In this document you will find a summary of the theory for the course “Financial Accounting for Pre-MSc” taught at the University of Groningen. The summary gives you a good theoretical basis to then make the practice assignments so that you are completely ready for the exam.
,Table of Contents
Week 1 ........................................................................................................................................ 2
Chapter 1) Uses of Accounting Information and the Financial Statements ....................................... 2
Chapter 2) Analysing Business Transactions ....................................................................................... 9
Week 2 ...................................................................................................................................... 14
Chapter 3) Measuring Business Income ........................................................................................... 14
Chapter 4) Financial Reporting and Analysis .................................................................................... 18
Week 3 ...................................................................................................................................... 24
Chapter 5) The Operating Cycle and Merchandising Operations ..................................................... 24
Chapter 6) Inventories ...................................................................................................................... 28
Week 4 ...................................................................................................................................... 33
Chapter 7) Cash and Receivables ...................................................................................................... 33
Chapter 9) Long-Term Assets ............................................................................................................ 36
Week 5 ...................................................................................................................................... 41
Chapter 8) Current Liabilities and Fair Value Accounting ................................................................. 41
Chapter 10) Long-Term Liabilities ..................................................................................................... 44
Week 6 ...................................................................................................................................... 50
Chapter 11) Stockholders’ Equity ..................................................................................................... 50
Week 7 ...................................................................................................................................... 57
Chapter 12) The Statement of Cash Flows........................................................................................ 57
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,Week 1
Chapter 1) Uses of Accounting Information and the Financial Statements
Accounting as an Information System
• Accounting is an information system that measures, processes, and communicates financial
information about an economic entity. An economic entity is a unit that exists independently,
such as a business, a hospital, or a governmental body.
o Accountants focus on the needs of decision makers who use financial information whether
those decision makers are inside or outside a business or another economic entity.
Accountants provide a vital service by supplying the information decision makers need to
make “reasoned choices among alternative uses of scarce resources in the conduct of
business and economic activities.”
o Accounting is a link between business activities and decision makers in the following way:
▪ Accounting measures business activities by recording data about them for future use.
▪ The data are stored until needed and then processed to become useful information.
▪ The information is communicated through reports to decision makers.
▪ Based on information from accounting, decision makers take action that affect
subsequent business activities.
Business Goals and Activities
• A business is an economic unit that aims to sell goods and services to customers at prices that will
provide an adequate return to its owners. The two major goals of all businesses are profitability
and liquidity (both goals need to be met to succeed and survive):
o Profitability is the ability to earn enough income to attract and hold investment capital.
o Liquidity is the ability to have enough cash to pay debts when they are due.
• All companies, whether they are retailers, manufacturers, or service providers, pursue their goals
by engaging in operating, investing, and financing activities.
o Operating activities include buying, producing, and selling goods and services; hiring
managers and other employees; and paying taxes.
o Investing activities involve spending a company’s capital in ways that will help it achieve its
goals. They include buying the resources needed to operate the business, such as land,
buildings, and equipment, and selling those resources when they are no longer needed.
o Financing activities involve obtaining adequate funds to begin operating the business and to
continue operating it. They include obtaining capital from creditors, such as banks and
suppliers, and from the company’s owners. They also include repaying creditors and paying
a return to the owners.
• Financial analysis is the use of financial statements to determine that a business is well managed
and is achieving its goals. The effectiveness of financial analysis depends on the use of relevant
performance measures and financial ratios.
o To be relevant, performance measures must be well aligned with the two major goals of
business – profitability and liquidity. Profitability is commonly measured in terms of net
income, and cash flows are a common measure of liquidity.
o Financial ratios show how the elements of financial statements relate to each other. They
allow for comparisons from one period to another and from one company to another.
Financial and Management Accounting
• Internal decision makers use information provided by management accounting about financing,
investing, and operating activities to achieve the goals of profitability and liquidity. Managers and
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, employees who conduct the activities of the business need information about how they have done
in the past and what they can expect in the future.
• External decision makers use financial accounting reports to evaluate how well the business has
achieved its goals. These reports are called financial statements. Financial statements report
directly on the goals of profitability and liquidity and are used extensively both inside and outside
a business to evaluate the business’s success.
• It is important to distinguish accounting from the ways in which accounting information is
processed by bookkeeping and management information systems:
o Bookkeeping is mechanical and repetitive; it is the process, usually through the use of
computers, of recording financial transactions and keeping financial records.
o Management information systems (MIS) consists of the interconnected subsystems,
including accounting, that provide the information needed to run a business.
Ethical Financial Reporting
• Ethics is a code of conduct that applies to everyday life. It addresses the question of whether
actions are right or wrong, these actions are the product of individual decisions.
• Ethics is especially important in preparing financial reports because users of these reports must
depend on the good faith of the people involved in their preparation. Users have no other
assurance that the reports are accurate and fully disclose all relevant facts.
• The intentional preparation of misleading financial statements is called fraudulent financial
reporting. It can result from the distortion of records (e.g., the manipulation of inventory records),
falsified transactions (e.g., fictious sales), or the misapplication of various accounting principles.
• The Sarbanes-Oxley Act is a legislation of 2002 that ordered the Securities and Exchange
Commission (SEC) to draw up rules requiring the chief executives and chief financial officers of all
publicly traded U.S. companies to swear that, based on their knowledge, the quarterly statements
and annual reports that their companies file with the SEC are accurate and complete. Violation
can result in criminal penalty.
Decision Makers: The Users of Accounting Information
Management (internal users of accounting information)
• Management refers to the people who are responsible for ensuring that a company meet its goals
of profitability and liquidity. All companies pursue these goals by engaging in operating, investing,
and financing activities. Making decisions about these activities is the basic function of managers,
and to make good decisions, they must have timely and valid accounting information.
Users with a Direct Financial Interest (primary external users of accounting information)
• Investors, such as stockholders, who have invested capital in a company and thus acquired part
ownership in it have a direct financial interest in its success, and they depend on the financial
statements to evaluate how the business has performed.
• Creditors, those who lend money or deliver goods and services before being paid, are interested
mainly in whether a company will have the cash to pay interest charges and to repay the debt on
time.
Users with an Indirect Financial Interest
• Tax authorities: Government at every level is financed through the collection of taxes. Companies
and individuals pay many kinds of taxes, including federal, state, and city income taxes; Social
Security and other payroll taxes; excise taxes; and sales taxes. Each tax requires special tax returns
and often a complex set of records as well.
• Regulatory agencies: Most companies must report periodically to one or more regulatory
agencies at the federal, state, and local levels.
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