Chapter 1 - Fundamentals of Financial Accounting (Ch. 1) Flashcards

Organizational Forms

• Sole proprietorship: owned by one person; owner is personally liable for all debts.

• Partnership: owned by two or more people; each partner is personally liable for all debts.

• Corporation: a separate legal and accounting entity; owners (stockholders) are not personally liable for debts. Stock can be publicly or privately traded.

• Sole proprietorships are numerous, but corporations hold the majority of wealth due to limited liability.

The Accounting System

• Purpose: an information system to capture, analyze, record, and summarize activities affecting financial condition and performance; report results to decision makers.

• Users:

  • External users: creditors, investors, directors, government.

  • Internal users: managers, etc.

• Reports produced:
  1) Managerial accounting reports (For internal use) — detailed financial plans and updated operating performance for internal decisions (e.g., build/buy/rent decisions, product lines, staffing, financing).
  2) Financial accounting reports (financial statements) — prepared periodically for external users.

• External users rely on financial statements because they do not have access to detailed internal records.

The Four Basic Financial Statements and the Basic Concepts

• The Basic Accounting Equation:
  \text{Assets} = \text{Liabilities} + \text{Stockholders' Equity}

• The “Economic Entity” assumption: the business is separate from its stockholders; personal transactions of owners are not included in the company’s reports.

• Assets are economic resources controlled by the company with measurable value and future benefits. Examples of asset accounts include:

  • 1) Cash

  • 2) Accounts Receivable

  • 3) Supplies

  • 4) Equipment

  • (Software is also an asset in many statements.)

• Liabilities are obligations the company owes to creditors. Examples:

  • 1) Accounts Payable

  • 2) Note Payable

  • Note Payable arises when borrowing from a bank and signing a promissory note.

• If a company buys on credit, the amount owed is called Accounts Payable.

• Anything with "payable" in its name is a liability.

• Stockholders’ Equity represents owners’ claims to the company resources and consists of two parts:

  • PAID IN CAPITAL: amounts contributed directly to the company in exchange for stock (Contributed Capital).

  • EARNED CAPITAL: claims on amounts the company has earned through profitable operations (Net Income and Retained Earnings).

• Retained earnings can be further broken down into Net Income (and its components) and Dividends.

• Net Income and Dividends:

  • Net Income increases stockholders’ equity.

  • Net Income can be retained (Retained Earnings) or distributed as Dividends.

  • If revenues are less than expenses, the company would have a loss.

• Dividends are distributions of earnings to stockholders and are not considered an expense.

The Financial Statements in Order

• The four financial statements, typically prepared in this order:
  1) Income Statement
  2) Statement of Retained Earnings
  3) Balance Sheet
  4) Statement of Cash Flows

• The unit of measure assumption: results are reported in monetary units.

Income Statement

• Purpose: report revenues minus expenses for a period.

• Net Income equation:
  \text{Net Income} = \text{Revenues} - \text{Expenses}

• Sample (NOODLECAKE STUDIOS, INC., Month Ended Sept 30, 2018):

  • Total Revenues: 12{,}000

  • Total Expenses: 10{,}000

  • Net Income: 2{,}000

• Note: This example is a SINGLE STEP format where expenses are not broken into separate categories for the purpose of computing net income.

Statement of Retained Earnings

• Purpose: shows how net income and dividends affect retained earnings during the period.

• Example (NOODLECAKE STUDIOS, INC., Month Ended Sept 30, 2018):

  • Beginning Retained Earnings: 0

  • Add: Net Income: 2{,}000

  • Subtract: Dividends: 1{,}000

  • Ending Retained Earnings: 1{,}000

• Retained Earnings formula:
  \text{Beginning Retained Earnings} + \text{ Net Income } - \text{ Dividends } = \text{ Ending Retained Earnings }

• Question: Which retained earnings is reported on the Balance Sheet? It is the Ending Retained Earnings from this statement.

Balance Sheet

• Purpose: to report assets, liabilities, and stockholders’ equity at a specific point in time.

• Assets are listed in order of liquidity; liabilities are listed by when they are due.

• Assets (example):

  • Cash: 13{,}000

  • Accounts Receivable: 2{,}500

  • Supplies: 500

  • Equipment: 14{,}000

  • Software: 6{,}000

  • Total Assets: 36{,}000

• Liabilities:

  • Accounts Payable: 5{,}000

  • Note Payable: 20{,}000

  • Total Liabilities: 25{,}000

• Stockholders’ Equity:

  • Common Stock: 10{,}000

  • Retained Earnings: 1{,}000

  • Total Stockholders' Equity: 11{,}000

• Total Liabilities and Stockholders’ Equity: 36{,}000

• Balance sheet balance principle: Assets = Liabilities + Stockholders' Equity