Principles of Financial Accounting: Chapter 1

What are the four main financial statements and what order are they prepared in?

(Listed in order) Income Statement Statement of Stockholders' Equity Balance Sheet Statement of Cash Flows

Legal status of a partnership

*NOT* a separate legal entity

Legal status of a sole propreitorship

*NOT* a separate legal entity

Stockholders claim all resources in excess amounts owed to creditors, therefore...

...profits of the company are claimed solely by stockholders. We calculate a company's profits by comparing its revenues and expenses.

"Framework" for Financial Accounting

1. How is the business activity being measured? 2. How is the business activity being communicated?

When facing an ethical dilemma in your professional life:

1. Understand the ethical decision you face 2. Specify the options for alternative courses of action 3. Identify the impact of each option on the stakeholders' 4. Make a decision

Sole proprietorship

A business owned by one person.

Ethics

A code or moral system that provides criteria for evaluating right and wrong behavior.

Corporation

A company that is legally separate from its owners. The advantage of being legally separate is that the stockholders have limited liability.

Separate Legal Entity

A corporation conducts its affairs with the same rights, duties, and responsibilities of a person. It takes actions through its agents, who are its officers and managers.

Accounting

A system of maintaining records of a company's operations and communicating that information to decision-makers. Accountants *measure* the activities of the company and *communicate* measurements to others.

Financial Accounting

Accounting information that is provided for *external* users.

Managerial Accounting

Accounting information that is provided for *internal* users (managers)

Revenues

Amounts recognized when the company sells products or services to customers. *Think of earn*

Free market

An economic system in which prices and wages are determined by unrestricted competition between businesses, without government regulation or fear of monopolies. Firms are allowed to compete and customers are free to choose from a variety of products and services.

Financial Accounting Standards Board (FASB)

An independent, private-sector body that has primary responsibility for the establishment of GAAP in the United States. Establishes the financial accounting and reporting standards in the U.S. They make Generally Accepted Accounting Principles (GAAP) *NOT* a government body/agency Members include representatives from the accounting profession, large corporations, financial analysts, accounting educators, and government agencies.

International Accounting Standards Board (IASB)

An international accounting standard-setting body responsible for the convergence of accounting standards worldwide. The global counterpart to FASB Makes International Financial Reporting Standards (IFRS) Convergence efforts between FASB and IASB continue In 2002, they signed the Norwalk Agreement formalizing a commitment to the convergence of GAAP and IFRS.

Buildings are a(an)

Asset

Cash is a(an)

Asset

Equipment is a(an)

Asset

Supplies are a(an)

Asset

The accounts that represent the resources of the company

Assets

Accounting equation

Assets = Liabilities + Owner's Equity (A = L + OE)

Which financial statement reports the accounting equation?

Balance sheet

Retained earnings at the end of the year is calculated using:

Beginning retained earnings, net income, and dividends

What was the primary reason for the establishment of the 1933 Securities Act and the 1934 Securities Exchange Act?

Both acts designed to restore investor confidence and in 1934 Act created the Securities Exchange Commission (SEC).

Partnership

Business owned by two or more persons.

What is a balance sheet item?

Cash

Statement of Cash Flows

Changes in cash over a *period of time* No equation used for this statement

Internal Users

Company management

Which business form has the advantage of limited liability?

Corporation

Expenses

Cost of providing products and services and other business activities during the current period. Costs can be related to salaries, rent, supplies, and utilities. *Think of cost*

Net income

Difference between revenues and expenses. Other common names for net income include earnings or profit. If expenses exceed revenues, the difference between them is a negative amount, a net loss. If revenues exceed expenses, the difference between them is a positive net income.

Dividends

Distributions to stockholders & owners, typically in the form of cash. Dividends are *NOT* an expense.

Dividends (Distribute cash to stockholders') are a(an)

Dividend not an expense

What is a potential disadvantage for a corporation?

Double taxation 1. The company first pays corporate income taxes on income it earns 2. Stockholders then pay personal income taxes when the company distributes that income as dividends to them. Corporations may pay a higher or lower overall tax rate compared to partnerships and sole proprietorships.

Benefits of a sole propreitorship

Ease of formation No double taxation

Benefits of a partnership

Ease of formation No double taxation Shared investment & knowledge

Public comapny Accounting Oversight Board (PCAOB)

Ensures that auditors follow a strict set of guidelines when conducting their audits of public companies' financial statements. The PCAOB basically "audits the auditors."

Advertising expenses are a(an)

Expense

Interest expense is a(an)

Expense

Periodicity Assumption

External users need periodic information to make decisions; therefore, the economic life of a company can be divided into artificial time periods so that meaningful reports can be prepared for each period. The business never stops after each period! It is a way to keep track and compare information.

Financial accounting and reporting standards in the United States are established primarily by the:

Financial Accounting Standards Board (FASB)

What is meant by GAAP? Why should companies follow GAAP in reporting to external users?

GAAP stands for Generally Accepted Accounting Principles and they are created by the Financial Accounting Standards Board (FASB) in the U.S. Companies should follow GAAP in reporting to external users because it helps investors compare a company's financial information so they can decide where to invest or lend their resources. If companies did not follow GAAP, they will not be seen as a reputable business and investors will not invest in the company.

The body of rules and procedures that guide the measurement and communication of financial accounting information in the United States is known as:

Generally Accepted Accounting Principles (GAAP)

What occurred during the 1930s?

Great depression

How do we communicate business activities?

In Financial Accounting, we are concerned with communicating business activities to External Users (Investors and Creditors). We do this by compiling the information into reports called financial statements.

Going Concern Assumption

In the absence of information to the contrary, a business entity will continue to operate indefinitely. If something requires the business to stop "moving," then they are required to tell shareholders.

Revenues, expenses, and dividends are found in the

Income statement

Financial accounting should provide:

Information that is useful to investors and creditors in making decisions, helps to predict cash flow, and tells about economic resource, claims to resources, and changes in resources and claims.

What does it mean to say that the income statement, statement of shareholders' equity, and statement of cash flows measure activity over an *interval of time*, but the balance sheet measures activity at a *point in time*?

Interval of time refers to looking at the changes between revenues and expenses and comparing the net income and results to previous periods. By looking at an interval of time, you "start over" at zero and begin a new period so it will be easier to compare the income, stockholders' equity, and cash flow statements in the future. On the other hand, by looking at a point in time in your balance sheet, you will know the current balance at that exact moment in time. In a balance sheet, you will not want to know the change in balance, you will want to know the current balance without doing a lot of extra math.

External users

Investors and creditors

Creditors' claims to a corporation's resources are referred to as:

Liabilities

Accounts Payable is a(an)

Liability

Notes payable are a(an)

Liability

Benefits of a corporation

Limited liability of stockholders Easier to raise capital= more money Unlimited life

Private accounting

Means providing accounting services to the company that employs you.

What are the 2 primary functions of financial accounting?

Measure & communicate business activities to its users.

What is the primary purpose of financial accounting

Measure business activities and communicate those measures to external users to make decisions.

Drawbacks of a corporation

More difficult and costly to form Double taxation More regulations and paperwork

What is a disadvantage of sale proprietorship & partnership?

Owners must have sufficient personal funds to finance the business in addition to the ability to borrow money. Also, neither offers limited liability.

Stockholders' Equity

Owners' claims to resources/assets, which equal total assets minus total liabilities. Also known as Owners' equity.

What does "cooking the books" mean?

People purposely provide misleading financial accounting information. Reasons can be to hide the poor operating performance of the company, or to increase their personal wealth at the stockholders' expense.

Limited liability

Prevents stockholders from being held personally responsible for the financial obligations of the corporation.

Service revenue is a(an)

Revenue

Which organization has power over the other?

SEC has power over FASB

Legal status of a corporation

Separate legal entity

Income Statement

Shows *revenues* earned, *expenses* incurred, and the resulting *net income* over a *period of time* Equation use for this statement: Rev- Exp = NI

Balance sheet

Shows balances of *assets*, *liabilities*, and *owners' equity* at a *point in time* Equation used for the statement: Accounting equation Assets = Liabilities + Owners' Equity

Statement of Stockholders' Equity

Shows changes in *owners' equity* over a *period of time* Equation used for the statement: NI-Div = R/E

What are the three major legal forms of business organizations? Which one is chosen by most of the largest companies in the U.S.?

Sole proprietorship Partnership Corporation The largest companies in the U.S. are corporations

Generally Accepted Accounting Principles (GAAP) are best defined as:

Standards for presenting financial accounting information.

What happened in 1929?

Stock market crashed because people pulled their money out in fear.

Which body is primarily responsible for the establishment of GAAP in the United States? What body serves this function on an international basis?

The Financial Accounting Standards Board (FASB) is primarily responsible for the establishment of GAAP in the U.S. On an international basis, the International Accounting Standards Board (IASB) is the global counterpart to FASB and they establish International Financial Reporting Standards (IFRS)

Economic Entity Assumption

The activities of a company are kept separate and distinct from the activities of its owners, as well as other economic entities. An economic entity can be any organization or unit in society. The company is separate from its owners. If Walmart purchases a building, shareholders' do not pay property taxes on that building.

Securities and Exchange Commission (SEC)

The agency of the U.S. government that oversees U.S. financial markets and accounting standard-setting bodies. A U.S. government agency Has the power and responsibility for setting accounting and reporting standards for publicly traded companies. Delegates primary responsibilities for setting accounting and reporting standards for publicly traded companies to FASB, but the power remains with the SEC. SEC is the body that enforces the rules, while the FASB makes the rules with the okay of SEC.

Liabilities

The amount owed to creditors. Example liabilities would be amounts owed to suppliers, employees, utility companies, and the government (in the form of taxes). Liabilities are claims that must be paid by a specific date!

Public accounting

The field of accounting where accountants and their staff provide services on a fee basis. This can include auditing, tax, preparation/planning, and business consulting.

Generally Accepted Accounting Principles (GAAP)

The rules of financial accounting. All companies use these rules so investors can accurately compare financial information among companies when they are making decisions about where to invest or lend their resources.

International Financial Reporting Standards (IFRS)

The standards being developed and promoted by the International Accounting Standards Board.

Assets

The total resources of a company. Possible resources can be supplies, inventory for sale to customers, buildings, land, and investments. Some assets are purchased utilizing existing assets *OR* by obligating future assets. The future obligations are liabilities. Some assets may be contributed by owners. When an owner contributes assets, this establishes a right of the owner to a portion of the company's assets at some point in the future. The portion of assets available to owners is called Owners' Equity and is what's left after all liabilities are satisfied.

When does a corporation get double taxed?

They get taxed at the net income level and then taxed again when shareholders get their dividends.

Sarbanes-Oxley Act (SOX)

This act provides regulation of auditors and the types of services they furnish to clients, increases accountability of corporate executives, and addresses conflicts of interest for securities analysts, and provides for stiff criminal penalties for violators.

Note disclosures

This section of an annual report offers additional information either to explain the information presented in the financial statements or to provide information not included in the financial statements.

Management discussion and analysis (MD&A)

This section of an annual report typically includes management's views on significant events, trends, and uncertainties pertaining to the company's operations and resources.

Investors

Those who invest their funds in a business; maybe owners or stockholders. They have a right to share in the company's profits.

Auditors

Trained individuals hired by a company as an independent party to express a professional opinion of the conformity of that company's financial statements with GAAP. Auditors play a major role in investors' and creditors' decisions by adding credibility to a company's financial statements.

Investing activities

Transactions involving the purchase and sale of resources that are expected to benefit the company for several years, such as the purchase of equipment.

Operating activities

Transactions that relate to the primary operations of the company such as providing products and services to customers and associated costs of doing so, like rent, salaries, utilities, taxes, and advertising.

Financing activities

Transactions the company has with investors, such as issuing stock and borrowing money from a local bank.

Drawbacks of a sole preopreitorship

Unlimited liability of Owner Difficult to raise capital Limited life

Drawbacks of a partnership

Unlimited liability of owners Disagreements between partners Limited life

Annual report

Used to describe the formal document detailing a company's activities and financial performance. These reports are provided by companies each year. Two other important components of the annual report are: 1. Management discussion and analysis 2. Note disclosures to the financial statements.

Each share of ownership is typically referred to as...

a share of common stock

Assets and liabilities are found in the

balance sheet

The financial statement that represents the accounting equation is the:

balance sheet

The form of business organization that is legally separate from its owners is a:

corporation

A company's ________ _________ is an important indicator of management's ability to respond to business situations and the possibility of bankrupcy.

debt level

Creditors expect to receive only resources _________ to the amount owed to them.

equal

Balance =

point in time

Monetary Unit Assumption

requires that companies include in the accounting records only transaction data that can be expressed in terms of money.