Financial Accounting Ch. 1-3

Cost principle

An accounting principle that states that companies should record assets at their cost.

Journal

An accounting record in which transactions are initially recorded in chronological order.

Long-term investments

(1) investments in stocks and bonds of other corporations that companies hold for more than one year, and (2) long-term assets, such as land and buildings, not currently being used in the company's operations.

primary sources of financing activities

1. Borrowing money 2. Issuing shares of stock

order to complete financial statements

1. Income Statement 2. Retained Earnings Statement 3. Balance Sheet 4. Statement of Cash Flows

basic steps in the accounting process

1. analyze each transaction in terms of it's effect on accounts 2. enter the transaction into the journal 3. transfer the journal information to accounts in the ledger

journal contributes to the recording process by

1. disclosing in one place the complete effect of a transaction 2. provides a chronological record of transactions 3. helps prevent or locate errors because debit and credit amounts can be readily compared

Classified balance sheet

A balance sheet that contains a number of standard classifications and sections.

Corporation

A business organized as a separate legal entity having ownership divided into transferable shares of stock.

Sole proprietorship

A business owned by one person.

Partnership

A business owned by two or more persons associated as partners.

Statement of stockholders' equity

A financial statement that presents the factors that caused stockholders' equity to change during the period, including those that caused retained earnings to change.

Income statement

A financial statement that presents the revenues and expenses and resulting net income or net loss of a company for a specific period of time.

Statement of cash flows

A financial statement that provides financial information about the cash receipts and cash payments of a business for a specific period of time.

Balance sheet

A financial statement that reports the assets and claims to those assets at a specific point in time.

Retained earnings statement

A financial statement that summarizes the amounts and causes of changes in retained earnings for a specific period of time.

General ledger

A ledger that contains all asset, liability, stockholders' equity, revenue, and expense accounts.

Chart of accounts

A list of a company's accounts.

Trial balance

A list of accounts and their balances at a given time.

Comparative statements

A presentation of the financial statements of a company for more than one year.

Auditor's report

A report prepared by an independent outside auditor stating the auditor's opinion as to the fairness of the presentation of the financial position and results of operations and their conformance with generally accepted accounting standards.

Management discussion and analysis (MD&A)

A section of the annual report that presents management's views on the company's ability to pay near-term obligations, its ability to fund operations and expansion, and its results of operations.

Generally accepted accounting principles (GAAP)

A set of rules and practices, having substantial authoritative support, that the accounting profession recognizes as a general guide for financial reporting purposes.

Double-entry system

A system that records the dual effect of each transaction in appropriate accounts.

Comparability

Ability to compare the accounting information of different companies because they use the same accounting principles.

Full disclosure principle

Accounting principle that dictates that companies disclose circumstances and events that make a difference to financial statement users.

International Accounting Standards Board (IASB)

An accounting standard-setting body that issues standards adopted by many countries outside of the United States.

Economic entity assumption

An assumption that every economic entity can be separately identified and accounted for.

Monetary unit assumption

An assumption that requires that only those things that can be expressed in money are included in the accounting records.

Time period assumption

An assumption that the life of a business can be divided into artificial time periods and that useful reports covering those periods can be prepared for the business.

Ratio

An expression of the mathematical relationship between one quantity and another; may be expressed as a percentage, a rate, or a proportion.

Account

An individual accounting record of increases and decreases in specific asset, liability, stockholders' equity, revenue or expense items.

Certified Public Accountant (CPA)

An individual who has met certain criteria and is thus allowed to perform audits of corporations.

Basic accounting equation

Assets = Liabilities + Stockholders' Equity.

Intangible assets

Assets that do not have physical substance.

Property, plant, and equipment

Assets with relatively long useful lives that companies use in operating the business and are not intended for resale.

Current assets

Cash and other resources that companies expects to convert to cash or use up within one year or the operating cycle, whichever is longer.

Financing activities

Cash is often obtained from outside sources to start or expand a business.

Free cash flow computed as

Cash provided by operations minus capital expenditures minus cash dividends expressed in dolar value

Working Capital computed as

Current Assets minus Current Liabilities expressed in Proportion 1.44:1

Accounting transactions

Events that require recording in the financial statements because they affect assets, liabilities, or stockholders' equity.

Ratio analysis

Expresses the relationship among selected items of financial statement data. Expresssed in terms of either percentage, a rate or a simple proportion

Accounting Information is communicated through which documents

Income Statement Retained Earnings Statement Balance Sheet Statement of Cash Flows

Debt to total assets ratio measures

Measures the percentage of assets financed by creditors. higher percentage of dept financing , the riskier the business

Solvency ratios

Measures of the ability of the company to survive over a long period of time.

Profitability ratios

Measures of the operating success of a company for a given period of time.

Liquidity ratios

Measures of the short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash.

Notes to the financial statements

Notes that clarify information presented in the financial statements, as well as expand upon it where additional detail is needed.

Long-term liabilities (Long-term debt)

Obligations that a company expects to pay after one year

Current liabilities

Obligations that a company reasonably expects to pay within the next year or operating cycle, whichever is longer.

all businesses are involved in the following types of activity

Operating Investing Financing

Dividends

Payments of cash from a corporation to its stockholders.

Investing activities

Purchase of resources a company needs to operate the business

Sarbanes-Oxley Act (SOX)

Regulations passed by Congress in 2002 to try to reduce unethical corporate behavior.

Assets

Resources owned by a business

Solvency

The ability of a company to pay interest as it comes due and to repay the balance of debt at its maturity.

Liquidity

The ability of a company to pay obligations that are expected to become due within the next year or operating cycle.

Securities and Exchange Commission (SEC)

The agency of the U.S. government that oversees U.S. financial markets and accounting standard-setting bodies.

Net loss

The amount by which expenses exceed revenues. Net Loss = Expenses > Revenue

Net income

The amount by which revenues exceed expenses. Net Income = Revenues > Expenses

Retained earnings

The amount of net income retained in the corporation.

Conservatism

The approach of choosing an accounting method, when alternatives exist, that will least likely overstate assets and net income.

Going concern assumption

The assumption that the company will continue in operation for the foreseeable future.

Operating cycle

The average time required to go from cash to cash in producing revenues.

T account

The basic form of an account.

Materiality

The constraint of determining whether an item is large enough to likely influence the decision of an investor or creditor.

Expenses

The cost of assets consumed or services used in the process of generating revenues.

Liabilities

The debts and obligations of a business. Liabilities represent the amounts owed to creditors.

Public Company Accounting Oversight Board (PCAOB)

The group charged with determining auditing standards and reviewing the performance of auditing firms.

Ledger

The group of accounts maintained by a company.

Revenue

The increase in assets that result from the sale of a product or service in the normal course of business.

Debit

The left side of an account.

General journal

The most basic form of journal.

Stockholders' equity

The owners' claim on total assets.

Financial Accounting Standards Board (FASB)

The primary accounting standard-setting body in the United States

Journalizing

The procedure of entering transaction data in the journal.

Posting

The proces of transferring journal entries to the ledger accounts.

Reliability

The quality of information that gives assurance that it is free of error, is factual, and is neutral.

Relevance

The quality of information that indicates the information makes a difference in a decision.

Credit

The right side of an account.

Accounting information system

The system of collecting and processing transaction data and communicating financial information to interested parties.

Consistency

Use of the same accounting principles and methods from year to year within a company.

Current ratio measures

ability of company to pay short-term debt-paying

internal users of financial statements

are within the organization ... marking, management, human resources

accounts types with debit normal balance

asset dividends expense

Operating activities

begin once business has assets it needs from the other two activities.

Current ratio computed as

current assets divided by current liabilities. expressed in Proportion 1.44:1

Revenue entry effects

debit - decrease credit - increase normal balance - credit

common stock entry effects

debit - decrease credit - increase normal balance - credit

liabilities entry effects

debit - decrease credit - increase normal balance - credit

retained earnings entry effects

debit - decrease credit - increase normal balance - credit

Asset entry effects

debit- increase credit - decrease normal balance - debit

Expense entry effects

debit- increase credit - decrease normal balance - debit

dividends entry effects

debit- increase credit - decrease normal balance - debit

accounting

information system that identifies, records, and communicates the economic events of an organization

two types of users of financial statements are

internal users external users

accounts types with credit normal balance

liabilities common stock retained earnings Revenue

Earnings per share (EPS) computed as

net income minus preferred stock dividends divided by the average number of common shares outstanding during the year. expressed in dolar value

normal balance

on the side where the increase in account is recorded

external users of financial statements

outside organization... investors, creditors, IRS, SEC, customers, labor unions

Statement of cash flows

presents information about cash inflows and outflows from 1. Operating activities 2. Investing activities 3. Financing activities

purpose of financial statements

provide inputs for decision making

Free cash flow measures

provides insight into a company's cash gnerating ability

annual report

report prepared by corporate management that presents financial information and an independent auditor's report

Working capital measures

short-term ability to pay obligatons positive working capital - indicates likelihood that it will pay liabilities negative working capital - indicates that a company might not be able to pay creditors and may be forced into bankruptcy

Earnings per share (EPS) measures

the net income earned on each share of common stock.

Common stock

total amount paid in by stockholders for the shares they purchase.

Debt to total assets ratio computed as

total liabilities divided by total assets expressed as a percentage

Balance Sheet Classifications

• Current Assets • Long-term investments • Property, plant and equipment • Intangible assets • Current liabilities • Long-term liabilities • Stockholder's equity

Components of Annual Report

• Financial statements • Management discussion and analysis • Notes to financial statements • Auditor's report

constraints in financial reporting

• Materiality • Conservatism

Assumptions in Financial Accounting are

• Monetary unit assumption • Economic entity assumption • Time period assumption • Going concern assumption • Cost principle • Full disclosure principle

primary forms of business organization

• Sole proprietorship • Partnership • corporation

for financial information to be useful, it should possess:

• relevance • reliability • comparability • consistency

Advantages of corporation

•easier to transfer ownership •easier to raise funds •lower legal liability - no personal liability for stockholders

Disadvantages of Sole proprietorship

•owner personally liable for all business debts •financing may be difficult •transfer of ownership may be difficult

Disadvantages of partnership

•owners personally liable for all business debts • transfer of ownership may be difficult

Advantages of Sole proprietorship

•simple to establish •owner controlled •tax advantages that are more favorable than a corporation

Advantages of partnership

•simple to establish •shared control •broader skills and resources •tax advantages that are more favorable than a corporation

Disadvantages of corporation

•unfavorable tax treatment resulting in higher taxes paid by stockholders