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Accounting and financial reporting detailed summary
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Detailed summary of Accounting and Financial reporting book, Chapters: 1,2,3,4,5,6,8,9,10,12,14,15
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Chapter 1: accounting in action1.1. Identify the activities and users associated with accounting
Accounting is an information system consists of three basic activities – it identifies,
records and communicates the economic events of an organization to interested users.
As a starting point to the accounting
process, a company identifies the
economic events relevant to its
business.
Once a company identifies economic
events, it records those events in order
to provide a history of its financial
activities. Recording consists of
keeping a systematic, chronological
diary of events, measured in monetary
units.
Finally, the company communicates the collected information to interested users by
means of accounting reports. The most common of these reports are called financial
statements.
Data about accumulate information resulting from similar transactions are said to be
reported in the aggregate. By presenting the recorded data in the aggregate, the
accounting process simplifies a multitude of transactions and makes a series of activities
understandable and meaningful.
A vital element in communicating economic events is the accountant’s ability to analyze
and interpret the reported information. Analysis involves use of ratios, percentages,
graphs, and charts to highlight significant financial trends and relationships.
Interpretation involved explaining the uses, meaning, and limitations of reported data.
The accounting process includes the bookkeeping function.
Bookkeeping usually involves only the recording of economic events. It is therefore just
one part of the accounting process.
In total, accounting involves the entire process of identifying, recording, and
communicating economic events.
The financial information that users need depends upon the kinds of decisions they
make. There are two broad groups of users of financial information: internal users and
external users.
Internal users of accounting information are managers who plan, organize, and
run the business. These include marketing managers, production supervisors,
finance directors, and company officers.
To answer the questions, internal users need detailed information on a timely
basis. Managerial accounting provides internal reports to help users make
decisions about their companies.
External users are individuals and organizations outside a company who want
financial information about the company. The two most common types of external
users are investors and creditors.
Investors (owners) use accounting information to decide whether to buy, hold, or sell
ownership shares of a company.
Creditors (such as suppliers and bankers) use accounting information to evaluate the
risks of granting credit or lending money.
Financial accounting is the field of accounting that provides economic and financial
information for investors, creditors, and other external users. The information needs to
external users vary considerably.
Taxing authorities want to know whether the company complies with tax laws.
1
Accounting and Financial Reporting
,Regulatory agencies want to know whether the company is operating within prescribed
rules.
Customers are interested whether a company will continue to honor product warranties
and support its product lines.
Labor unions want to know whether companies have the ability to pay increased wages
and benefits to union members.
1.2. Explain the building blocks of accounting: ethics, principles, and assumptions
The standards of conduct by which actions are judged as right or wrong, honest or
dishonest, fair or not fair, are ethics. Effective financial reporting depends on sound
ethical behavior.
In order to ensure high-quality financial reporting, accountants present financial
statements in conformity with accounting standards that are issued by standard-setting
bodies, there are two:
- International Accounting Standards Board (IASB)
More than 130 countries follow standards referred to as International Financial
Reporting Standards (IFRS), this is determined by the IASB.
- Financial Accounting Standards Board (FASB)
Most companies in the United States follow standards issued by the FASB,
referred to as Generally Accepted Accounting Principles (GAAP).
As markets become more global, it is often desirable to compare the results of
companies from different countries that report using different accounting standards. In
order to increase comparability, in recent years the two standard-setting bodies made
efforts to reduce the differences between IFRS and U.S. GAAP. This process is referred to
as convergence.
IFRS generally uses one of two measurement principles, the historical cost principle or
the fair value principle. Selection of which principle to follow generally relates to trade-
offs between relevance and faithful representation.
Relevance means that financial information is capable of making a difference in a
decision.
Faithful representation means that the number and descriptions match what really
existed or happened – they are factual.
The historical cost principle (or cost principle) dictates that companies record assets
at their cost. This is true not only at the time the asset is purchased, but also over the
time the asset is held.
The fair value principle states that assets and liabilities should be reported at fair
value (the price received to sell an asset or settle a liability. Fair value information may
be more useful than historical cost for certain types of assets and liabilities.
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Accounting and Financial Reporting
,Assumptions provide a foundation for the accounting process; main assumptions are:
- The monetary unit assumption requires that companies include in the
accounting records only transaction data that can be expressed in money terms.
This assumption enables accounting to quantify (measure) economic events. The
monetary unit assumption is vital to applying the historical cost principle.
- The economic entity assumption requires that the activities of the entity be
kept separate and distinct from the activities of its owner and all other economic
entities. An economic entity can be any organization or unit in society.
A business owned by one person is generally a proprietorship. The owner is often the
manager/operator of the business. Usually, only a relatively small amount of money
(capital) is necessary to start in business as a proprietorship. The owner (proprietor)
receives any profits, suffers any losses, and is personally liable for all depts of the
business. There is no legal distinction between the business as an economic unit and the
owner, but the accounting records of the business activities are kept separate from the
personal records and activities of the owner.
A business owned by two or more persons associated as partners is a partnership. In
most respects a partnership is like a proprietorship expect that more than one owner is
involved. Typically, a partnership agreement (written or oral) sets forth such terms as
initial investment, duties of each partner, division of net income (or net loss), and
settlement to be made upon death or withdrawal of a partner. Each partner generally
has unlimited personal liability for the debts of the partnership. Like a proprietorship, for
accounting purposes the partnership transactions must be kept separate from the
personal activities of the partners.
A business organized as a separate legal entity under jurisdiction corporation law and
having ownership divided into transferable shares is a corporation. The holders of the
shares (shareholders) enjoy limited liability; that is, they are not personally liable for the
debts of the corporate entity. Shareholders may transfer all or part of their ownership
shares to other investors at any time. The ease with which ownership can change adds
to the attractiveness of investing in a corporation. Because ownership can be transferred
without dissolving the corporation, the corporation enjoys an unlimited life.
1.3. State the accounting equation, and define its components
The two basic elements of a business are what it owns and with it owes. Assets are the
resources a business owns. Claims of those to whom the company owes money
(creditors) are called liabilities. Claims of owners are called equity.
The basis accounting equation:
Assets = liabilities + equity
The accounting equation applies to all economic entities regardless of size, nature of
business, or form of business organization. The equation provides the underlying
framework for recording and summarizing economic events.
Assets are resources a business owns. The business uses its assets in carrying out such
activities as production and sales. The common characteristic possessed by all assets is
the capacity to provide future services or benefits.
Liabilities are claims against assets – that is existing debts and obligations. Businesses
of all sizes usually borrow money and purchase merchandise on credit. These economic
activities result in payables of various sorts.
Creditors may legally force the liquidation of a business that does not pay its debts. In
that case, the law requires that creditor claims be paid before ownership claims.
3
Accounting and Financial Reporting
, The ownership claim on a company’s total assets is equity. It is equal to total assets
minus total liabilities. Because the assets of a business are claimed by either creditors or
shareholders. To find out what belongs to shareholders, we subtract creditors’ claims
(the liabilities) from the assets. The remainder is the shareholders’ claim on the assets –
equity. It is often referred to as residual equity – that is, the equity “left over” after
creditors’ claims are satisfied. Equity generally consists of share capital – ordinary and
retained earnings.
A company may obtain funds by selling ordinary shares to investors. Share capital –
ordinary is the term used to describe the amounts paid in by shareholders for the
ordinary shares they purchase.
Retained earnings is determined by three items: revenues, expenses, and dividends.
Revenues are the gross increases in
equity resulting from business activities
entered into for the purpose of earning
income. Revenues usually result in an
increase in an asset.
Expenses are the cost of assets
consumed or services used in the
process of earning revenue. They are
decreases in equity that result from
operating the business.
Net income represents an increase in net assets which is then available to distribute to
shareholders. The distribution of cash or other assets to shareholders is called a
dividend. Dividends reduce retained earnings. However, dividends are not expenses. A
corporation first determines its revenues and expenses and then computes net income or
net loss. If it has net income, and decides it has no better use for that income, a
corporation may decide a dividend to its owners (the shareholders).
1.4. Analyze the effects of business transactions on the accounting equation
The system of collecting and processing transaction data and communicating financial
information to decision makers is known as the accounting information system.
Factors that shape an accounting information system include the nature of the
company’s business, the types of transactions, the size of the company, the volume of
data, and the information demands of management and others.
Accounting information systems rely on a process referred to as the accounting cycle.
Transactions (business transactions) are business’s economic events recorded by
accountants. Transactions may be external or internal.
- External transactions involve economic events between the company and some
outside enterprise.
- Internal transactions are economic events that occur entirely within one
company.
Equity is comprised of two parts:
- Share capital – ordinary is affected when the company issues new ordinary
shares in exchange for cash.
- Retained earnings is affected when the company earns revenue, incurs expenses,
or pays dividends.
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Accounting and Financial Reporting
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