How to use financial statements for business accounting? - Chapter 1


What are the main definitions?

Accounting can be defined as an information system that measures, processes, and communicates financial information about an identifiable economic entity. An economic entity is a unit that exists independently. Accounting can be seen as a link between business activities and decision makers.

A business is an economic entity that has the aim to sell goods and services to customers at prices that will provide an adequate return to its owners. All businesses have two major goals; liquidity and profitability. The need to earn enough income to attract and hold investment capital is the goal of profitability. In addition, business must meet the goal of liquidity. This means having enough cash available to pay debts when they are due.

All businesses pursue their goals by engaging in the following activities:

  • Operating activities such as selling goods and services to customers, and buying and producing of goods.

  • Investing activities like spending the capital of a company to achieve its goals. This includes buying resources necessary to operate such as land, buildings and equipment.

  • Financing activities involve obtaining funds to be able to begin a business and to continue operating it. It includes for example obtaining capital from owners and from creditors such as banks.

Using financial statements to determine whether a business is well managed and achieving its goals is called financial analysis. The effectiveness of such a financial analysis depends on the use of relevant performance measures. Management accounting is the internal managing of finance and is about financing, investing and operating activities to achieve profitability and liquidity. Financial accounting generates reports and communicates them to the external decision makers. These reports are called financial statements. Bookkeeping is the process of recording financial transactions and keeping financial records and is only a small part of accounting. Ethics is the code of conduct that is applicable to everyday life. Ethical financial reporting is important since fraudulent financial reports can have serious consequences.

Accounting data is used by management, users with direct financial interest and users with indirect financial interest. The management are the people who are responsible for ensuring that a company meets its profitability and liquidity goals. Users with direct financial interest are for example investors, like stockholders, or creditors. Users who have indirect financial interest are tax authorities, regulatory agencies and other groups such as labor unions and consumer groups.

The accountant must answer the following four basic questions in order to make an accounting measurement:

  1. What is measured?

  2. When should the measurement be made?

  3. What value should be placed on what is measured?

  4. How should what is measured be classified?

Business transactions are economic events that affect the financial position of businesses. Transactions are recorded in terms of money; this concept is called money measure. The money measure depends on the country in which the business is located. In international transactions exchange rates are used to translate one currency to another. For accounting purposes, a business is seen as a separate entity; it is distinct not only from its creditors and customers but also from its owners. It should have a completely separate set of records, and its financial records and reports should refer only to its own financial affairs.

Which business forms are there?

There are three basic forms of business, which are discussed below:

  • A sole proprietorship is a business owned by one person. The person is liable for all obligations of the business.

  • A partnership has two or more owners. The partners share the profits and losses of the business according to a prearranged formula. A partnership must be dissolved as the ownership changes; i.e. as a partner dies or leaves.

  • A corporation is a business unit chartered by the state and legally separated from its owners (the stockholders). The stockholders do not have direct control over the operations of the corporation. Because of the limited involvement in the corporation, their risk of loss is limited to the amount they paid for their shares. Therefore, stockholders often are willing to engage in risky activities.

To form a corporation, an application must be signed with the proper state official. This contains the articles of incorporation which form a contract between the state and the incorporators. The authority to manage the corporation is delegated by the stockholders to the board of directors and then to the management. A unit of ownership in a corporation is called a share of stock. In the articles of incorporation is stated how many shares a corporation is authorized to issue. The most universal form of stock is common stock. A board of directors is elected by the stockholders. They appoint managers to carry out the day-to-day work. Only the board has the authority to declare dividends, which are distributions of resources, usually in the form of cash, to the stockholders.

Corporate governance is the oversight of a corporation’s management and ethics by its board of directors. To strengthen corporate governance, an audit committee made up of independent directors who have financial expertise, is appointed by the board of directors. The audit committee is also responsible for reviewing the work of independent auditors of the company.

The income statement, also called the statement of operations, is the most important financial report since it shows whether a company achieved its goals of profitability and liquidity. The basic elements of the income statement are revenues, expenses and net income. When revenues exceed expense the difference is called net income. When expenses exceed revenues the difference is called net loss. The retained earnings of a business are its income-producing activities minus amounts that have been paid to stockholders.

What is meant by financial position?

Financial position refers to the economic resources that belong to a company and the claims against those resources at a particular time. Another term for claims is equities. As every corporation has two types of equities: creditors’ equities and stockholders’ equity, the following equation holds:

Economic Resources = Creditors’ Equities + Stockholders’ Equities.

In accounting terminology the economic resources are called assets and creditors’ equities are called liabilities. This gives the following accounting equation:

Assets = Liabilities + Stockholders’ Equity

Examples of assets are: monetary items as cash and non monetary items such as inventory and land. Liabilities are present obligations of a business to pay cash, transfer assets, or provide services to other entities in the future. Among them are debts, amounts owed to suppliers to borrowed money. The owner’s equity is called the stockholder’s equity. It has two parts:

  1. the amount that stockholders invest in the business: contributed capital

  2. the equity of the stockholders generated from the income-producing activities of the business and kept in use in the business: retained earnings.

Revenues and expenses are the increases and decreases in stockholder’s equity that result from operating a business. Retained earnings can therefore increase as a result of revenues and decrease as a result of expenses and the payment of dividends.

Four major financial statements are:

  • The income statement focuses on the company’s profitability. It summarizes the revenue earned and expenses incurred by a business over a period of time. This will give the net income.

  • The statement of retained earnings shows the changes in retained earnings over a period of time. It is the difference between the old and the new net income, less the dividends paid to stockholders.

  • The balance sheet is used to show the financial position of a business on a certain date. Usually a balance sheet is made at the end of a month or year. The balance sheet presents a view of the business as the holder of the resources, or assets, that are equal to the claims against those assets. On the left side of the balance sheet are the assets, on the right side the liabilities and the stockholder’s equity. Both sides of the balance sheet must be equal.

  • The statement of cash flows is directed toward the company’s liquidity goal. The outcome of the cash flows statement should be equal to the amount of cash on the balance sheet.

To ensure that financial statements are understandable for their users, generally accepted accounting principles (GAAP) have been developed. These principles provide guidelines for financial accounting.

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