Financial Accounting Ch. 1

Financial Statements

Business documents that are used to communicate info needed to make business decisions. Four financial statements are prepared.

International Financial Reporting Standards (IFRS)

Companies who are incorporated in or do significant business in another country might be required to publish financial statements using the IFRS, a set of global accounting guidelines, formulated by the IASB; a set of standards that are used by more than 116 nations. Generally less specific and based more on principle than US GAAP. IFRS leaves more room for professional judgment.

Equity (Continued)

Consists of two main components: contributed capital and retained earnings.

Contributed Capital

Equity increases with owner contributions and revenues. Owner contributions to a corporation are referred to as contributed capital. A stockholder can contribute cash or other assets (such as equipment) to the business and recieve capital.

Revenues

Equity is also increased by revenues. They are earnings that result from delivering goods or services to customers. (e.g. Sales revenue, service revenue, and rent revenue).

Two Major Fields of Accounting

Financial and Managerial

Monetary Unit Assumption

In the US, we record transactions in dollars because the dollar is the medium of exchange. The value of a dollar changes over time, and a rise in the price level is called inflation. During periods of inflation, a dollar will purchase less. But accountants assume that the dollar's purchasing power is stable. This is the basis of the assumption, which requires that the items on the financial statements be measured in terms of a monetary unit.

Faithful Representation

Info that is faithfully representative is complete, neutral, and free from error. These basic accounting assumptions and principles are part of the foundation for the financial reports that companies present.

Statement of Retained Earnings

Informs users about how much of the earnings were kept and reinvested in the company. Retained Earnings, Beginning+Net Income or -Net Loss for the period - Dividends for the period = Retained Earnings, Ending

Taxing Authorities

Local, state, and federal governments levy taxes. Income tax is calculated using accounting info. Good accounting records can help individuals and businesses take advantage of lawful deductions. Without good records, the IRS can disallow tax deductions, resulting in a higher tax bill plus interest and penalties.

Return on Assets (ROA)

Measures how profitably a company uses its assets. Net income/Average total assets. ROA = Net income / Average total assets Average Total Assets = (Beginning total assets + Ending total assets) / 2

Accounting Equation

Measures the resources of a business (what the business owns or has control of) and the claims to those resources (what the business owes to creditors and to the owners). The accounting equation is made up of three parts--assets, liabilities, and equity--and shows how these three parts are related. Assets appear on the left side of the equation, and the liabilities and equity appear on the right side. Assets = Libilities + Equity

Investors

Outside investors who have some ownership interest often provide the money to get a business going. Supopose you're considering investing in a business. How would you decide whether it is a good investment? In making this decision, you miht try to predict the amount of income you would earn on the investment. Also, after making an investment, investors can use a company's financial statements to analyze how their investment is performing.

Audit

An examination of a company's financial statement and records to ensure that corporations are being honest about their records following the guidelines of faithful representation. The independent accountants then issue an opinion that states whether the financial statements give a fair picture of the company's financial situation.

Creditors

Any person or business to whom a business owes money; Before extending credit to a business, a creditor evaluates the company's ability to make the payments by reviewing its financial statements. Creditors follow the same process when you need to borrow money for a new car or house. The creditor reviews accountining data to determine your ability to make the loan payments. Are you a good risk for the bank?

Going Conern Assumption

Assumes that the entity will remain in operation for the foreseeable future. Under the going concern assumption, accountants assume that the business will remain in operation long enough to use existing resources for their intended purpose.

Income Statement Process

Reports the net income or net loss of the business for a specific period. Presents a summary of a business entity's revenues and expenses for a period of time, such as a month, quarter, or year. The income statement tells us whether the business enjoyed net income or suffered a net loss. Mad up of Revenues and Expenses. - Heading includes the name of the business, the title of the statement, and the time period. An income statement always represents a period of time, for example, a month or year. - The revenue accounts are always listed first and then subtotaled if necessary. - Each expense account is listed separately from largest to smallest and then subtotaled if necessary. - Net income is calculated as total revenues minus total expenses.

Characteristics and Organization of a Corporation

Separate Legal Entity: A corp. is a business entity formed under state law. The state grants a charter which is the document that gives the state's permission to form a corp. This is called an authorization because the state authorizes or approves the establishment of the corporate entity. A corp. is a distinct entity from a legal perspective. It is an entity that exists apart from its owners, who are called the stockholders or shareholders. However, the corporation has many of the rights that a person has. The ownership interest of a corporation is divided into shares of stock. A person becomes a stockholder by purchasing the stock. Continuous Life and Transferability of Ownership: Stockholders may transfer stock as they wish--by selling or trading the stock to another person, giving the stock away, bequeathing it in a will, or disposing of the stock in any other way. Because corporations have continuous lives regardless of changes in the ownership of their stock, the transfer of the stock has no effect on the continuity of the corp. Sole proprietorships and partnerships, in contrast, end when their ownership changes for any reason. A corp.'s life is not dependant on a specific individual's ownership. No Mutual Agency: means that the stockholder of a corp. cannot commit the corp. to a contract unless that stockholder is acting in a different role, such as an officer in the business. Mutual agency of the owners is not present in a corporation as it is in a partnership. Limited Liability of Stockholders: A stockholder has limited liability for the corporation's debts. The most that stockholders can lose is the amount they originally paid for the stock (Depending on state law, this limited liability would also apply to an LLC member) The combination of limited liability and no mutual agency means that persons can invest unlimited amounts in a corporation with only the fear of losing whatever amount the individual has invested if the business fails. This attractive feature enables a corporation to raise more money than proprietorships and partnerships. Separation of Ownership and Management: stockholders own the business, but a board of directors--elected by the stockholders--appoints corporate officers to manage the business. Thus, stockholders do not have to disrupt their personal affairs to manage the business. This may create problems. Corp. officers may decide to run the business for their own benefit rather than for the benefit of the company. Stockholders may find it difficult to lodge an effective protest against management because of the distance between them and the top managers. Corporate Taxation: Corporations are separate taxable entities. They pay a variety of taxes not paid by sole proprietorships or parnerships. Depending on the state in which the organization incorporated and the state in which the corporation operates, the taxes could include one or both of the following: - Federal and state income taxes. Corporate earnings are subject to double taxation. First, corp. pay their own income tax on corporate income. Then, the stockholders pay personal income tax on the dividends that they recieve from corporations. This is different from sole proprietorships and partnerships. - Annual franchise tax levied by the state. The franchise tax is paid to keep the corporation charter in force and enables the corporation to continue in business. Government Regulation: To protect persons who loan money to a corp. or who invest in its stock, states monitor the actions of corporations. Corporations are subjected to more government regulation than other forms of business, which is a disadvantage for corporations and can be expensive. Organization of a Corporation: As noted earlier, the creation of a corporation begins when its organizers, called the incorporators, obtain a charter from the state. The charter includes the authorization for the corporation to issue a certain number of shares of stock, which represent the ownership in the corporation. The incorporators pay fees, sign the charter and file the required documents with the state. Once the first share of stock is issued, the corporation comes into existence. The incorporators agree to a set of bylaws, which act as the constitution for governing the corporation. Bylaws are the rule book that guides the corporation. The ultimate control of the corporation rests with the stockholders, who normally receive one vote for each share of stock they own. The stockholders elect the members of the board of directors, which sets policy for the corporation and appoints the officers. The board elects a chairperson, who usually is the most powerful person in the corporation. The board also designates the president, who as chief executive officers manages day-to-day operations. Most corporations also have vice presidents in charge of sales, operations, accounting and finance, and other key areas.

The Securities and Exchange Commission (SEC)

The US government agency that oversees the US financial markets. It also oversees those organizations that set standards (like the FASB).

Generally Accepted Accounting Principles (GAAP)

The guidelines for accounting info. It is the main US accounting rule book and is currently created and governed by the FASB. In order to use and prepare financial statements, it is important that we understand these. It rests on a conceptual framework that identifies the objectives, characteristics, elements, and implementation of financial statements and creates the accptable acconting practices. The primary objective of financial reporting is to provide info useful for making investment and lending decisions. To be useful, info must be relevant and have faithful representation. It allows users of the info to make a decision.

Accounting

The information system that measures business activities, processes the information into reports and communicates the results to decision makers; the language of business.

Equities

The owners of a corporation are referred to as stockholders/shareholders. The owners' claims to the assets of the business are called equity. It represents the amount of assets that are left over after the company has paid its liabilities. It is the company's net worth.

Statement of Retained Earnings

The statement of retained earnings shows the changes in retained earnings for a business entity during a time period, such as a month, quarter, or year. The net income for the month is the net income that was calculated on the income statement. -The heading includes the name of the business, the title of the statement, and the time period. A statement of retained earnings always represents a period of time. - The beginning retained earnings is $0 because Smart Touch Learning began this month; therefore, it had no beginning retained earnings. The beginning retained earnings will always be the ending retained earnings from the previous time period. - Net income is transferred from the income statement. - The dividends are subtracted from retained earnings. If there had been a net loss rather than a net income, this would also be subtracted.

Businesses

Use accounting to set goals, measure progress toward those goals, and make adjustments when needed. The financial statements give owners the info they need to help make those decisions. Financial statements are helpful when, for example, a business owner wants to know whether his or her busieness has enough cash to purchase another computer.

Accountants

We tend to think of them as boring and dry, but they participate in a broad range of activities such as the investigation of financial evidence, the development of computer programs to process accounting info, and the communication of financial results to interested parties. The knowledge of accounting is used to help make business decisions.

Net Loss

When expenses are greater than revenues

Net Income

When revenues are greater than expenses, the result of operations is a profit

Financial Accounting Standards Board (FASB)

a privately funded organization that oversees the creation and governane of accouting standards in the US. It works with governmental regulatory agencies like the Securities and Exachange Commission. The FASB also works with congressionally created groups like the Public Company Accounting Oversight Board (PCAOB) and private groups like the American Institute of CPAs (AICPA), Institute of Management Accountants (IMA), and the International Accounting Standards Board (IASB)

Accounts Payable

a short-term liability that will be paid in the future. A payable is always a liability.

Assets

an economic resource that is expected to benefit the business in the future. Something of value that the business owns or has control of. Cash, Merchandise, Inventory, Furniture, and Land are examples of assets.

Transaction

any event that affects the financial position of the business and can be measured with faithful representation. Transactions affect what the company has (assets), owes (liabilities), and/or its net worth (equity).

Dividends

can be paid in the form of cash, stock, or other property. Not expenses. The corp. may or may not make dividend payments to the stockholders. They are the opposite of owner contributions and, therefore, decrease equity. This is a distribution of earnings to stockholders.

Certified Management Accountants (CMA's)

certified professionals who specialize in accounting and financial management knowledge. Generally, CMA's work for a single company. Find out more on the Institute of Management Accountants (IMA) web site

Managerial Accounting

focuses on info for internal decision makers, such as the company's managers and employees. (e.g. How much money should the business budget for production? Should the business expand to a new location? How do actual costs compare to budgeted costs?)

Certified Public Accountants (CPA's)

licensed professional accountants who serve the general publics. THey work for public accounting firms, businesses, government entities, or educational institutions. Although requirements vary between states, to be certified in a professions, one must meet the educational and/or experience requirements and pass a qualifying exam. The American Institute of Certified Public Accountants (AICPA) web site contains a wealth of info about becoming a CPA, career opportunities, and exam requirements.

Financial Accounting

provides info for external decision makers, such as outside investors, lenders, customers and the federal government. (e.g. Should I invest in the business? Is the business profitable? Should we lend money to the business? Can the business pay us back?)

Common Stock

represents the basic ownership of a corporation

Cost Principle

states that acquired assets and services should be recorded at their actual cost (also called historical cost). It means we record a transaction at the amount shown on the receipt--the actual amount paid. Even thouh the purchaser may believe the price is a bargain, the item is recorded at the price actually paid and not at the "expected" cost. (e.g. Smart Touch Learning purchased land for $20,000. The business might believe the land is instead worth $25,000. The cost principle requires that they record the land at $20,000. It holds that the accounting records should continue reporting the historical cost of an asset over its useful life. Why? Because cost is a reliable measure. Suppose Smart Touch Learning holds the land for six months. During that time land prices rise, and the land could be sold for $30,000. Should its accounting value-0the figure on the books-- be the actual, or the current market value? According to this principle, it should be $20,000.

Contributed Capital

the amount contributed to the corporation by its owners ( the stockholders). The basic element of contributed capital is stock, which the corporation issues to the stockholders as evidence of their ownership.

Expenses

the costs of selling goods or services. The opposite of revenues and, therefore, decrease equity. (e.g. rent expense, salaries expense, advertising expense)

Retained Earnings

the equity earned by profitable operations that is not distributed to stockholders. There are three types of events that affect retained earnings: dividends, revenues, and expenses. Dividends represent decreases in retained earnings through the distribution of cash, stock, or other property to stockholders. Revenues are increases in retained earnings from delivering goods or services to customers. Revenues are earnings. (e.g. If Smart Touch Learning provided e-learning services and earned $5,500 of revenue, the business's retained earnings increased by $5,500. Expenses are the decreases in retained earnings that result from operations. For example, Smart Touch Learning paid salaries of $1,200 to its employees and that is an expense that decreases retained earnings.)

Accounts Receivable

the right to receive cash in the future from customers for goods sold or for services performed

Individuals

Accounting can help you manage your money, evaluate a new job, and better decide whether you can afford to buy a new computer.

Signs for Transactions

Add Accounts Payable, Add Common Stock, Add Revenues, Subtract Expenses, Subtract Dividends

Economic Entity Assumption

An economic entity is an organization that stands apart as a separate ecomomic unit. We draw boundaries around each entity to keep its affairs distinct from those of other entities. An entity refers to one business, separate from its owners. A business can be organized as a sole proprietorship, partnership, corporation, or limited-liability company (LLC).

Liabilities

Claims to those assets come from two sources: liabilities and equity. These are debts that are owed to creditors' claims on the business's assets. For example, a creditor who has loaned money to a business has a claim to some of the business's assets until the business pays the debt. Many liabilites have the word payable in their titles.

Balance Sheet

Reports on the assets, liabilities, and stockholders' equity of the business as of a specific date. A snapshot of the entity. AN investor or creditor can quickly assess the overall health of a business by viewing the balance sheet. -The heading against shows the name of the business and the title of the financial statement. Notice that the date is different. The balance sheet shows the date as a specific date, not a period of time. - Each asset account is listed separately and then totaled. Cash is always listed first. - Liabilities are listed separately and then totaled. Liabilities that are to be paid first are listed first. - Retained earnings is taken directly from the statement of retained earnings. - The balance sheet must always balance. (Stockholders' Equity: Common Stock, Retained Earnings, Total Stockholders', Total Liabilities and Stockholders' Equity)

Income Statement

Provides info about profitability for a particular period for the company. Revenues-Expenses= Net Income or Net Loss

Balance Sheet

Provides valuable info to financial statement users about economic resources the company has (assets) as well as debts the company owes (liabilities). Allows decision makers to determine their opinion about the financial position of the company. Assets = Liabilities + Stockholders' Equity

Statement of Cash Flows

Reports on a business's cash receipts and cash payments for a period of time. Cash flows from operating, investing, and financing activities.