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Accounting Overview

Essay by   •  May 29, 2011  •  Research Paper  •  1,311 Words (6 Pages)  •  962 Views

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Our modern economy requires successful business owners to understand the relationship between economics and accounting and finance. According to Block & Hirt (2005), the study of economics provides a structure of decision making in the areas of risk analysis, pricing theory through relationships in supply and demand, comparative return analysis, and many other more important economic forces. Business owners and financial managers must understand the institutional structure of the Federal Reserve System, the commercial banking system and the interrelationships between the various sectors of the economy. Understanding these various sectors of the economy are part of the key planning strategies that will improve their day-to-day business decision making. In essence, gross domestic product, industrial production, disposable income, unemployment, inflation, interest rates, and taxes are the important variables of our economy which must fit into a business owners' decision model and need to be applied correctly in their strategy planning (Block & Hirt, 2005, p 5). Business owners face tough and difficult decisions on a daily basis not only from the external economic factors but also internally, from analyzing the company's financial statements. These statements are like a road map and a key of success in business planning and decision making. The three most important financial statements that most business owners need to start with are: 1) income statements; 2) balance sheets; 3) the statement of cash flows.

There are two kinds of audiences, internal and external. Internal users that include company management and board of directors; on the other hand, external users are shareholders, fund managers and analysts that break down the company's "credit worthiness", share value, dividends and future earnings. A major device for business owners is the income statement which measures the profitability of a firm over a period of time Ð'- this could be a year, a quarter or even a month (See table 1) in a standard format. Items are individually recorded in a progressive process so the audiences can see the profit or loss with each entry (Block & Hirt, 2004). Furthermore, the difference between revenues and expenses is calculated to represent the company's net income or net loss. The income statement reports incomes and expenses on a transaction basis but are not factored into any major economic events. The limitations of the income statement is that accounting values are established primarily by actual transactions, and income that is gained or lost during a given period is a function of verifiable transactions. Changes in the net worth of the firm that are not the result of verifiable transactions will not appear on the income statement. For example, a new airport being built on property adjacent to a business represents an increase in the real worth of the firm, however, the whole of the change in the worth of the firm will not be the result of verifiable transactions on the income statement (Block & Hirt, 2004).

Another format of the financial statement is the balance sheet. According to Block & Hirt (2004), the balance sheet indicates what the firm owns and its assets are financed in the form of liabilities or ownership interest. Furthermore, the balance sheet sketches an outline of the firm's holdings and obligations while the income statement shows the profitability of the firm. Therefore, with these two statements together are intended to answer two questions for a given period: how much did the firm make or lose, and what is the measure of its worth? (See table 2). The balance sheet does not represent the result of transactions for a specific month, quarter or year. In contrast, the income statement does represent the results of transactions. Rather, the balance sheet is a cumulative chronicle of how all transactions have affected the corporation. The balance sheet items are stated on a cost basis rather than at current market value (Block & Hirt, 2004). The limitations of the balance sheet are as follows: 1) it does not reflect current value; 2) judgments and estimates are used; and 3) it omits many items of value. The balance sheet is just one key statement used in considering the purchasing a private business. It is the theoretical value of the enterprise if buyers were to purchase it, liquidate the assets and shut its doors. The liquidation value is not the same as the true value of a business, which is how much cash it can generate for business owners in the future. So the balance sheet is limited in its use for making an investment decision (about.com, 2007).

The final financial statement, the statement of cash flows emphasizes the critical nature of cash flow to the operation of the firm (Block & Hirt, 2004). A cash flow statement differs from the balance sheet and income statement because it acts as a kind of corporate checkbook that reconciles the other two statements. The cash flow statement records the company's cash transactions (the inflows and outflows) during the given period (See table 3). This statement shows whether all

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