Financial Accounting Basics

Financial Accounting

keeping the financial score for the entity

Entity

organizational element about which accounting information is collected

Cost

all costs are historical; numbers are recorded at their original acquisition cost

Objectivity

"arm's length negotiation"

Going Concern

company will be around long enough to use up assets and pay all liabilities; an assumption that the company will continue it's operations at least one year into the future

Earned Revenue Recognition

rendered goods and services

Recognized Revenue

expectation of payment

Matching

expenses should be matched with revenues in the period they occur

Consistency

follow the same procedures each accounting period so can compare financial statements

Conservatism

cautious approach; if multiple options exist, pick the least favorable and optimistic way to present financial statements

Materiality

what kind of info should be recorded in financial statements? if you knew the fact, it could change your mind; 5% guideline

Full Disclosure

"Full Monty" must disclose all relevant information

Accounting Equation

Assets = Liabilities + Stockholders Equity

Assets

something of future economic value

Liability

something owed

Contingent liability

liability that cannot be objectively quantifiable

Stockholder's Equity

capital plus retained earnings

Capital

investment by the stockholders

Retained Earnings

Earnings retained in the business

Ending Retained Earnings

Beginning RE plus NIAT (net income after tax) minus Dividends

Dividend

distribution of retained earnings to stockholders

Expense

expired asset

Revenue

rendered goods and/or services with the expectation of payment

Accounting Process

recording, classifying, reporting, interpreting

Chart of Accounts

"Accountant's Bible" or "Index"--list of the names and account numbers for all accounts

General Journal

"Book of Original Entry"--shows the debits and credits for each accounting transaction

General Ledger

list of all transactions for the accounting period sorted by account number

Debit

entry on the left side of a general ledger account

Credit

entry on the right side of a general ledger account

Trial Balance

list of all accounts showing that the total debits equal the total credits

Adjusting Entry

reconciles (make consistent) a general ledger account to a backup schedule

Closing Entries

at end of period, all revenue and expense accounts closed to Retained Earnings

Reversing Entries

reversing an accrual entry from a previous period

Contra account

an account used to keep the balance in another account visible after net calculations

Accrual Basis

accounting based on transactions

Cash Basis

accounting based on cash in/cash out (i.e. Real World)

GAAP

Generally Accepted Accounting Principles

Controller

usually the top accounting person in a company

Income Statement

matches revenue with expense over a period of time (profit and loss statement)

Cost of goods sold

cost of what is not there; beginning inventory plus net purchases minus ending inventory

Formula for Cost of Goods Sold

beginning inventory plus net purchases minus ending inventory

Non-cash charges

deduction on income statement but no cash paid out; ex: depreciation, amortization, depletion, gain or loss on asset sale

Examples of Non-cash charges

depreciation, amortization, depletion, gain or loss on asset sale

Gross Profit

Net Revenue minus cost of goods sold

SG&A

selling, general, and administrative expense (aka operating expenses)

Operating income

Gross profit minus S, G & A (operating expenses); income from the core business

Non-Operating Income (aka “other”)

interest income and expense, capital gain or loss

Balance Sheet

shows assets equals liabilities plus stockholders' equity at a point in time (financial snapshot)

Current

within 12 months or one operating cycle

Current assets

assets that will be used up or converted to cash within one year

Current liabilities

liabilities which are due within one year

Statement of Changes in Cash Position

difference between two balance sheets expressed in cash

"Close the books"

At the end of the period, close (move) all the revenue and expense account balances on the income statement to retained earnings; resets the income statement to zero to begin the next period

Every Accountant Really Enjoys Love

Debit: Expense, Asset; Credit: Revenue, Equity, Liabilities

How can a company "make" money and not have any cash?

The company keeps its books on the accrual basis which follows transactions, but the Real World operates on the cash basis of cash in/cash out

Why does a for-profit company need to make a profit?

To reward the stockholders for taking the investment risk

Why does a not-for-profit entity need to make a profit?

Cash donations must exceed the cash paid out to build reserves and to fund future activities

Who pays the corporation or business entity income taxes?

The customer pays the taxes. Revenue must cover all expenses which includes taxes.

What is the difference between a for-profit entity and a not-for-profit entity?

income tax vs no tax; stockholders vs no owners

How do taxes matter?

Taxes represent unavoidable cash out which makes the cash unavailable for reinvestment in the business

Fair

estimate of value based on references to other objective values (e.g. fair value accounting) and/or auditors' opinion after considering all management assertions in the financial statements

Managerial Accounting

Using accounting and non-accounting information to make decisions

External users

stockholders, bankers, lenders, creditors, vendors

Internal users

people making decisions about costs

FASB

Financial Accounting Standards Board

“Capitalize It”

Put the amount on the balance sheet; generally, as an asset to be depreciated or amortized. Increases net income

“Expense It,” “Write It Off”

Deduct the amount on the income statement; decreases net income

Book value of an asset

original cost minus accumulated depreciation; found on the balance sheet in assets

Market value of an asset

value paid out by a willing buyer and willing seller

Book value of a company

common stockholders’ equity

Market value of a company

value paid by a willing buyer and willing seller

Sales vs revenue

there is no difference

Accured

estimated

net income

revenue minus expense

prepaid expense

paid cash but have not yet received the goods and services

Unearned revenue (customer deposits)

received cash but have not yet rendered the goods and services

depreciation, amortization, depletion

method of cost allocation of long-term assets over the estimated useful life under the matching principle (does not represent wear and tear or loss of value)

depreciation

allocation of original costs over the estimated useful life of a tangible asset

amortization

allocation of original costs over the estimated useful life of an intangible asset

depletion

allocation of original costs over the estimated useful life of a natural resource asset

Depreciation, amortization or depletion verses accumulated depreciation, accumulated amortization, or accumulated depreciation

expense for the period (expense on I/S) versus sum of the expenses across all periods since the asset was placed in service (contra asset account on the B/S)

six elements of internal control

establishment of responsibility, segregation of duties, documentation procedures, physical controls, independent internal verification, human resource control

establishment of responsibility

“who” is responsible

segregation of duties

for “what” is “who” responsible

documentation procedures

required paperwork to trace the transaction

physical controls

physical barriers

independent internal verification

check by someone independent of the process

human resource control

hiring people with the appropriate skills

check and balance

organizing work so people naturally check on each other

calander year

accounting year ends on december 31

fiscal year

accounting year ends on any month dictated by the company

Other Income and Expense (non-operating portion of the income statement)

interest income, interest expense, gain or loss on the sale of assets

value chain

all the processes and procedures which add value to product or services in the customers eyes (value added, non-value added)

supply chain

all the activities to get the product made in the hands of customer

tax expense

an expense to the company that appears on the income statement (ex: income tax, employer payroll taxes, sales tax paid by company on its purchases)

tax pass through

taxes collect on behalf of a governmental entity and passed through to the entity; neither a revenue nor expense; may appear on balance sheet as liability if not yet paid (ex: sales tax, excise tax, employee payroll taxes)

“B to B” (Business to Business)

companies selling primarily to other companies

“B to C” (Business to Customer)

companies selling primarily to consumers

“C level”

the executive level of a company (e.g. chief officers)

annuity cash flow pattern

same amount (in or out) in each period