STATEMENT

What is the statement of financial position?

The statement of financial position is another name for the balance sheet. It is one of the main financial statements and it reports an entity's assets, liabilities, and the difference in their totals.  The amounts reported on the statement of financial position are the amounts as of the final moment of an accounting period.

The structure of the statement of financial position is similar to the basic accounting equation. For instance, a corporation will report amounts in the following format: Assets = Liabilities + Stockholders' Equity. A nonprofit organization's format will be: Assets = Liabilities + Net Assets.

The statement of financial position must reflect the basic accounting principles and guidelines such as the cost, matching, and full disclosure principle. Accordingly, the statement of financial position is more meaningful when it is prepared under the accrual method of accounting.

MASSBOOX
What is stockholders' equity?

Stockholders' equity (also known as shareholders' equity) is one of the three elements of a corporation's balance sheet and the accounting equation as outlined here: assets = liabilities + stockholders' equity.

Some view stockholders' equity as a source (along with liabilities) of the corporation's assets. Others think of stockholders' equity as the owners' residual claim after the liabilities have been paid. Stockholders' equity is also the corporation's total book value (which is different from the corporation's worth or market value).

The amount of stockholders' equity is presented in the balance sheet in the following subsections:
Paid-in capital. Generally this subsection reports the amounts that the corporation received when it issued shares of capital stock.
Retained earnings. Generally this is the cumulative earnings of the corporation minus the cumulative amount of dividends declared.
Accumulated other comprehensive income. This is the cumulative amount of income (or loss) that has not been included in the net income reported on the corporation's income statement.
Treasury stock. This reduction of stockholders' equity is the amounts spent by the corporation to repurchase but not retire its own shares of capital stock.
The changes which occurred in stockholders' equity during the accounting period are reported in the corporation's Statement of Stockholders' Equity (one of the main financial statements).

NET ASSETS

What is the meaning of net assets?

Net assets is defined as total assets minus total liabilities. In a sole proprietorship the amount of net assets is reported as owner's equity. In a corporation the amount of net assets is reported as stockholders' equity.

In a not-for-profit (NFP) organization the amount of total assets minus total liabilities is actually reported as net assets in its statement of financial position. The net asset section for the NFP organization is divided into three classifications:
unrestricted net assets
temporarily restricted net assets
permanently restricted net assets.
The changes in these net asset classifications are reported in the organization's statement of activities.

WHAT IS ACCOUNTING

What is accounting?

Accounting is the recording of financial transactions plus storing, sorting, retrieving, summarizing, and presenting the information in various reports and analyses. Accounting is also a profession consisting of individuals having the formal education to carry out these tasks.

One part of accounting focuses on presenting the information in the form of general-purpose financial statements (balance sheet, income statement, etc.) to people outside of the company. These external reports must be prepared in accordance with generally accepted accounting principles often referred to as GAAP or US GAAP. This part of accounting is referred to as financial accounting.

Accounting also entails providing a company's management with the information it needs to keep the business financially healthy. These analyses and reports are not distributed outside of the company. Some of the information will originate from the recorded transactions but some of the information will be estimates and projections based on various assumptions. Three examples of internal analyses and reports are budgets, standards for controlling operations, and estimating selling prices for quoting new jobs. This area of accounting is known as management accounting.

Another part of accounting involves compliance with government regulations pertaining to income tax reporting.

Today much of the recording, storing, and sorting aspects of accounting have been automated as a result of the advances in computer technology.

BALANNCE

1. Balance Sheet

Let's see how the basic accounting principles and guidelines affect the balance sheet of Mary's Design Service, a sole proprietorship owned by Mary Smith. (To learn more about the balance sheet go to Explanation of Balance Sheet and Quiz for Balance Sheet.)

A balance sheet is a snapshot of a company's assets, liabilities, and owner's equity at one point in time. (In this case, that point in time is after all of the transactions through September 30, 2016 have been recorded.) Because of the economic entity assumption, only the assets, liabilities, and owner's equity specifically identified with Mary's Design Service are shown—the personal assets of the owner, Mary Smith, are not included on the company's balance sheet.


The assets listed on the balance sheet have a cost that can be measured and each amount shown is the original cost of each asset. For example, let's assume that a tract of land was purchased in 1956 for $10,000. Mary's Design Service still owns the land, and the land is now appraised at $250,000. The cost principle requires that the land be shown in the asset account Land at its original cost of $10,000 rather than at the recently appraised amount of $250,000.

If Mary's Design Service were to purchase a second piece of land, the monetary unit assumption dictates that the purchase price of the land bought today would simply be added to the purchase price of the land bought in 1956, and the sum of the two purchase prices would be reported as the total cost of land.

The Supplies account shows the cost of supplies (if material in amount) that were obtained by Mary's Design Service but have not yet been used. As the supplies are consumed, their cost will be moved to the Supplies Expense account on the income statement. This complies with the matching principle which requires expenses to be matched either with revenues or with the time period when they are used. The cost of the unused supplies remains on the balance sheet in the asset account Supplies.

The Prepaid Insurance account represents the cost of insurance that has not yet expired. As the insurance expires, the expired cost is moved to Insurance Expense on the income statement as required by the matching principle. The cost of the insurance that has not yet expired remains on Mary's Design Service's balance sheet (is "deferred" to the balance sheet) in the asset account Prepaid Insurance. Deferring insurance expense to the balance sheet is possible because of another basic accounting principle, the going concern assumption.

The cost principle and monetary unit assumption prevent some very valuable assets from ever appearing on a company's balance sheet. For example, companies that sell consumer products with high profile brand names, trade names, trademarks, and logos are not reported on their balance sheets because they were not purchased. For example, Coca-Cola's logo and Nike's logo are probably the most valuable assets of such companies, yet they are not listed as assets on the company balance sheet. Similarly, a company might have an excellent reputation and a very skilled management team, but because these were not purchased for a specific cost and we cannot objectively measure them in dollars, they are not reported as assets on the balance sheet. If a company actually purchases the trademark of another company for a significant cost, the amount paid for the trademark will be reported as an asset on the balance sheet of the company that bought the trademark.

2. Income Statement

Let's see how the basic accounting principles and guidelines might affect the income statement of Mary's Design Service. (To learn more about the income statement go to Explanation of Income Statement and Quiz for Income Statement.)

An income statement covers a period of time (or time interval), such as a year, quarter, month, or four weeks. It is imperative to indicate the period of time in the heading of the income statement such as "For the Nine Months Ended September 30, 2016". (This means for the period of January 1 through September 30, 2016.) If prepared under the accrual basis of accounting, an income statement will show how profitable a company was during the stated time interval.

09X-table-02
Revenues are the fees that were earned during the period of time shown in the heading. Recognizing revenues when they are earned instead of when the cash is actually received follows the revenue recognition principle and the matching principle. (The matching principle is what steers accountants toward using the accrual basis of accounting rather than the cash basis. Small business owners should discuss these two methods with their tax advisors.)

Gains are a net amount related to transactions that are not considered part of the company's main operations. For example, Mary's Design Service is in the business of designing, not in the land development business. If the company should sell some land for $30,000 (land that is shown in the company's accounting records at $25,000) Mary's Design Service will report a Gain on Sale of Land of $5,000. The $30,000 selling price will not be reported as part of the company's revenues.

Expenses are costs used up by the company in performing its main operations. The matching principle requires that expenses be reported on the income statement when the related sales are made or when the costs are used up (rather than in the period when they are paid).

Losses are a net amount related to transactions that are not considered part of the company's main operating activities. For example, let's say a retail clothing company owns an old computer that is carried on its accounting records at $650. If the company sells that computer for $300, the company receives an asset (cash of $300) but it must also remove $650 of asset amounts from its accounting records. The result is a Loss on Sale of Computer of $350. The $300 selling price will not be included in the company's sales or revenues.

3. The Notes To Financial Statements

Another basic accounting principle, the full disclosure principle, requires that a company's financial statements include disclosure notes. These notes include information that helps readers of the financial statements make investment and credit decisions. The notes to the financial statements are considered to be an integral part of the financial statements.

Additional Information and Resources

Because the material covered here is considered an introduction to this topic, many complexities have been omitted. You should always consult with an accounting professional for assistance with your own specific circumstances.

COMPARATION

Other Characteristics of Accounting Information

When financial reports are generated by professional accountants, we have certain expectations of the information they present to us:

We expect the accounting information to be reliable, verifiable, and objective.
We expect consistency in the accounting information.
We expect comparability in the accounting information.
1. Reliable, Verifiable, and Objective

In addition to the basic accounting principles and guidelines listed in Part 1, accounting information should be reliable, verifiable, and objective. For example, showing land at its original cost of $10,000 (when it was purchased 50 years ago) is considered to be more reliable, verifiable, and objective than showing it at its current market value of $250,000. Eight different accountants will wholly agree that the original cost of the land was $10,000—they can read the offer and acceptance for $10,000, see a transfer tax based on $10,000, and review documents that confirm the cost was $10,000. If you ask the same eight accountants to give you the land's current value, you will likely receive eight different estimates. Because the current value amount is less reliable, less verifiable, and less objective than the original cost, the original cost is used.

The accounting profession has been willing to move away from the cost principle if there are reliable, verifiable, and objective amounts involved. For example, if a company has an investment in stock that is actively traded on a stock exchange, the company may be required to show the current value of the stock instead of its original cost.

2. Consistency

Accountants are expected to be consistent when applying accounting principles, procedures, and practices. For example, if a company has a history of using the FIFO cost flow assumption, readers of the company's most current financial statements have every reason to expect that the company is continuing to use the FIFO cost flow assumption. If the company changes this practice and begins using the LIFO cost flow assumption, that change must be clearly disclosed.

3. Comparability

Investors, lenders, and other users of financial statements expect that financial statements of one company can be compared to the financial statements of another company in the same industry. Generally accepted accounting principles may provide for comparability between the financial statements of different companies. For example, the FASB requires that expenses related to research and development (R&D) be expensed when incurred. Prior to its rule, some companies expensed R&D when incurred while other companies deferred R&D to the balance sheet and expensed them at a later date.

How Principles and Guidelines Affect Financial Statements

The basic accounting principles and guidelines directly affect the way financial statements are prepared and interpreted. Let's look below at how accounting principles and guidelines influence the (1) balance sheet, (2) income statement, and (3) the notes to the financial statements.

REVENUE

8. Revenue Recognition Principle
Under the accrual basis of accounting (as opposed to the cash basis of accounting), revenues are recognized as soon as a product has been sold or a service has been performed, regardless of when the money is actually received. Under this basic accounting principle, a company could earn and report $20,000 of revenue in its first month of operation but receive $0 in actual cash in that month.

For example, if ABC Consulting completes its service at an agreed price of $1,000, ABC should recognize $1,000 of revenue as soon as its work is done—it does not matter whether the client pays the $1,000 immediately or in 30 days. Do not confuse revenue with a cash receipt.

9. Materiality
Because of this basic accounting principle or guideline, an accountant might be allowed to violate another accounting principle if an amount is insignificant. Professional judgement is needed to decide whether an amount is insignificant or immaterial.

An example of an obviously immaterial item is the purchase of a $150 printer by a highly profitable multi-million dollar company. Because the printer will be used for five years, the matching principle directs the accountant to expense the cost over the five-year period. The materiality guideline allows this company to violate the matching principle and to expense the entire cost of $150 in the year it is purchased. The justification is that no one would consider it misleading if $150 is expensed in the first year instead of $30 being expensed in each of the five years that it is used.

Because of materiality, financial statements usually show amounts rounded to the nearest dollar, to the nearest thousand, or to the nearest million dollars depending on the size of the company.

10. Conservatism
If a situation arises where there are two acceptable alternatives for reporting an item, conservatism directs the accountant to choose the alternative that will result in less net income and/or less asset amount. Conservatism helps the accountant to "break a tie." It does not direct accountants to be conservative. Accountants are expected to be unbiased and objective.

The basic accounting principle of conservatism leads accountants to anticipate or disclose losses, but it does not allow a similar action for gains. For example, potential losses from lawsuits will be reported on the financial statements or in the notes, but potential gains will not be reported. Also, an accountant may write inventory down to an amount that is lower than the original cost, but will not write inventory up to an amount higher than the original cost.

ACCOUNTING

ACCOUNTING

Introduction to Accounting Principles

There are general rules and concepts that govern the field of accounting. These general rules–referred to as basic accounting principles and guidelines–form the groundwork on which more detailed, complicated, and legalistic accounting rules are based. For example, the Financial Accounting Standards Board (FASB) uses the basic accounting principles and guidelines as a basis for their own detailed and comprehensive set of accounting rules and standards.

The phrase "generally accepted accounting principles" (or "GAAP") consists of three important sets of rules: (1) the basic accounting principles and guidelines, (2) the detailed rules and standards issued by FASB and its predecessor the Accounting Principles Board (APB), and (3) the generally accepted industry practices.

If a company distributes its financial statements to the public, it is required to follow generally accepted accounting principles in the preparation of those statements. Further, if a company's stock is publicly traded, federal law requires the company's financial statements be audited by independent public accountants. Both the company's management and the independent accountants must certify that the financial statements and the related notes to the financial statements have been prepared in accordance with GAAP.

GAAP is exceedingly useful because it attempts to standardize and regulate accounting definitions, assumptions, and methods. Because of generally accepted accounting principles we are able to assume that there is consistency from year to year in the methods used to prepare a company's financial statements. And although variations may exist, we can make reasonably confident conclusions when comparing one company to another, or comparing one company's financial statistics to the statistics for its industry. Over the years the generally accepted accounting principles have become more complex because financial transactions have become more complex.

Basic Accounting Principles and Guidelines

Since GAAP is founded on the basic accounting principles and guidelines, we can better understand GAAP if we understand those accounting principles. The following is a list of the ten main accounting principles and guidelines together with a highly condensed explanation of each.

1. Economic Entity Assumption
The accountant keeps all of the business transactions of a sole proprietorship separate from the business owner's personal transactions. For legal purposes, a sole proprietorship and its owner are considered to be one entity, but for accounting purposes they are considered to be two separate entities.

2. Monetary Unit Assumption
Economic activity is measured in U.S. dollars, and only transactions that can be expressed in U.S. dollars are recorded.

Because of this basic accounting principle, it is assumed that the dollar's purchasing power has not changed over time. As a result accountants ignore the effect of inflation on recorded amounts. For example, dollars from a 1960 transaction are combined (or shown) with dollars from a 2016 transaction.

3. Time Period Assumption
This accounting principle assumes that it is possible to report the complex and ongoing activities of a business in relatively short, distinct time intervals such as the five months ended May 31, 2016, or the 5 weeks ended May 1, 2016. The shorter the time interval, the more likely the need for the accountant to estimate amounts relevant to that period. For example, the property tax bill is received on December 15 of each year. On the income statement for the year ended December 31, 2015, the amount is known; but for the income statement for the three months ended March 31, 2016, the amount was not known and an estimate had to be used.

It is imperative that the time interval (or period of time) be shown in the heading of each income statement, statement of stockholders' equity, and statement of cash flows. Labeling one of these financial statements with "December 31" is not good enough–the reader needs to know if the statement covers the one week ended December 31, 2016 the month ended December 31, 2016 the three months ended December 31, 2016 or the year ended December 31, 2016.

4. Cost Principle
From an accountant's point of view, the term "cost" refers to the amount spent (cash or the cash equivalent) when an item was originally obtained, whether that purchase happened last year or thirty years ago. For this reason, the amounts shown on financial statements are referred to as historical cost amounts.

Because of this accounting principle asset amounts are not adjusted upward for inflation. In fact, as a general rule, asset amounts are not adjusted to reflect any type of increase in value. Hence, an asset amount does not reflect the amount of money a company would receive if it were to sell the asset at today's market value. (An exception is certain investments in stocks and bonds that are actively traded on a stock exchange.) If you want to know the current value of a company's long-term assets, you will not get this information from a company's financial statements–you need to look elsewhere, perhaps to a third-party appraiser.

5. Full Disclosure Principle
If certain information is important to an investor or lender using the financial statements, that information should be disclosed within the statement or in the notes to the statement. It is because of this basic accounting principle that numerous pages of "footnotes" are often attached to financial statements.

As an example, let's say a company is named in a lawsuit that demands a significant amount of money. When the financial statements are prepared it is not clear whether the company will be able to defend itself or whether it might lose the lawsuit. As a result of these conditions and because of the full disclosure principle the lawsuit will be described in the notes to the financial statements.

A company usually lists its significant accounting policies as the first note to its financial statements.

6. Going Concern Principle
This accounting principle assumes that a company will continue to exist long enough to carry out its objectives and commitments and will not liquidate in the foreseeable future. If the company's financial situation is such that the accountant believes the company will not be able to continue on, the accountant is required to disclose this assessment.

The going concern principle allows the company to defer some of its prepaid expenses until future accounting periods.

7. Matching Principle
This accounting principle requires companies to use the accrual basis of accounting. The matching principle requires that expenses be matched with revenues. For example, sales commissions expense should be reported in the period when the sales were made (and not reported in the period when the commissions were paid). Wages to employees are reported as an expense in the week when the employees worked and not in the week when the employees are paid. If a company agrees to give its employees 1% of its 2016 revenues as a bonus on January 15, 2017, the company should report the bonus as an expense in 2016 and the amount unpaid at December 31, 2016 as a liability. (The expense is occurring as the sales are occurring.)

Because we cannot measure the future economic benefit of things such as advertisements (and thereby we cannot match the ad expense with related future revenues), the accountant charges the ad amount to expense in the period that the ad is run.

(To learn more about adjusting entries go to Explanation of Adjusting Entries and Quiz for Adjusting Entries.)

CORPORATIONS

CORPORATIONS

CORPORATIONS

INTRODUCTION TO CORPORATIONS

A corporation is an legal entity created by state law. It has a distinct and separate existence from the individuals who created it, and those who control its operations. Corporations are commonly classified as profit or nonprofit, and public or nonpublic. A profit corporation's survival depends upon its ability to make profits. A not-for-profit corporation relies on donations and grants. Public corporations issue stock that is widely held and traded. Shares of a nonpublic corporation are usually held by a small number of individuals. Regardless of the form or purpose of corporations, all must be created according to either state or federal statutes.

CHARACTERISTICS OF A CORPORATION

A corporation has the ability to enter into contracts, incur liabilities, and buy, sell, or own assets in its corporate name. These provisions can be found in the charter or articles of incorporation. Ownership of a corporation is divided into shares of stock. Stocks can be issued in different classes. All shares of stock in the same class have identical rights and privileges. The buying and selling of shares does not effect the business activities of the corporation. Shareholders' liability is limited to the amount they invested.

CHARACTERISTICS OF A CORPORATION

The corporation is subject to considerable more regulation than other forms of business organization. Corporations are also subject to greater taxes. Earnings are taxed before they are distributed to shareholders, and again when shareholders report them on their individual tax returns. The IRS does under certain conditions allow a corporation to be taxed in a manner similar to a partnership, provided it has a small number of shareholders. All corporations are subject to federal income taxes. The payment of state income taxes depends upon where the corporation was incorporated and in which states it conducts business.

ORGANIZATION OF A CORPORATION ORGANIZATIONAL STRUCTURE OF A CORPORATION

1) Shareholders of a corporation elect the board of directors.

2) The board of directors are responsible for determining corporate policies and electing officers.

3) Officers are responsible for operations and hiring employees. When shareholders are not pleased with the performance of the board of directors, they can elect new directors.

ADVANTAGES/DISADVANTAGES OF CORPORATIONS

The major advantages of corporations as a form of business are:

1- limited liability of shareholders,

2- large capital formation,

3- ease of transfer of ownership,

4- continuity of existence.

The disadvantages of corporations are:

1- double taxation of profits,

2- possible conflicts between management and shareholders,

3- government regulations.

SHAREHOLDERS' EQUITY

The shareholders' equity (that is, owners' equity of a corporation) consists of primarily paid-in capital and retained earnings. Paid-in capital represents the funds paid for shares of stock. When more than one class of stock is issued, separate paid-in capital accounts are maintained. The retained earnings account should normally have a credit balance, and it represents past net income that has been accumulated by the corporation. Dividends are paid out of retained earnings resulting in debit to retained earnings account. If the retained earnings account balance is itself a debit, a deficit has been incurred by the corporation, i.e. losses in excess of profits.

CHARACTERISTICS OF STOCK

The number of shares of stock a corporation may issue is stated in the articles of incorporation. Shares can be issued with or without par. A par value does not reflect the true value of the stock, it is merely an arbitrary monetary figure. The par value of a stock can be found on the stock certificate which also serves as evidence of ownership. Most states require that a stock be assigned a stated value. It is the responsibility of the board of directors to either assign a par or stated value to shares of stock.

CHARACTERISTICS OF STOCKS

Shares of ownership in a corporation are capital stock. Shares owned by shareholders are referred to as stock outstanding. The creditors of a corporation have no legal claim against shareholders. The law requires, however, that a specific minimum contribution of shareholders be held by the corporation as protection for creditors. The percentage is determined by state laws, and is known as legal capital. The percentage of investment held as legal capital tends to be low, similar to the par or stated value of the stock.

CLASSES OF STOCK

All shareholders of a corporation are entitled to basic rights. These rights differ according to classes of stock. Common stock possesses most of the voting powers, while preferred stock has preferential rights to a share in the distribution of earnings, and often has first claim to assets in the event of liquidation. Each common stoch shareholder also has a preemptive right to any new issue. The specific rights of a stock are found in either the charter or the stock certificate. The board of directors decides if earnings should be distributed to shareholders as dividends. Distribution of dividends is not guaranteed, and the decision is usually based upon the needs of a corporation.

TYPES OF PREFERRED STOCK

Preferred shareholders are assured of receiving dividends before any common shareholder. When preferred stock is participating, preferred shareholders can share in excess profits with common shareholders. Nonparticipating preferred stock is limited to a fixed dividend. When a preferred stock is cumulative, the preferred shareholder is entitled to all dividend payments in arrears before any common shareholder can be paid a dividend. A preferred stock that is both cumulative and participating is the most attractive to investors.

ISSUANCE OF STOCK

The entries to record investments of shareholders are similar to most other forms of business. A cash or an asset account is debited, and a capital account is credited. A corporation must keep detailed records of shareholders investments if it plans to pay the correct amount of dividends to the appropriate individuals. It also uses these records to sent shareholders financial reports and proxy forms. When corporations issue stock, it rarely sells at its par value. The price of a stock is influenced by many factors.

PREMIUMS AND DISCOUNTS ON STOCK

When stock is issued at a higher value than par, a premium on stock account is credited. If a stock is issued below par, a discount on stock account is debited. Under certain circumstances, a corporation may decide to return a premium as a dividend at a later date. When a stock is issued at a discount, shareholders may be liable up to the amount of the discount in the event of a liquidation. The discount on capital account is classified as a contra paid-in capital account, and is subtracted from other capital accounts when determining the total shareholders' equity.

STOCK SUBSCRIPTION

When a corporation does not want to sell its own shares, it can sell its stock to an underwriter who resells it at a higher price to earn a profit. The advantages of issuing stock through an underwriter are that it relieves a company from marketing tasks, and the company may even receive funds before shares are sold. Stock can be subscribed at par, below par, or above par.

STOCK SUBSCRIPTION

When a company sells its stock directly to investors, a Stock Subscription Receivable account is debited for each sale. A Stock Subscribed account is credited upon the initial offering of the subscription. When a subscription has been paid in full, Stock Subsdcribed account is debited and the appropriate stock account credited. At the same time the stock certificates are issued to shareholders. To keep track of subscription payments a subscribers ledger shows individual accounts. Paper stock certificates are currently phased out and replaced by computerized entries.

TREASURY STOCK

Treasury stock represents stock that has been issued, subscribed in the past, and later repurchased from shareholders. Motives for repurchasing shares may be to provide employees with stock bonuses, use these stocks for employee savings plans, or to boost the market value of the stock. If treasury stock is reissued or cancelled, it is no longer treasury stock. The accounting method most commonly employed to record the purchase and sale of treasury stock is the cost basis. The purchase or sale price is used to record the entry with no consideration given to par value or original issue price. When the stock is resold a Paid-In Capital from Sale of Treasury Stock account is used to record any premiums or discounts on sales.

EQUITY PER SHARE

Equity per share represents the book value of a share (not its market value). Equity per share is calculated by dividing total shareholders' equity by the number of shares outstanding. In the event more than one type of stock has been issued, the equity must be allocated among the different types. The presence of preferred stock reduces the amount of equity available to common stock shareholders. The equity per share has an insignificant influence on the market price of a stock: earnings per share, dividend payments, and future expectations are far more influential.

ORGANIZATION COSTS

Any expenditure incurred when the corporation is formed, is charged to the Organization Costs account. This account is an intangible asset that has no value in the event the corporation is liquidated. The Internal Revenue Code allows Organization Costs to be amortized, but this must be done within five years. Organization Costs are usually not large, and their amortization has little effect on net income.

CORPORATIONS

CORPORATIONS

INTRODUCTION TO CORPORATIONS

A corporation is an legal entity created by state law. It has a distinct and separate existence from the individuals who created it, and those who control its operations. Corporations are commonly classified as profit or nonprofit, and public or nonpublic. A profit corporation's survival depends upon its ability to make profits. A not-for-profit corporation relies on donations and grants. Public corporations issue stock that is widely held and traded. Shares of a nonpublic corporation are usually held by a small number of individuals. Regardless of the form or purpose of corporations, all must be created according to either state or federal statutes.

CHARACTERISTICS OF A CORPORATION

A corporation has the ability to enter into contracts, incur liabilities, and buy, sell, or own assets in its corporate name. These provisions can be found in the charter or articles of incorporation. Ownership of a corporation is divided into shares of stock. Stocks can be issued in different classes. All shares of stock in the same class have identical rights and privileges. The buying and selling of shares does not effect the business activities of the corporation. Shareholders' liability is limited to the amount they invested.

CHARACTERISTICS OF A CORPORATION

The corporation is subject to considerable more regulation than other forms of business organization. Corporations are also subject to greater taxes. Earnings are taxed before they are distributed to shareholders, and again when shareholders report them on their individual tax returns. The IRS does under certain conditions allow a corporation to be taxed in a manner similar to a partnership, provided it has a small number of shareholders. All corporations are subject to federal income taxes. The payment of state income taxes depends upon where the corporation was incorporated and in which states it conducts business.

ORGANIZATION OF A CORPORATION ORGANIZATIONAL STRUCTURE OF A CORPORATION

1) Shareholders of a corporation elect the board of directors.

2) The board of directors are responsible for determining corporate policies and electing officers.

3) Officers are responsible for operations and hiring employees. When shareholders are not pleased with the performance of the board of directors, they can elect new directors.

ADVANTAGES/DISADVANTAGES OF CORPORATIONS

The major advantages of corporations as a form of business are:

1- limited liability of shareholders,

2- large capital formation,

3- ease of transfer of ownership,

4- continuity of existence.

The disadvantages of corporations are:

1- double taxation of profits,

2- possible conflicts between management and shareholders,

3- government regulations.

SHAREHOLDERS' EQUITY

The shareholders' equity (that is, owners' equity of a corporation) consists of primarily paid-in capital and retained earnings. Paid-in capital represents the funds paid for shares of stock. When more than one class of stock is issued, separate paid-in capital accounts are maintained. The retained earnings account should normally have a credit balance, and it represents past net income that has been accumulated by the corporation. Dividends are paid out of retained earnings resulting in debit to retained earnings account. If the retained earnings account balance is itself a debit, a deficit has been incurred by the corporation, i.e. losses in excess of profits.

CHARACTERISTICS OF STOCK

The number of shares of stock a corporation may issue is stated in the articles of incorporation. Shares can be issued with or without par. A par value does not reflect the true value of the stock, it is merely an arbitrary monetary figure. The par value of a stock can be found on the stock certificate which also serves as evidence of ownership. Most states require that a stock be assigned a stated value. It is the responsibility of the board of directors to either assign a par or stated value to shares of stock.

CHARACTERISTICS OF STOCKS

Shares of ownership in a corporation are capital stock. Shares owned by shareholders are referred to as stock outstanding. The creditors of a corporation have no legal claim against shareholders. The law requires, however, that a specific minimum contribution of shareholders be held by the corporation as protection for creditors. The percentage is determined by state laws, and is known as legal capital. The percentage of investment held as legal capital tends to be low, similar to the par or stated value of the stock.

CLASSES OF STOCK

All shareholders of a corporation are entitled to basic rights. These rights differ according to classes of stock. Common stock possesses most of the voting powers, while preferred stock has preferential rights to a share in the distribution of earnings, and often has first claim to assets in the event of liquidation. Each common stoch shareholder also has a preemptive right to any new issue. The specific rights of a stock are found in either the charter or the stock certificate. The board of directors decides if earnings should be distributed to shareholders as dividends. Distribution of dividends is not guaranteed, and the decision is usually based upon the needs of a corporation.

TYPES OF PREFERRED STOCK

Preferred shareholders are assured of receiving dividends before any common shareholder. When preferred stock is participating, preferred shareholders can share in excess profits with common shareholders. Nonparticipating preferred stock is limited to a fixed dividend. When a preferred stock is cumulative, the preferred shareholder is entitled to all dividend payments in arrears before any common shareholder can be paid a dividend. A preferred stock that is both cumulative and participating is the most attractive to investors.

ISSUANCE OF STOCK

The entries to record investments of shareholders are similar to most other forms of business. A cash or an asset account is debited, and a capital account is credited. A corporation must keep detailed records of shareholders investments if it plans to pay the correct amount of dividends to the appropriate individuals. It also uses these records to sent shareholders financial reports and proxy forms. When corporations issue stock, it rarely sells at its par value. The price of a stock is influenced by many factors.

PREMIUMS AND DISCOUNTS ON STOCK

When stock is issued at a higher value than par, a premium on stock account is credited. If a stock is issued below par, a discount on stock account is debited. Under certain circumstances, a corporation may decide to return a premium as a dividend at a later date. When a stock is issued at a discount, shareholders may be liable up to the amount of the discount in the event of a liquidation. The discount on capital account is classified as a contra paid-in capital account, and is subtracted from other capital accounts when determining the total shareholders' equity.

STOCK SUBSCRIPTION

When a corporation does not want to sell its own shares, it can sell its stock to an underwriter who resells it at a higher price to earn a profit. The advantages of issuing stock through an underwriter are that it relieves a company from marketing tasks, and the company may even receive funds before shares are sold. Stock can be subscribed at par, below par, or above par.

STOCK SUBSCRIPTION

When a company sells its stock directly to investors, a Stock Subscription Receivable account is debited for each sale. A Stock Subscribed account is credited upon the initial offering of the subscription. When a subscription has been paid in full, Stock Subsdcribed account is debited and the appropriate stock account credited. At the same time the stock certificates are issued to shareholders. To keep track of subscription payments a subscribers ledger shows individual accounts. Paper stock certificates are currently phased out and replaced by computerized entries.

TREASURY STOCK

Treasury stock represents stock that has been issued, subscribed in the past, and later repurchased from shareholders. Motives for repurchasing shares may be to provide employees with stock bonuses, use these stocks for employee savings plans, or to boost the market value of the stock. If treasury stock is reissued or cancelled, it is no longer treasury stock. The accounting method most commonly employed to record the purchase and sale of treasury stock is the cost basis. The purchase or sale price is used to record the entry with no consideration given to par value or original issue price. When the stock is resold a Paid-In Capital from Sale of Treasury Stock account is used to record any premiums or discounts on sales.

EQUITY PER SHARE

Equity per share represents the book value of a share (not its market value). Equity per share is calculated by dividing total shareholders' equity by the number of shares outstanding. In the event more than one type of stock has been issued, the equity must be allocated among the different types. The presence of preferred stock reduces the amount of equity available to common stock shareholders. The equity per share has an insignificant influence on the market price of a stock: earnings per share, dividend payments, and future expectations are far more influential.

ORGANIZATION COSTS

Any expenditure incurred when the corporation is formed, is charged to the Organization Costs account. This account is an intangible asset that has no value in the event the corporation is liquidated. The Internal Revenue Code allows Organization Costs to be amortized, but this must be done within five years. Organization Costs are usually not large, and their amortization has little effect on net income.

UNIT COSTS

UNIT COSTS

UNIT COSTS

PROCESS COST SYSTEM

The process cost system is used by firms manufacturing identical products in a continuous mass production. As opposed to job order cost systems where unit costs are determined for separate jobs, in process cost systems, there is only one product and, therefor, only one overall unit cost. But, separate unit costs for each department reflect the manufacturing process as the product moves from department to department.

PROCESS COST INVENTORIES

Each department work in process inventory is debited for 1- the goods transferred to it and 2- the conversion costs (made of direct materials, direct labor and an apportioned factory overhead). It is credited for the goods transferred to the next department (or finished goods).

EQUIVALENT UNITS OF PRODUCTION

The number of products which could have been manufactured from start to finish by a department in a given period is known as the equivalent units of production. This number takes into account the beginning and ending inventory being made of products in different stages of production: both are converted to full or equivalent units before being added and subtracted (respectively) from actual total production of completed units.

UNIT PROCESSING COST

The unit processing cost is calculated by dividing the total processing cost assigned to the department by the equivalent units of production. This cost is further broken down into direct materials unit cost and conversion unit cost.

JOINT PRODUCT COST

When two or more products are produced simultaneously in a single manufacturing process, the joint material, labor and/or overhead must be apportioned to the different products. A common allocation method is based on the relative sales value of each product. When one of the products has a much lower value, it is called a byproduct. A byproduct is valued at net realizable value.

MANAGERIAL ACCOUNTING REPORTS

The desirable features of a managerial accounting reports are accuracy, clarity, conciseness, relevance and timeliness. Reports are not desirable if their cost exceeds any potential benefit.

GROSS PROFIT ANALYSIS

Gross profit analysis reveals whether a change in gross profit is attributable to sales volume, selling price or cost of production. The cost of production is further analyzed with variable costing or absorption costing. The purpose of the analysis is to help management make production, pricing, sales mix decisions as well as control costs.

VARIABLE COSTING

In variable costing, also known as direct costing, all the variable cost, and only variable costs, are assigned to cost of goods. A manufacturing margin (or marginal income) is derived by subtracting this variable cost from sales, and the factory overhead together with other selling and administrative expenses are deducted from it to arrive at net income. Variable costing reveals the effect of changing volume of production on net income.

 Sales minus Variable costs = manufacturing margin (or marginal income)

Manufacturing margin

          minus          factory overhead

          minus          other selling and administrative expenses

--------------------------------------------------------

Net income

ABSORPTION COSTING

In absorption costing, both variable and allocated overhead costs are assigned to cost of goods sold. Variable and absorption costing are similar if goods sold and goods manufactured are equal. When they are not equal, the absorption costing method reveals the effect of changes in inventory on net income.

Statement of Cash Flows

Statement of Cash Flows

Statement of Cash Flows

THE CASH BASIS FUNDS STATEMENT

SOURCES OF CASH

1) Operating income - is usually the largest and most frequent source of cash provided a business is profitable. When revenues exceed expenses, cash flow increases. When expenses exceed revenues, cash flow decreases.

2) Issuance of capital stock or long-term debt.

3) The sale of noncurrent assets such as equipment, land, buildings, patents, etc.

CASH PROVIDED BY OPERATIONS

CONVERSION OF NET INCOME FROM A ACCRUAL BASIS TO A CASH BASIS

1) The following items should be added to net income: depreciation expenses, increases in current liabilities, decreases in current assets, and the amortization of bond discount or intangible assets.

2) The following items should be subtracted from net income: amortization of bond premium, increases in current assets, and decreases in current liabilities.

WORKING CAPITAL FUNDS STATEMENT

SOURCES OF WORKING CAPITAL

1) Operating income - when revenues exceed expenses.

2) The issuance of long-term debt.

Example: Issued a $50,000 bond due to mature in ten years.

3) The issuance of capital stock.

Example: 10,000 shares of $100 par preferred stock are sold to

shareholders for $105 a share.

4) The sale of noncurrent assets. Example: building, land, bonds,

equipment, etc.

WORKING CAPITAL FUNDS STATEMENT

USES OF WORKING CAPITAL

1) The declaration of cash dividends.

Example: The board of directors issues a declaration that all

common shareholders will receive $0.50 for each share held.

2) The retirement of long-term debt.

Example: Full payment is made to bondholders at maturity.

3) The purchase of noncurrent assets. Example: equipment, land,

buildings, etc.

WORKING CAPITAL FUNDS STATEMENT

WORKING CAPITAL IS NOT AFFECTED BY THE FOLLOWING TRANSACTIONS

1) Those that are only between current asset accounts.

Example: Cash is used to purchase inventory.

2) Those that are only between current liability accounts.

Example: A 90 day note is drawn up for a trade receivable.

3) Those that are only between current asset and current

liability accounts.

Example: A cash payment is made to reduce accounts payable.

MANAGERIAL ACCOUNTING

MANAGERIAL  ACCOUNTING

MANAGERIAL  ACCOUNTING

FINANCIAL VS. MANAGERIAL ACCOUNTING

Accounting information is usually divided into two types: 1) financial and 2) managerial. Financial information (i.e. balance sheet and income statement) is prepared periodically, and is primarily intended for outsiders of the firm. Financial information is also useful to management in directing the current operations of a business and planning. Managerial accounting provides additional both historical and estimated data, which is intend specifically for management to run current operations and to plan for the future. The information generated is far more extensive than in financial accounting, and the reports are based on management's needs.

THE MANAGEMENT PROCESS

Managerial accounting gives management the information to perform the functions of control and planning. The control function is concerned with the process of directing the operations of an enterprise to achieve its goals. Planning is concerned with developing and setting goals for the use of company resources and formulating methods to achieve these goals. Control and planning decisions are the responsibility of management. The controller of a company gives advice but assumes no responsibility for managerial decisions. Results of management decisions are continuously compared to the goals, and the goals themselves are periodically revised.

INTRODUCTION TO RESPONSIBILITY ACCOUNTING

When all major planning and operating decisions are made by one or a few individuals of a business, it is considered to be a centralized organization. The larger a business becomes, the more difficult it is to remain centralized. When an organization becomes decentralized, it is divided into separate units. Each of these units is delegated responsibilities for planning and control. Managers are not required to seek approval from upper management for normal operating decision. The level of decentralization varies greatly among companies because each one has specific and unique circumstances. Managerial accountants assist managers of decentralized organizations.

DECENTRALIZED OPERATIONS

Decentralized operations are usually classified according to the scope of responsibility assigned and the decision making authority delegated to managers. The three types of decentralized operations are: 1) cost center, 2) profit center, and 3) investment center.

COST CENTERS

A budget is the tool used for planning and controlling costs. It represents a written statement of management's plans for the future in financial terms. Budget performance reports are prepared to compare actual results with budgeted figures. It is the management's responsibility to investigate variances, determine their cause, and suggest improvements. Often there are good explanations for these variances, and variances do not necessarily reflect poor management.

PROFIT CENTERS

Managers of profit centers are responsible for expenses and revenues. The income statement is usually the report used to evaluate performance. Income statements for profit centers can emphasize either gross profit or operating income, in addition to showing revenues and expenses of that department. Difficulties arise when expenses are apportioned among departments. Some expenses (period costs and indirect costs) reported on departmental income statements are assigned based on subjective criteria, and the method of allocation is often questionable. Direct costs are under the direct control of the department. Indirect costs are company wide and are referred to as overhead.

INVESTMENT CENTERS

Investment center managers are responsible for revenues, expenses, and invested assets. Results can be measured by evaluating operating income, rate of return on investment, and residual income. Because operating income only represents revenues and expenses with no consideration for the amount of invested assets, it does not portray a clear picture of profitability. The rate of return on investment and residual income offer more informative approaches.