Accounting and Business Structure

Overview of business system

Corporate Objectives
Widening role of Accounting for Business Decision Making; Value Creation for
Shareholders
Creating shareholder value depends on bringing about a positive pattern of cash
flows in excess of investor expectations.
A business that is successfully managed in all parts as an integrated system will
generate such cash flows over time and well into the futurethus becoming a value
creating company.
Three basic management decision areas of economic purpose:

Investment decisions.

Operating decisions.
Financing decisions.

Financial statements

Balance sheets.
Income (operating) statements.
Cash flow statements.
Statements of changes in shareholders(owners) equity.

Key analytical processes used in interpreting the performance and value of the business
system

Financial accounting.
Investor analysis.
Managerial economics.

Financial Analysis is based on financial statements and accounting data whereas

Economic analysis and trade-offs is based on cash flows.
Investment Decisions

Working capital (cash balances, receivables due from customers, and inventories,
less trade credit from suppliers and other normal current obligations).
Physical assets (land, buildings, machinery and equipment, office furnishings,
computer systems, laboratory equipment, etc.).
Major spending programs (research and development, product or service
development, promotional programs, etc.) and acquisitions.

Operating Decisions

Financing Decisions
Financing section begins with profit after taxes, which normally is a major source of
funding for a company.
Two key areas of strategy and trade-off decisions are identified:

The disposition of profits.

Shaping the companys capital structure.

Basic three-way split of after-tax profit among:

Owners.
Lenders.
Reinvestment in the business.

Ultimate goalvalue creation through positive cash flows in excess of the cost of
capital over time.

Nature of Business Activity

Business entities are organized to earn a profit.

Internal Revenue Service (IRS) does not recognize the separate existence of a
proprietorship from its owner. That is, a sole proprietorship is not a taxable entity;
the businesss profits are taxed on the individuals return.
Like a sole proprietorship, a partnership is not a taxable entity. Individual partners
pay taxes on their proportionate shares of the businesss profits.

Financing
A liability is an obligation of a business. e.g. Notes Payable, Bonds Payable, Tax
Payable
Capital stock is the term used by accountants to indicate the dollar amount of stock
sold to the public.

Stockholders Permanent form of financing, no due date of repayment

Creditors Not a permanent form of financing, repayment of amount and interest
is due

Investing
An asset is a future economic benefit to a business.
Operating
Revenue - An inflow of assets resulting from the sale of goods and services.
Expense - An outflow of assets resulting from the sale of goods and services

Financial Statements
Accounting - The process of identifying, measuring, and communicating economic
information to various users.

Internal Users Management Accounting

External Users Financial Accounting

Accounting Equation
Assets = Liabilities + Owners Equity
Balance sheet - The financial statement that summarizes the assets, liabilities, and
owners equity at a specific point in time. Alternate term: Statement of financial position.
Income statement - A statement that summarizes revenues and expenses. Alternate
term: Statement of income.
A statement of retained earnings explains the change in retained earnings during the
period. The net income less any dividends declared during the period.
Statement of cash flows - The financial statement that summarizes a companys cash
receipts and cash payments during the period from operating, investing, and financing
activities.

Conceptual Framework Foundation of Financial Statement

The accounting profession has developed a conceptual framework for accounting that
aids accountants in their role as interpreters and communicators of relevant information.
Purpose of Conceptual Framework:

Principles and standards

Assumptions in preparation of financial statements

Economic Entity Concept Financial statement shows financial position of an entity

only and does not intermingle the personal assets and liabilities of the employees or any
of the other stockholders.
Asset Valuation: Cost or Fair Value?
Cost principle/ historical cost, all assets are initially recorded at the cost to acquire
them.
Fair Value, A recent accounting rule requires a company to determine the amount an
asset could be sold for, rather than the amount it could be bought for, when market
prices are used to value assets on the balance sheet.
Going Concern Accountants assume that the entity being accounted for is a going
concern. That is, they assume that company is not in the process of liquidation and that
it will continue indefinitely into the future.

Business is not a going concern, we assume that it is in the process of

liquidation, market value is important for assets.

Business is a going concern, we assume that it is not in the process of

liquidation, historical cost is justifiable for assets.

Time Period Assumption accountants assume that it is possible to prepare an

income statement that accurately reflects net income or earnings for a specific time
period.
Generally Accepted Accounting Principles. GAAP The various methods, rules,
practices, and other procedures that have evolved over time in response to the need to
regulate the preparation of financial statements.
Summary of Recognition and Measurement Concepts

Setting Accounting Standards

Securities and Exchange Commission (SEC) - The federal agency with ultimate
authority to determine the rules for preparing statements for companies whose stock is
sold to the public.
Financial Accounting Standards Board (FASB) - The group in the private sector with
authority to set accounting standards.
Unfortunately, accounting standards can differ considerably from one country to another.
The International Accounting Standards Board (IASB) was created in 2001. Prior to
that time, the organization was known as the International Accounting Standards
Committee (IASC), which was formed in 1973 to develop worldwide accounting
standards. Organizations from many different countries, including the FASB in this
country, participate in the IASBs efforts to develop international reporting standards.
The Audit of Financial Statements - The process of examining the financial
statements and the underlying records of a company to render an opinion as to whether

the statements are fairly presented. Note that the auditors report is an opinion, not a
statement of fact. An auditor cannot be a consultant simultaneously.
There are four common types of auditor's reports,

Unqualified opinion - When the Auditor concludes that the Financial Statements
give a true and fair view in accordance with the financial reporting framework
used.
Qualified report is given by the auditor in either of these two cases but have no
pervasive effect on financial statement.
o When the financial statements are materially misstated

o When the auditor is unable to obtain audit evidence regarding particular

account balance
An Adverse Opinion Report is issued on the financial statements of a company
when the financial statements are materially misstated and such misstatements
have pervasive effect on the financial statements.
A Disclaimer of Opinion is issued in either of the following cases:
o When the auditor is not independent or when there is conflict of interest.
o When the limitation on scope is imposed by client, as a result the auditor is
unable to obtain sufficient appropriate audit evidence.
o When the circumstances indicate substantial problem of going concern in
client.
o When there are significant uncertainties in the business of client.

Materiality - The magnitude of an accounting information omission or misstatement

that will affect the judgment of someone relying on the information. Pencil / Computer
assets depreciation example.
Conservatism - The practice of using the least optimistic estimate when two estimates
of amounts are about equally likely. For example, inventory held for resale is reported on
the balance sheet at the lower-of-cost-or-market value.

Financial statements are prepared under the Accruals Concept of accounting which
requires that income and expense must be recognized in the accounting periods to which
they relate rather than on cash basis.
Substance over form is an accounting principle used "to ensure that financial
statements give a complete, relevant, and accurate picture of transactions and events".
In accounting for business transactions and other events, the measurement and
reporting is for the economic impact of an event, instead of its legal form. Do not hide
the true intent of the transaction.
Contingent Liability (Liability disclosed but not accrued) - A potential obligation that
may be incurred depending on the outcome of a future event. A contingent liability is
one where the outcome of an existing situation is uncertain, and this uncertainty will be
resolved by a future event. A contingent liability is recorded in the books of accounts
only if the contingency is probable and the amount of the liability can be estimated. E.g.
Lawsuits & product warranties.
An extraordinary item in accounting is an event or transaction that is considered
abnormal, not related to ordinary company activities, and unlikely to recur in the
foreseeable future. Gains or losses included in a company's financial statements.
Off-balance sheet - An asset or debt that does not appear on a company's balance
sheet. Items that are considered off balance sheet are generally ones in which the
company does not have legal claim or responsibility for. For example, loans issued by a
bank are typically kept on the bank's books. If those loans are securitized and sold off as
investments, however, the securitized debt is not kept on the bank's books. One of the
most common off-balance sheet items is an operating lease.
In financial accounting, reserve is any part of shareholders' equity, except for basic
share capital.

Distributable (revenue) reserves and non-distributable (capital) reserve.

Events after the balance sheet date are significant financial events that occur after
the date of the balance sheet, but prior to the date that the financial statements are
issued.
Transactions in Foreign Currency

Initial recognition- Translate the foreign currency amount into the functional
currency at the spot exchange rate on the transaction date.
Reporting at period end
o For monetary items - Cash, payables, receivables; re-translate using closing
rate at period end
o For non-monetary items - Inventory, non-current assets; Not re-translated,
kept at initial recognition amount
o If there is a revaluation to fair value, re-translate at the exchange rate at the
date of the FV adjustment.
Settlement - Re-translate using exchange rate at settlement

Exchange differences (in the functional currency) upon re-translation or settlement

are recognized in P&L.

Consolidated Financial Statement - The combined financial statements of a parent

company and its subsidiaries.

A classified balance sheet separates both assets and liabilities into current and
noncurrent.
Current assets are cash & other assets that are reasonably expected to be realized in
cash or sold or consumed during the normal operating cycle of a business or within one
year if the cycle is shorter than one year.
Long term assets Investment, PPE, Intangibles.
tangible assets.

Cost Principle of valuation for

Current liability - An obligation that will be satisfied within the next operating cycle or
within one year if the cycle is shorter than one year.
Preferred stock is a form of capital stock that carries with it certain preferences. For
example, the company must pay dividends on preferred stock before it makes any
distribution of dividends on common stock. Similarly in liquidation.
Related Party Transaction - A business deal or arrangement between two parties who
are joined by a special relationship prior to the deal. For example, a business transaction
between a major shareholder and the corporation, such as a contract for the
shareholder's company to perform renovations to the corporation's offices, would be
deemed a related-party transaction. All companies must report related party
transactions.
Transfer Pricing
The amount charged when one division sells goods or services to another division is
called a transfer price. This price affects the profit measurement for both the selling
division and the buying division. A high transfer price results in high profit for the selling
division and low profit for the buying division. A low transfer price has the opposite
effect.

General Transfer-Pricing Rule

Transfer price = Additional outlay cost per unit incurred because good are transferred +
Opportunity cost per unit to the organization because of the transfer
Sun Coast Food Centre (production) & Gulf Division (retailing)
Scenario 1: No Excess Capacity

Suppose a local organization makes a special offer to the Gulf Division manager to buy
several hundred loaves of bread and sell at $9.60. Gulf Division would reject the offer.

Scenario II: Excess Capacity

Transfer price = Outlay cost + Opportunity cost
$7.25 = $7.25

+ 0

Zero opportunity cost because the Food Processing Division can still satisfy all of its
external demand for bread.
If Gulf Division accepts special offer:

When the general rule cannot be implemented, organizations turn to other transferpricing methods,
Transfers Based on the External Market Price
A common approach is to set the transfer price equal to the price in the external market.

Negotiated Transfer Prices

Many companies use negotiated transfer prices. Division managers or their
representatives actually negotiate the price at which transfers will be made. Sometimes
they start with the external market price and then make adjustments for various reasons.
Drawbacks: competition in division managers, negotiation skills in evaluating managers
for profitability

Cost-Based Transfer Prices

Variable Cost - One approach is to set the transfer price equal to the standard
variable cost. The problem with this approach is that even when the producing
division has excess capacity, it is not allowed to show any contribution margin on
the transferred products or services.
Full Cost - An alternative is to set the transfer price equal to the full cost of the
transferred product or service. Full (or absorption) cost is equal to the products
variable cost plus an allocated portion of fixed overhead.

Dysfunctional Decision-Making Behavior

Basing transfer prices on full cost entails a serious risk of causing dysfunctional decisionmaking behavior. Full cost-based transfer prices lead the buying division to view costs
that are fixed for the company as a whole as variable costs to the buying division. This
can cause faulty decision making.
Standard versus Actual Costs
Transfer prices should not be based on actual costs, because such a practice would allow
an inefficient producing division to pass its excess production costs on to the buying
division in the transfer price.

ASSESSMENT OF BUSINESS PERFORMANCE

Three major viewpoints of financial performance analysis.

Managers.
Owners (investors).
Lenders and creditors.

Balanced Score-card approach

Lead and Lag Measures: The Key to the Balanced Scorecard

Lead indicators of performance are measures of nonfinancial and financial

outcomes that guide management in making current decisions that will result in
desirable results in the future. E.g. marketshare
Lag indicators are measures of the final outcomes of earlier management
decisions. Examples of lag indicators are a companys profit and cash flow.