The Accounting Cycle - ACC 210 Exam 1 - Chapter 1

Accounting

A system of maintaining records of a company’s operations and communicating that information to decision makers

Accounting is referred to as…

…the language of business

Financial accounting

Measurement of business activities of a company and communication of those measurements to decision makers outside of the company (external reporting).

Who is financial accounting useful to?

investors and creditors

can be useful to managers

Managerial Accounting

Focuses on information provided to managers only (internal reporting).

Investors

Want to make good decisions related to buying or selling their shares of company stock.

Creditors

Lend money to a company, expecting to be paid back the loan amount plus interest.

Assets

Resources of a company.

Liabilities

Amounts owed to creditors.

Stockholders’ equity

Owners’ claims to resources, which arise primarily from contributions by the owners and company operations. Also, shareholders’ equity, owners’ equity, or just equity.

Claim to resources

Liabilities + stockholders equity

Fundamental Accounting Equation

Assets = Liabilities + Stockholders’ equity

Revenues

Amounts recognized when the company sells products or services to customers.

Expenses

Costs of providing products and services and other business activities during the current period.

Net income Equation (sometimes referred to as earnings or profits)

NE = Revenue - Expenses

Dividends

Distributions to stockholders, typically in the form of cash.

Dividends are NOT…

An expense

Sole Proprietorship + Advantages

• Simple to establish

• Owner-controlled

• Tax advantages

Partnership + Advantages

• Simple to establish

• Shared control

• Broader skills and resources

• Tax advantages

Corporation + Advantages

• Easier to transfer ownership

• Easier to raise funds

• No personal liability

Why do we say corporations suffer from "double taxation"?

They pay taxes on the corporate level and, if distributed, dividends are taxed at the individual level as well

Corporate limited liability means…

Stockholders of corporations are not personally liable for corporate debts

The Role of Financial Accounting

• Provides a service to make resource allocation decisions

• Accounting is the process of measuring business activity in monetary terms

Three Categories of Business Activity

• Financing activities: transactions with investors and creditors

• Investing activities: transactions involving the purchase of resources that are expected to benefit the company

• Operating activities: transactions related to primary operations

Purchasing equipment for a business is an example of what kind of business activities?

Investing activities

Four basic financial statements that summarize a business:

• income statement

• statement of stockholders’ equity

• balance sheet

• statement of cash flows

Plus footnotes (Communication/data to users)

• Clarify and expand on information in financial statements

Plus MD&A (Communication/data to users)

• Opportunity to describe future plans and place past performance in context

Income statement

• reports the company’s revenues and expenses over an interval of time

• If revenues > expenses, then net income

• If revenues > expenses, then net loss

Statement of Stockholders’ Equity

• Stockholders’ equity = common stock + retained earnings

• common stock = external source

• retained earnings = internal source

Balance sheet

• Presents the financial position of the company on a particular date

• Resources = assets

• Liabilities and stockholders’ equity

• Organized in the same way as the fundamental accounting equation

The retained earnings account balance changes due to…

Net income or loss adjusted for any dividends paid to stockholders

Statement of Cash Flows

• Measures activities involving cash receipts and cash payments over an interval of time

• Operation cash flows —> cash transactions involving revenues and expenses

• Investing cash flows —> cash transactions involving purchase and sale of long-term assets

• Financing cash flows —> cash transactions involving lenders and stockholders

The Statement of Cash Flows covers…

The same time period as the income statement. Both are flow reports that measure financial activity over a span of time

Elements of an Annual Report

• Management Discussion and Analysis (MD&A) - Presents management’s view on the company’s ability to fund operations and expansion, and its results of operations

• Notes to the financial statements - clarify additional details, provide additional details

• Auditors’ report - Auditors’ opinion on the fairness of the presentation of the financial position

• The footnotes

Auditors

• Trained individuals hired by a company as an independent party to express a professional opinion of the extent to which financial statements are prepared in accordance with GAAP

Role of Auditors

• Help ensure that management has appropriately applied GAAP in preparing the company’s financial statements

• Help investors and creditors in their decisions by adding credibility to the financial statements

Auditors must…

Be certified public accountants to sign and issue official audit opinions for public and private companies

Generally Accepted Accounting Principles (GAAP)

• Rules for the U.S.

• Common set of rules, standards, and procedures for financial reporting

The financial accounting rules we follow in the US are known as

GAAP

Objectives of Financial Accounting

• Is useful to investors and creditors making decisions

• Helps to predict cash flows

• Tells about economic resources, claims to resources, and changes in resources and claims

Conceptual Framework Appendix

• Qualitative characteristics

• Enhancing qualitative characteristics

• Cost-effectiveness constraint

• Underlying assumptions

Assumptions that underlie GAAP

• Economic entity

• Monetary unit

• Periodicity

• Going concern

Qualitative Characteristics of Useful Financial Information

Relevance:

• Confirmatory value

• Predictive value

• Materiality

Faithful representation:

• Completeness

• Neutrality

• Freedom from error

Decision Usefulness:

• Comparability (consistency)

• Verifiability

• Timeliness

• Understandability

Retained earnings equation

Beginning Retained Earnings + Net Income (or Loss) − Dividends Paid

Which financial statement is generally prepared first?

Income statement

Which financial statement is generally prepared second?

statement of stockholders equity

Which financial statement is generally prepared third?

Balance sheet

Receiving a dividend would be classified as a(n):

Operating Activity

Paying a dividend would be classified as a(n):

Financing activity

The Securities and Exchange Commission defines a public company as one that:

Has its securities sold to the public.

An amount is considered material if…

Its omission from or misstatement in a company’s financial statements could influence a user’s decision about the company

The cost constraint suggests that

The benefits of providing financial information must exceed the costs of gathering, processing, auditing, and distributing it