Financial Accounting - CH 1 & 2
|Four Principal Activities of Business Firms:|| 1.Establishing goals and strategies|
|What are the 2 sources Financing comes from?|| 1. Owners|
|Investments are made in the following:|| 1. Land, buildings, equipment|
2. Patents, licenses, contractual rights
3. Stock and bonds of other organizations
5. Accounts Receivable
|What are the 4 areas for conducting operations?|| 1. Purchasing|
|What are the 4 commonly used conventions in financial statements?|| 1. The accounting period|
2. The number of reporting periods
3. The monetary amounts
4. The terminology and level of detail in the financial statements
|Common Financial Reporting Conventions, Accounting Period||The length of time covered by the financial statements. (The most common interval for external reporting is the fiscal year).|
|Common Financial Reporting Conventions, Number of reporting periods||The number of reporting periods included in a given financial statement presentation, Both U.S. GAAP and IFRS require firms to include results for multiple reporting periods in each report.|
|Common Financial Reporting Conventions, Monetary amounts||This includes measuring units, like thousands, millions, or billions, and the currency, such as dollars ($), euros (€), or Swedish kronor (SEK)|
|Common Financial Reporting Conventions, Terminology and level of detail in the financial statements||U.S. GAAP and IFRS contain broad guidance on what the financial statements must contain, but neither system completely specifies the level of detail or the names of accounts. Therefore, some variation occurs.|
|Characteristics of a Balance Sheet||A Balance Sheet:|
1. is also known as a statement of financial position;
2. provides information at a point in time;
3. lists the firm's assets, liabilities, and shareholders' equity and provides totals and subtotals; and
4. can be represented as the Basic Accounting Equation.
Assets = Liabilities + Shareholders' Equity
|Accounting Equation Components|| 1. Assets|
3. Share Holder's Equity
|Assets|| Assets are economic resources with the potential to provide future economic benefits to a firm. |
Examples: Cash, Accounts Receivable, Inventories, Buildings, Equipment, intangible assets (like Patents)
|Liabilities|| Liabilities are creditors' claims for funds, usually because they have provided funds, or goods and services, to the firm.|
Examples: Accounts Payable, Unearned Income, Notes Payable, Buildings, Accrued Salaries
|Shareholders' Equity|| Shareholders' Equity shows the amounts of funds owners have provided and, in parallel, their claims on the assets of a firm. |
Examples: Common Stock, Contributed Capital, Retained Earnings
|What are the separate sections on a Balance Sheet (Balance sheet classification)||1. Current assets represent assets that a firm expects to turn into cash, or sell, or consume within approximately one year from the date of the balance sheet (i.e., accounts receivable and inventory).|
2. Current liabilities represent obligations a firm expects to pay within one year (i.e., accounts payable and salaries payable).
3. Non-current assets are typically held and used for several years (i.e., land, buildings, equipment, patents, long-term security investments).
4. Noncurrent liabilities and shareholders' equity are sources of funds where the supplier of funds does not expect to receive them all back within the next year.
|Income Statement||1. Sometimes called the statement of profit and loss by firms applying IFRS|
2. Provides information on profitability
3. May use the terms net income, earnings, and profit interchangeably
4. Reports amounts for a period of time
5. Typically one year
6. Is represented by the Basic Income Equation:
Net Income = Revenues - Expenses
|Revenues||(also known as sales, sales revenue, or turnover, a term used by some firms reporting under IFRS) measure the inflows of assets (or reductions in liabilities) from selling goods and providing services to customers.|
|Expenses||measure the outflow of assets (or increases in liabilities) used in generating revenues.|
|Relationship between the Balance Sheet and the Income Statement|| 1. The income statement links the balance sheet at the beginning of the period with the balance sheet at the end of the period.|
2. Retained Earnings is increased by net income and decreased by dividends.
|Statement of Cash Flows|| The statement of cash flows (also called the|
cash flow statement) reports information about
cash generated from or used by:
2. investing, and
3. financing activities during specified time periods.
The statement of cash flows shows where the firm obtains or generates cash and where it spends or uses cash.
|Classification of Cash Flows|| 1. Operations: |
cash from customers less cash paid in carrying out the firm's operating activities
cash paid to acquire noncurrent assets less amounts from any sale of noncurrent assets
cash from issues of long-term debt or new capital less dividends
|Inflows and Outflows of Cash|
|The Relationship of the Statement of Cash Flows to the Balance Sheet and Income Statement||-The statement of cash flows explains the change in cash between the beginning and the end of the period, and separately displays the changes in cash from operating, investing, and financing activities.|
-In addition to sources and uses of cash, the statement of cash flows shows the relationship between net income and cash flow from operations.
|Statement of Shareholders' Equity||This statement displays components of shareholders' equity, including common shares and retained earnings, and changes in those components.|
|Other Items in Annual Reports||Financial reports provide additional explanatory material in the schedules and notes to the financial statements.|
|Who are the 4 main groups of people involved with the Financial Reporting Process|| 1. Managers and governing boards of reporting entities.|
2. Accounting standard setters
and regulatory bodies.
3. Independent external auditors.
4. Users of financial statements.
|What is the Securities and Exchange Commission (SEC)?||An agency of the federal government, that has the legal authority to set acceptable accounting standards and enforce securities laws.|
|What is the Financial Accounting Standards Board (FASB)?||a private-sector body comprising five voting members, to whom the SEC has delegated most tasks of U.S. financial accounting standard-setting.|
|GAAP||1. Common terminology includes the pronouncements of the FASB (and its predecessors) in the compilation of accounting rules, procedures, and practices known as generally accepted accounting principles (GAAP).|
2. Recently, the FASB launched its codification project which organizes all of U.S GAAP by topic (for example, revenues), eliminates duplications, and corrects inconsistencies.
|FASB board members make standard-setting decisions guided by a conceptual framework that addresses:|| 1. Objectives of financial reporting.|
2. Qualitative characteristics of accounting information including the relevance, reliability, and comparability of data.
3. Elements of the financial statements.
4. Recognition and measurement issues.
|Sarbanes-Oxley Act of 2002.|| Concerns over the quality of financial reporting have led, and continue to lead, to government initiatives in the United States.|
Sarbanes-Oxley Act of 2002 established the Public Company Accounting Oversight Board (PCAOB), which is responsible for monitoring the quality of audits of SEC registrants.
|International Financial Reporting Standards (IFRS)||-The International Accounting Standards Board (IASB) is an independent accounting standard-setting entity with 14 voting members from a number of countries. Standards set by the IASB are International Financial Reporting Standards (IFRS).|
-The FASB and IASB Boards are working toward converging their standards, based on an agreement reached in 2002 and updated since then.
|Auditor's Opinion||Firms whose common stock is publicly traded are required to get an opinion by an independent auditor who:|
1.Assesses the effectiveness of the firm's internal control system for measuring and reporting business transactions
2.Assesses whether the financial statements and notes present fairly a firm's financial position, results of operations, and cash flows in accordance with generally accepted accounting principles
|Basic Accounting Conventions and Concepts||1. Materiality is the qualitative concept that financial reports need not include items that are so small as to be meaningless to users of the reports.|
2. The accounting period convention refers to the uniform length of accounting reporting periods.
3. Interim reports are often prepared for periods shorter than a year. However, preparing interim reports does not eliminate the need to prepare an annual report.
|Cash vs. Accrual Accounting||Cash basis|
A firm measures performance from selling goods and providing services as it receives cash from customers and makes cash expenditures to providers of goods and services.
A firm recognizes revenue when it sells goods or renders services and recognizes expenses in the period when the firm recognizes the revenues that the costs helped produce.
|What Is an Account? How Do You Name Accounts?||-An account represents an amount on a line of a balance sheet or income statement (i.e., cash, accounts receivable, etc.).|
-There is not a master list to define these accounts since they are customized to fit each specific business's needs.
-Accountants typically follow a conventional naming system for accounts, which increases communication.
|What Accounts Make up the Typical Balance Sheet?|
|Current assets and current liabilities (Balance Sheet Classifications)||Receipt or payment of assets that the firm expects will occur within one year or one operating cycle.|
|Noncurrent assets and noncurrent liabilities (Balance Sheet Classifications)||Firm expects to collect or pay these more than one year after the balance sheet date.|
|Duality Effects of the Balance Sheet Equation (Assets = Liabilites + Shareholders' Equity)||Any single event or transaction will have one of the following four effects or some combination of these effects:|
1.INCREASE an asset and INCREASE either a liability or shareholders' equity.
2.DECREASE an asset and DECREASE either a liability or shareholders' equity.
3.INCREASE one asset and DECREASE another asset.
4.INCREASE one liability or shareholders' equity and DECREASE another liability or shareholders' equity.
A T-account is a device or convention for organizing and accumulating the accounting entries of transactions that affect an individual account, such as Cash, Accounts Receivable, Bonds Payable, or Additional Paid-in Capital.
|T-Account Conventions: Assets|
|T-Account Conventions: Liabilities|
|T-Account Conventions: Shareholders' Equity|
|Debit vs. Credit|
While T-accounts are useful to help analyze how individual transactions flow and accumulate within various accounts, journal entries formalize the reasoning that supports the transaction.
The attached standardized format indicates the accounts and amounts, with debits on the first line and credits (indented) on the second line:
| Revenue or Sales:|
(Common Income Statement Terms)
|Assets received in exchange for goods sold and services rendered.|
| Cost of Goods Sold:|
(Common Income Statement Terms)
|The cost of products sold.|
| Selling, General, and Administrative (SG&A):|
(Common Income Statement Terms)
|Costs incurred to sell products/services as well as costs of administration.|
| Research and Development (R&D) Expense:|
(Common Income Statement Terms)
|Costs incurred to create/develop new products, processes, and services.|
| Interest Income:|
(Common Income Statement Terms)
|Income earned on amounts lent to others or from investments in interest-yielding securities.|
|Unique Relationships Exist Between the Balance Sheet and the Income Statement|
|Important Account Differences||1. Balance sheet accounts are permanent accounts in the sense that they remain open, with nonzero balances, at the end of the reporting period.|
2. In contrast, income statement accounts are temporary accounts in the sense that they start a period with a zero balance, accumulate information during the reporting period, and have a zero balance at the end of the reporting period.
|The Financial Statement Relationships can be summarized as:|
-After preparing the end-of-period income statement, the accountant transfers the balance in each temporary revenue and expense account to the Retained Earnings account.
-This procedure is called closing the revenue and expense accounts. After transferring to Retained Earnings, each revenue and expense account is ready to begin the next period with a zero balance.
|Expense and Revenue Transactions|
|Dividend Declaration and Payment|
|Issues of Capital Stock|
|Posting||1. After each transaction is recognized by a journal entry, the information is transferred in the accounting system via an activity known as posting.|
2. The balance sheet ledger accounts (or permanent accounts) where these are posted begin each period with a balance equal to the ending balance of the previous period.
3.The income statement ledger accounts (or temporary accounts) have zero beginning balances.
|Adjusting Entries|| There are some journal entries that are not triggered by a transaction or exchange.|
-Rather, journal entries known as adjusting entries, result from the passage of time at the end of an accounting period or are used to correct errors (more commonly known as correcting entries).
|Four Basic Types of Adjusting Entries|| 1.Unearned Revenues|
|Closing Process||1. After adjusting and correcting entries are made, the income statement can be prepared.|
2. Once completed, it is time to transfer the balance in each temporary revenue and expense account to the Retained Earnings account. This is known as the closing process.
3. Each revenue account is reduced to zero by debiting it and each expense account is reduced to zero by crediting it.
4. The offset account—Retained Earnings—is credited for the amount of total revenues and debited for the amount of total expenses.
5. Thus, the balance of ending Retained Earnings for a period shows the difference between total revenues and total expenses.
|Preparation of the Balance Sheet||1. After the closing process is completed, the accounts with nonzero balances are all balance sheet accounts.|
2. We can use these accounts to prepare the balance sheet as at the end of the period.
3. The Retained Earnings account will appear with all other balance sheet accounts and now reflects the cumulative effect of transactions affecting that account.
|Final Step in Preparing Financial Statements: The Cash Flow Statement||1. The statement of cash flows describes the sources and uses of cash during a period and classifies them into operating, investing, and financing activities.|
2. It provides a detailed explanation for the change in the balance of the Cash account during that period.
3. Two approaches can be used to prepare this statement: Direct and Indirect