Understanding Financial Statements A Basic Overview

Introduction to Accounting and A Conceptual Overview

The Business Environment All countries have three basic forms of business organization:
Sole Proprietorships Partnerships (general and limited) Limited liability companies

The Business Environment

Sole Proprietorship -- A business form for which there is one owner. This single owner has unlimited liability for all debts of the firm.
Oldest form of business organization. Business income is accounted for on the owners personal income tax form.

Summary for Sole Proprietorship

Advantages Simplicity Low setup cost Quick setup Single tax filing on individual form Disadvantages Unlimited liability Hard to raise additional capital Transfer of ownership difficulties

The Business Environment

Partnership -- A business form in which two or more individuals act as owners.
Business income is accounted for on each partners personal income tax form.

Types of Partnerships
General Partnership -All partners have unlimited liability and are liable for all obligations of the partnership. Maximum Number of Partners can be 20 (India)

Limited Partnership

-- Limited partners have liability limited to their capital contribution (investors only). In some countries like USA, at least one general partner is required and all general partners have unlimited liability. In some other countries, like India, all partners can have limited liabilities.

Summary for Partnership

Advantages Disadvantages Can be simple Unlimited liability for the general partner Low setup cost, higher than sole proprietorship Difficult to raise additional capital, but Relatively quick setup easier than sole Limited liability for limited proprietorship partners Transfer of ownership difficulties

The Business Environment

Corporation -- A business form legally separate from its owners.
An artificial entity that can own assets and incur liabilities. Business income is accounted for on the income tax form of the corporation.

Summary for Corporation

Advantages Disadvantages Limited liability Double taxation Easy transfer of ownership More difficult to Unlimited life establish Easier to raise large More expensive to set quantities of capital up and maintain

Accounting as an Information System

Todays accountant focuses on the ultimate needs of decision makers who use accounting information, whether those decision makers are inside or outside the business.

Accounting as an Information System

Accounting is not an end in itself, but is an information system that measures, processes, and communicates financial information about an identifiable economic entity.

Accounting as an Information System

Accounting is a link between business activities and decision makers.
Accounting measures business activities by recording data about them for future use.
The data are stored until needed and then processed to become useful information.

Accounting as an Information System

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B U S IN E S S A C T IV IT IE S

D E C IS IO N MAKERS

D a ta

In fo rm a tio n

A C C O U N T IN G MEASUREMENT A c c o m p lis h e d b y re c o rd in g o f d a ta P R O C E S S IN G A c c o m p lis h e d b y s to ra g e a n d p re p a ra tio n o f d a ta C o m m u n ic a tio n A c c o m p lis h e d b y re p o rtin g

The Users of Accounting Information

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D E C IS IO N M A K E R S

M ANAGEM ENT F in a n c e O p e ra tio n s a n d P ro d u c tio n M a rk e tin g H u m a n R e s o u rc e s In fo rm a tio n S y s te m s A c c o u n tin g

T H O S E W IT H D IR E C T F IN A N C IA L IN T E R E S T In v e s to rs C re d ito rs

T H O S E W IT H IN D IR E C T F IN A N C IA L IN T E R E S T T a x A u th o ritie s R e g u la to rs L a b o r U n io n s C u s to m e rs E c o n o m ic P la n n e rs

Questions Asked by Internal Users

Is cash sufficient to pay bills? What is the cost of manufacturing each unit of product? Can we afford to give employee pay raises this year? What product line is most profitable?

Questions Asked by External Users

Is the company earning satisfactory income? How does the company compare in size and profitability with competitors? Will the company be able to pay its debts when they become due?

Business Goals, Activities, and Performance Measures

A business is an economic unit that aims to sell goods and services to customers at prices that will provide an adequate return to its owners. Businesses, though different, have similar goals and engage in similar activities.

Business Goals and Activities

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B U S IN E S S G O A L S

B U S IN E S S A C T IV IT IE S

P R O F IT A B IL IT Y

F IN A N C IN G

O P E R A T IN G

L IQ U ID IT Y

IN V E S T IN G

3 Types of Business Activity

Financing Investing Operating

Financing Activities
It
Takes

MONEY
to Make

MONEY!

Two Ways of Outside Financing of a Corporation

Borrowing money (Outside liabilities) Issuing shares of stock in exchange for cash (Equity)

Basic Terms
Assets - resources owned by a business Liabilities - debts and obligations of the business - represents claims of creditors on the assets of the business Common stock - stock representing the primary ownership interest in a corporation

Investing Activities
Obtaining the Resources or Assets needed to operate the business Examples of assets...
Cash Accounts Receivable Inventory Buildings, Equipment, Furniture

Investing Activities - Examples

Purchase or sale of computers, delivery trucks, furniture, buildings Purchase or sale of investments

What Are Revenues?

Revenues are the assets that result from sale of a product or service.

Examples of Revenues
Taxi Company - sells services
Theatre - sells services & products Retail Store - sells products

What Are Expenses?

Expenses are the costs of assets consumed or services used to generate revenues. Examples...
Cost of sales Store operating expenses General and administrative expenses Interest expense

Examples of Expenses
Taxi Company - fuel, maintenance, insurance Theatre - salaries, supplies, film rental, concessions to resale Retail Store - utilities, taxes, rent, supplies, salaries

Net Income
Net Income is the excess of revenues over expenses.
Revenue Expenses Net income Rs 10,000 3,000 Rs 7,000

Summary of Business Activities

Goals and Strategies

Long Term Land, Buildings, and Equipment Contractual Rights Stocks and Bonds

Investing

Short Term Cash Accounts Receivable Inventories Stocks and Bonds Purchasing Production Marketing Administration Operating

Short Term Banks Suppliers Financing Employees Governments

Long Term Long-Term Creditors Owners

Elements of an

Financial Statements
Income Statement Statement of Retained Earnings Balance Sheet Statement of Cash Flows

Management Discussion and Analysis Notes to Financial Statements Auditor's Report

Management Discussion and Analysis

Covers three aspects of a company:
liquidity - ability to pay near-term obligations capital resources - ability to fund operations and expansions results of operations

Notes to Financial Statements

Provide additional information not included in body of statements Does not have to be numeric Examples:
Description of accounting policies or explanation of uncertainties and contingencies Statistics and voluminous details

Auditor's Report
Auditor, a professional accountant who conducts an independent examination of the financial accounting data presented by a company. Auditor gives an unqualified opinion if the financial statements present the financial position, results of operations, and cash flows in accordance with GAAP.

Relation between Business Activities and Balance Sheet and Income Statement
Goals and Strategies Noncurrent Land, Buildings, and Equipment Patents Investments in Securities Current Cash Accounts Receivable Inventories Marketable Securities Current Notes Payable Accounts Financing Payable Salaries Payable Income Taxes Noncurrent Bonds Payable Common Stock Retained Earnings

Investing

Payable Assets
(Balance Sheet) Sales Revenue Cost of Goods Sold Selling Expense Administrative Expenses Interest Expense Income Tax Expense Operating Liabilities and Shareholders Equity (Balance Sheet)

Net Income (Income Statement)