CHAPTER 1 BUSINESS: WHATS IT ALL ABOUT?

CHAPTER OVERVIEW
The chapter begins with a discussion of the purpose of a business, including a discussion of both for-profit organizations and not-for-profit organizations. Next, the nature of business operations is discussed. The four types of businesses are discussed: service, merchandising, manufacturing, and financial services. The first part of the chapter concludes with a discussion of the general forms of business ownership: sole proprietorships, partnerships, and corporations, including the advantages and disadvantages of each. The second part of the chapter begins with a discussion of business activities and the events, resources, and agents affecting business transactions. The third part of the chapter discusses the nature of information in general and accounting information in particular. The users of accounting information are discussed, including management, regulators, creditors, and investors. The last part of the chapter is an introductory discussion of the four basic financial statements (each financial statement is discussed in detail in later chapters . The balance sheet is introduced, along with the accounting elements: assets, liabilities, and shareholders! e"uity. Next, the income statement is introduced, along with the accounting elements: revenues and expenses. The statement of changes in shareholders! e"uity is then explained, including the common causes for changes in the e"uity accounts. #astly, the statement of cash flows is introduced and compared with the information presented on the income statement. $t the end of the chapter, there is a short discussion of general business ris%s, including general strategic ris%s, operating ris%s, financial ris%s, and information ris%s.

LEARNING OBJECTIVES
$fter completing &hapter ', your students should be able to: 1. 2. 3. 4. (escribe what a business does and the various ways a business can be organized. &lassify business transactions as operating, investing, or financing activities. (escribe who uses accounting information and why accounting information is important to them. )dentify the elements and explain the purpose of the four basic financial statements *the income statement, the statement of changes in shareholders! e"uity, the balance sheet, and the statement of cash flows*and be able to use basic transaction analysis to prepare each statement. &opyright + ,-'' .earson /ducation, )nc. publishing as .rentice 0all '-'

5. 6.

)dentify the elements of a real company!s financial statements. (escribe the ris%s associated with being in business and the part that ethics plays in business.

CHAPTER OUTLINE
Purpose an Or!an"#a$"on o% a Bus"ness &LO 1' ). $ business is formed to provide goods or services for the purpose of ma%ing a profit for its owner or owners. )). To start a business you need capital. a. &apital is the name for the resources used to start and run a business. b. &apital comes from investors (owners . c. &apital comes from creditors (lenders . ))). 1usinesses can be classified as a for-profit organization or a not-for-profit organization. a. $ for-profit firm has the goal of ma%ing a profit for its owners. b. $ not-for-profit firm has the goal of providing goods or services to its clients. )2. 1oth types of organizations add value*something customers are willing to pay for. Teaching Tip 3se /xhibit '.' to explain the concept of adding value. T(e Na$ure o% Bus"ness Opera$"ons &LO 1' ). The operation of the business depends on what it is organized to do. )). There are four types of businesses. a. Service organization 4 does something for its customers. b. Merchandising b siness 4 sells a product to its customers. i. !holesale compan" 4 buys goods, adds value, and then sells them to other companies. ii. #etail compan" 4 buys goods, adds value, and then sells them to customers who consume them. c. Man fact rer 4 ma%es the products it sells. d. $inancial services firm 4 deals in services related to money. Teaching Tip $s% the students to suggest examples of each type of business: service, merchandiser, manufacturer, and financial services. .oint out that many businesses are combinations of one or more types.

&opyright + ,-'' .earson /ducation, )nc. publishing as .rentice 0all

'-,

O)ners("p S$ru*$ure o% a Bus"ness &LO 1' ). 1usiness ownership usually ta%es one of three forms: a. Sole proprietorship 4 a company with a single owner. i. Not separate from its owner in terms of responsibility and liability. ii. The business is the owner and the owner is the business. b. %artnership 4 a company owned by two or more individuals. i. 5imilar to a sole proprietorship. ii. Not separate from the owners in terms of responsibility and liability. c. &orporations 4 a special legal form for a business in which the business is a legal entity separate from the owners. i. &an have a single owner or a large number of owners. ii. 6wnership in a corporation is divided into units called shares of common stoc%. iii. 6wners are called shareholders or stoc%holders. iv. Stoc' e(change 4 a mar%etplace where buyers and sellers exchange their shares of stoc%. $lso called a stoc' mar'et. v. The Sec rities and )(change &ommission *S)&+ 4 the agency that monitors the stoc% mar%et and the financial reporting of the firms that trade in the mar%et. vi. $dvantages of a corporation include diversification and limited liability. vii. (isadvantages of a corporation include separation of management and ownership and double taxation of corporate income. ,ividends are the earnings of a corporation distributed to the owners of the corporation. Teaching Tip (iscuss with the students the advantages and disadvantages of each form of business ownership. Bus"ness A*$"+"$"es an $(e ,-o) o% Goo s an Ser+"*es &LO .' ). $n entrepreneur is a person who starts a business. )). /ach step in the process of developing a business is classified as an exchange 4 who gets what and who gives what in return. /xchanges are also called transactions. ))). $ transaction is classified as: a. 6perating 4 related to the general operations of the firm. b. )nvesting 4 related to buying and selling items that the firm will use for longer than a year. c. 7inancing 4 those transactions that deal with how a business gets its funding. )2. $n exchange or transaction involves who gets what and who gives what in return. 2. 8hen an owner invests in the business, it is called a contribution or contributed capital. a. &ontrib ted capital is an owner!s investment in a company. b. The business gives ownership. c. The business gets capital. 2). 8hen a business repays a loan, it gives the economic resource of cash to the lender. This amount includes the amount of the loan, called the principal, plus interest, which is the cost of borrowing money.

&opyright + ,-'' .earson /ducation, )nc. publishing as .rentice 0all

'-9

Teaching Tip 3se /xhibit '.9 to illustrate how a business wor%s. In%or/a$"on Nee s %or 0e*"s"on 1a2"n! "n Bus"ness &LO 3' ). )nformation is needed for decisions, such as: a. 0ow to finance the business: b. 8hat type of business organization to use: c. .urchase;ac"uisition decisions. d. 5ales;collection decisions. Teaching Tip $s% students how a business comes up with the funds to ac"uire additional assets. #ead students to see that a company can borrow (liabilities , or use invested funds (shareholders! e"uity , or hopefully, earn it (also shareholders! e"uity . #ater, you can associate the terms <paid-in capital= and <retained earnings= with the latter two. 5tudents may say that a company buys other assets with cash> however, remind them that this would not change total assets. )). ))). $n operating cycle begins with cash, converts cash to inventory, sells the inventory, and turns the inventory sales bac% into cash. $ccounting information provides information about: a. #even e 4 the amount the company has earned from providing goods or services to customers. b. )(penses 4 costs incurred to generate the revenue. c. 8hat goods are left at the end of the period. Teaching Tip 3se /xhibit '.? to illustrate the operating cycle. W(o Nee s "n%or/a$"on A4ou$ $(e Transa*$"ons o% $(e Bus"ness? &LO 3' ). @anagement i. )nformation about what the business has done. ii. )nformation about what the business is currently doing. iii. )nformation about where the business is going. )). The financial statements are based on a set of guidelines called generall" accepted acco nting principles *-..%+. a. The 5ecurities and /xchange &ommission sets the rules for corporations that trade on public stoc% exchanges. Teaching Tip

&opyright + ,-'' .earson /ducation, )nc. publishing as .rentice 0all

'-?

.oint out that the 5/& only has authority over the accounting rules of public companies*those whose stoc% is traded on a public exchange. b. The 5/& has delegated much of its responsibility for setting financial standards to the $inancial .cco nting Standards /oard *$.S/+. The 7$51 is a group of professional business people, accountants, and accounting scholars who have the responsibility of setting current accounting standards. c. The % blic &ompan" .cco nting 0versight /oard *%&.0/+ is a group formed to oversee the auditing profession and the audits of public companies. d. The 1nternational $inancial #eporting Standards *1$#S+ are international guidelines for financial reporting, used in many places around the world. e. The 1nternational .cco nting Standards /oard *1.S/+ is the group that sets international financial reporting standards. Teaching Tip 3se /xhibit '.A to illustrate the relationships between the groups responsible for financial reporting. ))). )2. The 1nternal #even e Service *1#S+ is the federal agency responsible for federal tax collection. $ certified p blic acco ntant *&%.+ is someone who has met specific education and exam re"uirements set up by individual states to ma%e sure that only individuals with the appropriate "ualifications can perform audits. To sign an audit report, an accountant must be a &.$.

O+er+"e) o% $(e ,"nan*"a- S$a$e/en$s &LO 5' ). 7our basic financial statements: a. 1alance sheet b. )ncome statement c. 5tatement of changes in shareholders! e"uity d. 5tatement of cash flows )). The notes to the financial statements are the information provided with the four basic financial statements that describes the company!s maBor accounting policies and provides other disclosures to help external users better understand the financial statements. ))). 1alance sheet a. The balance sheet shows the accounting e"uation in detail. b. )t has three parts 4 assets, liabilities, and shareholder!s e"uity. c. (escribes the financial position of the company at a specific point in time. d. .ssets i. Things of value owned by a business ii. .rovide future benefit iii. 5omeone has a right (or claim to the asset e. 2iabilities i. &laims to the assets by creditors ii. $mounts owed to those who have loaned to the company f. Shareholders3 e4 it" &opyright + ,-'' .earson /ducation, )nc. publishing as .rentice 0all '-A

&laims to the assets by the owners $lso called net assets ($ssets 4 #iabilities There are two types 4 contributed capital and retained earnings. #etained )arnings is the total of all net income amounts minus all dividends paid in the life of the company. g. $ccounting e"uation illustrated by the balance sheet i. $ssets C &laims ii. $ssets C #iabilities D 6wners! /"uity h. 0eading i. Name of the company ii. Name of the financial statement iii. (ate (one specific date iv. $iscal "ear is a year in the life of the business. )t may or may not coincide with the calendar year. i. &omparative balance sheets are the balance sheets from consecutive fiscal years for a single company. Teaching Tip /xplain the balance sheet as a <snapshot= or <still-frame= photo of the business. Teaching Tip 3se /xhibit '.E to illustrate how transactions affect the accounting e"uation. )2. )ncome statement a. $lso %nown as statement of earnings, statement of operations, or profit and loss statement. b. The income statement shows all revenue minus all expenses for an accounting period 4 a month, a "uarter, or a year. c. 5et income e"uals all revenues minus all expenses for a specific period of time. Teaching Tip /xplain the income statement as a <video= or <movie= of the business. 2. 5tatement of changes in shareholders! e"uity a. Statement of changes in shareholders3 e4 it" starts with the beginning amount of contributed capital and shows all changes during the accounting period. Then the statement shows the beginning balance in retained earnings with its changes. The usual changes to retained earnings are the increases from net income and the decreases for dividends paid to shareholders. b. #etained earnings are the total of all net income amounts minus all dividends paid in the life of the company. c. Fetained earnings are not the same as cash. &opyright + ,-'' .earson /ducation, )nc. publishing as .rentice 0all '-G

i. ii. iii. iv.

2).

d. &ontrib ted capital $dditions 4 additional investments by owners. i. (eductions 4 not covered in this course. e. Fetained earnings i. $dditions 4 net income ii. (eductions 4 dividends f. 5tatement of changes in shareholders! e"uity is the bridge from the income statement to the balance sheet 5tatement of cash flows a. Statement of cash flo6s shows all cash collected and disbursed during a period of time. /ach cash amount is classified as one of three types. b. &ash from operating activities are cash transactions that relate to the everyday, routine transactions needed to run the business. i. )nflows 4 cash received from customers. ii. 6utflows 4 cash routinely paid to produce and sell goods and services. c. &ash from investing activities are transactions involving the sale and purchase of long-term assets used in the business. i. )nflows 4 cash received from selling long-term productive assets. ii. 6utflows 4 cash paid to ac"uire long-term productive assets. d. &ash from financing activities are transactions related to how a business is financed. i. )nflows 4 cash received from investors (owners or creditors. ii. 6utflows 4 cash paid to repay loans and ma%e distributions (dividends to owners. Teaching Tip

$s an introduction to this topic, as% students where their money comes from and what they use it for. &ategorize their suggestions as operating, investing, or financing. '. 6perating 4 salaries;wages from Bobs> rent payments, food, etc. ,. )nvesting 4 purchasing or selling investments> buying a house 9. 7inancing 4 borrowing or repaying money 6r, 5et up three unlabeled columns on the board (or screen, etc. . $s% students to call out any %ind of activity associated with a business. Hou can drop each item into the appropriate column and then as% students to come up with names for the columns. Teaching Tip $s% students which of the three activities is most important and why. $lso as% them whether they believe cash flows in each area should be a net inflow or a net outflow. Teaching Tip $s% students whether they believe a net increase or a net decrease in cash is more desirable.

&opyright + ,-'' .earson /ducation, )nc. publishing as .rentice 0all

'-E

Teaching Tip 3se /xhibit '.'? to show how the financial statements are interrelated. Rea- Co/pan6 ,"nan*"a- S$a$e/en$s &LO 7' ). .ublicly traded corporations are ones that sell their stoc% on the public stoc% exchanges. )). $ll publicly traded corporations must prepare the four financial statements every year. ))). 6ne of the most important filings a company can ma%e is the '--I. )t provides a comprehensive overview of the business. )2. The '--I must be filed using a computer language called 7/#2 (/xtensible 1usiness Feporting #anguage . This is a technology that enables firms to report information in a standardized way that ma%es the data immediately available and interactive. Bus"ness R"s28 Con$ro-8 an E$("*s &LO 9' ). .art of planning and running a business is identifying ris%s. )). #is' is danger, anything that exposes us to potential inBury or loss. a. Fis% that a product failure will result in death of consumers b. Fis% that someone will steal assets from the company c. Fis% that poor "uality inventory will be purchased and sold ))). Fis%s relate to all aspects of the business. a. Jeneral strategic ris%s 4 should we mar%et our cigarettes to teenagers: b. 6perating ris%s 4 should we operate without a bac%up power supply: c. 7inancial ris%s 4 should we borrow money or obtain investors: d. )nformation ris%s 4 should we use a manual accounting system: )2. 8hy ta%e ris%s: a. /very ris% has a potential reward. b. &ontrols are activities performed to minimize or eliminate certain ris%s. Teaching Tip $s% students to describe examples of ris%s that relate to a Bob that they have held.

&opyright + ,-'' .earson /ducation, )nc. publishing as .rentice 0all

'-K

&8.%T)# 1 T)5-M15:T) ;:1<

5.M) 99999999999999999999999999999999999 S)&T105 9999999999999 ,.T)999999999999

99999999999999999999999999999999999999999999999999999999999999999999999999999 9 LLLLL '. The primary purpose of a business is to: a. .ay taxes to the )F5 b. 5ell a product c. 5ell goods and;or services to ma%e a profit for the owner(s d. 0elp others 5ources of capital include: a. 6wners (investors b. &reditors (lenders c. 1oth $ and 1 d. None of the above $ll of the following are types of for-profit businesses, except: a. @erchandising companies b. 5ervice companies c. 7inancial service companies d. &haritable organizations 8hat is the name of the group that has much of the responsibility for setting financial standards: a. .ublic &ompanies $ccounting 6versight 1oard b. 7inancial $ccounting 5tandards 1oard c. 5ecurities and /xchange &ommission d. None of the above $ business may be organized as a: a. &orporation b. 5ole proprietorship c. .artnership d. $ny of the above $ repayment of the principal of loans to creditors would be shown on the statement of cash flows as a(n : a. 6perating activity b. )nvesting activity c. 7inancing activity d. Fevenue activity

LLLLL ,.

LLLLL 9.

LLLLL ?.

LLLLL A.

LLLLL G.

&opyright + ,-'' .earson /ducation, )nc. publishing as .rentice 0all

'-M

LLLLL E.

/very business transaction is made up of: a. Fesources b. $gents c. /vents d. $ll of the above The balance sheet contains information about: a. Fevenues and expenses b. &ash inflows and outflows c. $ssets, liabilities, and e"uity d. $ll of the above The income statement provides information about: a. The financial position of the company at a point in time b. The financial position of the company for a period of time c. The amount of cash generated by operations d. The performance of the company for a period of time 8hich of the following financial statements reports the financial position of a company: a. The statement of cash flows b. The statement of changes in owners! e"uity c. The balance sheet d. The income statement

LLLLL K.

LLLLL M.

LLLLL'-.

.5S!)# =)> - &8.%T)# 1 ? T)5-M15:T) ;:1< '. ,. 9. ?. A. G. E. K. M. '-. & & ( 1 ( & ( & ( &

&opyright + ,-'' .earson /ducation, )nc. publishing as .rentice 0all

'-'-