3 Week 3 Accounting – The Language of Business
Week 3 Accounting The Language of Business
Introduction
Learning Objectives
By the end of this week you will
- Define accounting and understand it’s importance
- Identify the users and uses of accounting
- Classify different forms of business organisations
- Explain the importance of ethics in accounting
- Understand the Accounting Equation
- Prepare the four Basic Financial Statements
- Utilize the T Account Device for analyzing transactions
This chapter should take you 10-12 minutes to read and time in class to complete and In-Class Case Study.
Accounting: The Language of Business
- Define Accounting and understand it’s importance
The study of accounting is a discipline of logic and language. The ‘double entry’ system dates back to 1495 and hasn’t changed much since, because it’s simplicity reflects the reality of exchanging one item of value for another of equal value.
Accounting is a system that identifies, gathers, measures, records, organizes and reports economic transactions, these exchanges of items with economic value.
Like any discipline it has its share of jargon and a special language. If we understand the simple logic that underlies the system, we can then learn the words that are used in accounting. Fundamentally, accounting is the language of business and is spoken in every organization, every government, every family, in every country in the world. Being able to speak the language will support your personal, professional, and academic goals.
A wide variety of users depend on transparent, relevant, understandable financial information that provides a true representation of the economic events. A vital element in communicating economic events is the accountant’s ability to analyze and interpret this information. Accountants use ratios, percentages, graphs, and charts to analyze and interpret financial information. They use this information to highlight significant financial trends and relationships.
Whether you plan to own your own business, work for a business, invest in a business – whatever you choose, studying accounting will teach you to read and interpret financial information which is a valuable set of skills.
- Identify the users and uses of accounting.
Who uses accounting information and reports? Initially, one would say “Accountants, bankers, business owners, etc.” What about artists? What about students? In fact, everyone depends on reliable and accurate accounting information to make decisions on a daily basis. The student might be looking for what courses to take, by studying the economic outlooks they can determine where job growth will be in the foreseeable future, and therefore, choose the right courses to support a career in that industry or region. Artists can determine pricing for their art, where is the best place to stage a performance, and how to successfully finance such a venture. We all use accounting information to make decisions about our future.
Users need information for decision making. Internal users of accounting information work for the organizing and are responsible for planning, organizing, and operating the entity. The area of accounting known as managerial accounting serves the decision-making needs of internal users. External users do not work for the organizing and include investors, creditors, labour unions, and customers. Financial accounting is the area of accounting that focuses on external reporting and meeting the needs of external users. This book addresses financial accounting. Managerial accounting is covered in other books.
- Forms of Business Organizations
The three forms of business organization are the proprietorship, the partnership, and the corporation.
A proprietorship is a business owned by one individual. It has a limited life, in that it ends when the owner dissolves it, or passes away. It has unlimited liability, in that creditors may be paid from the personal assets of the owner, if the organization’s assets are not sufficient to cover the outstanding debts. It is taxed in the hands of the owners (a ‘T1’ in Canada), that is the profits are added to your personal income on the personal tax return.
A partnership is a business owned by two or more individuals. Like a proprietorship, it has a limited life and unlimited liability. It is also taxed in the hands of the owners, as each reports their portion of the organization’s profits on their personal income tax return. A limited-liability partnership is a partnership in which one partner cannot create a large liability for the other partners.
A corporation is a business owned by shareholders. It is considered a separate legal entity in the eyes of the law. It has an unlimited life, as the share can be sold, traded or bequeathed on the death of the owner. It offers the protection of limited liability, in that the shareholder’s losses are limited to their investment, without risking any personal assets. The corporation is taxed separately from it’s owners and files a corporate tax return each fiscal year (a ‘T2’ in Canada).
|
Sole Proprietorship |
Partnership |
Corporation |
|
Single Owner |
Two or more owners |
One or more owners |
|
Limited Life |
Limited Life |
Unlimited Life |
|
Unlimited Liability |
Unlimited Liability |
Limited Liability |
|
Taxed under the owner |
Taxed under the partners |
Taxed as an entity |
- Understand the importance of Ethics in Accounting
Accounting is highly regulated and adherence to the rules is vital to economic stability, as it promotes faith in the economic systems. The rules in Canada are called GAAP (Generally Accepted Accounting Principles) and they follow IFRS (International Financial Reporting Standards). When the rules are broken, it can lead to dire economic consequences.
Enron was a multinational energy corporation that broke all the rules and defrauded it’s investors, customers and the government. There were dire consequences to these actions. Twenty thousand employees lost their jobs and ten billion dollars of pensions disappeared. It led to investors worldwide losing confidence in the markets, ultimately leading to a worldwide recession. The movie “The Smartest Guys In The Room” is an expose of the Enron fraud and it’s consequences.
- Accounting Basics – The Accounting Equation
The Accounting Equation
Assets = Liabilities + Owner’s Equity
Like all good equations, the left side always equals the right side, that’s why there’s an equal sign in between. In the Language of business, we call the left side of the accounting equation (and the left side of any entry) Debit. The right side is known as Credit. Debits and credits do not mean good, bad, positive, or negative it simply means left side or right side. The accounting equation is used to reflect economic transactions; whereby, something of value is exchanged for something of equal value. For example, we spend cash to purchase furniture of equal value to the cash given up; or the organization provides a service in exchange for a promise to pay. That is why in every accounting journal entry the debits always equal the credits, keeping the accounting equation in balance.
- The Financial Statements
The main objective of the financial statements is to provide information about the business’ resources, claims to its resources, and its ability to earn a profit and generate cash to allow investors and creditors (external users) to make decisions about a business. There are four basic financial statements: the balance sheet, income statement, statement of owner’s equity and cash flow statement.
The Balance Sheet (sometimes called statement of financial position) provides information about the economic resources that the business can use to carry out its business activities to earn a profit and the claims to these economic resources. The balance sheet is like a snapshot of the company’s financial condition at a specific moment in time (usually the end of a month, quarter, or year). Assets, liabilities, and owner’s equity are reported in the balance sheet.
Assets are things of value that are owned by the organization, or resources of economic value that are owned by the organization. These assets are utilized by the organization to produce revenue or future cash inflows. Some examples of assets include: cash, accounts receivable, prepaid expenses, land, buildings, vehicles, patents, etc.
Liabilities are debts that are owed by the company to external third parties. In other words, liabilities are present debts and obligations. The persons or entities a company owes money to are called creditors. Examples of Liabilities are: note payable, accounts payable and unearned revenue (which represents advance payments made by customers).
Owner’s equity is the owner’s claim on total assets. It is equal to total assets minus total liabilities. The owner’s equity is increased by investments by the owner or the generation of revenue. It is decreased by the owner withdrawing assets (usually cash) from the organization or by incurring expenses. The account used is called ‘Capital’ ,in a sole proprietorship the equity account is called Capital, name of the owner, in a partnership there is a separate capital account for each owner, with the name of each owner added to ‘capital’, in a corporation it is called share capital.
The Income Statement (sometimes called statement of earnings or statement of operations) reports the profitability of the business’s operations over a specified period of time (a month, quarter, or year).
The Expanded Accounting Equation
Assets = Liabilities + Owner’s Equity + (Revenues – Expenses)
Revenues increase owner’s equity and expenses decrease owner’s equity. Profit results when revenues exceed expenses for the period. Therefore, profit increases owner’s equity. A loss is the result of expenses being greater than revenues. Therefore, a loss decreases the owner’s equity. Profit is also referred to as net income or earnings.
Revenues are increases in net assets (i.e. an increase in an asset or a decrease in a liability and an increase in owner’s equity) that result from business activities performed to earn profit. Common sources of revenue include sales, fees, services, commissions, interest, and rent.
Expenses are the costs of assets consumed or services used in the company’s ordinary business activities. Expenses are decreases in assets or increases in liabilities, excluding withdrawals made by the owners, and result in a decrease to owner’s equity. Examples of expenses are: telephone expense, supplies expense, and rent expense.
A cash flow statement reports where cash is being generated and used in your business. It shows if your business has enough cash on hand to pay for day-to-day expenses and asset purchases.
A cash flow statement shows the net increase or decrease in cash during a period. It also highlights your business’s ability to raise cash when needed.
A basic difference between an income statement and a cash flow statement is that the former determines if your company is making a profit, while the latter checks if your company is generating cash to fund expenses and stay operational.
Here are the components of a cash flow statement:
- Operating activities: Cash flow from day-to-day operations to reconcile net income with the actual cash used for company operations.
- Investing activities: Cash flow from or to noncurrent assets. An example is the sale or purchase of property or a piece of machinery.
- Financing activities: Cash flow from financing activities—typically includes cash raised by issuing shares.
A statement of owner’s equity details the changes in owners’ investment from the start to the end of an accounting period—a time frame usually covering an entire year. However, an accounting period can also be shorter (quarterly or half-yearly) depending on a business’s accounting practices.
A statement of shareholders’ equity is what is reported for a corporation. While the balance sheet provides a snapshot of your company’s assets, liabilities, and shareholders’ equity as on the reporting date, the statement of shareholders’ equity shows the changes in the value of your business over a period of time. It also shows how stockholders’ investments have fared over time and is used by owners to make decisions on the future issuances of shares.
Here are the components of a statement of shareholders’ equity:
- Common stock: Company stocks that entitle shareholders to the issuance of dividends or profits and voting rights.
- Preferred stock: Company stocks for which profits are paid out to shareholders before common stock dividends.
- Additional paid-in capital: Additional amount paid by investors over the par value or face value of the shares of stock.
- Retained earnings: Total earnings that are retained as income and reinvested in the business after paying out dividends to shareholders.
- Treasury stock: Company stocks that are repurchased from investors to avoid hostile takeover or to boost stock price.
- The T-Account
The T-Account is a device used by accountants to determine the recording of entries and calculate balances.
Assets and expenses are on the left side of the accounting equation; therefore, they have a ‘normal’ debit balance. To increase the balance in an account with a debit balance you need a debit to increase an asset or expense. A credit entry would decrease an asset or an expense. Conversely, in order to increase a liability, owner’s equity or revenue account it needs a credit entry, and therefore, a debit would decrease the balance in a revenue, owner’s equity or liability account.
