Financial Accounting Chapter 1

Financial Accounting

- Provides external users with information - Investors, creditors, customers - Those who are not directly involved in managing and operating the business Objective : provide relevant and timely information for the decision-making needs of users outside of the business Ex: financial reports on the operations and condition of the business are useful for banks in deciding whether to lend money to the business - General-purpose financial statements: 1 type of financial accounting report that is distributed to external users "General-purpose" because there are a wide range of decision-making needs that these reports are designed to serve

Managerial accounting

- Provides internal users with information - Managers and employees Those who are directly involved in managing and operating the business - Objective: provide relevant and timely information for managers' and employees' decision-making needs - Usually sensitive information (ex: info about customers, plans to expand the business) and not distributed outside the business - Private Accounting: Managerial accountants employed by a business

Role of Accounting in Business

- provide information for managers to use in operating the business - Provides information to other uses in assessing the economic performance and condition of the business Accounting: Information system that provides reports to users about the economic activities and condition of a business, Means by which businesses' financial information is communicated to users - Process by which accounting provides this information to users: 1. Identify users 2. Assess users' information needs 3. Design the accounting information system to meet users' needs 4. Record data about business activities and events 5. Prepare financial statements reports for users

Statement of Cash Flows

1. Cash flows from operating activities: Reports a summary of cash receipts and cash payments from operations Net cash flow from operating activities normally differs from the amount of net income for the period Difference occurs because revenues and expenses may not be recorded at the same time that cash is received from customers or paid to creditors 2. Cash flows from investing activities: Reports the cash transactions for the acquisition and sale of assets 3. Cash flows from financing activities: Reports the cash transactions related to cash investments by stockholders, borrowings, and dividends

Business entity may take the form of ...

1. Proprietorship Owned by 1 person Most of business entities in the U.S. Easy and inexpensive Resources are limited to those of the owner Used by small businesses Ex: A & B Painting 2. Partnership Owned by 2 or more individuals 10% of business organizations in the US (combined with limited liability companies) Combines the skills and resources of more than one person Ex: Jones & Smith, Architexts 3. Corporation Organized under state or federal statutes as a separate legal entity Generates 90% of business revenues 20% of the business organizations in the U.S. Ownership is divided into shares called stock Used by large businesses Ex: Apple Inc. or Ford Motors 4. Limited liability company (LLC) Combines the attributes of a partnership and a corporation 10% of business organizations in the US (combined with partnership) Often used as an alternative to a partnership Has tax and legal liability advantages for owners

Types of businesses

1. Service businesses Provide services rather than products Ex: Southwest Airlines (Transportation), Walt Disney Company (Entertainment) 2. Retail (or Merchandising) businesses Sell products they purchase from other businesses Ex: Walmart (general merchandise), Amazon (music, videos, ...) 3. Manufacturing businesses Change basic inputs into products that are sold Ex: Ford Company (cars, trucks), Merck & Co (pharmaceutical drugs)

Principles

4 principles are an integral part of financial accounting (in addition to the characteristics and assumptions from before) 1. Measurement 2. Historical cost 3. Revenue recognition 4. Expense recognition

Role of Ethics in Accounting and Business

Accountants behave in an ethical manner so... information they provide will be trustworthy and useful for decision making Managers and employees behave in an ethical manner (in managing and operating a business) so... Others are willing to invest in or lean money to the business Ethics: Moral principles that guide individuals Unethical manner usually involves: 1. Failure of character Caused by Pressures from supervisors to meet company and investor expectations Started off as small violations but became big violations as the company's financial problems became worse 2. Culture of greed and ethical indifference Senior managers created a culture of greed and indifference to the truth

Financial Statements

Accounting reports that are prepared for users after transactions have been recorded and summarized Primary financial statements of a corporation are: 1. Income statement: Summary of the revenue and expenses for a specific period of time, includes Net income, net profit, or earnings, Net loss 2. Statement of stockholders' equity: Summary of the changes in stockholders' equity that have occurred during a specific period of time 3. Balance sheet: List of the assets, liabilities, and stockholders' equity as of a specific date 4. Statement of cash flows: Summary of the cash receipts and cash payments for a specific period of time Data presented in the income statement, statement of stockholders' equity, and the statement of cash flows are for a period of time Data presented in the balance sheet are for a specific date

Generally Accepted Accounting Principles (GAAP)

Accounting standards, principles, and assumptions that define how financial information will be reported in the U.S. Accounting standards: Rules that determine the accounting for individual business transactions (determine how to count business transactions) Accounting principles and assumptions: Provide the framework upon which accounting standards are constructed Financial Accounting Standards Board (FASB): Primary responsibility for developing accounting standards in the U.S. Maintain an electronic database called the Accounting Standards Codification which Contains all accounting standards that make up GAAP Securities and Exchange Commission (SEC): Agency of the U.S. government that has authority over the accounting and financial disclosure for companies May issue Staff Accounting Bulletins on accounting matters that many not have been addressed by the FASB International Accounting Standards Board (IASB): Countries outside the U.S. use accounting standards and principles adopted by them IFRS is more "principles-based" while GAAP is more "rules-based"

Time period assumption

Allows a company to report its economic activities on a regular basis for a specific period of time Financial condition and changes are reported periodically on a consistent basis In the U.S., reports are required on a yearly basis with quarterly reports Fiscal year: Annual accounting period adopted by a company Most common is the calendar year beginning Jan 1 and ending Dec 31 Natural business year: Used instead of the calendar year Fiscal year that ends when business activities have reached the lowest point in its annual operating cycle, 12 months period Allows more time to prepare financial reports

Accounting Equation

Assets - resources owned by a business Ex: cash, land, buildings Rights of claims to the assets are divided into: 1. Rights of the creditors (person or company that the business owes money to) Liabilities - debts of the business which are the rights of creditors 2. Rights of owners Equity - rights of owners Stockholders' equity - equity for a corporation since stockholders own a corporation Owners' equity - equity for a proprietorship, partnership, or limited liability company - Shows the relationship among assets, liabilities, and equity Assets = Liabilities + Equity - Liabilities are shown before equity because creditors have first rights to the assets - Serves as the basic foundation for the accounting systems of all companies & is used by the smallest and largest businesses

Assumptions

Assumptions Financial accounting and generally accepted accounting principles (GAAP) are based upon these assumptions 1. Monetary unit 2. Time period 3. Business entity 4. Going concern

Business Transactions and the Accounting Equation

Business transaction: Economic event or condition that changes an entity's financial condition Ex: purchasing land Not ex: change in a business's credit rating because it doesn't directly affect cash, asset, liability, or stockholders' equity amount All businesses transactions is the change in the elements of the accounting equation

Measurement principle

Determines the amount that will be recorded and reported Requires that amounts be objective and verifiable Objective if - It is based upon unbiased evidence Verifiable if - It can be conformed by a third party Arm's-length Transactions: Transactions between 2 independent parties

Expense recognition principle

Expense - amounts used to generate revenue Requires expenses to be recorded in the same period as the related revenue Allows the reporting of a profit or loss for the period

Monetary unit assumption

Financial reports are expressed in a single money unit, or currency Provides a common measurement of the effects of economic events and transactions Determined by the country in which the company operates

Interrelationships among Financial Statements

Financial statements are prepared in the order of the income statement, statement of stockholders' equity, balance sheet, and statement of cash flows Order is important because the financial statements are interrelated: 1. Income statement & Statement of Stockholders' equity Net income or net loss reported on the income statement is also reported on the statement of stockholders' equity as either an addition (net income) to or deduction (net loss) from the beginning retained earnings 2. Statement of stockholders' equity & Balance sheet Common stock, retained earnings, and total stockholders' equity at the end of the period are reported on the statement of stockholders' equity and balance sheet 3. Balance sheet & statement of cash flows The cash reported on the balance sheet is also reported as the end-of-period cash on the statement of cash flows - The interrelationships serve as a check on whether the financial statements are prepared correctly

Business entity assumption

Limits the economic data in financial reports to those directly related to the activities of the business So, business is viewed as an entity separate from its owners, creditors, or other businesses Ex: accountant for a business with 1 owner would record the activities of the business only and would not record the personal activities, property, or debts of the owner

business

Organization in which resources (inputs), such as materials and labor, are assembled and processed to provide goods or services (outputs) Objective is to earn a profit -Difference between the amounts received from customers and the amounts paid for the inputs

Historical cost principle or cost principle

Recording an item at its initial transaction price Amounts do not change until another transaction occurs

Statement of Stockholders' Equity

Reports the changes in stockholders' equity for a period of time Prepared after the income statement because the net income or net loss for the period is reported in the Retained Earnings column Prepared before the balance sheet because the amount of common stock and retained earnings must be reported on the balance sheet So, connecting link between the income statement and the balance sheet Retained earnings statement: Summary of the changes in the retained earnings in a corporation that have occurred during a specific period of time

Going Concern Assumption

Requires that financial reports be prepared assuming that the entity will continue operating into the future Justifies reporting items such as equipment, buildings, and land at their initial or historical cost rather than liquidation or forced sale values

Revenue recognition principle

Revenue - amount earned from providing services or selling goods to customers Revenue is recorded when the services have been performed or goods are delivered to the customer

Characteristics of Financial Information

Useful financial reports must have 2 important characteristics: 1. Relevance: Information has the potential to impact decision making 2. Faithful representation: Information accurately reflects an entity's economic activity or condition Relevance and faithful representation are enhanced by: 1. Comparability: Allows users to identify similarities and differences among reported items 2.Verifiability: Allows users to agree on the meaning of reported items 3. Timeliness : Requires distribution of financial reports in time to influence a user's decision 4. Understandability: Requires clear and concise financial reports that facilitate user interpretation and analysis

Ratio of Liabilities to Stockholders' equity

Useful in analyzing the ability of a company to pay its creditors Ratio of liabilities to stockholders' equity = (total liabilities)/(total stockholders' equity) Ratios less than 1 are protective to creditors Lower the ratio, the better able the company is to withstand poor business conditions and to pay its obligation to creditors Lower ratio is better since the bottom should be larger (equity > debt)

Opportunities for Accountants

more frauds in business --> More businesses now recognize the importance and value of accounting information Auditors: Accountants who provide audit services verify the accuracy of financial reports, accounts, and systems Public accounting: Accountants and their staff who provide services on a fee basis Accountant may practice as an individual or as a member of a public accounting firm Public accountants who have met a state's education, experience, and exam requirements may become Certified Public Accountants (CPAs) CPAS starting salaries > private accountants starting salaries