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Uses of Accounting Information and the Financial Statements – Chapter 1

Financial & Managerial Accounting, 8th Edition by Needles, Powers,

Crosson

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Key Concepts / Terms• Accounting – an information system that

measures, processes, and communicates financial information about an “economic entity.”

• Economic entity – a unit that exists independently, such as a business, a hospital or a governmental body. These entities aim to sell goods and services to customers at prices that will provide an adequate return to its owners.

• Two important concepts – profitability and liquidity. See definitions page 5.

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Key Concepts / Terms

• Businesses have three types of accounting activities:

• Operating – selling goods and services; employing managers and workers; buying and producing goods and services; paying taxes.

• Investing – spending the capital of the business in ways that will help the business achieve its goals: buying land, buildings, equipment, etc.

• Financing – obtaining adequate funds, or capital, to begin operations and to continue operations.

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Key Concepts / Terms

• Financial accounting – generates financial statements which communicates accounting information to EXTERNAL decision makers.

• Management accounting – generates financial reports which communicates accounting information to INTERNAL decision makers.

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Key Concepts / Terms

• Accounting (analysis, interpretation and use of accounting information) compared to bookkeeping (mechanical and repetitive; the process of recording financial transactions and keeping financial records).

• MIS (Management Information System) – interconnected subsystems that provide information needed to run a business.

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Business Activities and Decision Makers

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Key Concepts / Terms

• Ethics – a code of conduct that applies to everyday life. Are actions right or wrong?

• Fraudulent financial reporting – the intentional preparation of misleading financial statements. It can result from the distortion of records, falsified transactions, or the misapplication of various accounting principles - Enron Corporation and Worldcom. Cause of the Sarbanes-Oxley Act (SOX) in 2002 by the Securities and Exchange Commission (SEC).

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Key Concepts / Terms

• Management – refers to the people who are responsible for operating a business and meeting its goals of profitability and liquidity. Functions include:

– Financing the business

– Investing resources

– Producing goods and services

– Marketing goods and services

– Managing employees

– Providing information to decision makers

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Key Concepts / Terms

• Other groups of decision makers:– Users with a direct financial interest such as

investors and creditors. – Users with an indirect financial interest such as

tax authorities, regulatory agencies such as the SEC (Securities and Exchange Commission), labor unions, financial analysts, consumer groups, customers, etc.

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Key Concepts / Terms

• To make an accounting measurement, the accountant must ask the following four questions: – What is measured?– When should the measurement be made?– What value should be placed on what is

measured?– How should what is measured be classifed?

• Business transactions – economic events that affect a business’s financial position.

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Key Concepts / Terms

• Money measure – terms of money (US Dollar) in which business transactions are recorded. Exchange rates occur between countries (i.e. – British Pound).

• Separate entity – for accounting purposes, a business is distinct not only from its creditors and customers but also from its owners.

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Key Concepts / Terms

• There are three basic forms of business: sole proprietorship, partnership, and corporation.

• Sole proprietorship – a business owned by one person. The owner takes all of the profits and losses and is liable for all of the business’s obligations. Represent the largest number of business in the U.S., but are the smallest in size.

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Key Concepts / Terms

• Partnership – similar to a sole proprietorship, but has two or more owners (partners). The partners share the profits and losses of the business according to a prearranged formula. Generally, any partner can obligate the business to contracts, and the personal resources of each partner can be called on to pay the obligations. A partnership must be dissolved if the ownership changes, such as the death of a partner. A new partnership must be formed.

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Key Concepts / Terms

• Corporation – business chartered by the state and legally separate from its owners (called stockholders or shareholders). Stockholders (own stock) do not directly control the corporation.

• Stockholders elect a board of directors who then employ a professional management team.

• Stockholders enjoy limited liability, can sell their shares without dissolving the corporation, and cannot bind the corporation to contracts (mutual agency).

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Key Concepts / Terms

• Articles of incorporation – articles approved by the state in which the corporation exists that form the company charter, essentially becoming a contract between the corporation and the state.

• Stock – can be preferred or common. • Stockholders receive dividends solely at the

discretion of the board of directors. • corporate governance; audit committee (see pg.

19)

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Key Concepts / Terms

• Assets = Liabilities + Stockholder’s Equity (Accounting Equation)

• Assets – the economic resources of a company that are expected to benefit the company’s future operations. Examples: Cash, Accounts Receivable, Inventory, Land, Buildings, Equipment, Vehicles, Trademarks, etc.

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Key Concepts / Terms

• Liabilities – a business’s present obligations to pay cash, transfer assets, or provide services to other entities in the future. Examples: Accounts Payable, Loans, Deferred Revenues, etc.

• Stockholder’s Equity – represents the claims of the owners of a corporation to the assets of the business. Essentially, it is what is left over when all of the liabilities are paid. Also referred to as “net assets”.

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Key Concepts / Terms

• If the accounting equation is rewritten: Stockholder’s Equity = Assets – Liabilities

• Stockholder’s Equity consists of two components: Contributed Capital and Retained Earnings.

• Contributed Capital consists of two components: the par value of the stock sold and the amount paid over par value which is called Additional Paid-In Capital.

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Key Concepts / Terms

• Retained earnings – the accumulation of the company’s net income and net loss since inception. As such, it is affected by revenues, expenses and dividends.

• Net income = revenues – expenses

• Net loss = when expenses exceed revenues

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Key Concepts / Terms

• Financial Statements: – Income Statement – summarizes revenues

earned and expenses incurred. Shows net income or net loss.

– Statement of Retained Earnings – shows the changes in retained earnings over an accounting period.

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Key Concepts / Terms

• Financial Statements:

– Balance Sheet – shows the financial position of a business on a certain date, usually the end of the month or year. Often called the statement of financial position. Includes assets, liabilities and stockholder’s equity accounts.

– Statement of Cash Flows – focuses on liquidity; shows the cash inflows and cash outflows of a business.

• See Exhibit 5 for relationships among the four basic financial statements.

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Income Statement

Net income figure used to prepare statement of retained earnings.

Date reflects revenues and expenses incurred over a period of time.

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Income Statement (con’t)Summarizes revenues and

expenses over an accounting period.

Shows whether the goal of profitability was achieved.

Often considered the most important

financial statement.

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Statement of Retained Earnings

Net income figure comes from income statement.

Ending balance of retained earnings used to prepare the balance sheet.

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Balance SheetDate reflects account balances as of a certain date.

Ending balance of Retained Earnings comes from statement of retained earnings.

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Statement of Cash Flows

Begins with net income from income statement.

Cash at end of month should be the same as Cash account balance on balance sheet.

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Key Concepts / Terms

• Generally Accepted Accounting Principles (GAAP) – provides guidelines for accounting; “encompass the conventions, rules, and procedures necessary to define accepted accounting practice at a particular time.”

• The practice of accounting is always growing, changing, and improving.

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Key Concepts / Terms

• Certified Public Accountant (CPA)

• Audit – an examination of a company’s financial statements and the accounting systems, controls, and records that produce them.

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Key Concepts / Terms

• Organizations that influence GAAP:

– Public Company Accounting Oversight Board (PCAOB)

– Financial Accounting Standards Board (FASB)

– American Institute of Certified Public Accountants (AICPA)

– Securities and Exchange Commission (SEC)

– Governmental Accounting Standards Board (GASB)

– International Accounting Standards Board (IASB)

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Key Concepts / Terms

• Professional Ethics – key for the accountant; set by the AICPA.

– Integrity: the accountant is honest and candid and subordinates personal gain to service and the public trust.

– Objectivity: the accountant is impartial and intellectually honest.

– Independence: the accountant avoids all relationships that impair or even appear to impair his or her objectivity.

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Key Concepts / Terms

– Due care: the accountant must exercise due care in all activities, carrying out professional responsibilities with competence and diligence.

• Institute of Management Accountants (IMA) – set code of ethics for management accountants.