Intro to Financial Accounting Chapter 1

Bookkeeping

A part of accounting that involves only the recording of economic events.

Internal Users of Accounting Data

Finance, marketing, human resources, management

External Users of Accounting Data

Investors and creditors

Sarbanes-Oxley Act (SOX)

Requires companies to review internal control and take responsibility for the accuracy and completeness of their financial reports.

Steps in Ethical Financial Reporting

1. Recognize an ethical situation and the ethical issues involved

2. Identify and analyze the principal elements in the situation

3. Identify the alternatives, and weight the impact of each alternative on various stakeholders

Dewey & LeBoeuf LLP Case

The 2012 collapse of the global mega firm Dewey & LeBoeuf culminated in one of the largest law firm bankruptcies and white-collar criminal trials in U.S. history. Executives were indicted for allegedly orchestrating a massive scheme to manipulate financial statements, allowing the firm to secure loans and hide severe debt and revenue shortfalls

Generally Accepted Accounting Principles (GAAP)

Standards that are generally accepted and universally practiced. These standards indicate how to report economic events.

Financial Accounting Standards Board (FASB)

The primary accounting standard-setting body in the United States.

Securities and Exchange Commission (SEC)

Monitors the stock market and enforces laws regulating the sale of stocks and bonds

International Accounting Standards Board (IASB)

An international accounting standard-setting body responsible for the convergence of accounting standards worldwide.

The Korean Discount

A difference in share price due to inadequate and inaccurate financial reports of South Korean companies, leading to lower investor confidence.

Operating Guidelines

Assumptions, Principles, and Constraints

Monetary Unit Assumption

Requires that companies include in the accounting records only transaction data that can be expressed in money terms. Assumes that the dollar is stable and price-level changes do not distort financial statements.

Hyperinflation

A very rapid rise in the price level; an extremely high rate of inflation.

Which two continents are usually affected by hyperinflation?

Africa and South America

Dollarization

The practice of using the dollar or some other foreign currency together with, or instead of, a domestic currency in a country

Inflation and Dollarization in Zimbabwe

Zimbabwe's currency crisis peaked in 2008 when hyperinflation reached an estimated 89.7 sextillion percent, driven by the central bank printing money to fund government deficits. This rendered the local currency worthless, forcing the country to officially abandon the Zimbabwe dollar in 2009 and adopt a multi-currency system primarily anchored by the US dollar.

Economic Entity Assumption

Requires that activities of the entity be kept separate and distinct from the activities of its owner and all other economic entities. A parent company consolidates the operations of its subsidiaries under the economic entity assumption.

Forms of Business Ownership

Proprietorships, partnerships, and and corporations

Proprietorship

- Owned by one person

- Owner is often manager/operator

- Owner receives any profits, suffers any losses, and is personally liable for all debts

Partnership

- Owned by two or more persons

- Often retail and service-type businesses

- Generally unlimited personal liability

- Partnership agreement

Corporation

- Ownership divided into shares of stock

- Separate legal entity organized under state corporation law

- Limited liability

A business organized as a separate legal entity under state law having ownership divided into shares of stock is a

corporation

Historical Cost Principle (or cost principle)

Dictates that companies record assets at their cost. Preferred by accountants.

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). Preferred by economicsts

Most assets are reported on a cost basis. When do companies apply the fair value principle extensively?

Only in situations where assets are actively traded, such as investment securities

Basic Accounting Equation of Corporations

Assets = Liabilities + Stockholder's Equity

Basic Accounting Equation of Proprietaries

Assets = Liabilities + Owner's Equity

Basic Accounting Equation of Partnerships

Assets = Liabilities + Partner's Equity

Basic Accounting Equation

- Provides the underlying framework for recording and summarizing economic events.

- Assets must equal the sum of liabilities and stockholders’ equity.

- If a business is liquidated, claims of creditors (liabilities) must be paid before ownership claims (stockholders’ equity).

Assets

Economic resources a business owns. Provide future services or benefits. (Ex. Cash, Supplies, Equipment, Patents, Agreements not to compete, etc.)

Liabilities

Claims against assets (debts and obligations) and Creditors (party to whom money is owed). (Ex. Accounts payable, notes payable, salaries and wages payable, sales and real estate taxes payable, etc.)

Stockholders' Equity

Ownership claim on total assets. Referred to as residual equity. Common stock and retained earnings.

Common Stock

Term used to describe the total amount paid in by stockholders for the shares they purchase.

Retained Earnings

An amount earned by a corporation and not yet distributed to stockholders.

Dividends

A distribution by a corporation to its stockholders.

Investments by stockholders

Represents the total amount paid in by stockholders for the shares they purchase.

Revenues

Result from business activities entered into for the purpose of earning income (Ex. sales, fees, services, commissions, interest, dividends, royalties, and rent.)

How do dividends affect the balance sheet?

Reduce retained earnings, but is NOT an expense

How do revenues affect the balance sheet?

Increase net income, retained earnings, and stockholder's equity

Expenses

The cost of assets consumed or services used in the process of earning revenue. (Ex. salaries expense, rent expense, utilities expense, tax expense, etc.)

How does issuance of common stock affect the balance sheet?

Increases cash and therefore stockholder's equity

Transactions

A business's economic events recorded by accountants.

External Transactions

Exchanges of economic value between one entity and another entity.

Internal Transactions

Exchanges within an entity, which may or may not affect the accounting equation

Stockholders' Equity Equation

Common stock + retained earnings

Retained Earning's Equation

Revenues - Expenses - Dividends

Investment of Cash by Stockholders

Increase assets, increase equity (and common stock)

Purchase of Equipment for Cash

Decrease cash, increase equipment

Purchase of Supplies on Credit

Increase supplies, increases accounts payable

Services Performed for Cash

Increase cash, increase revenue/retained earnings

Purchase of Advertising on Credit

Increase in accounts payable and decreases retained earnings

Services Performed for Cash and Credit

Increases assets and owner's equity.

Payment of Expenses

Decrease cash, increased expenses

Payment of Accounts Payable

Decrease cash, decrease accounts payable

Receipt of Cash on Account

Increase cash, decrease accounts receivable

Summary of Transactions

1. Each transaction must be analyzed in terms of its effect on:

a. The three components of the basic accounting equation.

b. Specific types (kinds) of items within each component.

2. The two sides of the equation must always be equal.

3. The Common Stock and Retained Earnings columns indicate the causes of each change in the stockholders' claim on assets.

Four Financial Statements Companies Prepare

Income statement, retained earnings statement, balance sheet, and statement of cash flows

Income Statement

Reports the profitability of the company’s operations over a specific period of time. Lists revenues first, followed by expenses. Shows net income (or net loss). Does not include investment and dividend transactions between the stockholders and the business.

Net income will result during a time period when...

....revenues exceed expenses

Net income is needed to...

...determine the ending balance in retained earnings.

Retained Earnings Statement

Reports the changes in retained earnings for a specific period of time. The time period is the same as that covered by the income statement. Information provided indicates the reasons why retained earnings increased or decreased during the period.

Ending balance in retained earnings is needed in...

...preparing the balance sheet.

Balance Sheet

Reports the assets, liabilities, and stockholders’ equity at a specific date. Lists assets at the top, followed by liabilities and stockholders’ equity. Total assets must equal total liabilities and stockholders’ equity. Is a snapshot of the company’s financial condition at a specific moment in time (usually the month-end or year-end).

Balance sheet and income statement are needed to...

...prepare the statement of cash flows.

Statement of Cash Flows

Information on the cash receipts and payments for a specific period of time.

Answers the following:

Where did cash come from?

What was cash used for?

What was the change in the cash balance?

Which of the following financial statements is prepared as of a specific date?

Balance Sheet

Public Accounting

Careers in auditing, taxation, and management consulting serving the general public.

Private Accounting

Careers in industry working in cost accounting, budgeting, accounting information systems, and taxation.

Governmental Accounting

Careers with the I R S, the F B I, the S00E C, public colleges and universities, and in state and local governments.

Forensic Accounting

Uses accounting, auditing, and investigative skills to conduct investigations into theft and fraud.

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