LO1 Categorise business types and organisational forms.
LO2 Describe accounting and its role in business decisions.
LO3 Identify users of financial information.
LO4 Describe the fundamental accounting equation and elements of financial.
LO5 Explain the structure of basic financial statements.
LO6 Understand the importance of ethical decisions in financial reporting and business
1. Business Types and Organisational Forms
Business Types
Service Companies – do not make or sell goods; instead, they provide a service to customers or clients. eg. Hilton Hotels, provides lodging services; Virgin Airline, provides air transportation services.
Manufacturers – make products from raw inputs. eg. Lenovo uses electronic components to build computers.
Merchandisers – sell the goods that manufacturers produced.
Wholesalers – sell exclusively to other businesses
Retailers – sell to customers
Organisational Forms
Sole Proprietorship is owned by one individual who often manages the business as well. Sole proprietorship is relatively inexpensive to form. They are not legally separate from their owners, all of their profits (or losses) become part of the proprietor’s taxable income. The proprietor is also personally liable for all of the business’s debts.
A partnership is similar to a proprietorship, but it has two or more owners rather than one. A partnership agreement outlines how to profits (or losses) are to be shared and how to ownership of the business can change (for example, by adding a new partner, buying out an existing partner, or dissolving the partnership). As sole proprietors attempt to expand their businesses, they often add partners to obtain the resources the business needs to grow.
A corporation is a separate legal entity. Corporations are taxed separately from their owner, and their owners cannot be held liable for more than their investments in the corporation – a major advantage to an investor. A corporation’s ownership is divided into shares of stock. When a relatively small number of individuals own the stock, the corporation is a privately held company.
Public companies sell stock on the stock market to reach many more individuals.
In addition to the limited liability advantage, another major advantage of a corporation is that at any time, stockholders can sell all or part of their shares to someone else. These advantages make it easier for a corporation to raise large amounts of money to finance its growth.
A corporation’s major disadvantage is the higher cost of its creation, primarily due to higher legal fee.
2. Accounting and Business Decisions
Accounting Defined
Accounting is an information system designed by an organisation to capture (analyse, record, and summarise) the activities affecting its financial condition and performance and them communicate the results to decision makers, both inside and outside the organisation.
When business owners, manager, investors, and creditors talk about business operations, they use accounting as their language, so accounting is often referred to as the language of business.
Accounting Professionals
Every organisation needs accountants to help its owner(s) understand the financial effects of business decisions and to assist in communicating financial information for making decisions.
Accountants who are employed by a single business or nonprofit organisation work in private accounting.
Accountants who charge a fee for their services to businesses and nonprofit organisations work in pubic accounting.
Certified Public Accountant (CPA) is who has passed a rigorous exam and been in practice in public accounting.
Users of Financial Information
Managerial Accounting Reports include detailed financial plans and continually updated reports about the financial performance of the business.
The reports are made available only to the company’s managers (internal users of the information) so that they can make business decisions such as whether to build, buy, or rent a building; whether to continue borrow from creditors.
Sole proprietors and partners who manage their own businesses and other managers who are hired by owners clearly have an interest in receiving th best, most up-to-date information for use in make these decisions.
Financial Accounting Reports called financial statements that a business prepares periodically to provide information to people it does not employ. These external financial statement users are not given access to the company’s detailed internal records, so they rely extensively on the financial statements. Creditors and investors are the two primary external user groups, but toher external users also find the information helpful.
Creditors (anyone to whom many is owed)
- Banks evaluate the risk of lending money to a business based on a review of its past performance and future prospects. Because banks take a risk when they lend money, they want to receive ongoing financial report from the business so they can monitor its progress and anticipate problems.
- Suppliers want to be sure that a business can pay them for the goods or services they deliver. They usually check the business’s credit standing and may ask for financial reports before entering into significant business relationships.
Investors
- External investors, unlike internal managers, do not have access to detailed internal records, but they are very interested in knowing how well the company is doing.
- Current and potential stockholders of corporations are a major group of external users. They need information that will help them to predict what their shares will be worth in the future and whether to buy, sell, or hold the stock.
Other external users
- Certain customers are concerned with the company’s ability to provide service on its products and honour its warranties.
- Various local, state, and federal governments collect taxes and monitor businesses based on the financial statements.
3. Business Financial Reports
The Accounting Equation
One of the keys to understanding financial reports is the concept that what a business owns must equal what a business owes to its creditors and owners.
The business owns the resources it uses to generate profits, pay its creditors, and provide a return to the owners. It owes money to its creditors and owners who have claims to the resources. Accountants use special name for these: Resources a business owns ae called assets. The claims it owes are called liabilities when they are held by creditors and owners’ equity when they are held by investors. The result is the fundamental accounting equation that provides the structure for accounting and financial reporting.
Assets
An asset is any resource controlled by the business that has measurable value and it expected to provide future benefits.
Initially, these assets would be reported in the business’s financial statements at their purchase price, also called their historical cost.
Liabilities
A liability is a measurable amount that a business owes to a creditor.
If it borrows from a bank, it would owe a liability called Notes Payable. This particular name is used because banks require borrowers to sign a legal documents called a not that describes details about the business’s promise to repay the bank.
The business would also owe payments to the suppliers who deliver ingredients and other supplies to the restaurant. When a company buys goods from suppliers, it usually does so on credit by promising to pay for them at a late date. the amount that is owed, as indicated on the supplier’s bill or invoice, is called Accounts Payable because purchase made using credit are said to be “on account.”
Wages Payable – A business could also owe wages to its employees
Taxes Payable – sales taxes to the government
Owner’s Equity
Owner’s equity represents the owner’s claim to the business.
The claim arises for two reasons:
- First, the owner has a claim on amounts he or she invested in the business by making direct contributions to the company.
- Second, the owner has a claim on the amounts the company has earned through profitable business operations.
The goal of most business owners is to generate profits because this increases owners’ equity and allows owners to receive more money back from the business than they put in (a return on their investment).
Profits are generated when the total amount earned from selling goods and services is more than all of the costs incurred to generate those sales.
The difference between total revenues and expenses is sometimes loosely called profit or earnings, but the preferred term in accounting is net income.
Revenues are sales of goods or services to customers.
If a business sells goods or services to customers “on account,” then, instead of receiving cash on delivery, the company receives a different asset form the customer: a promise to pay, called Accounts Receivable.
Expenses are all costs of doing business that are necessary to earn revenues.
Expenses, such as supplies, insurance, and rent, are paid for before they are used to generate revenues. Other expenses, such as utilities and employees’ wages, are paid for after they are used or owed to suppliers. Accountants says that expenses are incurred to generate revenues. This means that the activities giving rise to a cost (e.g., running an ad, using electricity) have occurred.
Separate entity assumption – Activities of the business are reported separately from personal activities of its owners.
Financial Statement
Income Statement
The income Statement (also called the statement of income or statement of operations) reports a business’s financial performance over a specific period.
Although the term profit is used widely for this measure of performance, accountants prefer to use the technical term net income or nt earning. A company measures its success by selling goods and/or providing services for more than the costs to generate those revenues. Each revenue and expense account is an accumulation of activities over a period of time.
In accounting, we assume we can report financial information in the standard monetary denomination of the country in which the business operates, such as reporting in dollars in the United States or euros in Germany. This is called the monetary unit assumption.
Statement of Owner’s Equity
A sole proprietorship will report a statement of owner’s equity.
Corporations prepare a more comprehensive statement of stockholders’ equity in a similar fashion.
The statement starts with the owner’s equity balance at the beginning of the period.
A net loss is which expenses exceed revenues would be subtracted.
Finally, any withdrawals made by the owner for the period would be subtracted to determine the owner’s equity balance at the end of the period.
Balance Sheet
The balance sheet is also known as the statement of financial position. The balance sheet’s purpose is to report the amount of a business’s assets, liabilities, and owner’s equity at the specific point in time.
Notice again that the heading specifically identifies the name of the entity and title of the statement. Unlike the other financial reports, the balance sheet is presented for a specific point in time. The assets are listed in order of how soon they are to be used or turned into cash. Likewise, liabilities are listed in order of how soon each is to be paid or settled.
Statement of Cash Flows
Net income does not necessarily equal cash because revenues are reported when earned and expenses are reported when incurred regardless of when cash is received or paid.
Statement of cash flows include only those activities in the Cash column, reflecting changes much like a video camera with a telephoto lens focused on activities affecting only cash.
The statement of cash flows is divided into three types of business activities:
- Operation activities. These activities are directly related to running the business to earn profit.
- Investing activities. These activities involve buying and selling productive resources with long lives, such as buildings, land, equipment, and tools, as well as investing funds in other businesses and lending to others.
- Financing activities. Any borrowing from banks, repaying bank loans, receiving investments from owners, or distributing business profits to owners are considered financing activities.
Notes to the financial Statements
The four basic financial statements are incomplete without notes that help those who study the statements to understand how the amounts were measured and what other information may affect their decisions.
