MAKE MONEY FROM MONEY

MAKE MONEY FROM MONEY

MAKE MONEY FROM MONEY

Humans have long engaged in borrowing and lending. There is evidence that these activities took place 5,000 years ago, in Mesopotamia (present-day Iraq) at the very dawn of civilization. But modern banking systems did not emerge until the 14th century in northern Italy.

The word “bank” comes from the Italian word for the “bench” on which the bankers sat to conduct business. In the 14th century the Italian peninsula was a land of city-states that benefited from the influence and revenue of the papacy in Rome. The peninsula was ideally located for trade between Asia, Africa, and the emerging nations

of Europe. Wealth began to accumulate, especially in Venice and Florence. Venice relied on sea power: institutions were created there to finance and insure voyages. Florence focused on manufacturing and trade with northern Europe, and here merchants and financiers came together at the Medici Bank.

MAKE MONEY FROM MONEY

Florence was already home to other banking families, such as the Peruzzi and the Bardi, and to different types of financial bodies— from pawnbrokers, who lent money secured by personal belongings, to local banks that dealt in foreign currencies, accepted deposits, and lent to local businesses. The bank founded by Giovanni di Biocide’ Medici in 1397 was different.

The Medici Bank financed long-distance trade in commodities such as wool. It differed from existing banks in three ways. First, it grew to a great size. In its heyday under the founder’s son, Cosimo, it ran branches in 11 cities, including London, Bruges, and Geneva. Second, its network was decentralized. Branches were managed not by an employee but by a local junior partner, who shared in the profits.

The Medici family in Florence were the senior partners, watching over the network, earning most of the profit, and retaining the family trademark, which symbolized the bank’s sound reputation. Third, branches took in large deposits from wealthy savers, multiplying the lending that could be given out for a modest amount of initial capital, and so multiplying the bank’s profits.

Statement of Cash Flows

Statement of Cash Flows

Statement of Cash Flows

The statement of cash flows provides information on the cash receipts and payments for a specific period of time. The statement of cash flows reports (1) the cash effects of a company’s operations during a period, (2) its investing transactions, (3) its financing transactions, (4) the net increase or decrease in cash during the period, and (5) the cash amount at the end of the period.

Reporting the sources, uses, and change in cash is useful because investors, creditors, and others want to know what is happening to a company’s most liquid resource. The statement of cash flows provides answers to the following simple but important questions.

1. Where did cash come from during the period?

2. What was cash used for during the period?

3. What was the change in the cash balance during the period?

Owner’s Equity Statement

For the Month Ended September 30, 2012.

As shown in Softbyte’s statement of cash flows, cash increased $8,050 during the period. Net cash flow provided from operating activities increased cash $1,350. Cash flow from investing transactions decreased cash $7,000. And cash flow from financing transactions increased cash $13,700. At this time, you need not be concerned with how these amounts are determined.

Owner’s Equity Statement

Owner’s Equity Statement

Owner’s Equity Statement

The owner’s equity statement reports the changes in owner’s equity for a specific period of time. The time period is the same as that covered by the income statement. Data for the preparation of the owner’s equity statement come from the owner’s equity columns of the tabular summary and from the income statement. The first line of the statement shows the beginning owner’s equity amount (which was zero at the start of the business). Then come the owner’s investments, net income (or loss), and the owner’s drawings. This statement indicates why owner’s equity has increased or decreased during the period.

Income Statement

What if Softbyte had reported a net loss in its first month? Let’s assume that during the month of September 2012, Softbyte lost $10,000. Illustration below shows the presentation of a net loss in the owner’s equity statement.

Owner's Equity Statement

If the owner makes any additional investments, the company reports them in the owner’s equity statement as investments.

Income Statement

Income Statement

The income statement reports the revenues and expenses for a specific period of time. (In Softbyte’s case, this is “For the Month Ended September 30, 2012.”) Softbyte’s income statement is prepared from the data appearing in the owner’s equity columns of Illustration below.

Income Statement

The income statement lists revenues first, followed by expenses. Finally, the statement shows net income (or net loss). Net income results when revenues exceed expenses. A net loss occurs when expenses exceed revenues.

Although practice varies, we have chosen in our illustrations and homework solutions to list expenses in order of magnitude. (We will consider alternative formats for the income statement in later chapters.)

Note that the income statement does not include investment and withdrawal transactions between the owner and the business in measuring net income. For example, as explained earlier, Ray Neal’s withdrawal of cash from Softbyte was not regarded as a business expense.

Financial Statements

Financial Statement

Financial Statements

Companies prepare four financial statements from the summarized accounting data:

1. An income statement presents the revenues and expenses and resulting net income or net loss for a specific period of time.

2. An owner’s equity statement summarizes the changes in owner’s equity for a specific period of time.

3. A balance sheet reports the assets, liabilities, and owner’s equity at a specific date.

4. A statement of cash flows summarizes information about the cash inflows (receipts) and outflows (payments) for a specific period of time.

These statements provide relevant financial data for internal and external users. Illustration below shows the financial statements of Softbyte.

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Note that the statements shown in Illustration above are interrelated:

1. Net income of $2,750 on the income statement is added to the beginning balance of owner’s capital in the owner’s equity statement.

2. Owner’s capital of $16,450 at the end of the reporting period shown in the owner’s equity statement is reported on the balance sheet.

3. Cash of $8,050 on the balance sheet is reported on the statement of cash flows.

Also, explanatory notes and supporting schedules are an integral part of every set of financial statements. We illustrate these notes and schedules in later chapters of this textbook. Be sure to carefully examine the format and content of each statement in Illustration above.

Detail at the categories in the basic accounting equation

Assets, Liabilities & Owner’s Equity

Let’s look in more detail at the categories in the basic accounting equation.

Assets

As noted above, assets are resources a business owns. The business uses its assets in carrying out such activities as production and sales. The common characteristic possessed by all assets is the capacity to provide future services or benefits. In a business, that service potential or future economic benefit eventually results in cash inflows (receipts). For example, Campus Pizza owns a delivery truck that provides economic benefits from delivering pizzas. Other assets of Campus Pizza are tables, chairs, jukebox, cash register, oven, tableware, and, of course, cash.

Liabilities

Liabilities are claims against assets—that is, existing debts and obligations. Businesses of all sizes usually borrow money and purchase merchandise on credit. These economic activities result in payables of various sorts:

• Campus Pizza, for instance, purchases cheese, sausage, flour, and beverages on credit from suppliers. These obligations are called accounts payable.

• Campus Pizza also has a note payable to First National Bank for the money borrowed to purchase the delivery truck.

• Campus Pizza may also have salaries and wages payable to employees and sales and real estate taxes payable to the local government.

All of these persons or entities to whom Campus Pizza owes money are its creditors. Creditors may legally force the liquidation of a business that does not pay its debts. In that case, the law requires that creditor claims be paid before ownership claims.

Owner’s Equity

The ownership claim on total assets is owner’s equity. It is equal to total assets minus total liabilities. Here is why: The assets of a business are claimed by either creditors or owners. To find out what belongs to owners, we subtract the creditors’ claims (the liabilities) from assets. The remainder is the owner’s claim on the assets—the owner’s equity. Since the claims of creditors must be paid before ownership claims,

owner’s equity is often referred to as residual equity.

The Basic Accounting Equation

The basic accounting equation

The Basic Accounting Equation

The two basic elements of a business are what it owns and what it owes. Assets are the resources a business owns. For example, Google has total assets of approximately $40.5 billion. Liabilities and owner’s equity are the rights or claims against these resources. Thus, Google has $40.5 billion of claims against its $40.5 billion of assets. Claims of those to whom the company owes money (creditors) are called liabilities. Claims of owners are called owner’s equity. Google has liabilities of $4.5 billion and owners’ equity of $36 billion.

We can express the relationship of assets, liabilities, and owner’s equity as an equation, this relationship is the basic accounting equation. Assets must equal the sum of liabilities and owner’s equity. Liabilities appear before owner’s equity in the basic accounting equation because they are paid first if a business is liquidated.

The accounting equation applies to all economic entities regardless of size, nature of business, or form of business organization. It applies to a small proprietorship such as a corner grocery store as well as to a giant corporation such as PepsiCo. The equation provides the underlying framework for recording and summarizing economic events.

What Is Accounting? - Accounting consists of three basic activities

What is accounting

What Is Accounting?

Why is accounting very popular today? What consistently top ranks as one of the career opportunities in business? What frequently rates among the popular majors on campus? What was the undergraduate degree chosen by Home Depot co-founder Arthur Blank, Nike founder Phil Knight, former acting director of the FBI Thomas Pickard, and numerous members of Congress? Why do these people choose accounting? They want to understand what was happening financially to their organizations. Accounting is the financial information system that provides these insights. In short, to understand your organization, you have to know the numbers.

Accounting consists of three basic activities—it identifies, records, and communicates the economic events of an organization to interested users. Let’s take a closer look at these three activities.

Three Activities

As a starting point to the accounting process, a company identifies the economic events relevant to its business. Examples of economic events are the sale of snack chips by PepsiCo, providing of telephone services by AT&T, and payment of wages by Ford Motor Company.

Once a company like PepsiCo identifies economic events, it records those events in order to provide a history of its financial activities. Recording consists of keeping a systematic, chronological diary of events, measured in dollars and cents. In recording, PepsiCo also classifies and summarizes economic events.

Finally, PepsiCo communicates the collected information to interested users by means of accounting reports. The most common of these reports are called financial statements. To make the reported financial information meaningful, PepsiCo reports the recorded data in a standardized way. It accumulates information resulting from similar transactions. For example, PepsiCo accumulates all sales transactions over a certain period of time and reports the data as one amount in the company’s financial statements. Such data are said to be reported in the aggregate. By presenting the recorded data in the aggregate, the accounting process simplifies a multitude of transactions and makes a series of activities understandable and meaningful.

A vital element in communicating economic events is the accountant’s ability to analyze and interpret the reported information. Analysis involves use of ratios, percentages, graphs, and charts to highlight significant financial trends and relationships. Interpretation involves explaining the uses, meaning, and limitations of reported data. Appendix A of this textbook shows the financial statements of PepsiCo, Inc.; Appendix B illustrates the financial statements of The Coca-Cola Company. We refer to these statements at various places throughout the text. At this point, they probably strike you as complex and confusing. By the end of this course, you’ll be surprised at your ability to understand, analyze, and interpret them.

Accounting consists of three basic activities

You should understand that the accounting process includes the bookkeeping function. Bookkeeping usually involves only the recording of economic events. It is therefore just one part of the accounting process. In total, accounting involves the entire process of identifying, recording, and communicating economic events.

Who Uses Accounting Data

The information that a user of financial information needs depends upon the kinds of decisions the user makes. There are two broad groups of users of financial information: internal users and external users.

INTERNAL USERS

Internal users of accounting information are managers who plan, organize, and run the business. These include marketing managers, production supervisors, finance directors, and company officers. In running a business, internal users must answer many important questions.

Internal users of accounting information

To answer these and other questions, internal users need detailed information on a timely basis. Managerial accounting provides internal reports to help users make decisions about their companies. Examples are financial comparisons of operating alternatives, projections of income from new sales campaigns, and forecasts of cash needs for the next year.