Comprehensive Accounting Principles and Financial Reporting

The Basic Business Cycle and Resource Allocation

• The basic business cycle consists of resource owners providing resources, categorized as inputs, to businesses. These businesses utilize the resources to provide goods and services, categorized as outputs, to consumers.

• There are three primary types of resources or inputs:

  • Financial resources.

  • Labor resources.

  • Physical resources.

Classifications of Accounting and Regulatory Bodies

• Accounting is divided into two distinct types based on the intended user:

  • Financial accounting: Targeted toward external users. This type of accounting must follow specific rules and is subject to being audited.

  • Managerial accounting: Targeted toward internal users. This involves reporting to the internal management themselves and does not require adherence to formal accounting rules.

• Financial accounting must follow rules to ensure that external users, specifically investors and creditors, can rely on the provided information.

• The Securities Exchange Commission (SEC) has granted the Financial Accounting Standards Board (FASB) the authority to establish these rules.

• These rules are known as Generally Accepted Accounting Principles (GAAP).

• Key organizations and terms include:

  • SEC: Securities Exchange Commission.

  • GAAP: Generally Accepted Accounting Principles.

  • FASB: Financial Accounting Standards Board.

The Accounting Equation and Stakeholder Definitions

• The fundamental accounting equation is expressed as:

  • $Resources = Claims$

  • $Assets = Liabilities + Stockholders' Equity$

  • $Assets = Liabilities + Common Stock + Retained Earnings$

• Retained Earnings is further defined by the following logic:

  • $Revenues - Expenses - Dividends$

• Definitions of stakeholders:

  • Creditor: An individual or organization that has loaned goods or services to a business.

  • Investor: A company or individual who provides assets or services in exchange for security certificates that represent ownership interests.

Methods for Modifying Asset Balances

• A company increases its assets through three primary channels:

  • Borrowing from creditors, which increases Liabilities.

  • Receiving from investors, which increases Common Stock.

  • Generating assets from operations, which increases Retained Earnings through revenues.

• A company decreases its assets by utilizing resources in operations, which decreases Retained Earnings through expenses.

Business Transactions and Transaction Types

• Business events are formally referred to as transactions.

• There are four main categories of business transactions:

  • 1. Asset Source Transaction: Result in an increase in Assets and an increase in Claims ($+Asset, +Claims$).

  • 2. Asset Use Transaction: Result in a decrease in Assets and a decrease in Claims ($-Asset, -Claims$).

  • 3. Asset Exchange Transaction: Involves an increase in one asset and a decrease in another asset ($+One Asset, -Another Asset$), resulting in no change to total assets.

  • 4. Claims Exchange Transaction: Involves an increase in one claim and a decrease in another claim ($+One Claim, -Another Claim$), resulting in no change to total claims.

• Specific types of Asset Source Transactions include:

  • a. Acquiring assets from owners ($+Asset, +Common Stock (CS)$).

  • b. Borrowing assets from creditors ($+Asset, +Liabilities$).

  • c. Earning assets from operations ($+Asset, +Retained Earnings (RE)$).

Components of Net Income and Retained Earnings

• The expanded accounting equation is represented as:

  • $A = L + SHE$

  • $A = L + CS + RE$

  • $A = L + CS + RE + Revenues - Expenses - Dividends$

• Retained Earnings logic:

  • Retained Earnings is increased ($+$) by Revenues.

  • Retained Earnings is decreased ($-$) by Expenses.

  • Retained Earnings is decreased ($-$) by Dividends.

• Terms of performance:

  • Revenues: Benefits earned by the company, typically by performing services or delivering goods.

  • Expenses: Sacrifices made by the company.

  • Net Income: Calculated as $Revenues - Expenses$. This reflects the benefits a company has earned less the sacrifices made to earn them. Net Income increases Retained Earnings and is a benefit to the owners (SHE).

  • Net Loss: Occurs if $Revenues - Expenses$ results in a negative number. A Net Loss decreases Retained Earnings.

  • Dividend: The payment of earned benefits to the owners. Retained Earnings is decreased by dividends.

• Specific examples of reporting events:

  • Earning benefits (revenues) by providing goods/services for cash: $+Cash, +RE (Revenues)$.

  • Sacrificing cash in order to earn benefits: $-Cash, -RE (Expenses)$.

  • Paying dividends to owners to share earnings: $-Cash, -RE (Dividends)$.

Historical Cost Principle and Financial Reporting Cycles

• The Historical Cost Principle dictates that assets are recorded at their cost, which is the amount paid to acquire them.

• Assets are not adjusted upward or downward based on current market or fair value.

• The Accounting Cycle refers to the period of time for which financial statements are prepared, which can be Monthly, Quarterly, or Yearly.

• The ending balance for one period automatically becomes the beginning balance for the subsequent period. For example, ending balances on 12/31/2021 serve as the beginning balances on 1/1/2022.

The Balance Sheet and Financial Ratios

• The Balance Sheet displays the accounts within the accounting equation in a vertical format at the end of the accounting cycle.

• The presentation order is Assets first, followed by Liabilities and Stockholders' Equity, following the equation $A = L + SHE$.

• Assets are listed in order of liquidity, which is how quickly they are converted into cash or used up.

• Relationship between accounts and cash:

  • Liabilities, Common Stock, and Retained Earnings on the right side of the equation are not cash.

  • Dividends are limited by the amount of Retained Earnings and the availability of cash.

  • The maximum dividend payment is the smaller of the total Retained Earnings or the total Cash.

• Financial ratios can show Liabilities, CS, and RE as a percentage ($\%$) of Total Assets:

  • $\frac{Liabilities}{Total Assets} = \% Liabilities$. This represents the amount of assets financed through debt.

  • $\frac{Common Stock}{Total Assets} = \% Common Stock$. This represents the amount of assets financed through owner investment.

  • $\frac{Retained Earnings}{Total Assets} = \% Retained Earnings$. This represents the amount of assets financed through operations.

The Income Statement and Performance Evaluation

• While the Balance Sheet shows the position at the end of a period, it does not show the changes during the period.

• The Income Statement details performance during the year, showing revenues, expenses, and the net effect on retained earnings.

• Income Statement structure:

  • $Revenues: XXX$

  • $Expenses: (XX)$

  • $Net Income (if positive) or Net Loss (if negative)$

• Dividends are not shown on the Income Statement. They are not an expense and are not part of net income.

• Expenses are sacrifices made to operate the business and earn revenue (e.g., electricity, rent, insurance, employee salaries).

• Dividends are profit distributions to stockholders rather than sacrifices to help the business earn revenue.

• Heading convention: "For the Year Ended 12/31/xx".

Statement of Changes in Stockholders’ Equity (SHE)

• This statement details what happened to the owners' equity accounts (CS and RE) during the year.

• Structure of the Statement of SHE:

  • Beginning Common Stock: $XX$

  • Plus Stock Issued: $XX$

  • Ending Common Stock: $XX$

  • Beginning Retained Earnings: $XX$

  • Plus Net Income: $XX$

  • Minus Dividends: $(XX)$

  • Ending Retained Earnings: $XX$

  • Total SHE: $XX$

The Statement of Cash Flows

• The Statement of Cash Flows (SCF) illustrates how cash changed from one year to the next and covers a period of time ("for the year ended").

• It identifies three types of business activities:

  • Financing Activities (FA): Transactions with stockholders and creditors. Examples include borrowing money (+), issuing stock (+), repaying loans (-), and paying dividends (-).

  • Investing Activities (IA): Buying and selling assets. Examples include purchasing assets like land or buildings (-) and selling off assets (+).

  • Operating Activities (OA): Transactions with customers, suppliers, and employees. Examples include selling products or services (+) and paying for expenses (-).

• Flow direction:

  • Inflows are increases in cash (+).

  • Outflows are decreases in cash (-).

• Preparation steps:

  • 1. Use the Cash column from the transaction analysis table.

  • 2. Categorize each item as FA, IA, or OA.

  • 3. Note the inflow or outflow sign (+ or -).

  • 4. List sections in order: OA first, IA second, FA third.

  • 5. Calculate net change by adding total net cash from the three activities. Add the beginning cash balance (from previous year's Balance Sheet) to arrive at the ending cash balance (current year's Balance Sheet).

• Analysis of SCF:

  • Cash flow from Operating Activities should be positive.

  • Cash flow from Investing Activities is typically better if it is negative, indicating the purchase of more assets for business use.

  • Cash flow from Financing Activities can be positive (borrowing/investment) or negative (repayment/dividends).

Articulation and Interrelatedness of Financial Statements

• Articulation describes the characteristic that financial statements are interrelated.

• Interrelations include:

  • The Statement of Cash Flows shows the change between Year 1 and Year 2. Beginning cash is on the Year 1 Balance Sheet; ending cash is on the Year 2 Balance Sheet.

  • The Statement of SHE shows changes in CS and RE. Beginning balances derived from Year 1 Balance Sheet; ending balances derived from Year 2 Balance Sheet.

  • The Income Statement produces Net Income, which is added to beginning Retained Earnings in the Statement of Changes in SHE to calculate ending Retained Earnings.

Corporate Reporting and Public Filings

• The SEC requires companies to file a 10-K annually, containing comprehensive performance info.

• For Target (Ticker Symbol: TGT), the March 9, 2022 report reflects the following terminology in its financial statements:

  • Consolidated Statements of Operations: Income Statement.

  • Consolidated Statements of Financial Position: Balance Sheet.

  • Consolidated Statements of Shareholder’s Investment: Statement of SHE.

  • Consolidated Statements of Cash Flows: Statement of Cash Flows.

• These filings can be accessed at www.sec.gov under "Company Filings."