chapter 1

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University of Toronto St. George
Rotman Commerce
Alexander Edwards

Chapter 1: The purpose and Use of Financial Statements Users and uses of accounting  Accounting: is the information system that identifies and records the economic events of an organization, and then communicates them to a wide variety of interested users.  The world’s economic system depends on highly transparent, reliable and accurate financial reporting, which is why accounting is called “the language of business”.  Users of accounting is broadly divided into 2 groups: internal and external users Internal users:  Internal users of accounting information plan, organize and run companies..  They work for the companies which includes finance director, marketing managers, human resource personals production supervisors, and production supervisors and company officers.  Internal users needs accounting information on timely basis to answer many financial related question which is crucial in order to run the company  accounting provide a variety of internal reports such as financial comparison of operating alternatives, projections of the profit from the new sale campaigns, analyses of sales costs, and forecast a cash need External users:  Investors use accounting information to make decisions to buy, hold or sell their ownership interest.  Lenders, such as bankers use accounting info to evaluate the risk of lending money.  Other creditors, such as suppliers use accounting info to decide whether or not to grant credit (sell on account) to a customer.  Investors, lenders, and other creditors are considered to be the primary or ley external users of accounting info.  Employees and labour unions want to know whether the company can provide employment opportunities and pay salaries and benefits.  Customers are interested in whether a company will support its product line and honour product warranties.  Tax authorities will want to know whether the company respect the tax laws.  Regulatory agencies that regulate companies that sell their shares to the public, want to know the company is operating within prescribed rules. Ethical behaviour by users:  In order for financial information to have value to its users, whether internal or external, it must be prepared by individuals with high standards of ethical behavior.  Ethics in accounting is of the utmost importance to accountants and decisions makers will rely on the financial information to produce.  The actions of both legal and responsible and to consider the organization’s interest when they make decisions. Accountants and other professionals have extensive rules of conduct to guide their behaviour with each other and the public.  Many companies today have codes of conduct that outlined their commitment to ethical behavior in their internal and external relationship.  When you analyze ethical situations, you must consider the following steps outlines below: 1. Recognize an ethical situation and the ethical issues involved: use their personal ethics or an organization’s code of ethics to identify ethical situations and issues. Some business and professional organizations provide within codes of ethics for guidance in common business situations. 2. Identify and analyze the main elements in the situation: identify the stakeholders—persons or groups who may be harmed or benefited. Ask the question: what are the responsibilities and obligations all the parties involved? 3. Identify the alternatives, and the weigh the impact of each alternative on various stakeholders: select the most ethical alternative, considering all the consequences. Sometimes there will be one right answer. Other situations involve more than one possible solution. The solutions require any evaluation of each alternative and the selection of the best one. Forms of business organization  There are three common forms of business organization: proprietorship, partnership and corporations Proprietorship:  Proprietorship: is a business owned by one person. It is often called a “sole” proprietorship because the owner has no partners.  This form of business organization is simple to set up and gives the owner control over the business.  In most cases, only a relatively small amount of money (capital) is needed to start in business as a proprietorship. The owner (proprietor) receives any profits, suffers any losses, and is personally liable (responsible) for all debts of the business. This is known as unlimited liability.  The life of the proprietorship is limited to the life of the owner.  The business profits are reported as self employment income and tax on the owner’s personal income tax return.  The business records of the proprietorship must be kept separate from those related to the owner’s personal activities.  The separation of business and personal records is now in its simplest form as the reporting entity concept.  Reporting and key concept requires the economic activity that can be identified with a particular company being kept separate and distinct from the activities of the owner(s) and of all other economic entities.  Examples of proprietorships are small hair salons, mechanics and small Retail Stores etc. Partnerships:  Partnership: is a business owned by more than one person. In most respects, a partnership is similar to a proprietorship except that there is more than one owner.  Partnerships are often formed because one person does not have and not economic resources to initiate or acts that the business, or because partners bring more unique scales or resources to the partnership.  Partnerships are normally formalized in a written partnership agreement that outlines the formation of the partnership, partners’ contributions, how profits and losses are shared, provisions for withdrawals of assets and/or partners, dispute resolution, and partnership liquidation.  Each partner generally has unlimited liability for all debts of the partnership, even if one of the partners created about debt. There are some situations where a partnership can be formed to limit liability for selected partners  Unlimited liability means that one of the partners can be forced to give up his or her personal assets in order to repay the partnership debt, just as can happen to an owner of proprietorship.  Assets are resources that provide future economic benefits for example; personal assets include cash, investments, house, furniture, car etc.  The prophets of the partnership are reported as sells employment income and text on each partner’s personal income tax return.  The reporting entity concept requires that partition records be kept separate from each partner’s personal activities.  Examples of partnerships are practices of lawyers, doctors, architects, engineers, and accountants. Corporations:  Corporation: is 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.  Individuals can become owners of shares were called shareholders by investing in relatively small amount of money  Shares are also known as stock  Since a corporation is a separate legal entity, its life is indefinite. That means it continues on regardless of who owns its shares. It is not affected by the withdrawal, death, or incapacity of an owner.  Buying shares in a corporation specially a large corporation is more often attractive than investing in a proprietorship or parturition because shares are easier to sell.  Successful corporations often have thousands of shareholders and their shares are traded on organized stock exchanges, such as the Toronto stock exchange in Canada.  Other factors that needed to be considered when deciding which organization form of organization to choose include legal liability and income tax.  Corporate shareholders are not responsible for corporate debts unless they have personally guaranteed them.  Most shareholders enjoy limited liability save the only visible losing the amount they have invested in the company’s shares.  All of advantages taken together—indefinite life, ease of transferring ownership, limited liability—make it easier for a corporation to raise capital with proprietorship and partnership.  Corporations the income tax as separate legal entities on any corporate profits  Revenues produced by corporation in Canada are far greater than partnership and proprietorship.  Public corporation: distribute their financial statements to investors, lenders, other creditors, other interested parties and the general public. Their shares are also listed on Canadian or other stock exchange.  Consolidated: this means that the financial results include all the companies that the corporation owns and controls.  Although the initial a result of these companies are consolidated of combined for reporting purposes, individual accounting records and financial statements are also produced for each specific company.  In order to accurately assess the performance and financial position of each company, it has to be possible to distinguish each company’s activities from the transactions of any other company, even as the companies are related. This is another application for the reporting entity concept  Private corporations: corporations that issues shares but they do not make them available to the general public nor are they traded on public stock exchanges.  Many private corporations do not have the same advantages or raising capital as do large corporations Generally accepted accounting principles for corporations  Generally accepted accounting principles (GAAP): include a broad policies and practices as well as rules and procedures that have substantive authoritative support an agreement about how to report economic events.  Accounting principles are also in commonly known as an accounting standards for accounting policies  Publicly traded corporations must use international financial reporting standards IFRS and serve local accounting standards developed by the International accounting standards board.  Private corporations rose users can beat different needs than publicly traded corporations, have a choice between using IFRS or accounting standards for private enterprises ASPE, developed by the Canadian Accounting standards board.  Proprietorship and partnerships and do not have to choose between IFRS and ASPE as their statements are generally prepared only for internal use of the owners 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 (debt financing) 2. Issuing ( selling) shares (equity financing) in exchange for cash.  A company can borrow money in various ways, it can take out a loan at the bank for borrowed money from other lenders. The purses for companies that the corporation owes money to are called lenders are creditors, what are the primary user groups of accounting information.  Liabilities: amounts owed to lenders and creditors—in the form of debt or other obligations.  Specific needs are given to different types of liabilities depending on their source  An operating line of credit is a pre-arranged backed loan for a maximum amount that allows a company to draw more money than there is on hands in its bank account, this results in and let them eat called bank indebtedness.  A company may also have a short-term loan payable to bank also known as a note payable, four the money borrowed to purchase things such as equipments.  It may have that long-term debt which can include mortgages payable, bonds payable, finance lease obligations, and other types of debt securities borrowed for long periods of time  A corporation may also obtain financing by selling shares of ownership to investors.  Common shares is the term used to describe the amount paid by investors were shares of ownership in a company.  Companies can also use cash for financing activities, such as a repaying debt or repurchasing shares from investors.  The claims of lenders and creditors differ from those shareholders  The lenders or creditor have the legal right to be paid at agreed time with the original lent money plus the interest added to the amount due or overdue. In the event of nonpayment, the lenders of creditors may force the company to sell assets to pay its debts  Shareholders have no crying too far right resources until the claims of lenders and creditors are satisfied.  Once the shares are issued, the company has no obligation to buy them back, whereas debt obligations must be repaid  Dividends: many companies pay shareholders in return on their investments on a regular basis, as long as there is enough cash to convert required payments to lenders and editors. Payments to shareholders are called dividends. Investing activities  Investing activities involve the purchase or sell of long lived assets that accompany needs in order to operate.  Assets: are resources that a company owns or controls. If the assets is capable of providing future economic benefits that can be short or long lived. Investing activities generally involve longer to assets such as computers, vehicles, buildings and land. Together they are referred to as property, plant and equipment and these are also known as capital assets or fixed assets  Cash is one of the more important assets owned by any business. If the company has excess cash that it does not need for a while, it might just invest it in debt securities such as bonds and equity securities such as shares of other corp
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