ACCOUNTING MIDTERM OUTLINE
I.
Generally Accepted Accounting Principles
a. Facilitates the comparability of financial statements among business entities
and with respect to a particular business entity over time
i. Guidelines for how financial statements are prepared—enhances
reliability
b. Defines standards of practice and professional conduct for accountants
c. May influence the definition of negligence for accountants
d. GAAP is a continuum
i. Organization can choose how to value its inventory; GAAP does not
mean that every financial statement is exactly the same
ii. SEC can get involved if an org goes beyond aggressive
e. Financial Accounting Standards Board (FASB)
i. Leading contributor of GAAP
ii. Independent body composed of CPAs, corporate executives, financial
analysts and academics
iii. Allows alternative ways of handling matters, as long as the method
chosen falls within GAAP and is fully disclosed
iv. Objectives:
1. To provide info to present and potential external users so they
can make rational economic decisions
2. To provide info relating to an entity’s cash inflows and
outflows because these flows eventually trickle down to
creditors and investors
a. It is easy to make a company look profitable, but hard to
make it look like it generates cash (a company can make
a lot of profit but generate no cash)
3. To provide info relating to assets, liabilities and equity and
changes in the during each reporting period
f. Accounting Information Qualities
i. Relevant: timely recording and presentation of info so it can be used
to forecast future performance and to aid understanding past
performance
ii. Reliable: info should be free from error and bias—number must be
accurate and verifiable by independent parties
iii. Comparable: users should be able to compare accounting info of one
entity with that of other similar entities using the same accounting
measure and with statements of the same entity over succeeding
periods of time
iv. Consistent: the entity should use the same accounting methods and
procedures from year to year (if it’s not consistent, you won’t be able
to tell whether the company is getting better or not)
g. Accounting Principles
i. Matching: expenses should be matched to benefits, which means
recorded in the period of time that benefited from the expenditure
rather than the period of time in which the expenditure occurred.
1. ie. log the same of a fridge in the same period as the company’s
cost for the fridge
ii. Conservatism: requires that “bad news” be recognized when the
condition becomes possible and the amount can be estimated,
whereas “good news” is recognized only when the even has actually
occurred.
1. Ie. record possible and potential expenses, but record revenue
when it actually happens
iii. Consistency: use the same method on financial statements over and
over again.
iv. Lower of Cost or Market: assets are presented at their historical cost
or their current market value, whichever is lower. GAAP rules do not
permit reflection if improved market value of assets.
v. Materiality: an event that is material, or significant, is one that may
affect the judgment, analysis or perception of the reader of the info.
This is a relative concept.
1. Determines how you record something; how material it is so
the organization (ie. buying a filing cabinet at a small law firm
v. the same at a Wal-mart office)
h. American Institute of Certified Public Accountants (AICPA)
i. Mission: provide members with resources, information, and
leadership
ii. Promotes uniform certification and licensing standards (CPA)
iii. Similar to ABA for lawyers
i. SEC
i. Federal agency
1. Administers federal securities laws
2. Only publicly traded organizations are subject to SEC
a. Have to file financial statements with the SEC every 3
months
ii. Participated with GAAP formation with FASB
iii. Chief legal authority having jurisdiction over accounting rules and
practices
iv. Prescribes manner and timing of the disclosure of info about the
financial condition and performance of business entities
v. Has the power to:
1. Specify the accounting rules that govern entities subject to its
jurisdiction
2. Review the resulting financial statements and to bring legal
proceedings against those who fail to comply
vi. Securities Exchange Act
II.
1. Provisions generally prohibit material misrepresentations in,
or omissions from, informational documents required to be
prepared by entities issuing securities to the public
j. Sarbanes Oxley Act
i. CEO and CFO must certify that financial statements accurately reflect
the financial condition of the company
1. Board dictates the direction of the company. President reports
to CEO and CEO reports to the Board. But President and CEO
can be the same person.
2. CFO: prepares and presents the financial statements to the
public and SEC; budget, etc.
a. With this Act, the CEO and CFO can be made to pay
more personally for fraud (takes some burden off of the
shareholders, because before the company could get
sued if something happened)
ii. Officers are required to certify company’s internal controls
iii. New standard for attorneys
1. An attorney who becomes aware of “credible evidence” that a
material violation of law or duty has occurred or is going to
occur is REQUIRED to report that evidence “up the ladder” in
the company
2. The attorney has to satisfy that herself that an appropriate
response has been made. If not, the attorney has to report
further up—board of directors or board committee
3. Attorney is PERMITTED, but not required, to reveal
confidential info to the SEC if the attorney thinks it will be
necessary to prevent the company official from committing a
material violation.
iv. Act was enacted to help boost confidence in the stock market and to
avoid fraud
k. Internal Controls keep track of things you value—make sure the components
are in place:
i. Control environment
ii. Risk assessment
iii. Control activities
iv. Information and communication
v. Monitoring
vi. *separation of duties/checks & balances; important checks on
handling of cash
1. internal controls need to be documented and you have to make
sure that people are following through with the procedures
Income Statements
a. Displays financial condition over a limited period of time (has a definite
beginning and end)
i. Comparable to a movie (income statement) v. a snapshot (BS)
b. Primary components:
III.
i. Revenues
1. Always listed first
2. Assets that a person or business receives from selling goods or
performing services
3. Also includes dividends and interest from investments
(separate reporting line)
4. Increases Owner’s Equity on balance sheet
ii. Expenses
1. Listed second
2. It is what you have to give up to generate your revenue
3. Assets that a business consumes in producing revenues
4. Decreases Owner’s Equity
5. Examples
a. COGS
b. Salaries
c. Depreciation
d. Rent
iii. Gain/(losses)
1. Difference between revenue and expense
2. Income statement is affected by the profitability of the
organization
c. Year-to-date
i. How have you operated during this time period (how they performed
for the specific month, and then a column with performance for the
whole year)
1. Everything is zero-ed out every year (gain/loss is brought over
to the balance sheet)
d. Pension v. Defined Contribution Plans
i. If pension plans are frozen, employees still get their pensions, they
just don’t grow
ii. 401(k) and defined contribution plans are similar
iii. funding a pension plan is an expense on the income statement
Balance Sheets
a. What is your financial condition? (keeps rolling over)
i. Starts when the organization starts; shows the net worth of an
organization
b. Static picture of the financial position of an individual or business at a
particular point in time
i. A financial photo
ii. Displays the financial status of the organization from inception to the
specified date
c. Consists of three different sections:
i. Assets
1. “Good will” value has to be re-evaluated every year (could
change on the balance sheet)
ii. Liabilities
d.
e.
f.
g.
h.
i.
iii. Equity
Net worth = (assets) – (liabilities)
ASSETS
i. Economic resources owned by an organization
1. Physical assets
2. Intangible assets (value with no physical existence)
a. Patents, copyrights, trademarks, etc.
ii. Always on the left side of the balance sheet
1. Cash  has to be turned into cash within one year
2. Accounts receivable  hopefully your customers will pay you
within one year
3. List your most liquid assets first (liquidity goes down from top
to bottom)
iii. Note: a security deposit is an asset because you will get it back
eventually
LIABILITIES
i. Debts owed
ii. Examples
1. Accounts payable, bonds payable, loans, etc.
2. Your car is an asset, the loan on it is a liability
iii. Right side of balance sheet
1. Accounts payable  you have purchased items, but you
haven’t paid for them yet
2. Accrued liability  you owe it, but you haven’t paid it yet
3. Bonds are basically longer termed loans
4. Pension liability (longer term; don’t have to pay them back
within one year)
EQUITY
i. Assets – Liabilities = Equity [net worth]
1. This is what the balance sheet shows
Key Balance Sheet Equation
i. Assets = Liabilities + Equity
1. Assets [debit (+)/credit (-)] = Liability [debit (-)/credit (+)] +
Equity [debit (-)/credit (+)]
ii. Debits must equal credits on all entries
Double-Entry Bookkeeping
i. Journal Entries
1. Used to record the transactions on either the balance sheet
and/or the income statement
2. Every transaction recorded produces equal and offsetting
entries to accounting records
3. The left side (DEBIT) of the equation must always equal the
right side (CREDIT) of the equation
4. Three essential questions
a. What has happened?
i. What has come into equity, what has gone out?
j.
IV.
b. Which accounts are affected?
i. What account should be used to reflect the
activity?
c. Which direction are the affects accounts moving?
i. Should the account be increased or decreased?
T-Accounts
i. A way to keep a running total of the amount in each account
ii. All combined T-Accounts must balance
1. Every account has its own “bucket” or T-Account (ie. cash,
accounts payable, etc.)
iii. This is how info is summarized during a period and then displayed at
the end of the month on the balance sheet
1. At any given time, you can strike a total on these accounts
2. The running total from the T-Accounts are put into the balance
sheet
Accruals
a. When and how do you record things?
i. Cash basis v. Accrual basis
1. Organization has to choose which method
a. Both determine net income; timing is the difference
between them
b. Sometimes allocate revenue and expenses to different
periods, resulting in different net incomes/losses
b. CASH BASIS
i. Simpler
ii. Focuses on the movement of cash and allocated revenues and expense
to the accounting period in which cash revenues are received or
expenses are paid
1. When you’re paid for something, you recognize the revenue.
When you pay for something, that is when you recognize the
expense
2. When the service is performed/goods are delivered is
irrelevant
iii. When the company actually delivers the goods or performs the
services are irrelevant
iv. Account method most often used for personal federal income tax
purposes
v. Not accepted by GAAP because of the matching principle
1. GAAP seeks to track transactions based on when the revenue
was earned or when the expense was incurred
2. Companies subject to SEC regulation cannot use cash basis
c. ACCRUAL BASIS
i. Recognize it when you OWE it
ii. Revenues are recognized when they are earned by sales or services,
not when payment is received
V.
iii. Expenses are charged against income in the period that those
expenses provide benefits not when they are paid
iv. Allocated revenues expense to the income statement before the cash
actually changes hands
v. Matches expenses to the revenues they produce
1. E.g. when you receive cash, the cash account increases and
accounts receivable is eliminated in a corresponding amount
2. You can recognize an expense early under the accrual method,
but not under the cash method
d. Deferrals
i. Recognize it when you EARN it
ii. When an event should not be realized until some later period even
though the cash related to that event is pair or received in the current
period
1. Ie. delay when you recognize something (after the cash
changes hands)
iii. Do not want to benefit the income statement of any period unless the
work is done in that period
iv. Deferred revenue/income: revenue that you haven’t recognized yet
because you haven’t earned it
1. Once you represent the client and do the work, that’s when you
recognize the revenue and replace the deferral
v. Deferred Expense:
1. If a lawyer pre-pays six years of rent  under the cash basis,
the entire expense can be recorded this year; under accrual
basis, pre-paid rent is an asset on the balance sheet because
the time hasn’t past yet
e. Adjusting Entries
i. Apportionment (defer to future period)
1. Advance cash for services not yet rendered
2. Prepaid insurance or prepaid rent
ii. Unrecorded expenses or revenues (accrue to current period)
1. Revenues earned but cash not collected
2. Expenses incurred but not paid in current period
iii. Balance sheet adjustments
iv. *balance sheet and income statements look different depending on
whether the organization uses accrual or cash basis
Inventory
a. An asset on the balance sheet not an expense on the income statement
until the item is sold
i. The revenue from that item is then matched with the expense (COGS)
from initially purchasing that item
b. Valued on the balance sheet at cost
i. The cost of the inventory is the sum of all the expenditures and
charges directly or indirectly incurred in bringing the inventory to its
present condition and location (valued at lower of cost or market)
c. Inventory = goods a business holds for sale to its customers in the regular
course of business
i. Merchandising companies buy things that are already in
sellable/finished format
ii. Manufacturing companies produce/change the format of something
d. Types
i. Raw Materials: materials used to make the goods which the company
manufactures
ii. Work in Progress: unfinished goods that the company has begun to
make but not yet completed
1. Each step in the process makes the item cost a little bit more
(this is how it is valued in the company’s inventory)
iii. Finished Goods: completed goods, ready for sale
e. Levels
i. Beginning Inventory: inventory on hand at the beginning of an
accounting period
ii. Ending Inventory: inventory on hand at the end of an accounting
period
iii. COGS: cost of inventory sold during the period (**on the income
statement)
f. Formulas
i. Beg. Inv. + Inv. Purchased or Manufactured – COGS = Ending Inv.
ii. COGS = Beg. Inv. + Inv. Purchased or Manufactured – Ending Inv.
iii. *worthless inventory/spoilage becomes an expense
g. Lower of Cost or Market
i. The cost of the inventory will be reduced on the balance sheet due to:
1. Physical damage
2. Deterioration
3. Obsolescence
4. Decline in price
ii. If the book value of inventory is reduced using LCM, the reduction is
treated as an addition to COGS for the period shown separately as a
loss on the statement
iii. Write off the inventory as an expense on the income statement when
it fades, deteriorates, etc.
h. Inventory Tracking Systems
i. Periodic
1. Neither the inventory or the COGS account is kept up to date
during the reporting period
a. Count all of the inventory and establish an inventory
balance in periodic intervals—know where everything
is and then get orders and pick the items out of the
warehouse
2. Physical inventory to determine inventory balance and COGS
ii. Perpetual
i.
1. All elements of every merchandising transaction are recorded
when they occur
2. Physical inventory to verify inventory counts
a. Know how many items you have and where the items
are at any given time
Inventory Costing Methods (*method affects the reported profitability)
i. Specific Identification
1. The actual cost of each item of inventory is specifically
identified to the goods during the merchandising process –
form the time they are purchased or produced through the
time they are sold
2. Makes sense for goods that are unique and/or very valuable
(ie. artwork or cars)
3. Does not make sense for fungible items (ie. gas)
ii. FIFO
1. Assumes that goods are sold in the order in which the business
originally purchased them
2. The first units of inventory purchased—the ones the business
has held the longest—are assumed to be first ones sold
3. Visualize a pipeline
4. During an inflationary period, your gross profit will be higher
with FIFO (assuming that your product increases in price)
a. A company using FIFO should look more profitable than
one using LIFO (makes it hard to compare a company
using LIFO with one using FIFO)
iii. LIFO
1. Assumes that the goods are sold in exactly the opposite of the
order in which the business originally purchases them
2. The units purchased most recently- the ones the business has
held the shortest amount of time- are assumed to be the first
ones sold
3. Visualize a bucket
4. The maj of organizations use LIFO b/c it is more conservative
than FIFO
a. LIFO shows lower gross profits and higher COGS (orgs
can thus pay lower taxes due to lower net income
shown)
b. You can have the same cash flow whether you use LIFO
or FIFO, just use LIFO to have a lower reported net
income
i. How you actually move inventory and how you
cost it can be different
iv. Average Cost
1. Averages the costs of all the units in inventory
2. The total cost basis of the inventory is divided by the total
number of units to produce an average cost per unit
VI.
VII.
3. To determine the COGS, multiply this average cost by the
number of units sold
j. Inventory Method Decisions
i. Method chosen affects both income and the valuation of inventory on
the balance sheet
ii. If costs are rising (inflationary economy), then inventory purchased
more recently cost more than older inventory.
1. In this case, the LIFO method produces a higher COGS an a
lower income than FIFO
iii. LIFO results in a lower inventory value on the balance sheet than FIFO
k. Inventory- Tax Matters
i. LIFO reports lower income which results in a lower income tax
obligation
ii. Entity must use the SAME inventory reporting method for GAAP
financial statements and for calculating income tax liability
iii. An entity can only change inventory flow assumptions one time in the
life of the company – it cannot shift back and forth between LIFO and
FIFO depending on inflation forecasts or any other factor
COGS
a. On the balance sheet
b. Reducing labor and lay-offs can lower COGS
Costs
a. Fixed
i. Costs that will be the same regardless of the volume produced. They
are regular and recurring
1. Ex: admin expenses, rent, management salaries
b. Variable
i. Costs that are volume-driven. They increase or decrease in response
to changes in production and distribution volume
1. Ex: production labor, materials, certain admin and distribution
costs
ii. More control over profitability here—produce more, pay more
c. Direct
i. Costs that are specifically identifiable to an individual profit
center/product. They include the costs of producing the product,
operating and staff expenses, and the costs of any service or functions
that the profit center outsources to others.
ii. You can see/touch them; directly related to the product
d. Indirect/Overhead
i. All of the support efforts that are necessary if the entire organization
is to function, such as accounting, legal, corporate staff, and
management information systems.
ii. Also includes all spending that supports all of the profit centers
combined and is really not divisible among them
iii. Organizations try to allocate overhead costs to certain products
1. Some allocate based on revenue; units sold, etc.
VIII.
IX.
Assets
a. Fixed assets
i. Assets that have an expected useful life of over one year
ii. Contributes to the earning power of the enterprise over that time
iii. Matching Principal dictates that the expense of the item should be
spread over the useful life of the asset
iv. Depreciation, depletion and amortization are methods of spreading
the expense
v. Examples: buildings, autos, etc.
b. Allocating Expenses
i. Depreciation [see IX, too]
1. Used for plant and equipment
2. Land is the only major long-loved asset whose cost does NOT
depreciate (assumption that land has an infinite useful life)
ii. Depletion
1. Equivalent of depreciation when the asset is a natural resource
like oil, gas, or timber
2. Divide the total cost of the natural resources by the total
number of available units
3. An expense to be deducted from revenue in calculating net
income
4. Affects the balance sheet in the same way as depreciation
iii. Amortization
1. Used for intangible assets like patents or trademarks
2. Allocates the cost of an intangible asset over its useful life
3. Usually amortized using the straight-line method
4. Usually do not use “accumulated amortization” accounts. The
value of the patent is simply reduced by the amount of
amortization
Depreciation
a. Does NOT attempt to match cost recognition to the actual physical wearing
out of the fixed asset over time due to the difficulty and subjectivity
associated with conducting periodic appraisals [more simplified]
b. Two Methods:
i. Straight Line
1. Cost allocated equally over the useful life
a. Don’t look at the actual wear and tear on the vehiclejust spread the cost out
b. Take the depreciable value and spread it out over the
number of years
ii. Accelerated Method [orgs use to lower taxes]
1. Sum-of-the-years’ Digits
a. Numerator = # of years of useful life remaining at the
beginning of the year
b. Denominator = sum of the years of useful life
c. Front loads the expenses
c.
d.
e.
f.
g.
2. Double Declining Balance
a. The normal, straight-line rate is doubled and the
doubled rate is applied each year to the book value of
the asset
Effect of Depreciation
i. Income Statement
1. Expense, which reduces net income
ii. Balance Sheet
1. Reduces the net carrying value of the asset
2. Retained earnings affected by net income
iii. Cash Flow Statement
1. No affect in any way
2. Entire cash payment made at acquisition
Depreciation allocates a purchase—the cash previously paid for the asset
when it was acquired
The process of depreciation provides NO cash to purchase the new asset
when the old one wears out
Three judgments necessary in allocating the cost of a fixed asset over time:
[all have significant consequences for the income statement and balance
sheet over time]
i. Historical Cost
1. What did you pay for the asset? Original purchase price of
asset; original installation and adaptation cost
2. Repairs and maintenance
a. YES- if it extends the useful life of the asset
b. NO- if it is simply a necessary repair incidental to the
ordinary operation of the asset
3. Sometimes, there is more than the purchase price of that asset
to take into account
ii. Scrap value and the depreciable base
1. Portion of a fixed asset which will not be used up over the life
of the asset
2. Original cost (what you paid for it) – Scrap value (what you can
sell it for) = depreciable base [what you spread out over the life
of the value]
3. Depreciable base is allocated over the expected useful life
iii. Expected useful life
1. Educated guess of how long the asset will remain in use
2. Accountants draw on guidelines contained in the Internal
Revenue Code to determine appropriate estimates
a. Land: none
b. Buildings: 30-40 years
c. Equipment: 10-15 years
d. *can stay within these ranges to be acceptable
Significance of judgments
i. High acquisition cost
1. Reduces current expenses, increases future expense
ii. High scrap value
1. Reduces the depreciable base reducing future expenses
recognized
iii. High useful life
1. Reduces the impact on reported income in any given period,
but extends the expense over a longer period of time
iv. *These judgment affect how profitable a company looks. Depends on
whether you want to bunch your expenses up and get them out of the
way, or spread them out over a longer period (do you want your
future/current financial statements to look better/worse)
1. but have to stay within GAAP
h. Bookkeeping Presentation
i. Leave what you paid for that asset the same as long as that asset is on
your books
ii. Depreciation expense is on the INCOME STATEMENT
iii. Accumulated depreciation is on the BALANCE SHEET
1. Called a contra-asset
2. Net fixed assets are on the balance sheet
i. Gain/Loss v. Income/Expense
i. Gains: increases in equity generally from non owner sources, which
result from peripheral or incidental transactions
ii. Gains/Losses
1. Incidental interest received or paid
2. Profit or loss on incidental sales of investments, property, plant
and equipment
3. Profits or losses resulting from litigation and casualties
4. Gains also include dividends received on investments
j. Mid-Course Changes
i. GAAP permits changes to be made in the depreciation calculations
based on changes in original assumptions (ie. how long the asset will
last)
ii. Prior financial statements do not have to be restated
iii. Apply revised assumptions to REMANING book value
k. Consistency Principle
i. GAAP prohibits changing from straight line to accelerated method for
a particular asset (but ALLOWS changes from accelerated to straight
line) – you can change to be more conservative but not the other way
around
ii. Consistency principle does NOT require that all assets of an entity be
depreciated according to the same method
l. Financial v. Tax Reporting
i. COGS (valuing inventory): must use same method for financial
reporting and tax reporting (ie. FIFO and LIFO)
ii. Depreciation: can use one method for financial reporting and a
different method for tax reporting
1. Financial reporting: straight line method
2. Tax reporting: accelerated method (reports lower earnings,
thus reduces income tax liability)
CREDITS/DEBITS
Debit & Credit example:
You can learn to understand to identify the two basic components of each transaction:
1.
2.
What did you get?
Where did it come from?
The debit is what you got
and
The credit is the source of the item you received.
Let's imagine that you purchase a computer with your credit card. Since the computer is what you received it's going
to result in a debit to the asset account for your computer. The credit will be applied to the credit card liability
account for the same amount.
The banks tend to confuse us because they are telling us the entry to their liability account. When you deposit money
in the bank, their liability to you increases. Since liabilities are credit accounts they are crediting our account. When
they reduce their liability to us, they are debiting their liability account.
So, if you can identify what you received and where it came from in every transaction you have debits and credits
mastered.
AFTER MIDTERM OUTLINE


Won’t ask about increasing/decreasing debits/credits
Ch. 6 Statement of Cash Flows
o When buying stocks, look at revenue side of the BS, price/earnings ratio,
dividends
o Find earnings at the bottom of the I/S
o Find shares outstanding in the equity section of the BS
o Orgs can pay dividends when they generate cash (you can’t just slice up net
income and distribute it)
o When buying stock look at demand, what competitors are doing; the type
of business
o Statement of Cash Flows
 Measures the financial viability of an entity
 An entity’s ability to meet its debts as they come due


Depends on the way in which cash in the business is managed
and the way in which it flows through the business
 Accrual method of accounting obscures the actual inflow and outflow
of cash (so look at this statement to see the cash side of it)
 A company can show a profit and not have any cash
o Statement of Changes in Financial Position
 Accounting statement that tracks an orgs’ cash flow for a specified
period
 It shows how much cash the company had at the start of the period,
the amount of cash it received during the period, the amount of cash it
paid out during the period, and how much cash it has at the end of the
period
o Categories of Statement
 Cash flows from operations
 Wages from job, buying books, tuition, etc.
 Cash flows from investing activities
 Selling or buying a car/coin collection, etc.
 Cash flows from financing activities
 Relates to liabilities and equity accounts
o Stock sales, dividends, etc.
 Loans
o Methods of Calculation (GAAP allows either, but direct is better)
 Direct method
 Tracks each of the operating activities that affect cash directly
 Indirect method
 Starts with the net income during the period and then
identities the types of transactions that would impact net
income in a way that differs from the impact of those
transactions on cash flows
o Depreciation expense hits income statement but you’re
not paying out cash each month for depreciation
expense (you have to adjust for it)
o Cash to Current Debt Ratio
 Retained operating cash flow = cash flow provided by operations less
cash paid out in dividends
 Comes from cash flow statement
 Short term debt and current portion of long term debts comes from
the BS
o Quality of Income Ratio
 Compare how much cash you’re showing to the amount of profit
you’re showing
 Operating income comes from the bottom of IS (the profit you
show on the IS)
Ch. 7 – Capital Accounts
o Equity = assets (-) liabilities
 Net worth
o Talking about the bottom right (equity) section of the BS
o Forms of Ownership
 Sole proprietorship
 One owner and one equity account
 Has not taken legal steps necessary to form some other kind of
organization
 A withdrawal of capital is not an expense b/c the withdrawal
has nothing to do with producing income
 Easy to organize; owner has complete control; owner receives
all income
 Owner has unlimited liability; may have difficulty attracting
quality EEs; could experience difficulties raising capital
o Can attach personal assets/go beyond sole
proprietorship
 Partnership
 More than one owner
 Separate capital account is used for each owner
 Can loan money to org—noted on the statements as loans
 Income is allocated to each partner’s equity account according
to the % of profits each partner is entitled to (as determined by
law or the partnership agreement)
 Increased ability to raise funds; profits flow directly through
partners’ tax return (don’t have to follow a separate return);
easy to establish (just an agreement not a bunch of paperwork)
 Partners are J/S liable; Increased opportunity for
disagreements; Profits must be shared; Life limited to life of
partners; unlimited liability from all partners?
 Limited liability partnership
 Has one general partner and one or more limited partners
o General partner is responsible for management
o Limited partners have liability limited to their
investment
 When profits are generated in operating the business are paid
to partners, those payments are reflected in accounts called
drawing accounts. Each partner has his own drawing account.
 Corporation [can be public or private]
 Separate legal entity
 Equity investments are represented by shares of stock
 Corporations do not create a separate equity account for each
investor
 Equity section segregated into:
o Capital/common stock
o Additional paid in capital
o Retained earnings
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Advantages
o Shareholders have limited liability
o Can raise funds through sale of stock
o Life of business is unlimited
 Disadvantage
o Incorporation takes time and money
o May result in higher taxes overall (double taxation)
 Have to file Articles of Incorporation to set up a corporation
o Basic structure of the corporation and why it is created
 Bylaws
o Govern the internal conduct of the corporation
o Private orgs can choose their accting methods; public
orgs have to use accrual method
o Unlike articles of incorporation, the bylaws are not
required to be filed with the secretary of state
 Board of directors can be vested with the power
to alter or repeal bylaws unless the power to do
so is reserved for the shareholders in the articles
of incorporation
 Stock represents actual partial ownership of a corporation
Additional Paid-in Capital
 Difference b/w what you sold stock for and the par value (par
value = minimum, below which stock won’t sell)
Retained Earnings
 Cum amount of earnings generated over time minus dividends
paid out