Financial Accounting - Chapter 1: Introducing Accounting in Business

Fundamentals and Importance of Accounting

Definition of Accounting:
- Accounting is an information system that identifies, records, and communicates financial information about an organization's business activities.

Importance of Accounting Flowchart

Core Accounting Activities:
- Identifying: Selecting business transactions and events relevant to an organization.
- Recording: Keeping a systematic, chronological log of monetary business activities.
- Communicating: Preparing financial reports such as financial statements, analyzing them, and interpreting the results for decision-makers.
Qualities of Accounting Information:
- Relevant Information: Information that affects the decision-making process of users.
- Reliable Information: Information that users can depend on as trustworthy and accurate.
- Comparable Information: Information formatted in a way that allows comparison across different time periods and between different companies.

Users and Uses of Accounting Information

External Users and Financial Accounting:
- Financial Accounting: The area of accounting that focuses on serving external users by providing them with general-purpose financial statements.
- External Users:
  - Lenders: Assess the creditworthiness and repayment capability of a business.
  - Shareholders: Evaluate profitability and decide whether to buy, hold, or sell stock.
  - Governments & Regulatory Bodies: Ensure tax compliance and regulatory adherence.
  - Consumer Groups: Monitor business practices and social impact.
  - External Auditors: Verify that financial statements conform to standard accounting principles.
  - Customers: Assess the ongoing stability and viability of a supplier.
Internal Users and Managerial Accounting:
- Managerial Accounting: The area of accounting that serves internal decision-makers by producing tailored, detailed reports for operational planning and strategy.
- Internal Users:
  - Managers: Plan, organize, and direct daily operating activities.
  - Officers: Make strategic, high-level business decisions.
  - Internal Auditors: Evaluate internal controls and operational efficiency.
  - Sales Staff: Target sales goals and analyze pricing performance.
  - Budget Officers: Plan and track corporate resource allocations.
  - Controllers: Oversee general accounting functions and financial reporting operations.

Career Opportunities and Sectors in Accounting

Major Accounting Areas and Specialized Roles:
- Financial Accounting Opportunities:
  - Financial statement preparation, financial analysis, auditing, regulatory reporting, consulting, corporate planning, and criminal investigation.
- Managerial Accounting Opportunities:
  - General accounting, cost accounting, budgeting, internal auditing, management consulting, controller operations, treasurer duties, and corporate strategy.
- Taxation Opportunities:
  - Tax return preparation, tax planning, regulatory compliance, tax investigations, tax consulting, tax law enforcement, legal support services, and estate planning.
- Accounting-Related Career Fields:
  - Commercial lending, financial consulting, security analysis, trading, corporate directorships, underwriting, financial planning, property appraisal, FBI investigations, market research, systems design, merger services, business valuation, forensic accounting, litigation support, and entrepreneurship.
Distribution of Accounting Jobs by Sector:
- Private Accounting: $60\%$ of all accounting jobs.
- Public Accounting: $24\%$ of all accounting jobs.
- Government, Not-for-Profit, & Education: $16\%$ of all accounting jobs.

Accounting Jobs by Area

Ethical Standards and Governance

Concept of Ethics:
- Ethics refers to beliefs that distinguish right from wrong actions.
- Ethics provides accepted standards of good and bad behavior, which are essential in accounting to maintain public trust and standard reporting integrity.
Guidelines for Making Ethical Decisions:
1. Identify Ethical Concerns: Use personal and professional ethics to recognize ethical issues or dilemmas.
2. Analyze Options: Weigh all good and bad consequences across potential courses of action.
3. Make Ethical Decision: Select the best option after evaluating all short-term and long-term consequences.
Sarbanes-Oxley Act (SOX):
- Passed by the United States Congress in 2002 to curb widespread financial abuses and corporate accounting scandals (such as those involving Enron, WorldCom, Tyco, and ImClone).
- Applies directly to public companies that issue stock to the public.
- Requires strict accounting oversight and stringent internal controls to foster transparency, accountability, and truthfulness in financial reporting.

Accounting Principles, Assumptions, and Regulatory Environment

Generally Accepted Accounting Principles (GAAP):
- The collection of concepts, standards, and rules governing financial accounting practices.
- Designed to ensure financial information is relevant, reliable, and comparable.
Regulatory and Standard-Setting Organizations:
- Securities and Exchange Commission (SEC): A United States federal government agency holding legal authority to establish financial reporting requirements and set GAAP for companies publicly issuing securities.
- Financial Accounting Standards Board (FASB): An independent private-sector body authorized by the SEC to establish broad and specific GAAP rules.
- International Accounting Standards Board (IASB): An independent international organization that issues International Financial Reporting Standards (IFRS) to harmonize global accounting practices. More than 100 countries permit or mandate IFRS.
Key Accounting Principles:
- Measurement Principle (Cost Principle): Accounting information must be based on actual cost incurred, supported by objective and verifiable evidence.
- Revenue Recognition Principle: Prescribes that revenue is recognized when earned, not necessarily when cash is received.
- Matching Principle (Expense Recognition Principle): Prescribes that a company must record its expenses in the same period as the revenues generated as a result of those expenses.
- Full Disclosure Principle: Requires financial reports to disclose all relevant details and background information that could significantly influence a user's decision.
Key Accounting Assumptions:
- Going-Concern Assumption: Presumes that a business will continue operating indefinitely rather than facing liquidation or sale.
- Monetary Unit Assumption: Assumes that business transactions can be measured and expressed in monetary units (e.g., U.S. Dollars).
- Time Period Assumption: Presumes that the ongoing life of a company can be divided into discrete time units such as months, quarters, or years.
- Business Entity Assumption: Presumes that a business enterprise is accounted for separately and distinctly from its owner(s) and any other business entities.
Forms of Business Entities:
- Sole Proprietorship: Unincorporated business owned by one person.
- Partnership: Unincorporated business owned by two or more individuals.
- Corporation: Business legally separate from its owners, issuing capital stock to shareholders.

The Accounting Equation

Basic Accounting Equation: $\text{Assets} = \text{Liabilities} + \text{Equity}$
Components of the Accounting Equation:
- Assets: Economic resources owned or controlled by a company that are expected to yield future benefits.
  - Examples: Cash, Accounts Receivable, Notes Receivable, Store Supplies, Vehicles, Buildings, Equipment, Land.
- Liabilities: Creditors' claims on a company's assets, representing obligations to transfer assets or provide services in the future.
  - Examples: Accounts Payable, Notes Payable, Taxes Payable, Wages Payable.
- Equity: The residual owner's claim on assets after deducting liabilities (net assets).
  - Contributed Capital (Common Stock): Amounts invested by shareholders in exchange for stock.
  - Retained Earnings: Cumulative net income retained in the business rather than distributed as dividends.
Expanded Accounting Equation: $\text{Assets} = \text{Liabilities} + \text{Common Stock} - \text{Dividends} + \text{Revenues} - \text{Expenses}$

Transaction Analysis and Walkthrough

Types of Business Activities and Events:
- External Transactions: Exchanges of value between two separate entities that alter the accounting equation.
- Internal Transactions: Exchanges within an entity that alter the accounting equation (e.g., using supplies).
- Events: Occurrences affecting an entity's financial position that can be reliably measured.
- Transaction Analysis: The systematic process of determining how transactions and events impact the accounting equation.
Detailed Walkthrough of Scott Company Transactions:
- Transaction 1 (Owner Investment): J. Scott invests $\$20{,}000$ cash to start the business in exchange for common stock.
  - Assets: Cash increases by $\$20{,}000$ .
  - Equity: Common Stock increases by $\$20{,}000$ .
  - Equation Balance: \20{,}000\text{ (Assets)} = \ $20{,}000\text{ (Liabilities + Equity)}$ .
- Transaction 2 (Purchase Supplies for Cash): Purchased supplies paying $\$1{,}000$ cash.
  - Assets: Cash decreases by $\$1{,}000$ ; Supplies increases by $\$1{,}000$ .
  - Balances: Cash $\$19{,}000$ , Supplies $\$1{,}000$ .
  - Equation Balance: \20{,}000\text{ (Assets)} = \ $20{,}000\text{ (Liabilities + Equity)}$ .
- Transaction 3 (Purchase Equipment for Cash): Purchased equipment paying $\$15{,}000$ cash.
  - Assets: Cash decreases by $\$15{,}000$ ; Equipment increases by $\$15{,}000$ .
  - Balances: Cash $\$4{,}000$ , Supplies $\$1{,}000$ , Equipment $\$15{,}000$ .
  - Equation Balance: \20{,}000\text{ (Assets)} = \ $20{,}000\text{ (Liabilities + Equity)}$ .
- Transaction 4 (Purchase Supplies and Equipment on Credit): Purchased Supplies of $\$200$ and Equipment of $\$1{,}000$ on account.
  - Assets: Supplies increases by $\$200$ ; Equipment increases by $\$1{,}000$ .
  - Liabilities: Accounts Payable increases by $\$1{,}200$ .
  - Balances: Cash $\$4{,}000$ , Supplies $\$1{,}200$ , Equipment $\$16{,}000$ , Accounts Payable $\$1{,}200$ , Common Stock $\$20{,}000$ .
  - Equation Balance: \21{,}200\text{ (Assets)} = \ $21{,}200\text{ (Liabilities + Equity)}$ .
- Transaction 5 (Borrow Cash from Bank): Borrowed $\$4{,}000$ cash from 1st American Bank.
  - Assets: Cash increases by $\$4{,}000$ .
  - Liabilities: Notes Payable increases by $\$4{,}000$ .
  - Balances: Cash $\$8{,}000$ , Supplies $\$1{,}200$ , Equipment $\$16{,}000$ , Accounts Payable $\$1{,}200$ , Notes Payable $\$4{,}000$ , Common Stock $\$20{,}000$ .
  - Equation Balance: \25{,}200\text{ (Assets)} = \ $25{,}200\text{ (Liabilities + Equity)}$ .
- Transaction 6 (Provide Services for Cash): Provided consulting services receiving $\$3{,}000$ cash.
  - Assets: Cash increases by $\$3{,}000$ .
  - Equity: Revenue increases by $\$3{,}000$ .
  - Balances: Cash $\$11{,}000$ , Supplies $\$1{,}200$ , Equipment $\$16{,}000$ , Accounts Payable $\$1{,}200$ , Notes Payable $\$4{,}000$ , Common Stock $\$20{,}000$ , Revenue $\$3{,}000$ .
  - Equation Balance: \28{,}200\text{ (Assets)} = \ $28{,}200\text{ (Liabilities + Equity)}$ .
- Transaction 7 (Pay Employee Salaries): Paid employee salaries of $\$800$ in cash.
  - Assets: Cash decreases by $\$800$ .
  - Equity: Expenses increase by $\$800$ (reducing total equity).
  - Balances: Cash $\$10{,}200$ , Supplies $\$1{,}200$ , Equipment $\$16{,}000$ , Accounts Payable $\$1{,}200$ , Notes Payable $\$4{,}000$ , Common Stock $\$20{,}000$ , Revenue $\$3{,}000$ , Expenses $\$800$ .
  - Equation Balance: \27{,}400\text{ (Assets)} = \ $27{,}400\text{ (Liabilities + Equity)}$ .
- Transaction 8 (Pay Cash Dividends): Paid $\$500$ cash dividends to shareholders.
  - Assets: Cash decreases by $\$500$ .
  - Equity: Dividends increase by $\$500$ (reducing total equity).
  - Final Balances: Cash $\$9{,}700$ , Supplies $\$1{,}200$ , Equipment $\$16{,}000$ , Accounts Payable $\$1{,}200$ , Notes Payable $\$4{,}000$ , Common Stock $\$20{,}000$ , Dividends $\$500$ , Revenue $\$3{,}000$ , Expenses $\$800$ .
  - Equation Balance: \26{,}900\text{ (Assets)} = \ $26{,}900\text{ (Liabilities + Equity)}$ .

Basic Financial Statements and Their Interrelations

The Four Basic Financial Statements:
1. Income Statement
2. Statement of Retained Earnings
3. Balance Sheet
4. Statement of Cash Flows
1. Income Statement:
- Purpose: Describes a company's financial performance (revenues and expenses) over a specific time period.
- Calculation: $\text{Net Income} = \text{Revenues} - \text{Expenses}$
- Scott Company Example (For Month Ended December 31, 2011):
  - Consulting Revenue: $\$3{,}000$
  - Salaries Expense: $\$800$
  - Net Income: $\$2{,}200$
2. Statement of Retained Earnings:
- Purpose: Reports changes in retained earnings over a specific time period. Net income increases retained earnings, while net losses and dividends decrease it.
- Scott Company Example (For Month Ended December 31, 2011):
  - Retained Earnings, Dec. 1, 2011: $\$0$
  - Plus: Net Income: $\$2{,}200$
  - Less: Dividends: $\$500$
  - Retained Earnings, Dec. 31, 2011: $\$1{,}700$

Interrelation of Balance Sheet and Statement of Retained Earnings

3. Balance Sheet:
- Purpose: Describes a company's financial position (assets, liabilities, and equity) at a specific point in time.
- Scott Company Example (As of December 31, 2011):
  - Assets: Cash $\$9{,}700$ + Supplies $\$1{,}200$ + Equipment $\$16{,}000$ = Total Assets $\$26{,}900$ .
  - Liabilities: Accounts Payable $\$1{,}200$ + Notes Payable $\$4{,}000$ = Total Liabilities $\$5{,}200$ .
  - Equity: Common Stock $\$20{,}000$ + Retained Earnings $\$1{,}700$ = Total Equity $\$21{,}700$ .
  - Total Liabilities and Equity: $\$5{,}200 + \$21{,}700 = \$26{,}900$ .
4. Statement of Cash Flows:
- Purpose: Summarizes cash inflows and outflows over a period of time across three categories:
  - Cash Flows from Operating Activities: Cash received from clients ( $\$3{,}000$ ), purchase of supplies ( $\$(1{,}000)$ ), cash paid to employees ( $\$(800)$ ) $\rightarrow$ Net cash provided by operating activities = $\$1{,}200$ .
  - Cash Flows from Investing Activities: Purchase of equipment ( $\$(15{,}000)$ ) $\rightarrow$ Net cash used in investing activities = $\$(15{,}000)$ .
  - Cash Flows from Financing Activities: Investment by shareholders ( $\$20{,}000$ ), borrowed at bank ( $\$4{,}000$ ), dividends paid ( $\$(500)$ ) $\rightarrow$ Net cash provided by financing activities = $\$23{,}500$ .
  - Net Increase in Cash: $\$1{,}200 - \$15{,}000 + \$23{,}500 = \$9{,}700$ .
  - Cash Balance: Dec. 1, 2011 = $\$0$ ; Dec. 31, 2011 = $\$9{,}700$ .

Financial Performance Analysis and Organizational Activities

Return on Assets (ROA):
- A primary measure of profitability assessing a company's operating efficiency in using its assets to generate profit.
- Formula: $\text{Return on Assets} = \frac{\text{Net Income}}{\text{Average Total Assets}}$
Return and Risk Relationship:
- Return: Represents the income or profit derived from investments.
- Risk: Represents the uncertainty surrounding the expected return on an investment.
- Higher expected returns generally carry higher degree of risk.
Three Major Organizational Activities:
- Financing Activities: Transactions that provide the capital required to start and operate a enterprise, including long-term borrowing and owner contributions.
- Investing Activities: Transactions involving the acquisition and disposal of long-term assets needed to manufacture goods or deliver services.
- Operating Activities: Primary daily business operations involved in producing revenue and incurring associated operating expenses.