Chapter 1- The Purpose and Use of Financial Statements .docx

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Management and Organizational Studies
Management and Organizational Studies 1023A/B
Maria Ferraro

Accounting Matters!!  Accounting is the information system that identifies and records the economic events of an organization, and then communicates them to a wide variety of users. Users and Uses of Accounting  There are two types of users: Internal users and external users.  Internal users of accounting information plan, organize, and run companies. o Include finance directors, marketing managers, human resource personnel, production supervisors, and company officers. o Accounting provides internal reports: Finance (whether there is enough money), marketing (what prices to charge), human resources (how many employees can we hire) and production (most profitable product line).  External users: There are several different types of external users in accounting. o Investors (make decisions to buy, sell, or hold ownership interest), creditors (suppliers and bankers need to evaluate risks of granting or loaning money). These are the two main types of external users of accounting information! o Labor unions (Can the company afford the pay rise we are demanding?), customers (will the company stay in business long enough to service the products I buy from it?). o Taxing authorities (does the company respect tax laws), regulatory agencies (is the company operating within prescribed rules) and economic planners (analyze and forecast economic activity).  Ethical behavior: in order for financial information to have value to its users, whether internal or external, individuals with high standards of ethical behavior must prepare it. o Consider the organization’s interests when making decisions. o Accountants have extensive rules of conduct to guide their behavior with each other and the public. o Many companies now have codes of conduct outlining their commitment to ethical behavior in external and internal relationships. Forms of Business Organization  There are three forms of business organizations: o Proprietorship- a business owned by one person.  Usually operated by the owner.  Simple to set up and gives you control over the business.  Usually a small amount of capital is needed to start the business.  The owner receives profits, suffers losses and is 100% liable.  Small service businesses such as hair salons, plumbers and mechanics are examples. Also farms and small retail stores. o Partnership- a business owned by more than one person.  Usually formed because one person does not have enough economic resources to initiate or expand the business, or because partners bring unique skills or resources to the partnership.  Each partner generally has unlimited liability for all debts of the partnership, even if one of the other partners created the debts.  Any one of the partners can be forced to give up his or her personal assets to repay the debts.  Typically used to organize retail and service businesses, including the professional practices of lawyers, doctors and accountants. o Corporation- a business organized as a separate legal entity owned by shareholders.  As an investor in a corporation you receive shares to indicate your ownership claim.  Successful organizations often have thousands of shareholders, and their shares are often traded on organized stock exchanges.  Corporate shareholders have limited liability equal to the amount invested  Corporations pay income taxes as separate legal entities on any corporate profits.  Revenue received by corporations is much greater than other business organizations.  Extremely large corporations are publicly traded, that is their shares are listed in the Canadian Stock Exchange.  Public corporations commonly distribute their financial statements to shareholders, creditors, other interested parties, and the general public upon request. (Loblaw’s, Shoppers)  Private corporations do not issue publicly traded shares. (Sobeys, McCain foods)  These companies almost never distribute their financial statements publicly. Business Activities  All businesses are involved in three types of activity: financing, investing and operating. Financing Activities  The two primary ways of raising outside funds for corporations are (1) borrowing money and (2) issuing (selling) shares in exchange for stock.  Corporations can borrow money in a variety of ways such as taking out loans from a bank or borrowing money from other lenders.  Amounts owed to creditors-in the form of debt and other obligations-are called liabilities.  Specific names are given to different types of liabilities: o Bank indebtedness results when corporations have taken funds from an operating line of credit with its bank. o It may have a short-term note payable to a bank for the money borrowed to purchase items needed. o It may also have long-term debt, which can include note payable, mortgages payable, lease obligations, and other types of debt securities borrowed for longer periods of time. o A corporation may also obtain financing by selling shares of ownership, or share capital, to investors. o Common shares are the term used to describe the amount paid by investors for shares of ownership in a company.  One class or type of share capital that a company can issue.  Can also use cash for financing activities such as repaying debt.  If you loan money to a company, you are one of its creditors. o In loaning money you specify a repayment schedule (paid by a certain time). Usually you add interest to the amount owing or amount overdue. o As a creditor, you have the legal right to be paid by the specified time period. In the event of nonpayment, you may force the company to sell its property to pay the debts. o The law requires that creditor claims be paid before shareholder claims. o If you buy companies shares instead of loaning it money, you have no legal right to expect any payments until all of its creditors are paid. o Once shares are issued, the company has no obligation to buy them back, whereas debt obligations must be repaid. o Payments to shareholders are called dividends. Investing Activity  Investing activities involve the purchase (or sale) of the long-lived sources- called assets- that a company needs in order to operate. o Assets are resources that a company owns. o Investing activities generally involve long-lived assets (vehicles, buildings.. etc.). o Together, long-lived assets and investing activities are referred to as property, plant and equipment or “property and equipment,” o Cash is one of the more important assets owned by any business.  Cash is not an investing activity!  Excess cash that companies have is invested in debt and equity securities of other corporations or organizations. o Investments are another example of an asset and an investing activity. Investments can be either short-term or long-term. Operating Activities  Most of a company’s long-lived assets are purchased through investing activities.  Operating activities are transactions, which create revenues and expenses.  Amounts earned from sales are referred to as revenues.  In accounting language revenues are increases in economic resources- normally an increase in an asset but sometimes a decrease in a liability-that result from a business’ operating activities.  Sources of revenue that are common to many businesses are sales revenue, service revenue, and interest revenue.  The right to receive money in the future is known as account receivable. o Accounts receivable are assets because they will result in a future benefit-cash-when the amounts owed are eventually collected. o Companies also have other types of receivables, such as income tax receivable (also known as “future income tax assets”) that is due from the government.  Items that are held for future sale to customers result in an asset called inventory or merchandise inventory. o Once the goods are sold, they are called expenses. o More specifically, the cost of the merchandise inventory sold is called cost of goods sold. o In accounting language, expenses are the cost of assets that are consumed or services that are used in the process of generating revenues.  Cost of goods sold, opera
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