n Learning Objectives
After studying this chapter, you should be able to:
n Explain how accounting information assists in making decisions.
n Describe the components of the balance sheet.
n Analyze business transactions and relate them to changes in the balance sheet.
n Compare features of proprietorships, partnerships, and corporations.
n Introduction
n Accounting - a process of identifying, recording, summarizing, and reporting economic information to decision makers in the form of financial statements
n Financial accounting - focuses on the specific needs of decision makers external to the organization, such as stockholders, suppliers, banks, and government agencies
n The Nature of Accounting
n The accounting systemis a series of steps performed to analyze, record, quantify, accumulate, summarize, classify, report, and interpret economic events and their effects on an organization and to prepare the financial statements.
n The Nature of Accounting
n Accounting systems are designed to meet the needs of the decisions makers who use the financial information.
n Every business has some sort of accounting system.
n These accounting systems may be very complex or very simple, but the real value of any accounting system lies in the information that the system provides.
n Accounting as an Aid to
Decision Making
Decision Making
n Accounting information is useful to anyone who makes decisions that have economic results.
• Managers want to know if a new product will be profitable.
• Owners want to know which employees are productive.
• Investors want to know if a company is a good investment.
• Creditors want to know if they should extend credit, how much to extend, and for how long.
• Government regulators want to know if financial statements conform to requirements.
n Accounting as an Aid to
Decision Making
Decision Making
n Fundamental relationships in the decision-making process:
n Financial and Management Accounting
n The major distinction between financial and management accounting is the users of the information.
n Financial accounting serves external users.
n Management accounting serves internal users, such as top executives, management, and administrators within organizations.
n Financial and Management Accounting
The primary questions about an organization’s success that decision makers want to know are:
What is the financial picture of the organization on a given day?
How well did the organization do during a given period?
n Financial and Management Accounting
Accountants answer these primary questions with three major financial statements.
n Balance Sheet - financial picture on a given day
n Income Statement - performance over a given period
n Statement of Cash Flows - performance over a given period
n Financial and Management Accounting
n Annual report - a document prepared by management and distributed to current and potential investors to inform them about the company’s past performance and future prospects.
n The annual report is one of the most common sources of financial information used by investors and managers.
n Financial and Management Accounting
n The annual report usually includes:
n a letter from corporate management
n a discussion and analysis of recent economic events by management
n footnotes that explain many elements of the financial statements in more detail
n the report of the independent auditors
n a statement of management’s responsibility for preparation of the financial statements
n other corporate information
n The Balance Sheet
n What are the different sections of the Balance Sheet?
n The Balance Sheet
Sections of the balance sheet:
n Assets - resources of the firm that are expected to increase or cause future cash flows (everything the firm owns)
n Liabilities - obligations of the firm to outsiders or claims against its assets by outsiders (debts of the firm)
n Owners’ Equity - the residual interest in, or remaining claims against, the firm’s assets after deducting liabilities (rights of the owners)
n The Balance Sheet
The balance sheet equation:
Assets = Liabilities + Owners’ Equity
or
Owners’ Equity = Assets - Liabilities
n The Balance Sheet
HAMILTON COMPANY
Balance Sheet
December 31, 1997
Assets Liabilities
Current assets: Current liabilities:
Cash $ 4,525 Accounts payable $ 9,800
Accounts receivable 2,040 Wages payable 3,765
Total current assets $ 6,565 Total liabilities $13,565
Plant assets:
Land $ 9,755
Equipment 6,500 Owners’ Equity
Total plant assets 16,255 Hamilton, capital 9,255
Total liabilities and
Total assets $22,820 Owners’ equity $22,820
============= =============
n Balance Sheet Transactions
n The balance sheet is affected by every transaction that an entity encounters.
n Each transaction has counterbalancing entries that keep total assets equal to total liabilities and owners’ equity, i.e., the balance sheet equation must always be balanced.
n Balance Sheet Transactions
n Just as the balance sheet equation must always balance, the balance sheet must also always balance.
n A balance sheet could be prepared after every transaction, but this practice would be awkward and unnecessary.
n Therefore, balance sheets are usually prepared monthly or on some other periodic schedule.
n Transaction Analysis
n Transactions are recorded in accounts, which are summary records of the changes in particular assets, liabilities, or owners’ equity.
n The account balanceis the total of all entries to the account.
n Transaction Analysis
n For each transaction, the accountant must determine:
n which specific accounts are affected
n whether the account balances are increased or decreased
n the amount of the change in each account
n Types of Ownership
n Three basic forms of ownership:
n Sole proprietorships
n Partnerships
n Corporations
n Types of Ownership
Sole Proprietorship
n A separate organization with a single owner
n Tend to be small retail establishments and individual professional or service business - for example, a single dentist, attorney, or public accountant
n The sole proprietorship is an individual entity that is separate and distinct from the owner.
n Types of Ownership
Partnership
n An organization that joins two or more individuals who act as co-owners
n Dentists, doctors, attorneys, and accountants tend to conduct their activities as partnerships. Some can be large international firms.
n The partnership is an individual entity that is separate and distinct from each of the partners.
n Types of Ownership
Corporation
n An “artificial entity” created under state laws
n Corporations have limited liability - corporate creditors have claims against corporate assets only.
n Individual investors are at risk only up to the amount they have invested in the corporation. Creditors cannot hold investors liable for the corporation’s debts.
n Types of Ownership
Corporation
n Owners are called shareholdersor stockholders.
n Publicly owned vs. privately owned corporations
n Public - Shares in the ownership are sold to the public on a stock exchange; the corporation can have many thousands of shareholders.
n Private - Shares in the ownership are owned by families, small groups of shareholders, and shares are not sold to the public.
n Types of Ownership
Management by the owners:
n Sole proprietorship - The owner is an active manager in day-to-day operation of the business.
n Partnership - Partners are usually active managers in day-to-day operations of the business.
n Corporation - Shareholders usually do not participate in the day-to-day operations of the business.
n Advantages and Disadvantages of Forms of Ownership
Corporations
n Advantages
n limited liability
n easy transfer of ownership - shares of stock can be bought and sold easily (stock exchanges)
n ease of raising ownership capital - many potential stockholders
n continuity of existence - life of the corporation continues even if its ownership changes
n Advantages and Disadvantages of Forms of Ownership
Corporations
n Disadvantages
n possibility of double taxation - corporation pays tax at the entity level and its owners pay taxes on distributions of earnings to them
n Advantages and Disadvantages of Forms of Ownership
Proprietorships and Partnerships
n Advantages
n no taxation at the entity level - income of sole proprietorship and partnership is attributed to the owners as individual taxpayers
n Advantages and Disadvantages of Forms of Ownership
Proprietorships and Partnerships
n Disadvantages
n unlimited liability - creditors of the business can look to the owners’ personal assets for repayment
n not easy to transfer ownership
n not easy to raise ownership capital - few, if any individuals interested in a particular proprietorship or partnership
n no continuity of existence - changes in ownership terminate the proprietorship or partnership
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