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Chapter 1: Financial Accounting and Its Environment

Major Types of Accounting

• Financial Accounting

  • Provides information to external decision makers (shareholders, creditors, regulators).

• Managerial Accounting

  • Provides information to internal decision makers (not publicly available).

• Tax Accounting

  • Tax Compliance: Calculation of tax liability after year-end transactions.

  • Tax Planning: Consideration of transactions beforehand to determine tax consequences.

• Accounting Information Systems

  • Processes and procedures for generating accounting information.

• Nonbusiness Organization Accounting

  • Addresses the accounting needs of non-profit organizations (hospitals, colleges, churches).

Overview of Financial Accounting

• Involves past transactions and events affecting financial statements for decision makers.

The Financial Accounting Process

1. Categorization of Past Transactions and Events

2. Measurement: Assessment of transaction attributes.

3. Recording and Summarization: Preservation of measurements, forming business records.

4. Historical Cost: The initial valuation of a transaction remains unchanged in the future.

Primary Financial Statements

• Balance Sheet: Displays assets, liabilities, and owners' equity at a specific time.

• Income Statement: Summarizes revenues and expenses over a period.

• Statement of Cash Flows: Details cash inflows and outflows over a period.

The Balance Sheet

• Assets: Resources owned by a firm.

• Liabilities: Future obligations to transfer value.

• Owners' Equity: Residual interest calculated as assets minus liabilities (e.g., Assets = $300, Liabilities = $50, Owners' Equity = $250).

• Example of a Balance Sheet:

  • Assets: Cash: $5,000; Accounts Receivable: $7,000; Inventory: $10,000; Equipment: $7,000

  • Liabilities: Accounts Payable: $8,000; Notes Payable: $2,000; Total Liabilities: $10,000

  • Owners' Equity: Total Assets: $29,000; Total Liabilities and Equity: $29,000

The Income Statement

• Purpose: Summarizes revenues and expenses for a specific timeframe.

• Revenues: Inflows from goods/services provided.

• Expenses: Costs incurred to generate revenues.

• Net Income: Positive result when revenues exceed expenses; a net loss occurs when expenses exceed revenues.

• Example Income Statement:

  • Revenues: Sales $63,000

  • Expenses: Cost of Goods Sold $35,000; General and Administrative $20,000; Tax $3,000

  • Net Income: $5,000

The Statement of Cash Flows

• Summarizes cash inflows and outflows over a period.

• Sections:

  • Operating Activities: Company operations.

  • Investing Activities: Long-term asset transactions.

  • Financing Activities: Activities related to long-term debts and equity.

Distinguishing Between Financial Statements

• Balance Sheet: Reports components as of a specific moment.

• Income Statement & Statement of Cash Flows: Cover transactions over a period.

Notes to the Financial Statements

• Clarify and expand on the presented material.

• Integral to understanding financial statements; e.g., inventory pricing policies.

Annual Reports

• Include significant events, future plans, and management discussions/analyses over the year.

Users of Financial Statements and Their Decisions

• Investors: Assess alternative investments.

• Variables:

  • Expected Return: Anticipated increase in wealth.

  • Risk: Variability surrounding estimated returns.

• Decisions made by investors, creditors, financial analysts, customers, employees, and regulatory authorities.

Two Roles of Financial Accounting

• Primary Objective: Provide useful information for business and economic decisions.

• Secondary Objective: Facilitate contract enforcement.