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Chapter 1

Chapter 1 Accounting Notes.docx

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ACTG 2010
Douglas Kong

Chapter 1 Accounting Notes Making good business decisions is almost impossible without relevant accounting info Accounting can also be relevant for personal decisions Business and Personal decisions that rely on Accounting: - Determining whether or not to buy a business and how much to pay - Calculating the amount of tax to pay - Evaluating whether to lend to a prospective borrower, and at what interest rate - Assess whether or not you can afford to borrow money - Decide if you can afford to go on vacation - Determine how to divide family assets in a divorce - Find out how much money you have in the bank - Determine how to invest money in a retirement savings or tax free savings account - Determine bonuses earned by management - Evaluate whether to expand your business - Assess whether to make a product or to purchase it from an outside supplier - Evaluate how well managers have managed a business - Assess how well a business has performed - Determine whether to donate money to a charity (management/effective money use) - Determine the worth of a business - Evaluate how much regulated businesses should be allowed to charge for their goods and services - Evaluate if the government has provided effective and efficient financial management - Decide whether to make a major purchase such as a computer or car Some points to consider about accounting: - Accounting is not a science, indeed it’s probably more of an art - Accounting isn’t precise or exact, many estimates have to be made and there is uncertainty around most accounting numbers - Accounting doesn’t provide the right answer, there can be multiple correct answers for an accounting situation - Accounting is flexible and requires judgement What is Accounting? Accounting: is a system for gathering data about an entity’s economic activity, processing and organizing that data to produce useful information about the entity, and communicating that info to people who want to use it to make decisions Entity: is an economic unit of some kind, such as a business, university, government, or even a person It is always important to note the difference between data and information; data is comprised of raw, unprocessed facts about an entity’s economic activity that are entered into an accounting system, whereas information is the result of organizing and presenting the data in ways that make it useful for decision making by stakeholders Most simply the process of accounting involves: 1. Gathering data 2. Processing and organizing data 3. Communicating information When designating an accounting system, accountants and managers have to make many decisions about what data should be gathered and how it should be organized Communicating using accounting info presents the same complexities people face with any form of communication, just as writers choose words to influence readers, accountants can use legitimate, alternative ways of reporting the economic activity of an entity to influence how people perceive financial info. Don’t confuse accounting and bookkeeping, bookkeeping is the process of recording financial transactions and maintaining financial records, and thus only represents one part of accounting. Accounting involves the design and management of information systems, how to account for and report an entity’s economic activity, and the analysis/interpretation of financial info Why Does Accounting Matter? Accounting matters because it has economic consequences- it affects people’s wealth- and it can have an impact on the decisions they make Economic Consequences: the effect of actions on people’s wealth and decisions Example: suppose you can account for a transaction in two legitimate/legal ways and one results in you paying less in taxes, you probably choose that one and the economic consequence is that you keep more money and the government gets less money or vice versa for the opposite decision Why Do People Need and Want Accounting Information More and better information allows for more informed decisions and without it a decision is a guess Not all information is equal; in making a decision, you would generally give more weight to the information that is most reliable and most relevant to your needs Cost-Benefit trade-off: the concept of comparing the benefits of an action with its costs, and of taking the action only if the benefits are greater While more info leads to better decisions, there are limits, it’s usually not possible or worthwhile to collect all the info on a subject, because first, gathering and analysing info is costly and takes time, and simply the benefit won’t be worth the cost, and second, there are limits to the amount of info people can effectively manage and process Too much info (aka ‘information overload’) can impair a person’s ability to make decisions The Accounting Environment How an entity reports its economic activity in its financial statements or other type of accounting report is influenced by the circumstances under which the activity is occurring Accounting was created to provide a record of economic activity and information useful in decision making, so it makes sense that accounting should be responsive to the environment and the people using the information The four key components of the accounting environment are: - Overall Environment - Entities - Stakeholders - Constraints Environment The political, cultural, economic, competitive, regulatory, and legal differences between countries help explain why accounting rules vary from country to country Entities Entities are the center of the accounting environment because stakeholders are looking for information about them and it’s the entities that typically provide the accounting information stakeholders need There are three categories of business entities: - Corporations - Proprietorships - Partnerships Corporations Corporation: a separate legal entity created under the corporation laws of Canada or of a province. A corporation has many of the rights and responsibilities of an individuals. For example a corporation must file tax returns, can be sued, enter into contracts etc. Ownership in a corporation is represented by shares, and the owners of shares are called shareholders. Shares: units of ownership in a corporation Shareholder: an entity that owns shares of a corporation and that is therefore an owner of a company Shareholder Equity: the owners’ equity of a corporation One of the most important features of a corporation is that it provides limited liability to its shareholders Limited Liability: shareholders aren’t liable for the obligations of the corporation or the losses it suffers (aka if the corporation borrows money and can’t repay it, the lender can’t demand repayment from the shareholders) Another attractive feature of a corporation is that share ownership is easily transferred without affecting the corporation, which simply carries on business with new owners Shares of public companies can be purchased by anyone interested in owning part of the company, where shares are usually traded on a stock exchange In contrast the shares of private corporations can’t be purchased unless the entity or its shareholders agree, and most corporations in Canada are private Public Corporations: a corporation whose shares or other securities are available for purchase by any entity that has an interest in owning the securities and the money to buy them, where the shares of these corporations are traded on a stock exchange Stock Exchange: a place (physical or virtual) where entities can trade securities of publicly traded entities Private Corporation: a corporation whose shares and other securities are not available for purchase without agreement with the private corporation or its shareholders Proprietorships Proprietorship: is an unincorporated business with one owner, unlike a corporation a proprietorship isn’t a separate legal entity A proprietorship doesn’t pay taxes instead the proprietor includes the money made by the proprietorship in their personal tax return, along with income from other sources such as employment Proprietor: the owner of a proprietorship If a proprietorship doesn’t meet its obligations, any entities that are owed money can attempt to recover it by seizing the proprietor’s personal assets such as their house, car, or bank account. An attractive feature of a proprietorship is that they are easy and inexpensive to set up Partnerships Partnership: is an unincorporated business owned by two or more entities called partners Partners: two or more entities that share ownership of an unincorporated business, can be either people or corporations Partnerships don’t pay taxes, and incomes are included in the partner’s income There are different types of partnerships, some of which provide limited legal liabilities to the partners Like proprietorships, partnerships are relatively easy/inexpensive to set up, however, since it involves more than 1 entity, it’s wise to have a partnership agreement, which adds cost and complexity The agreement is important, as it sets out the rights and responsibilities of the partners Not-for-Profit Organizations A large part of the Canadian economy isn’t dedicated to making money or profit Not-for-Profit Organizations: provide social, educational, professional, religious, health, charitable, and other services in the Canadian communities and around the world Examples are hospitals, charities, religious organizations, unions, clubs, daycare centres, and universities. Not-for-Profit organizations are exempt from paying income taxes and can incorporate and provide members with limited liability Governments Government plays a major role in the lives of Canadians, the various levels of government in Canada raise and spend hundreds of billions of dollars every year and financial reporting by governments is an important source of accountability. Individuals Individual people are also accounting entities as they often have to produce information in quantitative forms to meet the demands of everyday life through tasks/activities such as: - Filing an income tax return - Keeping track of finances - Borrowing money from banks - Insuring home and belongings - Preparing budgets Canadian Revenue Agency (CRA): the Canadian government agency responsible for administration and enforcement of federal tax laws Others Useful information on industries can sometimes be obtained from sources such as trade associations, industry publications, public interest groups, and government statistical departments Characteristics of Entities Each entity has characteristics that make it unique Characteristics that differentiate entities include: - Industry - Public vs Private - Size - Unionized vs Non-Unionized - Markets Characteristics are important for understanding an entity- what it does, and how it accounts for its economic activity Constraints How an entity accounts for its economic activity and what info it reports isn’t entirely up to the people preparing the info (although they have a strong influence over it), often the choices available are constrained by contracts, laws, accounting standards, and the info needs/demands of powerful stakeholders. Examples of Constraints: - The Income Tax Act which defines how certain transactions and economic events must be accounted for in calculating the amount of income tax an entity must pay - Corporations must meet the requirements of the laws it is incorporated under - Entities often enter voluntarily into contracts with other parties to do their accounting in a certain way - Above all, people involved in the accounting and financial reporting process have a responsibility to be ethical - Some entities must agree to follow formal sets of accounting rules such as ASPE or IFRS - Companies that trade on stock exchanges must meet the requirements of the securities laws of their provinces and the rules of the stock exchange Stakeholders: Different Users, Different Decisions, Different Information Stakeholders: groups and individuals that may be interested or have a
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