Ch1 & 9 (Rev. 1 10)

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The Role of Accounting in Business

Chapter 1 and Chapter 9 (pp. 260-267 only)

A200 - Survey of AccountingUniversity of Tennessee

Spring 2010

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Objectives

Chapter 1:

1. Describe the types and forms of businesses, how businesses make money,and business stakeholders.

2. Describe the three business activities: financing, investing, and operating.

3. Define accounting and explain its role in business.

4. Describe and illustrate the basic financial statements and how theyinterrelate.

5. Describe eight basic accounting concepts underlying financialreporting.

Chapter 9:

1. Describe basic financial statement analytical procedures.

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Obj. 3: Define Accounting and its role in Business

Accounting is an information system, also called “The language ofbusiness”. Accounting provides data to stakeholders so they can evaluatethe health and future prospects of the business.

Financial Accounting provides information to external stakeholders. We will study financial accounting in Chapters 1-8.

Managerial Accounting provides information to internal stakeholders. We will study managerial accounting in Chapters 10-14.

Purposes of a Financial Accounting system: • To report changes in the business’ financial condition over a period

of time.• To report the business’ financial condition at a single point in time

(end of period).

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Obj. 1: Types of Business

Manufacturer: Buys basic inputs (Materials, Labor, and Overhead) from suppliers. Converts them intoa finished product (“goods”) for sale to merchandisers.

Merchandiser: Also called “middlemen”. Buys finished goods from manufacturers and sells them to customers.

Service: Does not sell goods. Provides services to customers (human knowledge, talent, or strength).

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Obj. 1: Forms of Businesses

Proprietorship: Owned by one individual; Not a separate legal entity from owner.

Advantages: Easy and inexpensive to organize.

Disadvantages: Financial resources are limited to what the owner has or can individually raise. Owner is 100% liable for all business debt.Business income is taxed 100% to the owner. Proprietorship terminates when owner dies.

Partnership: Owned by two or more individuals or other entities.

Advantages: Easy and can be inexpensive to organize. Generally, morefinancial resources are available to partnerships than to proprietorships.

Disadvantages: Each partner is legally liable for the actions of other partners.Partnership income is taxed to the partners. Partnership terminates whenpartner dies.

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Obj. 1: Forms of Businesses

Corporation: Legal entity separate from its owners (stockholders.)

Advantages: Can generate large amounts of capital through sale of stock(ownership shares). Stockholders are at risk for only the amount they invested(limited liability). Corporation continues even if stockholders die.

Disadvantages: Stockholders may not have the control they desire overthe affairs of the corporation.

Limited Liability Company (LLC): Legal entity separate from its owners(owners are called members.)

Advantages: Members are at risk for only the amount they invested (limitedliability.) LLCs can generally raise more financial resources than proprietorshipsand partnerships.

Disadvantages: Business income is taxed to members. LLC terminates whenmembers die.

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Obj. 1: How do businesses make money?

Business Strategy: How a business gains an advantage over competitors. How the business increases revenues

and/or lowers costs to maximize profit.

Generally, businesses choose one of the following overall strategies:

Low-cost emphasis: Design and produce products or services ofacceptable quality at a cost lower than its competitors.

Premium-price emphasis: Design and produce products or services that have perceived unique qualities for which a customer is willing to pay a premium price.

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Obj. 1: Business Stakeholders

External Stakeholders

Capital Market stakeholders: Provide financial resources to business. Lenders: Want the business to succeed so they can be paid back with interest.

Owners/Stockholders: Want the business to succeed so they can earn a return on their investment.

Product/Service Market stakeholders: Sell goods or services to the business(suppliers) or buy goods or services from the business (customers). Theywant the business to succeed to they can continue dealing with it.

Government stakeholders: Collect taxes from the business and regulate businessactivities. Want the business to succeed so government revenues increase.

Internal Stakeholders

Business managers and employees: Want the business to succeed so they willcontinue to have jobs.

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Obj. 2: Describe the three business activities

Financing: Acquiring cash or other assets to (1) start a business, (2) acquire more assets, and (3) operate the business.

Investing: After obtaining financing, the business uses the funds toacquire the resources it needs to start operating. The resources a business invests in are called Assets.

Operating: After acquiring resources (assets), the business can beginoperations (the day-to-day business activities that

generateRevenue and Expenses.)

The Business Cycle:

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Obj. 2: Financing Activities

Financing: Acquiring cash or other assets to (1) start a business, (2) acquire more assets, and (3) operate the business.

The basic Accounting equation is:

Assets = Liabilities + Equity

Resources owned Creditors’ claims Owners’ claimsby the business = on the assets of + on the assets of

the business the business

The accounting equation reflects the two kinds of financing: Debt Financing and Equity Financing

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Debt Financing: Acquiring cash or other assets by borrowing. (more on debt financing in Chapter 8)

Business increases cash or other assets and also increases liabilities, because the amount borrowed must be paid back. See slide #12 for common liabilities.

Transaction 1: Starter Corporation began business in January 2010 byIssuing (signing) a note payable for $20,000 to First National Bank. Howdoes Starter’s accounting equation appear after this transaction?


20,000 = 20,000 + 0

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Obj. 2: Debt Financing

Common Liabilities (more on liabilities in Chapter 8)

• Accounts Payable: – Recorded when business buys supplies/goods or uses services (such as

employees’ labor) without paying cash in the current period. – Often called “open” accounts payable – no formal contract, no interest.– Usually short-term (due in less than one year.)

• Notes Payable: – Recorded when business borrows money (as from a bank) or buys goods

without paying cash in the current period.– Formal written contract stipulating specific term and interest due.– Sometimes short-term, sometimes long-term.– Seller chooses whether a payable is an open account or a note.

• Bonds Payable:

– Recorded when business borrows money from investors (bondholders).– Issuing bonds payable typically raises much more cash than issuing a note payable.– Formal written contract stipulating specific term and interest due.– Always long-term (due in more than one year.)

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Equity Financing: Acquiring cash or other assets by either selling ownershipshares (capital stock) in the business, or by operating the business, earningand then retaining its earnings (retained earnings). Equity financing increases equityand also increases cash or other assets.

Transaction 2: Starter Corporation raises another $200,000 in January by issuing (selling) capital stock to new owners in exchange for cash.

Assets = Liabilities + Equity 200,000 = 0 + 200,000

Transaction 3: Starter Corporation earns $8,000 in January by operating the business (selling goods or services.)


8,000 = 0 + 8,000

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Equity Financing: Dividends

When a business finances asset purchases with capital stock equity, theowners (stockholders) want a return on their investments. One way thebusiness gives stockholders a return is by distributing part of its earnings. This distribution is called a Dividend. Dividends can be distributed in cashor other property, or in new shares of stock (more on dividends in Chapter 8.)

Transaction 4: Starter Corporation distributes $200 of its January earnings to the stockholders in cash.


(200) = 0 + (200)

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Obj. 2: Investing Activities

After obtaining financing, the business uses the funds to acquire theresources it needs to start operating the business. The resources abusiness invests in are called Assets.

Common Assets (more on Assets in Chapters 5-7)

Tangible Intangible(physical substance) (no physical substance)

Cash PatentsAccounts receivable Trade namesPrepaid expenses Copyrights Supplies TrademarksLand Intellectual propertyEquipment GoodwillBuildingAutomobiles

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Obj. 2: Investing Activities

Businesses acquire Assets in one of four ways:

1. Trade another asset for the new asset. Transaction 5: Starter Corporationpurchases equipment in January for $125,000 cash.


125,000 (125,000) = 0 + 0

2. Borrow. Transaction 6: Starter purchases a building in January for $100,000, giving a note payable.

Assets = Liabilities + Equity 100,000 = 100,000 + 0

3. Issue stock to new owners (stockholders). See Transaction 2 on slide #13.4. Earn (sell goods or services). See Transaction 3 on slide #13.

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Obj. 2: Operating Activities

After acquiring resources (assets), the business can begin operations (the day-to-day business activities that generate Revenue and Expenses.)

Revenue: Amounts earned during the period from either selling products

or providing services. A transaction that increases Revenue increasesequity (via net income) and either increases assets or decreases liabilities.

See Transaction 3 on slide #13

Expenses: Amounts used during the period to help generate revenue. A transaction that increases Expense decreases equity (via net income)and either decreases assets or increases liabilities.

See Transaction 7 on the following slide

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Obj. 2: Operating Activities

Expenses: Costs incurred during the period to help earn Revenue. Cash may be paid in the same transaction, but often is not.

Transaction 7: Starter Corporation incurs the following expenses inJanuary:

Wages expense $3,000Rent expense 2,600Miscellaneous expense 750

Starter did not pay cash for any of these (it will in the future).


0 = 6,350 + (6,350)

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Obj. 3: Define Accounting and its role in Business

Accounting is an information system, also called “The language ofbusiness”. Accounting provides data to stakeholders so they can evaluatethe health and future prospects of the business.

Financial Accounting provides information to external stakeholders. We will study financial accounting in Chapters 1-8.

Managerial Accounting provides information to internal stakeholders. We will study managerial accounting in Chapters 10-14.

Purposes of a Financial Accounting system: • To report changes in the business’ financial condition over a period

of time.• To report the business’ financial condition at a single point in time

(end of period).

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Obj. 4: Describe and illustrate the Basic Financial Statements.

Reporting changes in financial condition over a period of time:

Income Statement: [ Revenues – Expenses = Net Income ]

Statement of Retained Earnings: [ Beginning RE + Net Income - Dividends = Ending RE ]

Statement of Cash Flows: [ Beginning Cash +/- Net Cash Flows from Operating, Investing, and Financing = Ending Cash ]

Reporting financial condition at a single point in time (end of the period):

Balance Sheet: [ Assets = Liabilities + Equity ]

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Obj. 4: Income Statement

Starter Corporation Income Statement

For the month ended January 31, 2010

Revenues: Fees Earned $8,000 (slide 11)

Expenses: Wages expense $ 3,000

Rent expense 2,600 (slide 16) Miscellaneous expense 750 (6,350)

Net Income: $1,650

Net Income (Revenue-Expenses) increases Equity (Retained Earnings)

Revenue increases Equity (RE) and Expenses decrease Equity (RE).

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Obj. 4: Retained Earnings Statement

Starter CorporationStatement of Retained Earnings

For the month ended January 31, 2010

Retained Earnings, January 1, 2010: $ 0 + Net Income 1,650

- Dividends (200) (slide 12)

Retained Earnings, January 31, 2010: $1,450

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Obj. 4: Balance Sheet

Starter CorporationBalance Sheet

as of January 31, 2010

Assets Liabilities

Cash $102,800 Accounts Payable $ 6,350Building 100,000 Notes Payable 120,000

Equipment 125,000

Stockholders’ Equity

Capital Stock 200,000 Retained Earnings 1,450

Total Liabilities &

Total Assets: $ 327,800 = Stockholders Equity: $327,800

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Obj. 4: Statement of Cash Flows

Reports cash inflows (increases) and cash outflows (decreases) in three categories:

Operating Activities: Cash received from customers (inflow)Cash paid for expenses (outflow)

Investing Activities: Cash received from sales of long-term assets (inflow) Cash paid for purchases of long-term assets (outflow)

Financing Activities: Cash received from the sale of capital stock or bonds (inflow)Cash paid for dividends, bond redemptions, and treasury stock (outflow)

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Obj. 4: Statement of Cash FlowsStarter Corporation

Statement of Cash FlowsFor the month ended January 31, 2010

Cash flows from Operating Activities:Cash inflow from customers $ 8,000Cash outflow for expenses ( 0)

Net Cash Flows from Operating Activities: $ 8,000

Cash flows from Investing Activities:Cash inflow from sale of Property, Plant & Equipment 0Cash outflow for Property, Plant & Equipment (125,000)

Net Cash Flows from Investing Activities: (125,000)

Cash flows from Financing Activities:Cash inflow from issuing stock 200,000Cash inflow from issuing notes payable 20,000Cash outflow for dividends to stockholders (200)

Net Cash Flows from Financing Activities: 219,800

Net Increase (Decrease) in Cash: 102,800+ Cash at January 1, 2010 (beginning balance) 0= Cash at January 31, 2010 (ending balance) $102,800

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Obj. 5: Describe eight basic accounting concepts underlying financial reporting

Generally Accepted Accounting Principles (GAAP) rule the preparation of financial statements

GAAP are written by the Financial Accounting Standards Board (FASB).GAAP are based on eight accounting concepts.

1. Business Entity Concept: We record transactions of different entitiesseparately. Owners are separate from their businesses, and each business is separate from all other businesses.

Real-life Fraud Transaction: Adelphia Communications (6th largest cableprovider in the U.S.) was owned by the Rigas family. In 2002, severalmembers of the family were convicted of fraud for treating company assets as their own, to the tune of about $2.3 billion. The business concealed theRigases’ use of company funds for stock purchases, real estate procurement,and other deals. Adelphia went bankrupt and the convicted family membersface up to 30 years in prison.

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Obj. 5: Basic Accounting Concepts

1. Business Entity Concept: We account for the activities of each entityseparate from all other entities.

Mark Stone owns and operates Stone Landscaping as a sole proprietorship. Mark’swife, Lisa, owns and operates Custom Food, a catering business, as a soleproprietorship. Mark and Lisa have one child, Joe, age 12. The Stones haveestablished a trust fund to finance Joe’s college education. The trust fund ismaintained by First Tennessee Bank, Inc. in Joe’s name.

How many different entities exist for Accounting purposes?

Answer: Six.

Mark and Lisa (married individuals are a single individual entity)Joe (individual entity)Stone Landscaping (business entity – sole proprietorship)Custom Foods (business entity – sole proprietorship)First Tennessee Bank, Inc. (business entity - corporation)Joe Stone Trust Fund (fiduciary entity)

In A200, we will account for business entities only.

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2. Cost Concept: We record assets at their historical cost (theamount actually incurred when the asset was acquired). Market value, asking price, replacement cost are irrelevant and are not recorded.

3. Going Concern Concept: We assume that a business is going to continue indefinitely unless otherwise indicated.

4. Matching Concept: We record a period’s Revenues on theperiodic Income Statement with the Expenses (costs) that helped to generate those revenues.

Real-life Fraud Transaction: World Com (2nd largest long-distancetelecom operator in U.S.) inflated net income by recording $3.8billion of expenses as assets. Result: bankruptcy and criminalconviction of CEO and CFO. Over $100 billion in stock marketlosses. Board of Directors fined $18 million.

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5. Objectivity Concept: We base entries in the accounting records and data reported on the financial statements on objective evidence.(Transaction: purchase invoice or receipt is objective evidence of anasset purchase.)

6. Unit of Measure Concept: We report all financial statement numbersin dollars (in the U.S.)

7. Accounting Period Concept: We report data on financialstatements in separate time compartments. (Transaction: April is not the same month as May, and 2009 is not the same year as 2010.)

Real-life Fraud Transaction: Fannie Mae (the Federal NationalMortgage Association), illegally shifted expenses between periods,pushing $107 million of earnings into future years. Result: CEO and CFO fired, and the company was forced to restate earnings.

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8. Adequate Disclosure Concept: We report in the financial statements and related footnotes all relevant data that readers need to understand thefinancial condition and performance (results of operations) of a business. We leave out irrelevant data.

Transaction: Reporting the total cash balance at the end of the year is adequate disclosure. The financial statements do not need to include thedetails of a $5.00 purchase of paper clips. Recall, though, that theObjectivity Concept requires that we be able to prove that $5.00 expenditure upon audit.

Real-life Fraud Transaction: Tyco International, one of the world’s largest electronics companies, failed to disclose secret loans to executives that were subsequently forgiven by the company (never paid back by the execs.) Result: CEO and others were forced to resign and were convicted in criminalproceedings; currently serving 8-25 year sentences.

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Accounting practice is overseen by the:

• SEC (Securities and Exchange Commission) – Has authority to set accounting principles for publicly-held

corporations– Delegates this function to the Financial Accounting Standards

Board (FASB).- Currently working to align U.S. generally accepted accounting principles

(GAAP) with international financial reporting standards (IFRS)

• Financial Accounting Standards Board (FASB) – Writes GAAP: the rules that determine the proper content and form

of financial statements.

• Public Company Accounting Oversight Board (PCAOB) – Helps regulate publicly-held companies as well as the

accounting industry – Created by Congress in the wake of fraud scandals of the 1990s.

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Ch. 9: Financial Statement Analysis

Comparative analysis of financial statement data:

• Vertical analysis of the Balance Sheet: • Each asset item expressed as a % of total assets• Each liability and equity item expressed as a % of total liabilities

and equities

• Vertical analysis of the Income Statement:• Each item of revenue and expense expressed as a % of net

sales revenue

• Horizontal analysis: • Compare two statements (two balance sheets, two income

statements, two statements of retained earnings, two cash flow statements). Find the dollar and % change of each item in the two statements.

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Vertical Analysis Ratios for Chapter 1

COGS % = Cost of Sales ÷ Net Sales Revenue

Measures how much of each dollar of revenue earned was usedto buy the goods the company sold.

Net Income % = Net Income ÷ Net Sales Revenue

Measures how much of each dollar of revenue is available to thecompany after all expenses for expansion (retained earnings) or fordistribution to owners (dividends).

Ch1 & 9 (Rev. 1 10)

Economy & Finance

Transcript of Ch1 & 9 (Rev. 1 10)