Appunti Business Economics

Introduction to accounting

Basics of a business entity

1. Business entity

A business entity is a voluntary association of people formed and organized to carry on a business.

• Resources: it uses materials, land, machinery, energy, employees.
• Outputs: to produce and sell some products/services.
• Profits: with the aim of realizing some profits for its owners.
• Finances: it finances its activity using the financial provisions of the owners, equity, or creditors, debt.

Running a business implies making decisions every day.

• Whether or not providing financial capital to a business entity can be a very risky decision.
• Good decisions depend on the quality of information.

Accounting is the process of identifying, measuring and communicating economic information about a business entity to a variety of users for decision making purposes.

Bookkeeping is simply the process of recording and summarising the business transactions and the preparation of financial statements.

• Think of bookkeeping as part of the accounting process.

The accounting process

4. Decision making.

1. Identifying. 2. Measuring. 3. Communicating. 4. Decision making.

Transactions that must be able to be reliably measured and recorded.

Used for a range of decisions by external and internal users.

Via financial statements, internal reports.

Analysis, recording and classifying transactions.

1. Identifying

The first component of the process is identifying business transactions.

• Business transaction: external exchange of something of value between 2 or more entities.
• Can be reliably measured and recorded.
• Examples:
• Payment of salaries.
• Purchase of an office photocopier.
• Capital contribution by company owners.

2. Measuring

The second component is measuring the information.

• Recording, classifying, and grouping business transactions.
• Similar items are gathered together, such as groups of expenses and income, assets and liabilities.

For instance:

• Product A is sold for 120€ > Revenue, + Cash.
• Product B is sold for 60€ on credit > Revenue, + Trade receivables.
• Purchase of an office photocopier > Asset, - Cash.
• Purchase of raw materials > Expenditure, - Cash.

3. Communicating

The third component is communication of relevant information.

• Financial statements.
• Internal documents, reports.

Relevant information:

• Information that makes a difference in decision making.
• To whom?

4. Accounting information and its role in decision making

Accounting information is designed to meet the needs of both internal and external users when concerning a business entity making decisions.

Internal users: managers and employees of a business entity who use the information to:

• Make decisions concerning operations.
• Sales mix, choice of raw materials, pricing, demand forecasting.
• Evaluate business success.
• Expand operations in new markets.
• Evaluate alternatives in the use of scarce, costly, resources.
• Money, people.

External users, a.k.a. stakeholders, are parties outside the entity who have a stake, interest, in the performance of the entity and use accounting information to make decisions about the entity.

External means that these users are not, yet, involved in the management of the entity.

Financial accounting vs. management accounting

2. Financial accounting is the preparation and presentation of financial statements to allow users to make decisions about the entity.

Financial statements are a set of annual reports directed towards the information needs of a wide range of users, mainly external.

• Statement of Cash Flows.
• Balance Sheet, a.k.a. Statement of Financial Position.
• Income Statement, a.k.a. Profit & Loss statement.
• Statement of Changes in Equity.

Financial accounting is regulated by rules.

Management accounting provides information for internal users.

Unlike financial accounting, management accounting:

• Generates monthly/weekly reports for internal audiences.
• Considers various parts of the entity rather than the overall entity.
• Is not regulated by rules.
• Core activities include:
• Formulating plans, forecasts and budgets.
• Providing information to be used in monitoring and control within the different parts of an entity.

Standards and regulations in accounting

3. Two key issues:

1. Transparency towards external stakeholders

• The information that is communicated to external users must be reliable.
• Corporate collapses, insider trading and company frauds have resulted in changes to corporate regulation.
• Main sources of company regulation:
• Corporations Act, 2001, Australia.
• Sarbanes Oxley Act, 2002, US.
• European Commission.
• Independent audit: financial statements are usually audited by independent external accounting firms.

2. Globalization and increased complexity

• Business entities are becoming larger, more diversified and multinational.

International standards

4. Generally accepted accounting principles, GAAP: a set of rules and practices, having substantial authoritative support that guide financial reporting.

The International Accounting Standards Board, IASB, an independent non-profit organization prepared and issued:

• The International Financial Reporting Standards, IFRS.
• Since 2005, most countries have complied with IFRS.
• IASB defines accounting rules in the EU and more than 100 other countries.

Qualitative characteristics of financial statements

5. The conceptual framework sets out the key concepts that underlie the preparation and presentation of financial statements for reporting entities.

Objective of financial reports:

• To provide information about the financial position, financial performance and cash flows of an entity that is useful to a wide range of users in making economic decisions.

Relevance:

• Information should help users in making a decision.

Faithful Representation:

• Implies that financial information faithfully represents the phenomena it purports to represent.
• Information must be complete, neutral and free from error.

Comparability:

• Users must be able to compare:
• Aspects of the entity across time.
• Different entities.

Verifiability:

• A company's accounting results must be reproducible, given the same data and assumptions, an independent accountant can produce the same result.

Timeliness:

• Information is available to all stakeholders in time for decision making purposes.

Understandability:

• The preparers should present information in the most understandable manner for users.

Definition and recognition of elements of financial statements

6. Assets: a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity.

Liabilities: a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources.

Equity: the residual interest in the assets of the entity after all its liabilities have been deducted.

Income: inflows or other enhancements of assets, or decreases in liabilities that result in an increase in equity other than those relating to contributions by equity participants.

Expenses: decreases in economic benefits in the form of outflows or depletions of assets or incurrence of liabilities that result in a decrease in equity other than those relating to distributions from equity participants.

Profit: the financial gain realized as the difference between the amount earned and the amount spent in a business activity.

Limitations

7. Limitations:

• Time lag in the distribution of information to users.
• Historical information based on past data.
• Subjectivity of information refers to the choices involved in inclusion of items to be reported and accounting policies to adopt.
• Costs of providing information.
• Information costs: costs involved in gathering, summarising and producing info contained in financial report.
• Release of competitive information: information in the financial report could be used by competitors.

Summary

• A business entity is a voluntary association of people formed and organized to carry on a business, with the aim of making profits.
• Process of accounting concerns identifying, measuring and communicating economic information for decision making.
• Users of accounting information may be external or internal.
• Management accounting concerns needs of internal users, while financial accounting focuses on reports for external users.
• Need for transparency.
• Entities have become larger, more diversified and multinational.
• GAAP and IFRS.
• Limitations of accounting relate to the time lag, historical nature of information and costs associated with releasing accounting information.

Business goals and sustainability

1. Goals of a business entity

• Maximising profits, shareholder value.
• A business entity should compensate owners/shareholders with a competitive financial return on investment and the protection of the entity’s assets.
• Management decision making is primarily concerned with increasing the ability to distribute dividends* to shareholders.
• But should managers make decisions purely for shareholders at the expense of other stakeholders?

*In companies, profits are allocated to shareholders via a dividend, or kept within the company as retained earnings.

2. Key drivers of sustainability

• Competition for resources.
• Population is continuously growing but resources are scarce.
• Climate change.
• Global warming driven by human emissions of greenhouse gases.
• Globalization and connectivity.
• Increases in connectivity has led to less time to both build reputations and/or destroy reputations, worldwide.
• Stakeholders theory: the purpose of a business entity is to work for the good of all stakeholder groups, not just to maximise shareholder wealth.
• Stakeholders commit “valuable resources, including not only money but their work, their careers, sometimes their lives to the corporation” (Estes, 1990, p. C1).
• Legitimacy theory: society allows the entity to operate, maximising shareholders value, as long as the entity agrees to act in a socially acceptable manner.

3. Corporate social responsibility

• Corporate social responsibility, CSR, refers to the responsibility an entity has to all stakeholders, including society in general and the physical environment in which it operates.
• Managers are motivated by the desire to do the right thing, so no economic motive behind acting in a socially responsible manner?
• Entities act in a socially responsible manner because there is ultimately some benefit to their profits.
• Avoiding interference from governments or other groups.
• Building reputation/brand.

4. Reporting and disclosure

• In addition to required financial reporting, business entities are voluntarily reporting on their sustainability practices.
• Triple bottom line reporting:
• 1. Economic performance.
• 2. Environmental performance.
• 3. Social performance.

Business structures

1. Business features and their functions

Business structure:

• A type of business entity that is legally recognized in a given jurisdiction.
• In most countries, the basic forms of business structure are:
• Sole trader.
• Partnership.
• Company.
• Trust**.

**In Anglo-Saxon countries.

Business structures differ in terms of:

• Ownership structure.
• Owner liability.
• Funding opportunities.
• Decision making responsibilities.
• Taxation.

2. Sole trader

A sole trader, or sole proprietorship, is an individual who controls and manages a business.

Key features:

• One owner, but it is possible to hire employees.
• The business is not a separate legal entity.
• The owner is liable for all the business debts.
• You can employ other people, you keep liability.
• Italy: Impresa individuale, partita IVA.

3. Partnerships

A partnership is an association between two or more persons who:

• Carry on a business as partners.
• Share profits or losses.

Key features:

• Enables sharing of ideas, skills and resources.
• Easy and cheap to establish.
• Some partnerships have a written agreement, others don’t.
• Italy: Società di persone.

Partnership agreement

The partnership agreement should include details of:

• The name of the partnership.
• The contributions of cash and other assets to the partnership made by each partner.

Methods of sharing profits or losses include:

• Sharing according to each partner’s capital contribution.
• Splitting profits or losses equally between the partners.
• Sharing them based on salary requirements.

Limited partnership, limited liability partnerships: in some countries there are limited liability partnerships, UK, or partnership in which some partners are not liable for business debts, Società in Accomandita Semplice, Italy.

A limited partnership has at least one general partner and at least one limited partner.

4. Company

A company is a business structure that has a separate legal identity from its owners and is taxed on its taxable income.

Key features:

• Owners of a company are known as shareholders.
• Independent legal entity, i.e. separate from the people who own, control and manage it.
• Shareholders have limited liability, for the purchase price of their shares only, not company debts.
• A company has unlimited life, not dissolved when owners die or change.
• Italy: Società di capitali.

Private companies

• A proprietary, or private, company is a company whose ownership is private.
• Private companies cannot offer their shares to the public:
• Shares cannot be traded on stock exchanges, e.g., NYSE, Nasdaq.
• Shares of these businesses are less liquid and the values are difficult to determine.
• Common form of business structure adopted by small and medium sized enterprises, SMEs, not always.

Public companies

• A public company is a company whose ownership is dispersed among the general public in many shares, which are freely traded.
• The shares of a public company are often traded on a stock exchange, listed public company:
• The act of being listed allows the market to determine the value of the company through daily trading.
• Listed companies have better opportunities for fundraising.
• Common form of business structur.