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Financial Accounting: A Business Process Approach
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Chapter 1
Business: What’s It All About?
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Chapter 1 Learning Objectives
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.
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Chapter 1 Learning Objectives
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.
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Ethics Matters
1. Is it legal?
Should Bernie Madoff have asked himself these questions?
2. Will it harm anyone?
3. Would you mind reading about your decision in the morning newspaper?
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Purpose of a BusinessLearningObjective 1
2. Add value
3. Sell to customers
1. Obtain capitalObtain the resources needed to
start and run a business
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Purpose and Organization of 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.
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Simple Business Model
Cash from Capital, Financing, Property, Plant, Equipment,Raw Materials,Labor,Inventory,Goods & Services
Product
Service
Value-addedconversion
INPUTS
OUTPUTS
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Nature of Business Operations
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)
Types of Companies:
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Your Turn 1-1
What is the main purpose of a business?
The main purpose of a business is 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
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Ownership Structure of Businesses
Sole Proprietorship--a single owner business
Partnership--a multiple-owner business
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. businesses are sole proprietorships.
More than 2/3 of U. S. companies’ profits are earned by corporations.
Only 2.5% of U. S. businesses are partnerships, and they earn less than 10% of all U. S. firms’ profits.
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Characteristics of Different Forms of Business
Government regulation
Personal liability
Taxation
Transfer of ownership
Ability to raise capital
1Liability 2 Taxation3 Ownership4 Capital5 Regulation
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Sole Proprietorship
Personal responsibility and liability
Income reported on individual’s tax return
Owned by one individual
Difficult to acquire capital
Minimal government regulation
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Partnerships
Partners share personal responsibility and liability
Income IS reported on each partner’s individual tax return
Partners usually create an agreement that describes how much work each will do and how the profit and loss will be divided.
Difficult to acquire capital
Minimal government regulation
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Corporations
Provides stockholders with limited liability.
A corporation is a popular form of business because . . .
Individuals can purchase small amounts of stock.
Allows for easy transfer of ownership.
More than two-thirds of U.S. firm’sprofits are made by corporations.
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Corporations
A corporation is a separate legal entity that can . . .
Own assets
Incur liabilities
Sue and be sued
Enter into contracts
Once the state issues a charter, the stockholders elect a board of directors.
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New Hybrid Forms of Business
LLPLimited Liability
Partnership
LLCLimited Liability
Corporation
Have characteristics of both corporations and partnerships
Limited Liability of a corporation
Tax advantages of a partnership
Mostly used by law, medical, and accounting profession
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Your Turn 1-2
What are the three major forms of business ownership?
From the owners’ point of view, what are the advantages and disadvantages of each form of
ownership?
The three major forms of ownership are:(1) sole proprietorships (single owner)
(2) partnerships (multiple owners) (3) corporations (widespread ownership)
Advantages: Sole Proprietorship and Partnership:
Owner control, single taxationCorporation:
Limited Liability, Ease of raising capital
Disadvantages: Sole Proprietorship and Partnership:
Liability, Difficulty to raise capitalCorporation:
Conflict of interest between management and owners,
Double taxation
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Business Transactions
OperatingActivities
InvestingActivities
FinancingActivities
LearningObjective 2
Business transactions are economic exchanges classified as:
Transactions related to
the generaloperations of
the firm
Transactions related to
buying andselling items the
firm willuse for more than a year
Transactions that deal
with how abusinessgets it
funding
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How a Business Works
Sara contributes$5,000 of her own money to start her
business.
Team Shirtsborrows $500from Sara’s
sisterto help financethe business.
Team Shirtspurchases
100 T-shirts froma T-shirt maker.
Team Shirtsdecides to
advertise thenew business.
Team Shirts
sells 90 T-shirts.
Team Shirtsrepays
the loan plusinterest to
Sara’sSister.
Transactions for Team Shirts’ First Month of Business
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Information Needs of Decision Makers
• Revenue from sales• Expenses incurred• Net income• Inventory• Reliability of Vendors
LearningObjective 3
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Operating Cycle
Start with cash
Purchaseinventory
Collect cashfrom
customers
Make sales to customers
End with more cash
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Who Needs Accounting Information?
ManagementThose 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.
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Your Turn 1-4
What are revenues and expenses?
What are the four basic financial statements?
Revenues are the amounts a company earns from providing goods or services to its customers.Expenses are the costs to earn those revenues.
The four statements include the income statement, balance sheet, statement of changes in shareholders’ equity, and the statement of cash flows.
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Who Sets the Guidelines?
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.
Public Company Oversight Board (PCAOB)
Financial Accounting Standards Board (FASB)
Mandated by the Sarbanes-Oxley Act.
Created by the SEC in response to 2001- 2002 accounting scandals to oversee audits of public
companies.
The SEC delegates much of the Accounting standard-
setting responsibility to the FASB. SEC retains and sometimes exercises its rights to set standards.
Generally Accepted Accounting Principles Auditing Standards
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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.
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Statement of Changes in Owner’s Equity Beginning equity + Contributions +/- Net income/loss - Dividends = Ending equity
Four Basic Financial Statements
Balance Sheet Assets = Liabilities + Equity
Income Statement
Revenues - Expenses = Net income
Statement of Cash Flows
Cash inflow - Cash outflow = Net cash flow
Accountants communicate financial information in the form of four basic financial statements.
LearningObjective 4
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Financial Statements
Dates of Financial Statements are Important!
The Balance Sheet is prepared “AS OF…” or “AT” a particular date, a “snapshot” in
time.
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Financial Statements
1. The Income Statement 2. Statement of Changes in Owner’s Equity3. Statement of Cash Flows
cover a period of time:“FOR THE PERIOD ENDING”
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Balance Sheet
Assets = Claims
Assets = Liabilities + EquityThings of
valueSomething owed
(creditors’ share of the assets)
Net Assets
(owner’s share of the assets)Economic
resources owned
Obligations/debt
Contributed Capital
Retained Earnings
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Your Turn 1-5
What are the two parts of Shareholders’ Equity?The two parts of shareholders’ equity are contributed capital and retained earnings (earned capital).
What is a fiscal year?A fiscal year is a year in the life of a business for
financial reporting purposes. It may beginat any time and ends a year later.
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Accounting Equation
Contributed Capital Retained
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
Team Shirts
All Liabilities +Assets
Shareholders' Equty
--Income Statement, --Statement of Changes in Shareholders’ Equity, --Balance Sheet, --Statement
of Cash Flows
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Income Statement
The amount earned from
providing goods or services to customers
Costs incurred to generate revenue
Difference between
revenues and expenses
. . .describes the activity of
a company during a period
Also called: Statement of
earnings, statement of operations, profit and loss statement
Revenue – Expenses = Net Income
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Your Turn 1- 6
What is included on the income statement? What is included on the balance sheet?
Describe the difference in the time periods captured by the income statement and the balance sheet.
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.
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Statement of Changes in Owners’ Equity
Contributed Capital:
Contribution by investors to obtain ownership in a
corporation.
Ownership is divided into shares of stock.
Total of all net income earned by the business
MinusDividends Paid to owners (Distributions to
owners)
Beginning balance +/- changes in contributed capital+/- changes in retained earnings = Ending balance
Retained Earnings:
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Statement of Cash Flows
Cash from Operating Activities
Cash from Investing Activities
Cash from Financing Activities
From customers’ purchases,
interest or dividend income
Cash Inflow
From sale of property
and equipment
From issuinglong-term debtor issuing stock
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Statement of Cash Flows
Cash Outflow
Cash from Operating Activities
Cash from Investing Activities
Cash from Financing Activities
To suppliers for inventory,
For employees’ salaries
To purchase plant and
equipment,Investments in
other firms
To repay long-termdebt principal,
To pay dividends to owners
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Your Turn 1 - 7
How is the income statement related to the balance sheet? In other words, how does the amount of net income affect the balance sheet?
Why is it necessary to have both an income statement and a statement of cash flows?Look at the statements for Team Shirts and explain why they are different.
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. Also, any transactions with owners (contributions and dividends) are not included on the income statement.
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Revenues -Expenses Net income
LearningObjective 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
Multi-step: Calculates net
income in steps
Income Statements
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Shows a subtotal for various classes of assets and liabilities, including current and long-term assets and liabilities, and shareholders’ equity
Real Company’s Financial Statements
Assets:
Current Assets
Property, Plant, and Equipment
Other Assets
Shareholders’ Equity:
Contributed Capital,
Retained Earnings,
Other Comprehensive
Income
Liabilities:
Current Liabilities
Long-term Liabilities
Classified Balance Sheet
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Risk: Anything that exposes us to potential injury or loss.
Can turn into significant losses, scandals, or total company failure.
LearningObjective 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
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Control: An activity performed to minimize or eliminate risk. A firm must establish and maintain control over its operations, assets, and information systems.
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.
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