Lesson notes Lesson 2: Economic Transactions and Accounting Equation Learning objectives This lesson begins with a discussion of the purpose of a business, including a discussion of forms of organizations. Next, the nature of business operations is discussed. The four types of businesses are discussed: service, merchandising, manufacturing, and financial services. It also concludes with a discussion of the general forms of business ownership: sole proprietorships, partnerships, and corporations. Then the lesson carries on with a discussion of business activities and the events, resources, and elements affecting business transactions. The focus of accounting equation (that is, A＝L＋OE) is explained in detail. The Beauty Photo Store, a local case we create, is presented to illustrate our points in this lesson Teaching hours Students major in accounting: 3 hours Others: 3 hours Teaching contents: Opening Story This lesson starts with an opening case of somewhat connection to the real life of students, that is, the funding and spending at college. Suggested items relating to the accounting topics are: Assets of a college student, for example, cash, CD player, computer, and the ways of funding these assets: sponsored by parents, sponsored by relatives, borrowed from relatives and acquaintance. We could deal with the above-mentioned financial issues from the following perspectives：How do we fund our daily expenditures and possessions？How do we spend the “funds” which we have sourced？What about the relationship between the “funds” which we have sourced and our daily expenditures and possessions？ Enterprises Students are asked to suggest examples of each type of business: service, merchandiser, manufacturer, and financial services. Point out that many businesses are combinations of one or more type. Students are going to understand: Concept of Enterprise, Definition of “enterprise”, Functions of an enterprise, Characteristics of an enterprise. There are three major forms of enterprise: Sole-proprietorship, Partnership, Corporations. And there are four types of enterprise: Service organization provides services (does something for you) rather than selling something; merchandising business buys goods, adds value to them, then sells them to customers; manufacturer – makes the products it sells; financial services company does not make tangible products and does not sell products made by other companies; deals in services related to money Resources in an Enterprise Major resources in an enterprise: 1. Human resources: properties, plant and equipment, supplies, raw materials, finished products or inventories 2. Financing (financial resources): For instance those in cash or bank deposits 3. Resources in material forms Movements of Material Resources in an Enterprise (An example-Beauty Photo Store) Movements of Material Resources in an Enterprise 1) Movements in a manufacturing enterprise cash/bank deposit→raw materials →work-in-process→finished products→fin→cash/bank deposit 2) Movements in a merchandising enterprise cash/bank deposit→inventory→ cash/bank deposit Activities of Enterprise Three major phases of business activities: 1) Inception 2) Operating 3) Liquidation Inception of Enterprise 1) Inception and investment of funds * External funding * State, legal persons, privates or foreign investors； * Financing from banking institutions, other legal persons or privates * Owners’ equity and liabilities 2) Forms of Investment * Monetary (cash/bank deposits) * Property, plants and equipment * Raw materials and goods,etc. 3) Sources and changes of funds * Increase of owners’equity or liabilities * Increase of assets Operating Activities Operating activities and changes of asset * Changes of assets in Beauty Photo Store * Connections between Beauty Photo Store and Suppliers, clients, etc. Liquidation of Enterprise 1) Liquidation of enterprise and payoff of funds * Payment of taxes * Distribution of profits * Declaration of dividends * Payoff of borrowings 2) Withdrawals and changes of funds * Decrease of assets * Decrease of liabilities or owners’ equity Accounting Transactions First of all, we define a business transaction as an event that affects the financial position of a business and may be reliably recorded. Further, we will explore the relationship between the Economic Activities and Accounting Elements. Accounting elements include assets, liabilities, owner’s equity, revenues, expenses and profit (loss). We should also know about the connection between the uses of funds and assets: the terms of cash, equipment and others are mentioned; and the connection between the resources of funds and equity: for instance, borrowings and equity of creditors － liabilities, investments and owner’s equity. Uses and changes of funds are studied here too. Beauty Photo Store case is reviewed here. from cash to equipment; using equipment to produce photos; from photos to cash. Circulation of funds: Uses of funds and assets, and payoff of funds for the Beauty Photo Store: Cost of equipment, cost of supplies, human costs？(What are the operating purposes for Beauty Photo Store？) Cash receptions and revenues by Beauty Photo Store, net increase of funds and profit, difference between uses and payoff of cash？(Nature of profit?) Accounting Transactions Accounting transactions-Economic exchange between two different accounting entities: Mutual exchange: A purchases an asset, paying cash or bearing the responsibility of paying cash in future; B sells the asset, earning the rights of receiving or collecting cash; One-way transaction: Investments or donations to another accounting entity Accounting Events: Accounting events-internal transferring of resources among departments of a same entity; allotments of raw materials for plants; Damages caused by earthquakes. External versus internal events: Between different entities or within a same entity Accounting Circumstances: Accounting circumstances-usually an outcome of collaboration of multiple events. Circumstances and their impacts: Changes in prices, exchange rates; How to determine these changes？E.g. uncollectability of receivables due to the liquidation of the debtor; Unpredictability Elaboration on Accounting Elements Assets-Liabilities-Owner’s equity-Revenues-Expenses-Profits Assets: Assets are economic resources owned by a business that are expected to be of benefit in the future. Further Thoughts on Assets: Human resources as an asset？for example, value and labor of Manager of Beauty Photo Store？Cameramen and shop assistants？Natural resources as an asset? Liabilities: Liabilities are creditor?ˉs claims to the assets. Liabilities are obligations to outsiders Owner’s Equity: Owner’s Equity is the owner’s claim to the assets. It is the amount of assets that remains after subtracting the liabilities. Changes in Owner’s Equity; Investments by owners and revenues, amounts earned by delivering goods or services to customers, increase owner’s equity. Withdrawals of assets from the business by owners and expenses decrease owner’s equity. Expenses occur when assets are used or liabilities increase as a result of earning revenues. Revenue: Revenues (sales) are increases in owners' equity arising from increases in assets received in exchange for the delivery of goods or services to customers. Revenues are increases in economic resources, either through increases to assets or reductions to liabilities Revenue Recognition: Revenue should be recognized in the financial statement when: 1) the performance has been achieved; 2) there is reasonable assurance regarding the measurement and collectability of the consideration Expense: Expenses are decreases in owners' equity that arise because goods or services are delivered to customers. Expenses are decreases in economic resources, either through outflows or the using-up of assets or incurrence of liabilities from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity’s normal business. Expense Recognition: Cost, expenditure, and expense; general recognition criteria. Approaches to expense recognition are Cost, Expenditure, and Expense. When we agree to pay out cash (or other assets) for goods or services received, we have incurred a cost. When we actually pay the cash, we have expenditure. When the benefits of the cost have been used and we put that cost (or a portion thereof) on the income statement, we have recognized an expense General Recognition Criteria Recognized items must meet the definition of a financial statement element and have a valid measurement basis and amount. Financial statement elements are based on future economic benefits or sacrifices; these must be probable for recognition to be appropriate. Expenses are decreases in economic resources, either by way of outflows or reductions of assets or incurrences of liabilities, resulting from an entity?ˉs ordinary revenue generating or service delivery activities. Asset or expense? if the asset recognition criteria are met, an asset is recorded. If not, an expense is recorded Approaches to Expense Recognition Definitional approach: expenses are created either through the reduction of an asset or the increase in a liability Matching approach: once revenues are determined in conformity with the revenue principle for any reporting period, the expenses incurred in generating the revenue should be recognized in that period Profit/Loss Income (profit or earnings) is the excess of revenues over expenses Accounting Equation Assets + Liabilities = Owners Equity Net Assets = Owner’s Equity Every accounting transaction has an equal affect on both sides of the equation. Purchase a $20,000 car for cash. Increase asset car and decrease asset cash by $20,000. No net change to assets. Purchase a $20,000 car on credit. Increase asset car and increase liabilities by $20,000. Dual Aspect of Accounting Equation Assets = Liabilities + Owner’s equity. LHS = RHS. First view: Resources = Obligations to creditors or claims on resources + Residual claim. Second view: Amounts invested in resources = how these amounts were financed. Resources = financed by creditors + financed by owners. An Illustration: Beauty Photo Store Changes to the accounting equation of Beauty Photo Store (see the powerpoints) Case for Discussion Marks and Spencer In 1882, a Russian refugee named Michael Marks came to the North East of England. Needing work, he put a tray round his neck and started selling haberdashery in the villages around Leeds. Two years later he borrowed ￡5 from his friend Isaac Dewhirst to buy stock, and was able to open a stall in Leeds market. Within ten years Marks’s success as a trader had enabled him to establish a chain of stalls in markets throughout North East England. In 1894, Marks realized that his business was getting too large for him to manage effectively on his own. He decided to form a partnership with Tom Spencer – and Marks & Spencer was born. The business continued to thrive and grow, so in 1903 Marks and Spencer registered their partnership as a private limited company. This allowed more people to become involved with managing the growing company and increase its finances by buying shares in the company. One shareholder was Israel Sieff, who became chairman of the company in 1917. Sieff can be credited with shaping the future of Marks & Spencer. By 1926, Marks & Spencer had opened 125 stores. In order to continue its successful development the company finally registered as a public limited company (plc) in order to obtain as much capital as possible to finance its continued growth. And the rest, as they say, is history. Suggested Questions 1) How many people started the original business that eventually became Marks & Spencer? 2) Who owned the original business? 3) Who owns Marks & Spencer plc? 4) Why do you think Marks & Spencer became a public limited company? 5) Do you think the business would have developed in the way it has if it was still owned by one person?