ACCY EXAM 1 - CH. 1 Definitions

Cash Flows from Financing Activities:

Cash Flows from Financing Activities: - ADD Cash received from issue of long-term debt - ADD Cash received from sale of common stock - SUBTRACT Payment of cash dividend on = Net cash provided by financing activities

Retained earnings

Cumulative net income that has not been distributed to the stockholders of a corporation as dividends

Current generally accepted accounting principles and auditing standards require that the financial statements of an entity show the following for the reporting period:

Current generally accepted accounting principles and auditing standards require that the financial statements of an entity show the following for the reporting period: - Balance sheet (or statement of financial position). - Income statement (or statement of earnings, or profit and loss statement, or statement of operations). - Statement of cash flows. - Statement of changes in stockholders' equity (or statement of changes in capital stock and/or statement of changes in retained earnings).

the use of cash

Depreciation expense does not require...

Decrease them

Dividends do what to retained earnings?

Earnings per share of common stock outstanding

Earnings per share of common stock outstanding Net income available to the common stockholders divided by the average number of shares of common stock outstanding during the period (usually referred to as EPS) is reported as a separate item at the bottom of the income statement because of its significance in evaluating the market value of a share of common stock.

transactions

Economic interchanges between entities that are accounted for and reflected in financial statements

Limitations of Financial Statements

Financial statements report quantitative economic information; they do not reflect qualitative economic variables. --> Thus, the value to the firm of a management team or of the morale of the workforce is not included as a balance sheet asset because it cannot be objectively measured. Such qualitative attributes of the firm are frequently relevant to the decisions and informed judgments that the financial statement user is making, but they are not communicated in the financial statements - It's unfortunate that the accounting process does not capture these kinds of data because often a company's human resources and information resources are its most valuable assets.

Net Sales

Gross Sales - Sales discounts - sales returns - allowances represent the amount of sales of merchandise to customers, less the amount of sales originally recorded but canceled because the merchandise was subsequently returned by customers for various reasons (wrong size, spouse didn't want it, and so on). The sales amount is frequently called sales revenue, or just revenue. Revenue results from selling a product or providing a service to a customer.

any additional paid-in capital because the total amount paid in, or invested, by the stockholders will be shown as common stock.

If no-par-value stock without a stated value is issued there won't be....

accumulated deficit (or just deficit)

If retained earnings has a negative balance because cumulative losses and dividends have exceeded cumulative net income, this part of stockholders' equity is referred to as an

common stock

If there is no-par value-stock then the stockholders investment will be shown as...

In addition to the financial statements themselves, the annual report will probably include several accompanying notes (sometimes called the financial review) that include explanations of the accounting policies and detailed information about many of the amounts and captions shown on the financial statements.

In addition to the financial statements themselves, the annual report will probably include several accompanying notes (sometimes called the financial review) that include explanations of the accounting policies and detailed information about many of the amounts and captions shown on the financial statements.

consolidated financial statements

In most instances, the financial statements issued by the parent corporation will include the assets, liabilities, revenues, expenses, and gains and losses of the subsidiaries. Financial statements that reflect the financial position, results of operations, and cash flows of a parent and one or more subsidiaries are called:

Unit of measurement

In the United States, the dollar is the_____________________ for all transactions. No adjustment is made for changes in the purchasing power of the dollar. No attempt is made to reflect qualitative economic factors in the measurement of transactions.

Merchandise inventory

Items held by an entity to be sold to customers during the normal course of business represents the cost to Main Street Store, Inc., of the merchandise that it has acquired but not yet sold. - Equipment represents the cost to Main Street Store, Inc., of the display cases, racks, shelving, and other store equipment purchased and installed in the rented building in which it operates. (The building is not shown as an asset because Main Street Store, Inc., does not own it.)

Matching revenue and expense is necessary if the results of the firm's operations are to reflect accurately its economic activities during the period.

Matching revenue and expense is necessary if the results of the firm's operations are to reflect accurately its economic activities during the period.

Bookkeeping

Procedures for sorting, classifying, and presenting

Revenue is recognized at the time of sale, which is when title to the product being sold passes from the seller to the buyer or when the services involved in the transaction have been performed. Passing of legal ownership (title) is the critical event, not the cash payment from buyer to seller.

Revenue is recognized at the time of sale, which is when title to the product being sold passes from the seller to the buyer or when the services involved in the transaction have been performed. ***Passing of legal ownership (title) is the critical event, NOT the cash payment from buyer to seller.***

at the time of sale

Revenue is recognized:

Accounting

Selection of alternative methods of reflecting the effects of certain transactions

Paid-in capital

The amount invested in the entity by the stockholders

Fiscal Year

The annual period used for reporting to owners, the government and others - many businesses select fiscal periods that relate to the pace of their business activity

The matching concept

The concept that expenses incurred in generating revenues should be deducted from revenues earned during the period for which results are being reported - does not mean that revenues and expenses for a period are equal. A fair presentation of the results of a firm's operations during a period of time requires that all expenses incurred in generating that period's revenues be deducted from the revenues earned. This results in an accurate measure of the net income or net loss for the period.

Statement of cash flows

The financial statement that explains why cash changed during a fiscal period. Cash flows from operating, investing, and financing activities are shown Because of the equality that exists between assets and liabilities plus stockholders' equity, the total of the changes in every other asset and each liability and element of stockholders' equity will equal the change in cash.

Statement of changes in capital stock

The financial statement that summarizes the changes during a fiscal period in capital stock and additional paid-in capital. This information may be included in the statement of changes in stockholders' equity. *** like the income statement, has a period of time orientation

Statement of Changes in Stockholders' Equity

The financial statement that summarizes the changes during a fiscal period in capital stock, additional paid-in capital, retained earnings, and other elements of stockholders' equity *** like the income statement, has a period of time orientation

Statement of changes in retained earnings

The financial statement that summarizes the changes during a fiscal period in retained earnings. This information may be included in the statement of changes in stockholders' equity. *** like the income statement, has a period of time orientation

Income Statement

The principal purpose of the _________________, or statement of earnings, or profit and loss statement, or statement of operations, is to answer the question "Did the entity operate at a profit for the period of time under consideration?" The question is answered by - first reporting revenues from the entity's operating activities (such as selling merchandise) and - then subtracting the expenses incurred in generating those revenues and operating the entity. - Gains and losses are also reported on the income statement. - Gains and losses result from nonoperating activities, rather than from the day-to-day operating activities that generate revenues and expenses. - The income statement reports results for a period of time, in contrast to the balance sheet focus on a single date. In this sense, the income statement is more like a movie than a snapshot; it depicts the results of activities that have occurred during a period of time.

Limitations of Financial Statements (CONT.)

The principle of consistency suggests that an entity should not change from one generally accepted method of accounting for a particular item to another generally accepted method of accounting for the same item, BUT it is possible that two firms operating in the same industry may follow different methods. ** This means that COMPARABILITY between firms may NOT be appropriate, or if comparisons are made, the effects of any differences between the accounting methods followed by the firms must be understood.

Transactions --> accounts --> Financial statements

Transactions --> accounts --> Financial statements

Accounts

Transactions are summarized in:

Income statement

Transactions that affect the income statement also affect the balance sheet. - For example, a sale made for cash increases sales revenue on the income statement and increases cash, an asset on the balance sheet. - Likewise, wages earned by employees during the last week of the current year to be paid early in the next year are an expense of the current year. These wages will be deducted from revenues in the income statement and are considered a liability reported on the balance sheet at the end of the year. ****Thus, the income statement is a link between the balance sheets at the beginning and end of the year.

When the stock issued to the owners has a par value, there will usually be two categories of paid-in capital:

When the stock issued to the owners has a par value there will usually be two categories of paid-in capital: 1. common stock and 2. additional paid-in capital.

Common stock

_______ _______ reflects the number of shares authorized by the corporation's charter, the number of shares that have been issued to stockholders, and the number of shares that are he'd by the stockholders - when the ____ _____ has a par value or stated value the amount shown for common stock in the financial statement will always be: - Par value x # of stocks issued

Accounting entity

_________ ______ refers to the entity for which the financial statements are being prepared.

Materiality

_________ means that absolute exactness, even if that idea could be defined, is not necessary in the amounts shown in the financial statements. - Because of the numerous estimates involved in accounting, amounts reported in financial statements may be approximate, but they will not be "wrong" enough to be misleading. -- The financial statements of publicly owned corporations usually show amounts rounded to the nearest thousand, hundred thousand, or even million dollars. --> This rounding does not impair the informational content of the financial statements and probably makes them easier to read.

Assets

__________ are probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events." In brief, they represent the amount of resources controlled (which ordinarily means owned) by the entity. OFTEN tangible; - they can be seen and handled (such as cash, merchandise inventory, or equipment), - or evidence of their existence can be observed (such as a customer's acknowledgment of receipt of merchandise and the implied promise to pay the amount due when agreed upon—an account receivable).

Full disclosure

__________ means that the financial statements and notes should include all necessary information to prevent a reasonably astute user of the financial statements from being misled. - This is a tall order—one that the Securities and Exchange Commission (SEC) has helped to define over the years. - This requirement for full disclosure is one reason that the notes to the financial statements are usually considered an integral part of the financial statements.

Consistency

___________ in financial reporting is essential if meaningful trend comparisons are to be made using an entity's financial statements for several years. - It is inappropriate to change from one generally accepted alternative of accounting for a particular type of transaction to another generally accepted method, --> unless both the fact that the change has been made and the effect of the change on the financial statements are explicitly described in the financial statements or the accompanying notes to the financial statements.

Conservatism

____________ in accounting relates to making judgments and estimates that result in lower profits and asset valuation estimates rather than higher profits and asset valuation estimates. Accountants try to avoid wishful thinking or pie-in-the-sky estimates that could result in overstating profits for a current period. This is not to say that accountants always look at issues from a gloom-and-doom viewpoint; rather, they seek to be realistic but are conservative when in doubt.

Liabilities

_____________ are probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events." - Amounts owed to other entities. - For example, the accounts payable arose because suppliers shipped merchandise to Main Street Store, Inc., and this merchandise will be paid for at some point in the future. In other words, the supplier has a "claim" against the firm for the amount Main Street Store, Inc., has agreed to pay for the merchandise until the day it is paid for, and thus has become a creditor of the firm by supplying merchandise on account.

going concern concept

______________________________________ refers to the presumption that the entity will continue to operate in the future—that it is not being liquidated. This continuity assumption is necessary because the amounts shown on the balance sheet for various assets do not reflect the liquidation value of those assets.

Balance sheet

a listing of the organization's assets, liabilities, and stockholder's equity (also owner's equity) at a point in time - like a snapshot of the organization's financial position, frozen at a specific point in time - (also called statement of financial position)

Relationship between balance sheet and income statement

(Balance sheet) Assets = Liabilities + Stockholders' Equity <--- Net income = Revenues - Expenses (Income Statement) The arrow from net income in the income statement to stockholders' equity in the balance sheet indicates that net income affects retained earnings, which is a component of stockholders' equity

Limitations of Financial Statements (CONT.)

(Related to the use of the original cost principle) --> financial statements are NOT ADJUSTED to show the impact of INFLATION. EX: Land acquired by a firm 50 years ago is still reported at its original cost, even though it may have a significantly higher current value because of inflation. - Likewise, depreciation expense and the cost of goods sold—both significant expense elements of the income statement of many firms—reflect original cost, not replacement cost. ***** This weakness is not significant when the rate of inflation is low, BUT the usefulness of financial statements is seriously IMPAIRED when the inflation rate rises to double digits (WITH HIGH INFLATION).***

Stockholders' equity

(often referred to as owners' equity) is the ownership right of the stockholder(s) of the entity in the assets that remain after deducting the liabilities. (A car or house owner refers to his or her equity as the market value of the car or house less the loan or mortgage balance.) -sometimes referred to as net assets. This can be shown by rearranging the basic accounting equation: Assets - Liabilities = S.E. Another term sometimes used when referring to ___________________ is net worth. However, this term is misleading because it implies that the net assets are "worth" the amount reported on the balance sheet as stockholders' equity. Financial statements prepared in accordance with generally accepted accounting principles do not purport to show the current market value of the entity's assets, except in a few restricted cases.

Other accrued liabilities

- represent amounts owed to various creditors, including any wages owed to employees for services provided to Main Street Store, Inc., through August 31, 2017, the balance sheet date. -- Short-term debt represents amounts borrowed, probably from banks, that will be repaid within one year of the balance sheet date. -- Long-term debt represents amounts borrowed from banks or others that will not be repaid within one year from the balance sheet date.

Operating, investing, and financing

3 Principal activity groups that cause cash to change:

Subsidiary

A company whose stock is more than 50 percent owned by another corporation It is not necessary for the parent to own 100 percent of the stock of another corporation for the parent-subsidiary relationship to exist. - If one corporation owns more than half of the stock of another, it is presumed that the majority owner can exercise enough control to create a parent-subsidiary relationship. -- When a subsidiary is not wholly owned, the other stockholders of the subsidiary are referred to as minority stockholders, and their ownership rights are referred to as the noncontrolling interest.

Assets = Liabilities + Stockholder's equity

Accounting equation

Accrual Accounting

Accounting that recognizes revenues and expenses as they occur, even though the cash receipt from the revenue or the cash disbursement related to the expense may occur before or after the event that causes revenue or expense recognition Uses the accrual concept and results in recognizing revenue at the point of sale and recognizing expenses as they are incurred, even though the cash receipt or payment occurs at another time or in another accounting period. ** Thus, many activities of the firm will involve TWO TRANSACTIONS: 1. one that recognizes the revenue or expense and 2. the other that reflects the receipt or payment of cash. * The use of accrual procedures accomplishes much of the matching of revenues and expenses because most transactions between business firms (and between many firms and individuals) involve purchase/sale at one point in time and cash payment/receipt at some other point.

Financial statements

Accounts are summarized in:

Par value

An arbitrary value assigned to a share of stock when the company is organized. Sometimes used to refer to the stated value or face amount of a security

Limitations of Financial Statements (CONT.)

As already emphasized, the cost principle requires assets to be recorded at their original cost. ---> The balance sheet does not generally show the current market value or the replacement cost of the assets. For example, the trademark of a firm has virtually no cost; its value has developed over the years as the firm has successfully met customers' needs. Thus, trademarks usually are excluded from the balance sheet listing of assets even though they clearly have economic value to the firm.

Opportunity Costs

an economic concept relating to income forgone because an opportunity to earn income was not pursued.

Current assets

are cash and other assets that are likely to be converted into cash or used to benefit the entity within one year

Income taxes

are shown after all the other income statement items have been reported, because income taxes (often captioned as income tax expense or provision for income taxes) are a function of the firm's income before taxes.

current liabilities

are those liabilities that are likely to be paid with cash within one year of the balance sheet date.

Going concern

assumption of continuity of a company

accounting period

def: the period of time selected for reporting results of operations and changes in financial position. - Financial position will be reported at the end of this period (and the balance sheet at the beginning of the period will probably be included with the financial statements). For most entities, the ________ ________ will be one year in length.

Dividends

distributions of earnings that have been made to the stockholders ** REDUCE RETAINED EARNINGs

Depreciation

in accounting is the process of spreading the cost of an asset over its useful life to the entity—it is not an attempt to recognize the economic loss in value of an asset because of its age or use.

Gross profit

is the difference between net sales and cost of goods sold and represents the seller's maximum amount of "cushion" from which all other expenses of operating the business must be met before it is possible to have net income. --> net sales - cost of goods sold __________ _________ (sometimes referred to as gross margin) is shown as a separate subtotal because it is significant to both management and non-management readers of the income statement. The uses made of this amount will be explained in subsequent chapters. Selling, general, and administrative expenses represent the operating expenses of the entity. In some income statements, these expenses will not be lumped together as in Exhibit 2-2 but will be reported separately for each of several operating expense categories, such as wages, advertising, and depreciation

Objectivity

refers to accountants' desire to have a given transaction recorded the same way in all situations. - This objective is facilitated by using the dollar as the unit of measurement and by applying the cost principle. - As previously stressed, there are transactions for which the exercise of professional judgment could result in alternative recording results.

cost principle

refers to the fact that transactions are recorded at their original (historical) cost to the entity as measured in dollars. For example: - if a parcel of land were purchased by a firm for $8,600 even though an appraisal showed the land to be worth $10,000, the purchase transaction would be reflected in the accounting records and financial statements at its cost of $8,600. -- If the land is still owned and being used 15 years later, even though its market value has increased to $80,000, it continues to be reported in the balance sheet at its original cost of $8,600.

Accounts receivable

represent amounts due from customers who have purchased merchandise on credit and who have agreed to pay within a specified period or when billed by Main Street Store, Inc.

Accounts payable

represent amounts owed to suppliers of merchandise inventory that was purchased on credit and will be paid within a specific period of time

Long-term debt

represents amounts borrowed from banks or others that will not be repaid within one year from the balance sheet date.

Short-term debt

represents amounts borrowed, probably from banks, that will be repaid within one year of the balance sheet date.

Cash

represents cash on hand and in the bank or banks used by Main Street Store, Inc. - If the firm had made any temporary cash investments to earn interest, these marketable securities probably would be shown as a separate asset because these funds are not as readily available as cash.

Income from operations

represents one of the most important measures of the firm's activities. Income from operations (or operating income or earnings from operations) can be related to the assets available to the firm to obtain a useful measure of management's performance. --> Interest expense represents the cost of using borrowed funds. This item is reported separately because it is a function of how assets are financed, not how assets are used. --> Income taxes are shown after all the other income statement items have been reported, because income taxes (often captioned as income tax expense or provision for income taxes) are a function of the firm's income before taxes.

Interest expense

represents the cost of using borrowed funds. This item is reported separately because it is a function of how assets are financed, not how assets are used.

Accumulated depreciation

represents the portion of the cost of the equipment that is estimated to have been used up in the process of operating the business. - Note that one-tenth ($4,000 / $40,000) of the cost of the equipment has been depreciated. From this relationship, one might assume that the equipment is estimated to have a useful life of 10 years because this is the balance sheet at the end of the firm's first year of operations. - Depreciation in accounting = the process of spreading the cost of an asset over its useful life to the entity—it is not an attempt to recognize the economic loss in value of an asset because of its age or use.

Cost of goods sold

represents the total cost of merchandise removed from inventory and delivered to customers as a result of sales. This is shown as a separate expense because of its significance and because of the desire to show gross profit as a separate subtotal on the income statement. Frequently used synonyms are cost of sales and cost of products sold.

Additional paid-in capital

the difference between the total amount invested by the stockholders and the par value = Stockholders' investment - Par value ** If no-par-value stock without a stated value is issued ---> there won't be any additional paid-in capital -- because the total amount paid in, or invested, by the stockholders will be shown as common stock.

Corporation's Annual Report

the document distributed (or made available electronically) to shareholders that contains the reporting firm's financial statements for the fiscal year, together with the report of the external auditor's examination of the financial statements. ALSO INCLUDED: Highlights for the year (including net revenues) diluted earnings per share, and return on average stockholders' equity. - Most firms also include a historical summary of certain financial data for at least the past five years. -- The annual report document can be as simple as a transmittal letter from the president or chair of the board of directors along with the financial statements, or as fancy as a glossy, 150-page booklet that showcases the firm's products, services, and personnel, as well as its financial results.

Stock

the evidence of ownership of a company

Retained earnings

the second principal category of stockholders' equity, and it represents the cumulative net income of the entity that has been retained for use in the business.

Limitations of Financial Statements (CONT.)

Estimates are used in many areas of accounting; when the estimate is made, about the only fact known is that the estimate is probably not equal to the "true" amount. - It is hoped that the estimate is near the true amount (the concept of materiality); it usually is. -- For example, recognizing depreciation expense involves estimating both the useful life to the entity of the asset being depreciated and the probable salvage value of the asset to the entity when it is disposed of. --> The original cost minus the salvage value is the amount to be depreciated or recognized as expense over the asset's life. -- Estimates also must be made to determine pension expense, warranty costs, and numerous other expense and revenue items to be reflected in the current year's income statement because they relate to the economic activity of the current year. -- These estimates also affect balance sheet accounts. So EVEN THOUGH the balance sheet balances to the penny, DO NOT be misled by this aura of exactness. --> Accountants do their best to make their estimates as accurate as possible, but estimates are still estimates.

Examples of Cash Flows from Investing Activities:

Examples of Cash Flows from Investing Activities: SUBTRACT Cash paid for equipment

Examples of Cash Flows from Operating Activities

Examples of Cash Flows from Operating Activities: - Net income Add (deduct) items not affecting cash: -- ADD Depreciation expense -- SUBTRACT Increase in accounts receivable --SUBTRACT Increase in merchandise inventory -- SUBTRACT Increase in current liabilities = Net cash used by operating activities -- net income is the starting point for this measure of cash flow. -- Using net income also directly relates the income statement to the statement of cash flows. -- Next, reconciling items are considered (i.e., items that must be added to or subtracted from net income to arrive at cash flows from operating activities).: EXPLAINED BELOW: -- Depreciation expense is added back to net income because, even though it was deducted as an expense in determining net income, depreciation expense did not require the use of cash. Remember—depreciation in accounting is the process of spreading the cost of an asset over its estimated useful life. -- The increase in accounts receivable is deducted because this reflects sales revenues, included in net income, that have not yet been collected in cash. -- The increase in merchandise inventory is deducted because cash was spent to acquire the increase in inventory. -- The increase in current liabilities is added because cash has not yet been paid for this amount of products and services that have been received during the current fiscal period.

Limitations of Financial Statements (CONT.)

Financial statements do not reflect opportunity cost - For example: if an individual or organization maintains a non-interest-bearing checking account balance that is $3,000 more than that required to avoid any service charges, the opportunity cost associated with that $3,000 is the interest that could otherwise be earned on the money if it had been invested. ** Financial accounting does NOT give formal recognition to opportunity cost; however, financial managers should be aware of the concept as they plan the utilization of the firm's resources.