Introduction To Financial Statements

CHAPTER 1

Introduction to

Financial Statements

Chapter Outline

Study Objective 1 - Describe the Primary Forms of Business Organization

A business may be organized as a sole proprietorship, partnership, or corporation.

* Sole proprietorship - a business owned by one person

 Advantages

* simple to establish

* owner controlled

* tax advantages

 Disadvantages

* proprietor personally liable for all business debts

* financing may be difficult

* transfer of ownership may be difficult

* Partnership - a business owned by two or more people

 Advantages

* simple to establish

* shared control

* broader skills and resources

* tax advantages

 Disadvantages

* partners personally liable for all business debts

* transfer of ownership may be difficult

* Corporation - a separate legal entity owned by stockholders

 Advantages

* easier to transfer ownership

* easier to raise capital

* lower legal liability - no personal liability for stockholders

 Disadvantages

* unfavorable tax treatment

Study Objective 2 - Identify the Users and Uses of Accounting

The purpose of financial information is to provide inputs for decision making.

Accounting is the information system that identifies, records, and communicates the economic events of an organization to interested users.

The users of financial information fall into two groups--internal users and external users.

* Internal users - users within the organization.

* Internal users and questions they may ask:

Marketing What price will maximize the company's net income?

Human Resources Can we afford to give employees pay raises this year?

Finance Is cash sufficient to pay dividends to stockholders?

Management Which product line is most profitable? What should be eliminated?

* External users - users who are outside the organization.

* External users and questions they may ask:

Investors (current and potential) Is the company earning satisfactory income? How does the company compare in size and profitability with competitors?

Creditors (suppliers and bankers) Will the company be able to pay its debts as they come due?

IRS, SEC, FTC, labor unions, customers Is the company complying with rules and regulations? Is the company properly paying its taxes?

Ethics in financial reporting

* In 2002, Congress passed the Sarbanes-Oxley Act (SOX) to try to reduce unethical corporate behavior and decrease the likelihood of future corporate scandals.

* Effective financial reporting depends on sound ethical behavior.

* Steps for solving ethical dilemmas:

1. Recognize an ethical situation and the ethical issues involved.

2. Identify and analyze the principal elements in the situation.

3. Identify the alternatives, and weigh the impact of each alternative on various stakeholders.

Study Objective 3 - Explain the Three Principal Types of Business Activity

All businesses are involved in three types of activity. The accounting information system keeps track of the results of each of these activities.

* Financing activities - Cash is often obtained from outside sources to start or expand a business. The two primary sources are:

 Borrowing from creditors which creates a liability

* bank loan (note payable)

* debt securities (bonds payable)

* goods on credit from suppliers (accounts payable)

 Issuing ownership interests in the corporation to investors (selling stock to shareholders)

 In addition, financing activities include using cash to pay dividends to stockholders.

* Investing activities - Cash raised through financing activities is used for investing in resources (assets) needed to operate the business (i.e. land, buildings, delivery trucks, equipment, computers, furniture, etc.).

* Operating activities - Once a business has the assets it needs to get started, it begins its operations (the reason it is in business). Operating activities involve revenue and expenses.

 Revenue is generated from sales or services - related assets include accounts receivable, inventory, supplies, prepaid insurance

 Expenses are incurred in earning revenue - related liabilities include accounts payable, wages payable, interest payable, sales taxes payable, income taxes payable

Study Objective 4 - Describe