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Financial Accounting - summary chapter 1-12
Summary of Chapter 1-12 for Financial Accounting.
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Financial AccountingSummary
Chapter 1-12
Accounting as an information system
- Accounting: information system that measures, processes and communicates financial
information about an economic entity.
- Economic entity: unit that exists independently.
- Data about business activities are the input to the accounting system, and useful information
for decisions makers is the output.
Business goals and activities
- Business: economic unit that aims to sell goods and services to customers at prices that will
provide an adequate return to its owners.
- Profitability: ability to earn enough income to attract and hold investment capital.
- Liquidity: ability to have enough cash to pay debts when they are due.
- All companies pursue their goals by:
1. Operating activities: buying, producing, selling, hiring, paying taxes.
2. Investing activities: spending capital in ways that will help it achieve its goals.
3. Financing activities: obtaining adequate funds to begin and continue operating.
- Financial analysis: use of financial statements to determine that a business is well managed
and is achieving its goals.
- Performance measures: must be well aligned with profitability and liquidity.
- Financial ratios: show how elements of financial statements relate to each other.
Financial and management accounting
- 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.
- Financial accounting: external decision makers use financial accounting reports to evaluate
how well the business has achieved its goals.
- It is important to distinguish accounting from the ways in which accounting information is
processed by bookkeeping and management information systems:
o Bookkeeping: mechanical and repetitive; it is a process.
o Management information systems (MIS): consist of interconnected subsystems,
including accounting, that provide the information needed to run a business.
Ethical financial reporting
- Ethics: a code of conduct that applies to everyday life; actions are right or wrong.
- Fraudulent financial reporting: intentional preparation of misleading financial statements.
o To cover up financial weakness, to meet expectations of stockholders, to obtain a
loan, personal gain.
- Sarbanes-Oxley Act (2002): regulates financial reporting and accounting profession.
Decision makers: the users of accounting information
- People who use accounting information to make decisions fall into 3 categories:
o Those who manage a business.
Management: those who are responsible for ensuring that a company
meets its goals of profitability and liquidity.
Key decisions are based on accounting data.
o Those outside a business who have a direct financial interest in the business.
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, Investors: have invested capital in a company and have thus acquired part
ownership.
Creditors: lend money / deliver goods and services before being paid.
o Those who have an indirect financial interest in a business.
Tax authorities.
Regulatory agencies.
Other groups: labor unions, advisors of investors and creditors, consumer
groups, customers, general public, economic planners.
Governmental and not-for-profit organisations
- Managers of governmental and non-for-profit organisations perform the same functions as
managers of business.
Accounting measurement
- Four questions to make an accounting measurement:
o What is measured?
o When should the measurement be made?
o What value should be placed on what is measured?
o How should what is measured be classified?
- Financial accounting uses money to gauge the impact of business transactions on business
entities.
Business transactions
- Business transactions: economic events that affect a business’s financial position.
- Exchange of value, non-exchange transactions.
- To be recorded, a transaction must relate directly to a business entity.
Money measure
- Money measure: business transactions are recorded in terms of money.
- Money is the only factor common to all business transaction; comparison.
- Exchange rate: the value of one currency in terms of another.
Separate entity
- For accounting purposes, a business is a separate entity, distinct not only from its creditors
and customers but also from its owners.
The corporate form of business
- Three basic forms of business:
o Sole proprietorship: one person is the owner, takes all the profits or losses and is
liable for all obligations.
o Partnership: two or more owners, share profits and losses.
o Corporation: business unit chartered by the state, legally separate from its owners
(stockholders). Elect board of directors.
Formation and organization of a corporation
- Articles of incorporation: become a contract between state and incorporators.
- Stockholders: unit of ownership in a corporation is called a share of stock.
o Common stock: most universal form of stock.
- Board of directors: decides on major business policies.
o Corporate governance: the oversight of a corporation’s management and ethics by
its board of directors.
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, o Audit committee: made up of independent directors with financial expertise.
- Management: corporate policies, day-to-day operations, reporting financial results.
The financial statements and their elements
- Financial statements: primary means of communicating important accounting information
about a business to those who have an interest in the business. Accountant’s best effort to
represent what is real.
Income statement
- Income statement / statement of operations: shows whether a business achieved
profitability goal through its operating activities. Revenues, expenses, net income.
o Revenues: increases in stockholders’ equity; result from operating business.
o Expenses: decrease in stockholders’ equity; result from operating business.
o Net income: when revenues exceed expenses.
o Net loss: when expenses exceed revenues.
Statement of retained earnings
- Retained earnings: accumulated earnings generated by a business’s income-producing
activities less amounts that have been paid out to the stockholders.
- Statement of retained earnings: shows the changes in retained earnings over an accounting
period. Net income and dividends.
o Dividends: distributions of resources to stockholders.
Balance sheet
- Balance sheet / statement of financial position: shows financial position of a business on a
certain date.
o Assets: economic resources of a company that are expected to benefit future
operations. Cash, money, inventories, buildings, rights, trademarks, etc.
o Liabilities: present obligations to pay cash, transfer assets or provide services to
other entities in the future.
o Stockholders’ equity: claims of the owners of a corporation to the assets of the
business. Contributed capital + retained earnings.
Contributed capital: amount that stockholders invest in the business.
Par value: amount per share that when multiplied by the number of
common shares becomes the corporation’s common stock amount.
Additional paid-in capital: when the value received is greater than
par value.
- Accounting equation: assets = liabilities + stockholders’ equity.
Statement of cash flows
- Statement of cash flows: focuses on liquidity.
- Cash flows: inflows and outflows of cash into and out of a business.
- Net cash flows: difference between inflows and outflows.
- Divided into three major business activities:
o Cash flows from operating activities.
o Cash flows from investing activities.
o Cash flows from financing activities.
Relationships among the financial statement
- Income statement, statement of retained earnings and statement of cash flows indicate the
period to which they apply.
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, - Balance sheet gives the specific date to which it applies.
Focus on financial statement elements: financial ratios
- Data from specific elements of the financial statements is important to performance:
o Revenues: from the income statement.
o Net income: from the income statement.
o Cash flows from operating activities: from the statement of cash flows.
o Total assets: from the balance sheet.
o Total liabilities: from the balance sheet.
o Total equity: from the balance sheet.
- Financial ratios: show important relationships among the elements of the financial
statements. Can be used to assess performance and to compare. Most predictive:
o Profit margin = net income / revenues.
o Asset turnover = revenues / average total assets.
o Cash flow yield = cash flows from operating activities / net income.
o Debt to equity ratio = total liabilities / total equity.
Generally accepted accounting principles
- Generally accepted accounting principles (GAAP): developed to provide guidelines for
financial accounting.
GAAP and the independent CPA’s report
- Certified public accountant (CPA): audit financial statements, not an employee of company
being audited. Protect public by ensuring quality of professional service.
- Audit: examination of a company’s financial statements and the accounting systems,
controls and records that produces them. Purpose is to ascertain that the financial
statements have been prepared in accordance with GAAP. Credibility to a set of financial
statements.
Organizations that issue accounting standards
- Two organizations issue accounting standards used in the US:
o Financial Accounting Standards Board (FASB): developing rules on accounting
practice.
o International Accounting Standards Board (IASB): issues international financial
reporting standards (IFRS).
Other organizations that influence GAAP
- Public Company Accounting Oversight Board (PCAOB).
- American Institute of Certified Public Accountants (AICPA).
- Securities and Exchange Commission (SEC).
- Governmental Accounting Standards Board (GASB).
- Internal Revenue Service (IRS).
Professional conduct
- Integrity: accountant is honest and candid and subordinates personal gain to service and the
public trust.
- Objectivity: accountant is impartial and intellectually honest.
- Independence: accountant avoids all relationships that impair objectivity.
- Due care: carrying out professional responsibilities with competence and diligence.
- Institute of Management Accountants (IMA): has a code of professional conduct.
Emphasizes that management accountants have a responsibility to be competent in their
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