Intro to Financial Accounting Test Chapters 1-3

Definition of The Accounting Information System

Practice of recording information about an economic event and makes it available for business decisions

Forms of Business Organizations

Sole Proprietorship, Partnership, Corporation, Hybrid Form of Organization

Sole Proprietorship

Owned by 1 individual

Pros: don’t need to split profits, have flexibility, tax benefits (pay less), simple to establish

Cons: do all work, bear all losses, less resources/skills

Partnership

Owned by 2 or more individuals

Pros: share workload, combine different skill sets, simple to establish, tax benefit (pay less)

Cons: share profits, disagreements

Corporation

Public company that sells or buys shares/stocks

Pros: easier to transfer ownership, separate legal entity, easier to raise funds

Cons: tax disadvantage (double taxation: corporate tax on net income + tax on gains from share sale), less decision-making power, rules and regulations

Hybrid Form of Organization

Combining the positive sides of the three business organizations

Internal Users of Financial Information

People inside company

Example Departments: HR, finance, management, marketing, purchasing

External Users of Financial Information

Not part of company

Ex. Investors, auditors, bank, regulatory bodies (e.g. IRS)

Financing Activities

Involves raising funds

Ex. Debt financing (borrowing from bank/creditors), equity financing (selling shares)

Investing Activity

Using money to buy non-current assets (assets with a useful life of >1 year)

Ex. Machines, buildings, vehicles, equipment

Operating Activity

Day-to-day operations or activities

Ex. Producing and selling a product

Leads to revenue and incurs expenses (salaries, utilities, taxes)

Net Income Formula

Revenue - Expenses

(Ex. of revenue: Sales revenue, rent revenue, service revenue)

(Ex. of expense: Insurance expense, rent expense, salary expense, utility expense, supply expense)

Retained Earnings

Income you keep for future use

Retained Earnings Formula

Beginning Retained Earnings

+ Net income

- Dividends (money paid to stockholders)

= Ending Retained Earnings

Accounting Equation

Assets = Liabilities + Stockholders’ Equity

Current assets

Assets with a useful life of <1 year

Ex. Cash, supplies, inventory, receivables, prepaid expenses (insurance, rent)

Non-Current Assets

Assets with a useful life of >1 year

Ex. Equipment, building, land, vehicle, computer, long-term investment, PPE

Current liabilities

Short-term obligation owed

Ex. Account payable, notes payable, salaries payable, income tax payable, unearned revenue

Non-Current Liabilities

Long-term obligations

Ex. Bank loan, mortgage

Intangible Assets (Non-Current Asset)

A non-physical asset

Ex. Copyright, goodwill (brand name of company), trademark, patent

Classified balance sheet

Grouping items in balance sheet by their similarities (assets, liabilities, stockholders’ equity)

Profitability Ratio

Earnings per share: determines how much money a company is making

Profitability Ratio - Earnings Per Share

(Net income - preferred dividends) / weighted average of common shares outstanding

Liquidity Ratio

determines if a company can pay short-term obligations

Liquidity Ratio - Working Capitol

Current Asset - Current Liability

Liquidity Ratio - Current Ratio

Current Asset / Current Liability

• If 1, equal assets and liabilities

• If >1, more assets than liabilities (*want this*)

• If <1, less assets than liabilities

Solvency Ratio

determines if company can survive long-term (can pay off long-term debts)

Solvency Ratio - Debt to Asset Ratio

Total Liabilities / Total Assets

• If >1, more liabilities than assets (higher ratio, more debt)

• Want low ratio

Balance Sheet Purpose

Shows financial position of the company

Stockholder’ Equity

Common Stock + Retained Earnings

Statement of Cash Flow

Money flowing into company → inflow (+)

Money flowing out of company → outflow (-)

• Record operating activities, investing activities, financing activities

Annual Report

Financial Statement + management and discussion analysis (what affected the company) + notes to the financial statement (explains assets, equities, etc.) + independent auditor’s report (check for accuracy of statement; big 4: KPMG, PwC, Deloitte, Ernst & Young)

SEC

Securities and Exchange Commission - oversees stock market

FASB

Financial Accounting Standards Board - sets accounting rules

PCAOB

Public Company Accounting Oversight Board - sets rules for auditing

Two Main Qualities of Financial Accounting Information

Relevant and Faithfully Represented

What Makes Information Relevant

Materiality - if you make a small error and it has a large impact, that item is important/material

Predictive Value

Confirmative Value

What Makes Information Faithfully Represented

Free from error, accurate, unbiased, and complete

Enhancing Qualities of Financial Accounting Information

Comparability, Verifiability, Timeliness, Understandability

Comparability

A company should be able to compare their financial statement to other companies

Verifiability

Independent body should be able to verify information

Timeliness

Has to be prepared/recorded in a timely manner (should not have delays)

Understandability

Users of information should be able to understand the statement

Assumptions of Financial Accounting Information

Monetary unit, economic entity, periodicity, going-concern

Monetary unit

every financial statement must be expressed in terms of money

Economic Entity

the company’s information should be identifiable and separate from the personal financial information of the owner

Periodicity

The period under concentration can be divided into regular periods (eg. months, quarters)

Going-concern

a company will remain in operation for the foreseeable future

Principles That Guide U.S. GAAP

Historical Cost Principle, Fair Value Principle, Full Disclosure, Cost Constraint

Historical Cost Principle

Assets should be recorded at the purchasing cost (FASB recommends using this principle)

Fair Value Principle

Assets should be recorded at the current selling price

Full disclosure

Financial information should record everything and not hide anything

Cost Constraint

If making information public would come back to harm the company, don’t disclose it (only if it is legal, eg. an official is resigning)

Business Transaction

Any event that has financial impact on the business and can be measured reliably

Subcategories of Stockholders’ Equity

Revenue, expenses, dividends, common stock

When assets increase in value (normal balance)

Debit

When expenses increase/are incurred (normal balance)

Debit

When dividends increase/are paid (normal balance)

debit

When liabilities increase (normal balance)

Credit

When stockholders’ equity increases (normal balance)

Credit

When revenues increase (normal balance)

Credit

Order of Trial Balance Items

Assets, Liabilities, Equity, Revenue, Expenses

Chart of Accounts

list of all the accounts a company has