business at a point in time and changes in the financial condition over a period of time. This table summarizes the four basic financial statements and their objectives. In general, the financial statements are prepared in the order shown; the income statement is prepared first, then the retained earnings statement, followed by the balance sheet and finally, the statement of cash flows.
- The income statement summarizes revenue and expenses for a period of time in order to determine how well a company has performed and achieved its objective of generating profits. The time period covered by an income statement may vary depending on the needs of the stakeholders, but the time period may also be called a fiscal period. Since the objective of business operations is to generate a profit and profit can not be generated without revenue, the income statement begins by listing revenue. Revenue is followed by listing the expenses incurred in generating the revenue. By reporting the expenses and related revenues for a period, the expenses are said to be “matched” against the revenues. When revenues exceed expenses, the company has net income. A net loss results if expenses exceed revenues. The goal of a company is to maximize profits by either increasing revenues, decreasing costs or both. Businesses might survive net losses in the short run, but since a net loss decreases the overall assets of a company, in the long term, a business must earn net income to survive. During 2008, Hershey generated sales of $5,133, expressed in millions of dollars. Following the revenues, Hershey’s expenses are listed and they include cost of sales, selling and administrative, interest, income taxes and other. During 2008, Hershey earned net income of $311 million. The net income can be good or bad depending on the user. A creditor may determine the net income indicates sufficient profitability to repay an obligation. However, a stockholder may be disappointed that the $311 million of net income on $5,133 million of sales is not as successful when measured against a competitor’s performance.
- Retained earnings represent the accumulated profits of a business that have been reinvested in the business rather than paid out as dividends to the owners. Often times in growth companies, all earnings are retained in the business to fund expanding operations. Since retained earnings depend on net income, the time period covered by the retained earnings statement will be the same as the income statement. In 2008, Hershey began the year with $3,928 million in retained earnings. The $311 million of net income is the same net income amount reported on the income statement. During 2008, Hershey also declared dividends of $263 million resulting in $3,976 remaining in retained earnings at the end of 2008.
- A balance sheet reports the dollar amounts associated with the assets of a company and the sources of financing for those assets. As covered in the previous learning objective, a business can be financed by borrowing or owner investment. The balance sheet must therefore report the financial condition of a company at a point in time. The balance sheet is represented by the accounting equation of Assets = Liabilities + Stockholders’ Equity. The balance sheet for Hershey shows total assets as of December 31, 2009 of $3,635 million. Total liabilities at the same point in time amount to $3,285 million and total stockholders’ equity is reported at $350 million. Total liabilities and equity add up to $3,635 million, which is equal to the total assets.
- The balance sheet is prepared by listing the accounting equation in a vertical rather than horizontal form using these 5 steps.
- The statement of cash flows reports events that affect a company’s cash account during a fiscal period. However, the statement itself is prepared as of a point in time, like the balance sheet. The statement of cash flows is organized around the three business activities of financing, investing and operating. During 2008, Hershey’s operating activities generated a positive cash flow of $520 million. Hershey’s investing activities used $199 million primarily to purchase property, plant and equipment. Hershey’s financing activities used $413 million of cash, primarily due to repayment of debt and payment of dividends. Hershey also received $286 million by borrowing from creditors. Overall, during 2008, Hershey’s cash balance declined by $92 million to arrive at an end of period cash balance of $37 million. Another way to look at this statement is that Hershey generated $520 million of cash from operations which they used to expand operations and pay stockholders. This would indicated Hershey is in a strong operating position.
- The net cash flows from operating activities is reported first because the cash flow from operating activities is a primary focus of many of the company’s stakeholders. Creditors use cash flows from operations to assess if operating activities are generating enough cash to repay future obligations. For the long-term, a company can not survive without generating positive cash flow from operating activities.
- Net cash flows from investing activities is reported second because investing activities directly impact the operations of a company. Property, plant and equipment can provide the foundation for operations and growth in an organization. Investing activities can involve the acquisition or sale of long-term assets for cash during a period. A rapidly expanding company would expect a negative net cash flow from investing activities. In contrast, a company that is downsizing or selling off assets or segments of its business would expect positive cash flows from investing activities.
- Financing activities are transactions between a company and its creditors and owners. Cash flows in when cash is borrowed for a long-term financing objective or stock is issued for cash. Cash flows out when a debt is repaid, dividends are paid, or stock is repurchased.
- Preparing the financial statements in the order of income statement, retained earnings statement, balance sheet and statement of cash flows is important because the financial statements are integrated. Net income on the income statement links the income statement to the statement of retained earnings. Then, the final retained earnings balance from the statement of retained earnings is also reported on the balance sheet. Finally, the balance sheet and statement of cash flows are linked by the cash account. For the Hershey Company, #1 shows the net income number of $311 million on both the income statement and the statement of retained earnings. #2 then shows the ending retained earnings balance of $3,976 million both on the statement of retained earnings and also as a part of stockholders’ equity on the balance sheet. Finally, #3 integrates the balance sheet and the statement of cash flows by the cash balance of $37 million.
- Financial statements illustrated in the preceding section are prepared using accounting “rules” called generally accepted accounting principles or “GAAP”. These rules are necessary in order for stakeholders to be able to compare among companies and across time. Within the United States, the Financial Accounting Standards Board or “FASB” has the primary responsibility for developing accounting principles The FASB publishes Statements of Financial Accounting Standards as well as interpretations of these statements. Many countries outside of the United States use generally accepted accounting principles adopted by the International Financial Reporting Standards Board or IASB. Currently, the FASB and IASB are working together to reduce and eliminate deficiencies and develop a single set of accounting principles.
- The business entity concept limits the economic data recorded in an accounting system to data related to the activities of the company. A company is viewed as an entity separate from its owners, managers, and other creditors. Determines the amount initially entered into the accounting records for purchases, usually their cost or purchase price. Property values assessed for taxes, market values, and other appraised values are not used for recording assets by a company. The going concern concept assumes that a company will continue in business indefinitely. While it is unknown how long a business will continue, unless information exists that raises doubts about a company’s ability to continue, the company is assumed to be a going concern. The matching principle requires companies to recognize the expenses used to generate revenue in the same accounting period in which the revenues are recognized. Revenue recognition relates to when revenue would be recorded. Revenues are normally recorded at the time a product is sold or service is rendered. At the point of sale, the sales price has been agreed on, the buyer acquires ownership, and the seller has a legal claim against the buyer for payment. The objectivity concept requires that entries in the accounting records and data reported on financial statements be based on verifiable or objective evidence. In some cases, estimates and judgment factors would have to be used, but the most objective evidence available should be used. In the United States, since the dollar is our national currency, all economic data must be recorded in dollars. Even though relevant non-financial data can be used in financial statements, transactions and activities of a business are measured, summarized, reported, and compared using dollars. Financial statements are required to include any necessary footnotes or other disclosures that would contain all the necessary and relevant data for a stakeholder would need to understand the financial condition and performance of a company. The accounting period and concept requires that accounting data be recorded and summarized in financial statements for periods of time. The financial history of a company can be traced through a series of balance sheet and income statements over a period of time.