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Financial Accounting 1 for Business Administration midterm
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Lecture 14 April 2022
What is accounting? The activities
Accounting consists of three basic activities:
- Identifying
- Recording, and
- Communicating
An organization’s economic events to interested users
What is accounting? The organization
Organizations that use accounting:
- Companies (from sole proprietorships to huge conglomerates
- Non-profit organizations
- Government organizations
Different types of companies
1. (Sole) proprietorships: one owner who is decision maker
o No clear distinction between private money and company money
o Proprietors have unlimited liability for all debts of their company
o Profit is private income
o Many small companies stay proprietorships for their entire lifetime
2. Partnerships: multiple owners who make decisions
o Partnerships are similar to proprietorships but with more than one person
o Also unlimited liability
o Common in professional services (e.g., law firms; audit firms)
3. Corporations: legal entity that has many of the same rights as individuals
o Owners have shares that can be transferred
o Public corporation vs. private corporation
o Clear distinction between “private” and “company” money limited liability
o Owners do not necessarily make decisions: private vs. public corporations
Accounting in a corporation
Owners of corporations will want to know what the corporation’s managers are doing with
their money
- So, what is their share of the company worth?
The corporation’s equity changes as the corporation does things (i.e., transactions)
- The corporation’s operations affect what it owns and what it owes
, o Notice that equity only changes if the total value of what it owns and what it
owes changes
o For example: exchanging one asset for another does not change the value of
the corporation
What economic events are registered?
External and internal transactions that affect what the organization owns (assets), and / or
what the organization owes (liabilities)
- This includes transactions that do and transactions that do not affect equity
o In other words: changes in the value of the firm and changes in how this value
is invested in assets and liabilities
What transactions affects equity? (1) revenues and expenses
Company activities result in revenues and expenses
- Positive (revenues) and negative (expenses) changes in the value of equity
- Common sources of revenue are: sales, fees, interest, etc.
- Expenses are the cost of assets consumed or services used in the process of earning
revenue.
- Common expenses are: interest, salaries, rent, utilities, materials, etc.
The difference between the revenues and expenses in a period to as the Net Income for that
period. Net income is the change in the value of a company’s equity in the period due to the
company’s operations in that period.
What affects equity? (2) transactions with owners
Shareholders can invest in the firm
- (i.e., buy shares)
Shareholders can be paid by the firm
- Dividends
So there are two main components of owner’s equity
1. Share capital – ordinary (“paid-in capital”)
o Amount that shareholders have invested in the corporation
2. Retained earnings
o Cumulative income from previous periods not (yet) paid out as dividends
The expanded accounting equation
, What is accounting? The users
Who uses accounting data?
- Internal users, e.g.
o Managers within the firm to plan; organize etc.
- External users, e.g.
o Investors (potential as well as existing)
o Creditors
o Regulatory agencies
o Customers
o Labor unions
Financial accounting vs. management accounting
Financial accounting is subject to laws, regulations, and standards generally accepted
accounting principles (GAAP)
- Benefit: comparability. Each country has its own GAAP. There are also international
GAAP (e.g., IFRS)
- Management accounting is not subject to laws, regulations, and standards
In most countries, organizations are required by law to periodically publish specific financial
statements for outside users
- At least annually (in “annual reports”)
Principles and assumptions under IFRS
All GAAP are based on principles and assumptions. IFRS relies on, e.g.:
- Monetary unit assumption
o Assets, liabilities, equity, revenues, expenses should be expressed in monetary
terms
- Measurement principles
o How do we measure the amount that we record in the financial statements?
Historical cost principle record what you have paid in the past
Fair value principle record the current value
- Economic entity assumption
o Financial statements should report financial statements about the corporation
When is information useful?
Information is useful when it is
- Relevant
o Predictive value
o Confirmatory value
o Material
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