Who Needs Information About Transactions of the Business?
No part of any business can operate without information. The functions of the management of a company are to plan, to confrol, and to evaluate the operation of the business. To perform these functions effectively, management must have information about what the business has done, about what it is currently doing, and about where it looks like it is going or should be
M A K I N G I N B U S I N E S S
E X H I B I T 1 . 4
T h e O p e r a t i n g C y c l e
The operating cycle shows how a firm starts with cash and, after providing goods to its customers, ends uo with more cash.
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1 2 C H A P T E R 1 o B U S I N E S S : W H A T ' 5 l T A L L A B O U T ?
Generally accepted
accounting principles (GAAP) are the guidelines for financial reporting.
The Financial Accounting Standards Board (FASB) is the group that sets accounting standards. lt gets its authority from the SEC.
The Public Company Accounting Oversight Board (PCAOB) is a group formed to oversee the auditing profession and the audits of public companies. lts creation was mandated by the Sarbanes-Oxley Act of 2002.
E X F i l B t T 1 . 5
W h o S e t s t h e G u i d e l i n e s f o r F i n a n c i a l R e p o r t i n g ?
The U.S. Congress established the Securities and Exchange Commission (SEC) in 1934.
Auditing standards are set by the Public Company Oversight Board (PCAOB), and accounting standards (GAAP) are set by the Financial Accounting Standards Board GASB).
going. Traditionally, the accounting infotmation system has provided only very general data about the past transactions of a business firm. A business firm used to keep two sets of records, each for speciftc purposes: one set for financial reporthg and one set for internal decision mak- ing. Now, with modern computers and software that can organize information in a variety of ways with a few simple commands, one information system can accumulate and organize all data of a company. The managers of each business area-usually referred to as a department- can obtain and use whatever information is relevant to the decisions they make. Accountants, too, can obtain the information they need for preparing the basic financial statements.
The frnancial statements are based on a set ofguidelines called generally accepted ac- counting principles (GAAP). These guidelines are not exact rules. As you learn more about accounting, you will see that the amounts on the financial statements are not exact. To make the hnancial statements useful, we need to understand the guidelines and the choices used to construct them. Who sets the guidelines for financial reporting? As shown in Exhibit 1.5, at the top of the authority chain is the Securities and Exchange Commission (SEC). In the 1930s, Congress established the SEC to set the rules for corporations that trade on the pub- lic stock exchanges. The SEC has delegated much of the responsibility for setting financial standards to an independent group called the Financial Accounting Standards Board (FASB). This is a group ofprofessional business people, accountants, and accounting schol- ars who have the responsibility of setting current accounting standards. Accounting stan- dards dictate the way business events are reported, so it makes sense that businesses are very interested in what the FASB does. The newest player in the rule-setting game is a group called the Public Company Accounting Oversight Board (PCAOB). Mandated by the Sarbanes-Oxley Act in 2002, this independent board was created to oversee the auditing pro- fession and public company audits.
Securities and Exchange Commission (SEC)
Public Company Accounting Oversight Board
(PCAOB)
In response to the 2001-2002 discovery of accounting scandals, the SEC created the
PCAOB to oversee the auditing profession and the
audit of public companies.
Financial Accounting Standards Board
(FASB)
The SEC has delegated much of the standards-setting responsibility
to the FASB. The SEC retains and sometimes exercises the right
to set accountinq standards.
C H A P T E R 1 . O V E R V I E W O F T H E In many industries, there are regulatory agencies that require speciltc information from companies, particularly corporations. For example, the SEC requires corporations that trade on the stock exchanges to file many different kinds of reports about the company's transac- tions. We will come back to this topic near the end of the chapter when we turn our atten- tion to real company financial statements.
For all businesses, payroll taxes and sales taxes must be reported and paid to state rev- enue agencies. The Internal Revenue Service (IRS) requires information from businesses concerning income and expenses, even if the income from the business flows through to the owners as it does for sole proprietorships and partnerships.
When a company wants to borrow money, creditors-the people and flrms who lend money-require information about the company before they will lend money. Banks want to be sure that the loans they make will be repaid. The creditworthiness-a term indicating that a borrower has in the past made loan payments when due (or failed to make them when due)-of a business must be supported with information about the business. This informa- tion is usually very specific and very detailed.
Who else needs information about the business? Potential investors are information consumers. Suppose Tom wanted to find additional owners for his T-shirt business. That means he would be looking for someone who wanted to invest money in his T-shirt busi- ness in return for a portion of ownership in the company. A potential owner would want some reliable information about the business before making a financial investment. Pub- licly traded corporations-whose shares are traded on the stock exchanges-invite anyone willing and financially able to become an owner by offering for sale shares of stock in the corporation. Buying the stock of a corporation is investing in that corporation. Investors want information about a company before they will buy that company's stock. The SEC re- quires that the information provided by companies whose stock is publicly traded be accu- rate and reliable. That means the information in their financial statements must be audited.
Audited information means it has been examined by professional accountants, called certified public accountants (CPAs). We will talk more about that when we turn our at- tention to real company financial statements.
Finally, current and potential vendors, customers, and employees also need useful in- formation about the company. They need to evaluate a company's financial condition to make decisions about working for, or doing business with, the company.
Accounting Information: A Part of the Firm's Information System
Have you ever filed an address change with a company only to find later that one depart- ment uses your new address while another department of that same company continues to use your old address? Even with such common data as customer names and addresses, the information is often gathered and maintained in several different places within the same or- ganization. As computers and databases become more common, central data information systems are replacing departmental systems and eliminating their inefficiencies.
Because accountants have traditionally been the recorders and maintainers of finan- cial information, it makes sense that they have expanded their role as the keepers of busi- ness information systems to include more than financial information. The cost of obtaining business information has decreased rapidly in the past few years. The financial accounting information a company reports is now just a part of the total available business informa- tion. The accounting information is provided in four basic financial statements and sup- portlng notes.
Overview of the Financial Statements
There are four financial statements a company uses to report its financial condition and op- erations for a period of time.
1. Balance sheet 2. Income statement
3. Statement of changes in shareholders' equity 4. Statement of cash flows
F I N A N C I A L S T A T E M E N T S 1 3
The Internal Revenue Service (lRS) is the federal agency responsible for federal income tax collection.
A certified public accountant (CPA) is someone who has met soecific education and exam requirements set up by individual states to make sure that only individuals with the appropriate qualifications can perform audits. To sign an audit report, an accountant must be a CPA.
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l d e n t i f y th e e l e m e n t s a n d e x p l a i n t h e p u r p o s e o f t h e f o u r b a s i c f i n a n c i a l statements, and be able to prepare each statement- the income statement, the statement of changes in s h a r e h o l d e r s ' e q u i t y , t h e b a l a n c e s h e e t , a n d t h e statement of cash flows.
1 4 C H A P T E R 1 . B U S I N E S S : W H A T , S IT A L L A B O U T ?
Notes to the financial statements are information provided with the four basic statements that describes the company's major accounting policies and provide other disclosures to helo external users better understand the financial statements.
The balance sheet shows the accounting equation in detail.
The statement shows:
A company's set of financial statements includes these four basic statements as well as an important section called notes to the linancial statements. These notes, sometimes re- ferred to as footnotes, are an integral part of the set of financial statements. The notes de- scribe the company's major accounting policies and provide other disclosures to help external users better understand the financial statements. As you learn about the four state- ments, remember that you will be able to frnd additional information about each in the notes.
In this chapter, we will look at each financial statement briefly. Later chapters will go into each in detail.
Balance Sheet
A balance sheet describes the financial situation of a company at a specific point in time.
It is a snapshot that captures the items of value the business possesses at a particular mo- ment and how the company has financed them. A balance sheet has three parts:
I assets I liabilities
I shareholders'equity
Assets are things of value owned or controlled by a business. Cash and equipment are cornmon assets. When a business has an asset, someone has the rights to, that is, a claim to, that asset. There is a claim on every asset in a business. There are two groups who might have claims to a company's assets-creditors and owners.
The claims of creditors are called liabilities. Liabilities are amounts the business owes to others outside the business, those who have loaned money to the company and have not yet been fully repaid. For example, the amount of a loan-like your car loan-is a liability.
The claims of the owner are called shareholders' equity. Stockholders' equity and owners' equity are other names for the claims of the owners. Shareholders' equity is also called net assets because it is the amount left over after the amount of the liabilities is sub- tracted from the amount of the assets, or liabilities are netted out of assets.
There are two ways for the owners to increase their claims to the assets of the business.
One is by making contributions, and the other is by earning it. When the business is suc- cessful, the equity that results from doing business and is kept in the company is called retained earnings. We will see the difference between contributed capital and retained earnings more clearly when we go through the first month of business for Tom's Wear.
Together, assets, liabilities, and shareholders'equity make up the balance sheet, one of the four basic financial statements. The following relationship, called the accounting equa- tion, is the basis for the balance sheet:
ASSets
Assets Liabilities + Shareholders'equity
Each transaction that takes place in a business can be recorded in the accounting equa- tion, which is the basis of the balance sheet. In other words, every transaction is changing the balance sheet; but the balance sheet must stay in balance. Look at the transactions for Tom's Wear for January and see how each one changes the balance sheet.
Date Transaction
Assets -economic resources owned or controlled by the business.
Liabilities -obligations of the business to creditors.
Shareholders' equity -the owner's claims to the assets of the company. There are two types: contributed capital and retained earnings.
Claims
J a n u a r y 1 J a n u a r y 1 J a n u a r y 5 J a n u a r y 1 0 J a n u a r y 2 0 J a n u a r y 3 0 J a n u a r y 3 1
Tom contributes $5,000 of his own money to start the business in exchange for common stock.
Tom's Wear borrows $500 from Tom's mom for the business.
Tom's Wear buys 100 T-shirts for $400 cash.
Tom's Wear pays a public relations firm $50 cash for advertising.
Tom's Wear sells 90 of the T-shirts to Tom's friends for $10 each (cash).
Tom's Wear repays Tom's mom the $500 plus $5 interest.
T o m ' s W e a r d e c l a r e s a n d p a y s a $100 dividend.
C H A P T E R 1 . O V E R V I E W O F T H E F I N A N C I A L S T A T E M E N T S Before the hrst transaction, there are no assets, no liabilities, and no equity. So the bal-
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ance sheet equation is:
Assets 0
Assets 500 cash
Liabilities 0
Liabilities 0
Liabilities +
$500 notes payable
+ Shareholder's equity 0
+ Shareholder's equity + $5.000 common stock
Shareholder's equity
Tom starts his company as a corporation. That means the owner's equity will be called shareholder's equity, and his initial contribution will be classified as common stock. We will discuss the details of equity in Chapter 9. This is how the first transaction affects the ac- counting equation:
Assets 5.000 cash
Also on January 1, Tom's Wear borrows $500. This is how the second transaction af- fects the accounting equation:
A balance sheet can be prepared at any point in time to show the assets, liabilities, and equity for the company. If Tom's Wear prepared a balance sheet on January 2, these two transactions would be reflected in the amounts on the statement. Exhibit 1.6 shows the bal- ance sheet at that time. With every subsequent transaction the balance sheet will change.
There are several characteristics ofthe balance sheet that you should notice in Exhibit 1.6.
First, the heading on every financial statement specifies three things:
I the name of the company
I the name of the financial statement I the date
The date on the balance sheet is one specific date. If the business year for Tom's Wear, also known as its fiscal year, is from January 1 to December 31, the balance sheet at the beginning of the first year of business is empty. Until there is a transaction, there are no as- sets, no liabilities, and no equity.
The balance sheet in Exhibit 1.6 for Tom's Wear is dated January 2. Tom's Wear has been in business for only 2 days. Even though a business would be unlikely to prepare a bal- ance sheet just 2 days after starting the business, this is what the balance sheet for Tom's Wear would look like on January 2. The balance sheet shows the financial condition- assets, liabilities, and shareholder's equity-at the close of business on January 2. At this time, Tom's Wear had received $5,000 from the owner, Tom, and had borrowed $500 from Tom's mom. The total cash-$5,500-is shown as an asset, and the liability of $500 plus the shareholders' equity of $5,000 together show who has claim to the company's assets.
Because the balance sheet gives the financial position of a company at a specific point in time, a new, updated balance sheet could be produced after every transaction. However, no company would want that much information!When a company presents its revenues and
Tom's Wear, Inc.
Balance Sheet At January 2,2006
Assets Liabilities and Shareholder's Equity
A fiscal year is a year in the life of a business' lt may or may not coincide with the calendar year,
E X H I B I T 1 . 6
Balance Sheet for Tom's Wear at lanuary 2
This shows a balance sheet after just two days of business for Tom's Wear. Notice that the accounting equation is in balance: assets : liabilities * shareholder's eouitv.
Cash . $b,b00 N o t e p a y a b l e . . . $ 500 5,000
0 Common stock
Retained eamings Total liabilities and
Shareholder's equity .
t0m'sweal
Total assets $5,500 $5,500
1 6 C H A P T E R 1 o B U S I N E S S : W H A T ' S lT A L L A B O U T ?
Comparative balance sheets are the balance sheets from consecutive fiscal years for a single company.
expenses for an accounting period, the information makes up the income statement. The company must show the balance sheet at the beginning of that period and the balance sheet at the end of that period. Those two balance sheets are called comparative balance sheets.
For Tom's Wear, the first balance sheet for the fiscal year is empty. That is, at the beginning of the day on January 1, the accounting equation was 0 : 0 * 0. Before we look at the bal- ance sheet at January 31, we need to see the income statement for the month of January. We need the information on the income statement to see what happened during the time be- tween the two balance sheets.
1. What are the two parts of shareholder's equity?
2. What is a fiscal year?
Before we prepare an income statement for January for Tom's Wear or a balance sheet at January 31, we will look at each transaction that took place in January and see how each affects the accounting equation. This analysis is shown in Exhibit 1.7.
When a business is started, it begins with an empty balance sheet. For Tom's Wear, there are no assets, and therefore no claims, at the start ofbusiness on January 1. The first two transactions that started the business, Tom's contribution of $5,000 and the loan from Tom's mom for $500, occured on January 1. First, Tom's contribution increases assets by
$5,000 and shareholder's equity by $5,000, because the owner, Tom, has claim to the new asset. Then, Mom's loan increases assets by $500 and liabilities by $500. The company re- ceives an asset-cash-and a creditor-Tom's mom-has claim to it. Following these two beginning transactions, the operations of the business begin. Each transaction that takes place during the month is shown as it affects the balance sheet. Study each transaction in Exhibit 1.7 as you read the following description of each.
I On January 5, cash is decreased by $400 and inventory is increased by $400. This is called an asset exchange, because the company is simply exchanging one asset-cash-for another asset-inventory. Notice the entire effect of this exchange on the accounting equa- tion is on one side ofthe equation. That is perfectly acceptable. Also notice an asset exchange has no effect on shareholder's equity. Tom still has claim to the same dollar amount of assets.
I On January 10, Tom pays $50 for advertising. This is a cost Tom's Wear has in- curred to generate revenue. Assets are decreased, and retained earnings, a component of shareholder's equity, is decreased. Why is retained earnings decreased? Because when as- sets are decreased by $50, someone's claim must be reduced. In this case, the owner's claims are reduced when assets are decreased. Retained earnings is the part of shareholder's equity that reflects the amount ofequity the business has earned. (Throughout this book, as you study the transactions that take place in a business, you will see that all revenues in- crease retained earnings and all expenses decrease retained earnings.)
I On January 20, Tom's Wear sells 90 T-shirts for $10 each. This sale increases assets- cash-by $900. Who has claim to this asset? The owner has this claim. Revenues increase retained earnings. At the time of the sale, an asset is reduced. The company no longer has 90 of the original 100 T-shirts in the inventory. Because each shirt cost $4 (and we recorded the T-shirts at their original cost), the firm now must reduce the asset inventory by $360. That reduction in assets is an expense and so shareholder's claims-via retained earnings-al'e re- duced by the amount of that expense.
I On January 30, Tom's Wear pays off the $500 loan with $5 interest. The repayment of the $500 principal reduces cash and elirninates the obligation that had been recorded as a liability. In other words, that liability is settled. The $500 reduction in assets is balanced in the accounting equation with a $500 reduction in the claims of creditors. However, the inter- est represents the cost of borrowing money. For a business, that is called interest expense.
Like all expenses, it reduces the shareholder's claims by reducing retained earnings.
I On January 31, Tom's Wear pays a $100 dividend. That reduction in cash reduces the shareholder's claims to the assets of the firm, shown by the decrease in retained earn- ings. The $100, after it is distributed, is now pafi of Tom's personal financial assets, which are entirely separate from the business.
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