Financial Accounting Exam 1

What is the purpose of accounting

To identify, record, report, and analyze economic transactions to provide useful information to interested parties so that they can make informed decisions.

Who uses financial accounting

Managers (e.g., CEO, CFO)

• Assess company’s performance

• Performance evaluation

• Compensation

Investors

• Make investment decisions

Creditors (e.g., banks)

• Assess credit worthiness

Suppliers

• Determine credit terms

Government and regulators

• Enforce laws

• Identify fraud

What would happen if accounting information were unreliable

-The financial markets would cease to function efficiently and effectively

– Investors and creditors would cease to provide capital (invest) to companies

How do individuals raise capital (money) to start a company?

– Those who generate the idea can contribute money

– Investors outside the company can purchase ownership of the company

– Borrow money from banks or other individuals

How do company owners try to gain?

• Sell ownership interest for

  more than they paid

  (appreciation or capital

  gains).

• Receive a portion of the

  company’s earnings in

  cash (dividends).

What companies must prepare financial statements and provide them to the SEC and the public?

Publicly traded companies

– Financial statements are typically prepared at the end of each quarter and year

Do private companies have to prepare financial statements?

No, unless required by shareholders or creditors

– Private companies usually prepare financial statements for their owners and for tax purposes

Income Statement

• Period of time

• Revenue-Expenses = Net Income

Statement of Stockholder’s Equity

Change in these accounts

Period of time

Statement of Cash flows

Changes in cash

Period of time

Balance sheet set up

Name

Title of statement

Specific date (as of)

Unit measure

Assets order

Cash

AR

Inventories

Plants and equipment

Land

Liabilities order

( listed by maturity date)

Accounts Payable

Notes Payable

SE order

Common Stock

Retained Earnings

When are revenues recognized

Revenues are recognized when goods and services are delivered, not necessarily in the period when cash is received.

When are expenses recognized

Expenses are recognized in the same period as the revenues to which they relate, not necessarily in the period when cash is paid

Income Statement image

Statement of SE image

Why have both an Income Statement and a Statement of Cash

Flows?

Revenues do not always equal cash collected

– Reported expenses do not always equal cash paid

=> Net income does not usually equal the change in cash for the period

Statement of cash flows image

Three sources of capital for a company

- Equity (i.e., sell stock to investors)

– Debt (i.e., borrow from the bank)

– Profits or retained earnings

What are dividends and how do they affect retained earnings

Dividends are the distribution of a portion of a company’s earnings. They decrease retained earnings.

Separate entity

Business transactions are accounted for separately from the transactions of the owners

Monetary Unit

Financial results are reported in the national monetary unit (e.g., US dollar) without adjustments for inflation

Going Concern

Company is assumed to continue to operate in the foreseeable future

Common stock formula

# Shares issued * par value

Additional paid in capital formula

($ per share – par value) * # shares issued

Historical cost

• Assets are recorded this way

• cash paid plus

  dollar value of all noncash

  consideration given on the

  date of the exchange

What is an account

An organized format used by companies to accumulate the dollar

effects of transactions on each financial statement

Current ratio formula

Current assets/Current liabilities

What are the two fundamental qualities for accounting information to be useful

Relevance

– Faithful representation (reliability)

What is a T-Account

– A tool to summarize the effect of transactions, determine balances,

and draw inference about a company’s activities.

– Every account has a T-account

What is the general journal

– A chronological record of all transactions affecting a company

– The individual transactions of the company are recorded with journal entries

An journal entry includes

– Date of the event

– Accounts involved

– Direction of the effect

– Dollar amount of the effect

– Brief description of the transaction

What is the general ledger

– A record of all past transactions

organized by account

– All journal entries are posted to

the T-accounts in the ledger

What is a trial balance

– A list of all accounts and their balances.

– Used to check equality of debits and

credits

Classified balance sheet is a formatted trial balance

– Header

– Classified assets and liabilities

– Comparative data (previous years)

Who are the main players in the accounting communication

process

– Regulators

– Managers

– Board of Directors

– Auditors

– Information Intermediaries (e.g., financial analysts)

– Users (e.g., investors, creditors, government, suppliers, managers, etc.)

What is the primary responsibility of the Securities and Exchange

Commission (SEC)

- Protect investors, maintain fair, orderly, and efficient markets, facilitate capital formation

- Bring enforcement actions where fraudulent financial reporting is suspected

What is the primary responsibility of the FASB

- Set Generally Accepted Accounting Principles (GAAP)

What is the primary responsibility of the Public Company

Accounting Oversight Board (PCAOB)

- Set audit standards for independent auditors (CPAs) of public companies

- Inspect public accounting firms’ audits

What is the manager’s role in the accounting communication process

– Produce and prepare the information in the financial statements and disclosures

What is the role of the board of directors in the accounting

communication process

– Ensure that processes are in place for maintaining the integrity of the

• company’s accounting

• financial statement preparation

• and financial reporting

– Oversee the company, including the top executives

Audit opinions

Unqualified opinion:

Financial statements fairly present the financial condition and performance of the company (i.e., the

financial statements conform to US GAAP and are reasonably free of material misstatements).

Qualified opinion:

Financial statements fairly present the financial condition and performance of the company except for:

• a limited number of items in the financial statements deviating from US GAAP and/or

• the audit was limited in scope for a limited number of items in the financial statements

Adverse opinion:

Financial statements as a whole are materially misstated and do not accurately reflect the financial

performance or condition of the company.

Disclaimer of opinion:

Auditors could not obtain sufficient evidence to form an opinion on the financial statements

What is the role of financial analysts and who are their clients

– Specialize in specific industries and companies

– Aggregate and produce information about the company that is useful to their clients

Who are their clients?

– E.g., private investors, creditors, institutional investors

Managements disclosure process

Earnings Announcement

• Press release with quarterly

and annual earnings and

other key financial metrics

Earnings/conference call

• Opportunity for public to ask

senior management questions

about the company’s performance

• Additional insights into business

strategy and future expectations

Provide the annual or quarterly reports

• Description of the business

• Management’s Discussion

and Analysis (MD&A)

• Four financial statements

and related notes

• Auditor opinion

SEC Reports

Form 10K

Annual financial statements

• Audited by independent auditor

• Generally due <90 days after fiscal year end

Form 10-Q

Quarterly financial statements

• Reviewed by independent auditor NOT audited

• Generally due <45 days after fiscal quarter end

Form 8K

Major events

• Generally due <4 days after event

Proxy Statement

Used to solicit votes from shareholders

• Details about executive compensation

Form 4

Change in ownership by insiders (officers,

>10% ownership)

• Generally due <2 days after transaction

Gross profit

= Net sales - Cogs

Income from operations

= Sales - cogs - operating expenses

Income before income tax

pretax earnings = Sales - all expenses except income tax

Net income

= Sales - all expenses

What are internal controls

Policies and procedures put in place to ensure the reliability of financial reporting and to safeguard assets

Operating cycle

Purchase goods/services - pay suppliers - sell goods/services to customers - collect cash from customers

Revenue recognition journal entries

Elements of the income statement

Operating revenues:

Increases in assets or settlements of

liabilities from the ongoing operations of

the company.

Operating expenses:

Decreases in assets or increases in

liabilities from ongoing operations

incurred to generate revenues.

Other items:

Revenues, expenses, gains, or losses that

result from activities that are not central

to the ongoing operations.

Accounting cycle

Adjusting journal entries

Adjusting journal entries - Revenue