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Open Innovation

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  Innovation and entrepreneurship are at the heart of “creative destruction”. In his book, Open Innovation, Henry Chesbrough describes a new paradigm of open innovation that is in contrast to the traditional closed model. To understand open innovation, it is worthwhile to review the older model of closed innovation.   The Closed Innovation Model Under the concept of innovation that prevailed during most of the 20th century, companies attained competitive advantage by funding large research laboratories that developed technologies that formed the basis of new products that commanded high profit margins that then could be plowed back into research. This vertical integration of the research function meant that firms that could not afford such research were at a disadvantage. The vertically integrated concept of the research and development pipeline is depicted in the following diagram:   Closed Innovation Concept   In the above diagram, the red lines represent completed research projects, some of which may have resulted in patents, but that never made it to development. This often is the situation if the innovation is not useful to the company’s core business. Such completed research projects often are shelved until a market opportunity arises to use them, if such an…

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The price elasticity of demand measures the responsiveness of quantity demanded to a change in price, with all other factors held constant. Definition The price elasticity of demand, Ed is defined as the magnitude of: proportionate change in quantity demanded ———————————————————————— proportionate change in price Since the quantity demanded decreases when the price increases, this ratio is negative; however, the absolute value usually is taken and Ed is reported as a positive number. Because the calculation uses proportionate changes, the result is a unitless number and does not depend on the units in which the price and quantity are expressed. As an example calculation, take the case in which a product’s Ed is reported to be 0.5. Then, if the price were to increase by 10%, one would observe a decrease of approximately 5% in quantity demanded. In the above example, we used the word “approximately” because the exact result depends on whether the initial point or the final point is used in the calculation. This matters because for a linear demand curve the price elasticity varies as one moves along the curve. For small changes in price and quantity the difference between the two results often is negligible, but for large changes the difference may be more significant. To deal with this issue,…

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Industry Concentration

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The concentration of firms in an industry is of interest to economists, business strategists, and government agencies. Here, we discuss two commonly-used methods of measuring industry concentration: the Concentration Ratio and the Herfindahl-Hirschman Index. Concentration Ratio (CR) The concentration ratio is the percentage of market share owned by the largest m firms in an industry, where m is a specified number of firms, often 4, but sometimes a larger or smaller number. The concentration ratio often is expressed as CRm, for example, CR4. The concentration ratio can be expressed as: CRm  =  s1  +  s2  +  s3  +  … … +  sm where  si  =  market share of the ith firm. If the CR4 were close to zero, this value would indicate an extremely competitive industry since the four largest firms would not have any significant market share. In general, if the CR4 measure is less than about 40 (indicating that the four largest firms own less than 40% of the market), then the industry is considered to be very competitive, with a number of other firms competing, but none owning a very large chunk of the market. On the other extreme, if the CR1 measure is more than about 90, that one firm that controls more than 90% of the market is effectively a monopoly. While useful, the concentration ratio presents an incomplete picture of the concentration of…

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Game Theory

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Game theory analyzes strategic interactions in which the outcome of one’s choices depends upon the choices of others. For a situation to be considered a game, there must be at least two rational players who take into account one another’s actions when formulating their own strategies. If one does not consider the actions of other players, then the problem becomes one of standard decision analysis, and one is likely to arrive at a strategy that is not optimal. For example, a company that reduces prices to increase sales and therefore increase profit may lose money if other players respond with price cuts. As another example, consider a risk averse company that makes its decisions by maximizing its minimum payoff (maxmin strategy) without considering the reactions of its opponents. In such a case, the minimum payoff might be one that would not have occurred anyway because the opponent might never find it optimal to implement a strategy that would make it come about. In many situations, it is crucial to consider the moves of one’s opponent(s). Game theory assumes that one has opponents who are adjusting their strategies according to what they believe everybody else is doing. The exact level of…

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Auctions

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Auctions are mechanisms for determining prices. Auctions often are classified as one of the following auction types:  First-price sealed-bid auction – winner pays his bid. In this case, one should bid below one’s value an amount that depends on how many other bidders there are. The more bidders, the closer to one’s value that one should bid. There is a tradeoff between profit and the frequency of winning.    Second-price sealed-bid auction – winner pays highest losing bid. In this type of auction, the optimal strategy is to bid one’s value.  English auction – auctioneer begins with a low price. Bidders raise their bids until nobody is willing to bid higher. The optimal strategy in an English auction is to bid up to one’s value, staying in the auction until the bids exceed one’s value.  Dutch auction – auctioneer calls out prices beginning with a very high value and gradually reduces it. The first bidder to accept an offered price wins. The Dutch auction gets its name because of its use in the flower markets in Holland. Note that eBay defines Dutch auctions differently. On eBay, a Dutch auction is one in which there are multiple units of the same…

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Gross Domestic Product

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Economic growth is measured in terms of an increase in the size of a nation’s economy. A broad measure of an economy’s size is its output. The most widely-used measure of economic output is the Gross Domestic Product (abbreviated GDP). GDP generally is defined as the market value of the goods and services produced by a country. One way to calculate a nation’s GDP is to sum all expenditures in the country. This method is known as the expenditure approach and is described below.   Expenditure Approach to Calculating GDP The expenditure approach calculates GDP by summing the four possible types of expenditures as follows: GDP    =   Consumption    +  Investment    +  Government Purchases    +  Net Exports Consumption is the largest component of the GDP. In the U.S., the largest and most stable component of consumption is services. Consumption is calculated by adding durable and non-durable goods and services expenditures. It is unaffected by the estimated value of imported goods. Investment includes investment in fixed assets and increases in inventory. Government purchases are equal to the government expenditures less government transfer payments (welfare, unemployment payouts, etc.) Net exports are exports minus imports. Imports are subtracted since GDP…

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Consumer Price Index

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The most commonly reported measure of the consumer price levels in the United States is the Consumer Price Index (CPI). Published by the U.S. Department of Labor ‘s Bureau of Labor Statistics, the CPI is a fixed-weight price index using a fixed basket of goods that are representative of what a typical consumer purchases each month. There are many different CPI’s calculated by region, types of products, types of consumers, etc. The most commonly reported CPI is the CPI-U, which is the CPI for all urban consumers. Increases in the CPI level serve as a measure of the consumer inflation rate. The rate of inflation over a period of time is simply the percentage increase in the CPI over the period, often reported on an annualized basis. Uses of the CPI The CPI has many important uses, including the following: Economic indicator – the CPI is the most commonly reported measure of consumer prices. Reference for escalation agreements – labor contracts and other payment agreements that are indexed to inflation rely on the CPI. Deflator for economic series – when a series of data is to be adjusted so that it is reported in constant dollars, the CPI often is…

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The Business Cycle

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Economic growth is not a steady phenomenon; rather, it tends to exhibit a pattern as follows: an expansion of above-average growth a peak a contraction of below-average growth a trough or low-point The troughs then are followed by periods of expansion and the cycle generally repeats, though not in a regular manner. These fluctuations in economic growth are known as the business cycle and are depicted conceptually in the following diagram:   The Business Cycle   Indicators of the Business Cycle Because the business cycle is related to aggregate economic activity, a popular indicator of the business cycle in the U.S. is the Gross Domestic Product (GDP). The financial media generally considers two consecutive quarters of negative GDP growth to indicate a recession. Used as such, the GDP is a quick and simple indicator of economic contractions. However, the National Bureau of Economic Research (NBER) weighs GDP relatively low as a primary business cycle indicator because GDP is subject to frequent revision and it is reported only on a quarterly basis (the business cycle is tracked on a monthly basis). The NBER relies primarily on indicators such as the following: employment personal income industrial production Additionally, indicators such as manufacturing…

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Unemployment

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The percentage of the labor force that is seeking a job but does not have one is known as the unemployment rate. The unemployment rate is defined as follows: Unemployed Workers     x   100%   Employed  +  Unemployed Workers Unemployed workers are those who are jobless, seeking a job, and ready to work if they find a job. The sum of the employed and unemployed workers represent the total labor force. Note that the labor force does not include the jobless who are not seeking work, such as full-time students, homemakers, and retirees. They are considered to be outside the labor force. The labor force participation rate is the percentage of the adult population that is part of the total labor force. All of these measures consider only persons 16 years of age or older. The movement among the three groups can be illustrated as shown in the following diagram.   Model of Labor Force Movement       Employed                Unemployed       Not in the     Labor Force    The diagram shows seven possible movements: Employed  to  Employed  –  an employed person moves directly from one job to another job. Employed  to  Unemployed  –  an employed person moves to unemployed status either…

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to Consider When Starting a Company From business structure to taxes, there are numerous legal issues to address when starting a company, many of which can bring a promising start-up to a grinding halt if the proper steps are not taken. The following four issues most frequently cause problems. Trademarks :  Register your trademark. Simply reserving a domain name does not guarantee legal rights. Since interNIC does not deal with trademark disputes, federal trademarks take precedence over domain registrations. Unregistered trademarks do not hold up well; it is best to register the trademark federally. However, the PTO will not register a trademark if it is not distinctive enough. The U.S. government’s trademark database can be accessed at   Deals with cofounders :  Document all deals with cofounders in case disputes arise at a later date. Employees :  Consider legal issues of hiring employees. The largest area of potential liability for an entrepreneur often is employment law. Employees have many legal rights that must not be neglected. Contract liability :  Establish limits of liability in contracts by limiting the maximum liability to that of the contract and by excluding consequential damages.  

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Sources of Law Constitutional Law is based on a formal document that defines broad powers. Federal constitutional law originates from the U.S. constitution. State constitutional law originates from the individual state constitutions. Statutes and Ordinances are legislation passed on the federal, state, or local levels. Common Law is based on the concept of precedence – on how the courts have interpreted the law. Under common law, the facts of a particular case are determined and compared to previous cases having similar facts in order to reach a decision by analogy. Common law applies mostly at the state level. It originated in the 13th century when royal judges began recording their decisions and the reasoning behind the decisions. Administrative Law – federal, state, and local level. Administrative law is made by administrative agencies that define the intent of the legislative body that passed the law. The sources of law have both vertical and horizontal dimensions. Vertical dimensions include federal authority, state authority, and concurrent authority. Federalism refers to this form of government, in which there is national and local authority. Federal authority covers laws related to patents, pensions and profit sharing, and labor issues. State authority covers business association, contracts, and…

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Obtaining Legal Counsel

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Ways to Reduce Legal Costs Once a small company having no in-house legal staff finds itself in litigation, it already has lost since the legal fees it pays may be large with respect to the company’s size. In the U.S., losers do not have to pay the winner’s legal fees, except in the case of frivolous suits, which are rare. Larger companies already have their own legal staff so the incremental cost of litigation for them may be small. Unfortunately, there is no pro bona program for companies that cannot afford legal defense. Small companies therefore must take actions to reduce potential legal costs. The follow steps can reduce legal costs substantially: When at all possible, don’t litigate – negotiate. Put into contracts a clause requiring the losing party to pay the winning party’s legal fees. Put an arbitration clause into contracts. Note that arbitration is binding and enforceable in court whereas mediation is non-binding. Purchase the broadest possible insurance policies in order to have the insurance company pay legal costs. Whenever possible, specify in contracts that any litigation be in your own state. The costs of going to court are much higher away from home. Types of Attorneys Two…

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Employment Law

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Duties to One’s Former Employer When starting a company, many entrepreneurs believe that the end justifies the means, and may be lax about fulfilling obligations to former employers. However, the fastest way to put a startup out of business is to sue it for violating duties to a former employer. Even if no duties were breached, such a lawsuit could result in over $100,000 in legal fees. There are two types of duties to former employers, those that arise from tort law and those that arise from contract law. Under agency law (tort law) there are three duties that an employee owes the employer: Duty of loyalty – the obligation to act only in the interest of one’s employer and not to compete with one’s employer. Even if one is working on one’s own project at home in the evening using one’s own computer and equipment, the project may constitute a breech of loyalty if it competes in the same line of business as that of the employer. Duty of obedience – the obligation to obey all reasonable orders of one’s employer. An act of insubordination is a violation of this duty. Duty of care – lack of performance is…

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Financial Accounting

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The purpose of accounting is to provide the information that is needed for sound economic decision making. The main purpose of financial accounting is to prepare financial reports that provide information about a firm’s performance to external parties such as investors, creditors, and tax authorities. Managerial accounting contrasts with financial accounting in that managerial accounting is for internal decision making and does not have to follow any rules issued by standard-setting bodies. Financial accounting, on the other hand, is performed according to Generally Accepted Accounting Principles (GAAP) guidelines. CPA’s The primary accounting professional association in the U.S. is the American Institute of Certified Public Accountants (AICPA). The AICPA prepares the Uniform CPA Examination, which must be completed in order to become a certified public accountant. To be eligible to become a CPA, one needs an undergraduate degree in any major with 150 credit hours of course work. Of these 150 credit hours, a minimum of 36 credit hours must be in accounting. Only about 10% of those taking the CPA exam pass it the first time. Accounting Standards In order that financial statements report financial performance fairly and consistently, they are prepared according to widely accepted accounting standards. These standards…

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Accounting Concepts

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Financial accounting relies on several underlying concepts that have a significant impact on the practice of accounting. Assumptions The following are basic financial accounting assumptions: Separate entity assumption – the business is an entity that is separate and distinct from its owners, so that the finances of the firm are not co-mingled with the finances of the owners. Going concern assumption – the business is going to be operating for the foreseeable future. Stable monetary unit assumption – e.g. the U.S. dollar Fixed time period assumption – info prepared and reported periodically (quarterly, annually, etc.) Principles The basic assumptions of accounting result in the following accounting principles: Historical cost principle – assets are reported and presented at their original cost and no adjustment is made for changes in market value. One never writes up the cost of an asset. Accountants are very conservative in this sense. Sometimes costs are written down, for example, for some short-term investments and marketable securities, but costs never are written up. Matching principle – matching of revenues and expenses in the period earned and incurred. Revenue recognition principle – revenue is realized (reported on the books as earned) when everything that is necessary to earn…

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sole proprietorship general partnership limited partnership limited liability partnership corporation (including S corporations) professional associations limited liability companies business trusts professional corporations There are six common issues that distinguish the different business forms: taxation liability risk and control continuity of existence transferability expense and formality Taxation and risk and control are the more significant issues. In addition to these common issues, there also are issues specific to each form. A one-person company generally has only three choices of business form: sole proprietorship, corporation, or a limited liability company. Multiple people typically have the additional options of general partnership, limited partnership, or a limited liability company. Liability is a risk that one exposes oneself to when starting a business. Two types of risk are tort risk and contract risk. A tort is an intentional or unintentional harm to the person or property of another. Some examples of tort risk are worker injury, product liability, automobile liability, and general liability, such as when somebody falls on a wet floor. Examples of contract risk are financing risk and risk with vendors and customers. Tort risk can be protected against by using insurance. 99% of businesses can get an insurance policy against all tort…

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The Sole Proprietorship

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The sole proprietorship is the most common form of business structure for small companies. It is viewed as being one and the same as its owner. This characteristic has the advantage of simplicity but also has the disadvantage of personal liability. Taxation A sole proprietorship has pass-through taxation. The business itself does not file a tax return; rather, the income passes through and is reported on the owner’s personal tax return. Liability The owner of a sole proprietorship has unlimited personal liability. However, with insurance for tort risk and contractual limitations for contract risk, the sole proprietor can insure against most risks and operate with near the same level of comfort as the owners of a corporation. Continuity of existence A sole proprietorship exists only as long as the owner is alive or until the owner decides to close the business. Risk and Control The control of a sole proprietorship belongs entirely to the owner, who also assumes the full risk of the business. Transferability Transferring one’s interest in a sole proprietorship is very easy – one simply prepares an asset purchase agreement and sells the assets. The assets of a sole proprietorship are transferred with the estate of the…

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A general partnership (or simply partnership) is an association of two or more people carrying on a business with the goal of earning a profit. A partnership is viewed as being one and the same as its owners. There is little formality involved in creating a partnership. In fact, if someone can establish that you are in business with somebody else, then there is a general partnership. The intention or lack thereof of having a formal partnership is not important. Existence of a Partnership Rules for determining the existence of a partnership are outlined in Part II of the Uniform Partnership Act (UPA). Some of these rules are summarized as follows: 1.  Joint tenancy, common property, part ownership, etc. does not by itself establish a partnership, regardless of whether the owners of the property share any profits from it. Three ways to jointly own property are: Tenants in common – when one dies, one’s portion of the partnership is transferred to one’s heirs. Joint tenancy – right of survivorship – when one dies, the entire interest goes to the other person. Tenancy by entirety – for example, a husband and wife. Each tenant owns by whole and by part. If…

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Limited Partnership

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A limited partnership (LP) consists of two or more persons, with at least one general partner and one limited partner. While a general partner in an LP has unlimited personal liability, a limited partner’s liability is limited to the amount of his or her investment in the company. LP’s are creatures of statute since they must file with the state to form them. Because of the limited liability of limited partnerships, they often are used as vehicles for raising capital. The limited partnership is a separate entity and files taxes as a separate entity. The statute that provided for the formation of limited partnerships was the Uniform Limited Partnership Act (ULPA), which dates back to 1916. In 1976, ULPA was revised into the Revised Uniform Limited Partnership Act (RULPA), which was amended in 1985 to address the issue of limited partners’ taking control. RULPA states that a limited partner shall not be liable as a general partner unless he or she takes control of the business. However, a limited partner is not considered to control the business if he or she is a member of the board of directors. Because the general partner is exposed to unlimited personal liability, LP’s…

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The Corporation

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  The corporation is the most sophisticated form of business entity and the most common among large companies. The corporate business form was well-developed under Roman law. In the second and third centuries, the corporate form was used by the early Christian church to hold and transfer church property, for example, for transferring control of parish assets to the new bishop when the previous bishop died. The corporate form was brought to the American colonies by the British. When to Incorporate A venture usually does not need to incorporate in its very early stages. The need for incorporation often arises from a specific event such as: The business begins to sell a product, opening up potential liability. The business seeks external financing, necessitating the need for a formal legal structure. Some other specific reason develops. From a venture capitalist’s point of view, C corporations are the preferred choice of business form because the VC partnership does not want to see the pass-through income. For entrepreneurs without VC funding, limited liability companies are the preferred choice since losses in the first few years can pass-through for personal tax deductions. Delaware now allows easy conversion from a limited liability company to a…

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Preservation of limited liability is an important issue specific to corporations. The corporate protection of limited liability can be lost through: Piercing of the corporate veil Defective incorporation Improper signing of documents. Piercing the Corporation Veil A court may pierce through the veil of liability protection if the corporation does not follow proper corporate formalities, if it is undercapitalized, or if it can be shown that it is a sham that was set up to defraud. If the corporate formalities are not followed, the corporation may be deemed to not be functioning as a corporation, but rather, as the alter ego of the owners. To prevent the corporate veil from being pierced, it is important to keep minutes of the board meetings and to not co-mingle bank accounts. These measures help to ensure that the corporation will be treated as a separate entity should it be sued. Case:  Edwards Company, Inc.  v.  Monogram Industries, Inc. Facts In 1977, Monogram Industries, Inc. acquired Entronic Corporation, a company that produced smoke detectors. Monogram made the puchase through a wholly-owned subsidiary called Monotronics, itself a corporation. Monogram owned 100% of Monotronics’ stock. Monotronics then formed the Entronic Company, a limited partnership in which…

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Where to Incorporate

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The internal affairs of a corporation are governed by the laws of the state in which it is formed. A corporation does not have to have an office or do business in the state in which it is incorporated; it need only have a registered agent in that state. There are companies such as CT Corporation System that will act as a registered agent in the state of incorporation. Delaware Delaware often is the preferred state of incorporation. Initially, Delaware gave management better rights in the event of a takeover, so in the 1940’s and 1950’s many corporations moved there. Delaware set up a court system that has expertise in commercial transactions and well-developed corporate law. Other states improved their corporate legal systems, but virtually every corporate attorney is familiar with Delaware law. Delaware also has the Delaware Asset Protection Trust, which permits one to set up a trust that cannot be touched by creditors but that allows one to get one’s money. Most other states require irrevocable trusts that prevent one from accessing one’s money once it is in the trust. The state of Alaska responded with a similar trust, but added spouses and children to the list of…

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Nevada Corporation

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Historically, Delaware has been the state of choice for incorporation. However, some other states such as Nevada have shaped their corporate laws in order to attract corporations. Here is how Delaware and Nevada compare on several points: Taxes on corporate earnings: Delaware taxes the proportion of corporate profits earned in Delaware. Nevada is tax-free, regardless of where the profits are earned. Annual franchise tax: Delaware and most other states have an annual franchise tax on corporations. Nevada does not. Annual disclosure: Delaware requires an annual report of stockholder meeting dates, business locations outside of Delaware, and the number and value of shares issued. Nevada requires only the current list of officers and directors. In both Delaware and Nevada, the officers and directors can be one person. Protection of officers and directors: Nevada provides broader protection against personal liability of officers and directors than does Delaware. Shareholder disclosure: Nevada and Wyoming are two states that allow bearer shares. When corporations first came into existence, their stock certificates were like cash in the sense that whoever was holding them at the moment legally was the owner. However, in order to protect their shareholders against theft of the stock certificates, corporations began to…

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 business transaction involves an exchange between two accounts. For example, for every asset there exists a claim on that asset, either by those who own the business or those who loan money to the business. Similarly, the sale of a product affects both the amount of cash (or cash receivable) held by the business and the inventory held. Recognizing this fundamental dual nature of transactions, merchants in medieval Venice began using a double-entry bookkeeping system that records each transaction in the two accounts affected by the exchange. In the late 1400’s, Franciscan monk and mathematician Luca Pacioli documented the procedure for double-entry bookkeeping as part of his famous Summa work, which described a significant portion of the accounting cycle. Double-entry bookkeeping spread throughout Europe and became the foundation of modern accounting. Two notable characteristics of double-entry systems are that 1) each transaction is recorded in two accounts, and 2) each account has two columns. In a double-entry system, two entries are made for each transaction – one entry as a debit in one account and the other entry as a credit in another account. The two entries keep the accounting equation in balance so that: Assets    =    Liabilities   +   Owners’…

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The Accounting Equation

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The resources controlled by a business are referred to as its assets. For a new business, those assets originate from two possible sources: Investors who buy ownership in the business Creditors who extend loans to the business Those who contribute assets to a business have legal claims on those assets. Since the total assets of the business are equal to the sum of the assets contributed by investors and the assets contributed by creditors, the following relationship holds and is referred to as the accounting equation :   Assets    =      Liabilities   +   Owners’ Equity Resources   Claims on the Resources Initially, owner equity is affected by capital contributions such as the issuance of stock. Once business operations commence, there will be income (revenues minus expenses, and gains minus losses) and perhaps additional capital contributions and withdrawals such as dividends. At the end of a reporting period, these items will impact the owners’ equity as follows:   Assets    =      Liabilities   +   Owners’ Equity         +   Revenues         –   Expenses         +   Gains         –   Losses         +   Contributions         –   Withdrawals These additional items under owners’ equity are tracked…

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The Accounting Cycle

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    The sequence of activities beginning with the occurrence of a transaction is known as the accounting cycle. This process is shown in the following diagram: Steps in The Accounting Cycle Identify the Transaction Identify the event as a transaction and generate the source document.   Analyze the Transaction Determine the transaction amount, which accounts are affected, and in which direction.   Journal Entries The transaction is recorded in the journal as a debit and a credit.   Post to Ledger The journal entries are transferred to the appropriate T-accounts in the ledger.   Trial Balance A trial balance is calculated to verify that the sum of the debits is equal to the sum of the credits.   Adjusting Entries Adjusting entries are made for accrued and deferred items. The entries are journalized and posted to the T-accounts in the ledger.   Adjusted Trial Balance A new trial balance is calculated after making the adjusting entries.   Financial Statements The financial statements are prepared.   Closing Entries Transfer the balances of the temporary accounts (e.g. revenues and expenses) to owner’s equity.   After-Closing Trial Balance A final trial balance is calculated after the closing entries are made.   The…

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The Source Document

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When a business transaction occurs, a document known as the source document captures the key data of the transaction. The source document describes the basic facts of the transaction such as its date, purpose, and amount. Some examples of source documents: cash receipt cancelled check invoice sent or received credit memo for a customer refund employee time sheet The source document is the initial input to the accounting process and serves as objective evidence of the transaction, serving as part of the audit trail should the firm need to prove that a transaction occurred. To facilitate referencing, each source document should have a unique identifier, usually a number or alphanumeric code. Prenumbering of commonly-used forms helps to enforce numbering, to classify transactions, and to identify and locate missing source documents. A well-designed source document form can minimize errors and improve the efficiency of transaction recording. The source document may be created in either paper or electronic format. For example, automated accounting systems may generate the source document electronically or allow paper source documents to be scanned and converted into electronic images. Accounting software often provides on-screen entry forms for different types of transactions to capture the data and generate the…

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Journal Entries

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After a transaction occurs and a source document is generated, the transaction is analyzed and entries are made in the general journal. A journal is a chronological listing of the firm’s transactions, including the amounts, accounts that are affected, and in which direction the accounts are affected. A journal entry takes the following format:   Format of a General Journal Entry Date Accounts Debit Credit mm/dd account to be debited xxxx.xx          account to be credited   xxxx.xx In addition to this information, a journal entry may include a short notation that describes the transaction. There also may be a column for a reference number so that the transaction can be tracked through the accounting system. The above format shows the journal entry for a single transaction. Additional transactions would be recorded in the same format directly below the first one, resulting in a time-ordered record. The journal format provides the benefit that all of the transactions are listed in chronological order, and all parts (debits and credits) of each transaction are listed together. Because the journal is where the information from the source document first enters the accounting system, it is known as the book of original entry….

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The General Ledger

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 While the journal lists transactions in chronological order, its format does not faciliate the tracking of individual account balances. The general ledger is used for this purpose. The general ledger is a collection of T-accounts to which debits and credits are transferred. The action of recording a debit or credit in the general ledger is referred to as posting. The posting of a journal entry to the general ledger accounts is a purely mechanical process using information already in the journal entry and requiring no additional analysis. To understand the posting process, consider a journal entry in the following format: General Journal Entry Date Accounts Debit Credit mm/dd Account 1 xxxx.xx          Account 2        xxxx.xx There are two ledger accounts affected by the above journal entry (Account 1 and Account 2). Each of these accounts is represented by a T-account in the general ledger. To post the entry to the ledger, simply transfer the information to the T-accounts: Ledger Accounts Account 1 mm/dd xxxx.xx                                                           Bal. xxxx.xx                                     Account 2                            mm/dd xxxx.xx                                          Bal. xxxx.xx Note that the debit portion of the journal entry…

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Debits and Credits

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In double entry accounting, rather than using a single column for each account and entering some numbers as positive and others as negative, we use two columns for each account and enter only positive numbers. Whether the entry increases or decreases the account is determined by choice of the column in which it is entered. Entries in the left column are referred to as debits, and entries in the right column are referred to as credits. Two accounts always are affected by each transaction, and one of those entries must be a debit and the other must be a credit of equal amount. Actually, more than two accounts can be used if the transaction is spread among them, just as long as the sum of debits for the transaction equals the sum of credits for it. The double entry accounting system provides a system of checks and balances. By summing up all of the debits and summing up all of the credits and comparing the two totals, one can detect and have the opportunity to correct many common types of bookkeeping errors. To avoid confusion over debits and credits, avoid thinking of them in the way that they are used…

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Trial Balance

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  A basic rule of double-entry accounting is that for every credit there must be an equal debit amount. From this concept, one can say that the sum of all debits must equal the sum of all credits in the accounting system. If debits do not equal credits, then an error has been made. The trial balance is a tool for detecting such errors. The trial balance is calculated by summing the balances of all the ledger accounts. The account balances are used because the balance summarizes the net effect of all of the debits and credits in an account. To calculate the trial balance, construct a table in the following format: Trial Balance Calculation     Account         Debits         Credits     Account 1 xxxx.xx   Account 2 xxxx.xx   Account 3 xxxx.xx   . . .     Account 4   xxxx.xx Account 5   xxxx.xx Account 6   xxxx.xx     . . .   ________ ________ Totals:  xxxx.xx  xxxx.xx In the above trial balance, the balances of Accounts 1, 2, and 3 are net debits, and the balances of Accounts 4, 5, and 6 are net credits. The totals of the debits and credits should be equal; if they are not,…

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Adjusting Entries

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In the accounting process, there may be economic events that do not immediately trigger the recording of the transaction. These are addressed via adjusting entries, which serve to match expenses to revenues in the accounting period in which they occur. There are two general classes of adjustments: Accruals – revenues or expenses that have accrued but have not yet been recorded. An example of an accrual is interest revenue that has been earned in one period even though the actual cash payment will not be received until early in the next period. An adjusting entry is made to recognize the revenue in the period in which it was earned. Deferrals – revenues or expenses that have been recorded but need to be deferred to a later date. An example of a deferral is an insurance premium that was paid at the end of one accounting period for insurance coverage in the next period. A deferred entry is made to show the insurance expense in the period in which the insurance coverage is in effect.   How to Make Adjusting Entries Like regular transactions, adjusting entries are recorded as journal entries. The following illustrates adjustments for accrued and deferred items.  …

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Closing Entries

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Revenue, expense, and capital withdrawal (dividend) accounts are temporary accounts that are reset at the end of the accounting period so that they will have zero balances at the start of the next period. Closing entries are the journal entries used to transfer the balances of these temporary accounts to permanent accounts. After the closing entries have been made, the temporary account balances will be reflected in the Retained Earnings (a capital account). However, an intermediate account called Income Summary usually is created. Revenues and expenses are transferred to the Income Summary account, the balance of which clearly shows the firm’s income for the period. Then, Income Summary is closed to Retained Earnings. The sequence of the closing process is as follows:   Close the revenue accounts to Income Summary. Close the expense accounts to Income Summary. Close Income Summary to Retained Earnings. Close Dividends to Retained Earnings.   The closing journal entries associated with these steps are demonstrated below. The closing entries may be in the form of a compound journal entry if there are several accounts to close. For example, there may be dozens or more of expense accounts to close to Income Summary.   1.  Close Revenue…

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Businesses report information in the form of financial statements issued on a periodic basis. GAAP requires the following four financial statements:  Balance Sheet – statement of financial position at a given point in time.   Income Statement – revenues minus expenses for a given time period ending at a specified date. Statement of Owner’s Equity – also known as Statement of Retained Earnings or Equity Statement.   Statement of Cash Flows – summarizes sources and uses of cash; indicates whether enough cash is available to carry on routine operations.   Balance Sheet  The balance sheet is based on the following fundamental accounting model:  Assets  =  Liabilities  +  Equity  Assets can be classed as either current assets or fixed assets. Current assets are assets that quickly and easily can be converted into cash, sometimes at a discount to the purchase price. Current assets include cash, accounts receivable, marketable securities, notes receivable, inventory, and prepaid assets such as prepaid insurance. Fixed assets include land, buildings, and equipment. Such assets are recorded at historical cost, which often is much lower than the market value.  Liabilities represent the portion of a firm’s assets that are owed to creditors. Liabilities can be classed as short-term liabilities (current)…

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Accounting standards are needed so that financial statements will fairly and consistently describe financial performance. Without standards, users of financial statements would need to learn the accounting rules of each company, and comparisons between companies would be difficult. Accounting standards used today are referred to as Generally Accepted Accounting Principles (GAAP). These principles are “generally accepted” because an authoritative body has set them or the accounting profession widely accepts them as appropriate. Securities and Exchange Commission (SEC) The Securities and Exchange Commission is a U.S. regulatory agency that has the authority to establish accounting standards for publicly traded companies. The Securities Act of 1933 and the Securities Exchange Act of 1934 require certain reports to be filed with the SEC. For example, Forms 10-Q and 10-K must be filed quarterly and annually, respectively. The head of the SEC is appointed by the President of the United States. When the SEC was formed there was no standards-issuing body. However, rather than set standards, the SEC encouraged the private sector to set them. The SEC has stated that FASB standards are considered to have authoritative support. Committee on Accounting Procedure (CAP) In 1939, encouraged by the SEC, the American Institute of Certified…

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The Balanced Scorecard

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Traditional financial reporting systems provide an indication of how a firm has performed in the past, but offer little information about how it might perform in the future. For example, a firm might reduce its level of customer service in order to boost current earnings, but then future earnings might be negatively impacted due to reduced customer satisfaction. To deal with this problem, Robert Kaplan and David Norton developed the Balanced Scorecard, a performance measurement system that considers not only financial measures, but also customer, business process, and learning measures. The Balanced Scorecard framework is depicted in the following diagram: Diagram of the Balanced Scorecard        Financial            Customer     Strategy     Business     Processes                  Learning     & Growth   The balanced scorecard translates the organization’s strategy into four perspectives, with a balance between the following: between internal and external measures between objective measures and subjective measures between performance results and the drivers of future results   Beyond the Financial Perspective In the industrial age, most of the assets of a firm were in property, plant, and equipment, and the financial accounting system performed an adequate job of valuing those assets. In the information age, much of the value of the firm is…

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