Elements of Accounting for Business, Not for Profit, and Governmental Organizations
Lead Author(s): Antonette McCaster
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This text covers accounting topics; such as account titles, journal entries and financial statements, for business, not-for-profit and governmental organizations.
Chapter 1 - The language of business
1.1 Students should be able to describe and differentiate between managerial and financial accounting.
1.2 Students should be able to describe and differentiate the organizational forms of business
1.3 Students should be able to outline the process of accounting
1.4 Students should be able to state the Accounting Equation and define the terms used.
1.5 Basis of Accounting
In an article published by Harvard University, Roethlisberger provides generalizations, derived from his research, which point to four areas that explain why there are breakdowns in communication: the use of assumptions, expectation of logical reasoning, personal relationships, and differences in the meaning of words.
According to Vella, dialogue education is a method of instructing learners using listening and respect.The main area of intersection with the twelve principles is how non evaluative listening helps to demonstrate respect for learners and build sound relationships. Vella believes that the lessons learned in a community education setting can be transferred to higher education in the learning to listen text.The seven design steps start with getting answers to the questions; who and why?
1.1 Managerial and Financial Accounting
Accounting is called the language of business as it communicates information to both people inside and outside of the organization. It tells the story of what has happened and provides details as to factors that contributed to the outcomes. Accounting is the process of gathering information and organizing it in a generally accepted way. Consequently, we divide accounting into two types; Financial & Managerial.
Examples of Who:
Creditors, Investors, Public, and
Examples of Who:
Board of Directors, Executives, Managers
Examples of What:
Income Statement, Balance Sheet,
Statement of Cash Flows, and Statement
of Owners' Equity.
Examples of What:
Budgets, Sales forecasts, productivity reports
and Accounts receivable aging reports.
Determine rather the following premises should utilize reports generated from financial accounting or managerial accounting.
The sales department wants to determine how well they are performing this month in relation to the targets they set.
An investor wants to purchase some stock in a company but isn't sure if the company is profitable.
The management team wants to determine if they are exceeding production quotas.
The bank is reviewing information to determine rather to approve a loan.
1.2 Types of Business Organizations
A proprietorship is owned by one person and is the easiest form of business to start. In the United States, this is the most common form of business. Many individuals can start a proprietorship by simply getting a business license. Additionally, many businesses that later become large corporations start out as small proprietorships. Any profit or loss earned by the business is legally the same as that of the owner. Consequently, if someone sues the business and wins, the owner can lose everything they own personally as well as everything they put into the business. However, the business is not a tax paying entity (pays no income tax), the owner is responsible for all taxes. For accounting purposes, we separate transactions of the business from those of the person.
A partnership is comprised of more than one person; generally called co-owners or partners. Any profit or loss earned by the business is legally the same as that of the owners; and it divided among the owners based upon the partnership agreement. Consequently, if someone sues the business and wins, the all of the owner can lose everything they own personally as well as everything they put into the business. However, the business is not a tax paying entity (outside of employment taxes), the owners are responsible for all taxes. Due to the risk associated with partnerships such as one partner taking on large amounts of debt with the knowledge of other partners, many utilize a general and limited partnership structure.
A limited-liability company can have one or multiple members. Any profit or loss is passed to the members and taxed at their individual tax rates. Additionally, the members are not responsible for the liabilities of the business. Consequently, this combines the limited liability protection of a corporation yet is taxed like a partnership.
A corporation is owned by stockholders and can consist of one or multiple owners. Unlike proprietorships and partnerships, a corporation is legally distinct from its owners and could theoretically "live" forever without interruption due to changes in ownership. Owners are also legally shielded from any debts of the business. The negative side is that it is a tax paying entity, responsible for both business and income taxes. When the profits are given to the owners (dividends), the owners are also taxed. This results in double taxation. Taxes being paid by the business when the profit is earned and again by the owners when the distributions are given.
The following table outlines the basic four types of forms a business can take:
There are other forms of organizations that are beyond the scope of this course including S-corps, franchises and limited liability partnerships.
Based upon the premise outlined, what type of business would most likely be formed?
You decide to start a business selling clothes that you designed. Everything you have personally and invested in the business would be lost if the business fails or is found liable in a lawsuit.
Limited liability corporation
You convice the shark tank to invest in your idea to start a business that builds custom cars. The shark tank investors sign as limited partners in your endeavor.
You hire an accountant to draw up papers to incorporate your business in Delaware. You purchase all the stock of the company.
You and five other individuals decided to build a business whereby everyone is a member.
Want more practice?
1.3 The process of Accounting
Accounting is the gathering of information. Today, this is generally done with the use of a variety of information systems. But what information do we gather? Recall we are telling the story of the business. This story includes where it started, what it did, and how it can be positioned for the future. In order to do this, we must look at each business transaction and analyze, record, summarize, and interpret.
All business transactions is an occurrence that has a financial impact on the business and an be reliably measured. They have two parts which include the business giving up something and the business receiving something; we call this a double-entry system. Consequently, every transaction affects at least two accounts. We first need identify, then classify the accounts we are using. Similar to any language, we must not only know the definition of a word but how to use it in a sentence. In accounting, we use tools to help us do some of these processes. We will discuss how to use them in the next chapter. To help us analyze a business transaction, we commonly use "T-accounts". These help us demonstrate what accounts were affected and rather they are increasing or decreasing.
We use journals and ledgers to record transactions. The journal process utilizes the skills we acquired in the analyze phase of the process. It is completed in three steps:
- Identify the account title to use and its appropriate classification
- Determine if an account is being increased or decreased.
- Apply the debit and credit rules
Organizations each have their own chart of accounts, or a list of words they use to discuss the financial transactions in their organization. The account is the basic summary device of accounting. Accounts are then classified as either and asset, liability, equity, revenue or expense.
Next, we use financial statements to summarize and interpret the information. These financial statements are interconnected and tells us different components about how the organization functioned. For example, an Income statement will tell us rather we had earned more than we spent. A Balance sheet will tell us how much cash we have. A statement of Cash Flows will tell us how much of our cash came from investing, and a statement of owner's equity will tell us how much of the organization does the owners own. There are a number of financial ratios that are done to gauge how well an organization has done, so that it can be compared to other organizations.
Accountants use a set of rules called, Generally Accepted Accounting Principles (GAAP). They are necessary so that users of accounting information can evaluate the results of the information using a set of standard criteria. In the United States, GAAP is developed by the Financial Accounting Standards Board for Business Organizations.
1.4 The Accounting Equation
The accounting equation is the cornerstone of how we view our financial world. Although there may be a number of derivatives, in its basic form it looks as follows:
Assets are those things of value to the organization that have a future benefit. This includes accounts such as cash, inventory, supplies and equipment. Assets are used to settle a debt, purchase other assets, provide goods and services, or can be sold. Cash in the bank is an asset because it can be used to buy other resources. Machinery and equipment are assets because they make the goods that the business sells or the services the business provides. Both finished (inventory) and unfinished products (supplies) are assets because they can be sold to generate cash. Equipment is an asset because it is used to make the goods that the business sells.
Liabilities signify a debt of the organization and is the amount owed to creditors. Examples are notes payable, accounts payable, and loans. This represents an item that will result in future outflows of resources.
Equity is what the owners own. Similar to mortgage equity, it can be calculated by subtracting an organization's liabilities from its assets. Another aspect of equity is that it represents all the prior years profits and losses. This is generally represented by subtracting expenses from revenue. This relationship is how the financial statements discussed earlier are interconnected.
Now that we've discussed what a business transaction is and what the accounting equation is, lets put these concepts together and determine the effect of transactions on the accounting equation. Previously we defined what an asset, liability and equity account represented.
Retained earnings is a component of Equity, that represents all of the prior year profits and losses. In other words, retained earnings are the profits that a company has earned to date, less any dividends or other distributions paid to investors.
Consequently, revenue is an increase in retained earnings and is generated from ordinary activities such as selling goods and services, returns from investing, or interest from lending. In the case of providing a good or service, it’s only income once the goods and services have been provided or delivered. If the organization receives cash prior to providing the good or service it is a liability because the business is obligated to return the funds should it fail to provide the agreed upon goods or services.
NOTE: We do not categorize contributions from the owner(s) as income; this is considered part of equity.
Expenses are decreases in retained earnings that denote the cost of doing business. An expense occurs when you receive a bill or invoice for goods or services. Anything that causes the business to lose money or assets is an expense because it causes business’ equity to decrease. If an asset loses value, that loss of value is an expense. The purchase of an asset is not an expense even though you spent the money. This is a purchase of a future benefit because you gained the value of the asset for future use.
NOTE: Distributions to owners are not expenses; this is considered part of equity.
Revenue - Expenses
Tony Sommerville decides to start a new business "Tony's Toys" to design custom cars and invests $10,000, which he obtained as a loan from the bank, to start it.
Step 1 identify the accounts and their classification:
In this transaction, the business "Tony's Toys" receives Cash. Cash is an asset. Because these funds were obtained via a loan, the business also has a debt owed to the bank; we will can this a bank loan and it represents what was given up by the organization. A bank loan is a liability.
Step 2 determine if the accounts is being increased or decreased.
Prior to this transaction the Tony's Toys had no cash; now it does. This represents an increase.
Prior to this transaction Tony's Toys had no liabilities; now it does. This represents an increase.
Now we can determine the affect on the accounting equation:
You can see how the accounting equation is true; $10,000 = $10,000. The accounting equation is balanced.
Which of the following is a correct derivative of the accounting equation
Liabilities = Equity + Assets
Equity = Assets + Liabilities
Equity = Assets - Liabilities
Assets = Liabilities - Equity
Which of these is a business transaction?
Tony's Toys opens for business
Tony's Toys places an order for parts
Tony's Toys pays an invoice for parts in the amount of $2,000.
Tony Sommerville hires a receptionist to help with administrative duties.
What is the correct order to analyze a business transaction?
Classify the accounts
Apply the debit/credit rules
Apply the accounting equation
Identify the accounts
Determine if the accounts are increasing or decreasing
1.5 Basis of Accounting
There are two basis of accounting that can be utilized by a business organization. This is either Cash or Accrual. Cash basis reflects transaction whenever cash is received or spent. Accrual basis reflects transactions whenever when revenues are earned and when expenses are incurred; regardless of cash. The cash basis of accounting will not provide a good measure of net income, because it recognizes the effect of transactions and events only when cash is received or disbursed. Consequently, Generally Accepted Accounting Principles (GAAP) requires the measurement focus of accrual basis of accounting be used for Financial Accounting.
The following table illustrates some differences between cash and accrual accounting.
In this chapter students learned the difference between managerial and financial accounting.
Students read about the different types of business organizations and compared the differences and similarities between them.
Students saw how we define a business transaction and provided an image of the financial accounting cycle
This chapter introduced the accounting equation.
This chapter discussed the basis of accounting and provided examples of cash vs. accrual events.
[Figure 1.1]: Image courtesy of Antonette McCaster, used with personal permission.
Harrison, W.T., Horngren, C.T. & Thomas, C.W. (2013). From Chapter 1 of Financial Accounting. Ninth Edition. Pearson Education, Inc.
Rogers, C.R., & Roethlisberger, F.J. (1991). Barriers and gateways to communication. Harvard Business Review, 69(6). 105-111.
Vella, J. (2002). Learning to listen, learning to teach: The power of dialogue in educating adults. San Francisco: Jossey-Bass.