FULL FINACC REVIEW NOTES

1.1: What’s the Purpose of Accounting

Terms/Definitions:

• Bookkeeping - the preservation of a systematic, quantitative record of an activity 

• Business - operated to make a profit for its owners

• Nonprofit organization - provides services in an effective and efficient manner

• Accounting Cycle - a standard set of procedures that involve analyzing, recording, classifying, summarizing, and reporting the transactions of a business

3 Functions of an Accounting System

1. Analysis of events

2. Routine bookkeeping

3. Structuring data for evaluation of performance and health of business

Define the word “Accounting.”

• Quantitative - numbers

• Financial - money

• Useful - beautiful theory but focus on practical usefulness

• Decisions - past information points to the future
  

Decision-Making Process 

1. Identify the issue

2. Gather information

3. Identify alternatives

4. Select the option that will result in the desired objective

“Capital/Financing”

A Business requires resources to pursue its objectives

• Buildings, Machines, Cash, a trained workforce

• To buy these resources →, a business requires MONEY

• This MONEY, used by businesses to get the resources necessary, is called “Capital” or “financing.”
  

Where does capital come from?

• Investors (owners), creditors (lenders), and the business itself from retained earnings

What Do Accountants Do in A Business

• Measure and report - measure and communicate results of business activities (keep score). → To measure these rules, they use the accounting cycle

• Advise - because of their detailed understanding of a company’s activities. Accountants are well-positioned to advise on company actions → structuring activities to reach business goals (generating profit, minimizing costs, and providing efficient services

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1.2 - Who Uses Accounting Information?

Terms/Definitions

• Managerial Accounting - focuses on information needed for planning, implementing plans, and controlling.

• Accounts Payable - refers to the amount of money owed to vendors.
  

Who Uses Accounting Information?

• Managerial Accounting - gathering and analyzing information for internal decision making → product costs, breakeven analysis, budgeting, performance evaluation, outsourcing production?

• Financial Accounting - gathering, reporting, and analyzing of information primarily for the benefit of external users such as investors and creditors →  credit analysis, regulatory uses (such as financial health of banks and insurance companies), estimating the value of a company

Financial Accounting: Financial Statements

• Balance Sheet  - list as a point in time, resources (assets), obligations (liabilities)

• Income statement - for a period of time (such as a year), how much profit was made

• Statement of Cash Flows - for a period of time (year), where did the cash come from?/where did the cash go? (Focuses on investing, operating, and financing activities)

Key External Users of Financial Statements

• Lenders - will the loan be repaid, current income, existing obligations, existing assets

• Investors - Is the business profitable now? AND What is the potential for the future?

Who ELSE Uses Accounting Information?

MANAGEMENT of the company 

• Planning 

• Daily monitoring

• evaluation

Use BOTH

• Managerial AND Financial accounting information
  

Other EXTERNAL Users of Financial Information

• Suppliers (Can you pay?), Customers (Will you be around in the future?), Employees(Able to pay? Around for the long term?), Competitors (Where are you strong? Why? Weaknesses), Government Agencies (Regulation, Compliance), The Press (Background, Investigation Trigger)

1.3 - Within What Kind of Environment Does Accounting Operate

Within What Kind of Environment Does Accounting Operate?

• Organization, Ethics, Technology

Accounting-related Organizations

• FASB (Financial Accounting Standards Board)- Private group (not GOVT), people experienced in business and accounting, PUBLIC PROCESS, No legal authority, Establishes GAAP (Generally Accepted Accounting Principles) in the United States

• GASB (Governmental Accounting Standards Board)- Sets the accounting and financial reporting standards for state/local governments following GAAP. Like FASB → GASB is a private, nongovernmental organization that seeks to improve accounting practices/procedures.

• SEC (Securities and Exchange Commission)- Legal authority to regulate financial markets and accounting, usually defers to FASB on accounting matters - ensures accurate and complete disclosure is provided for all publicly traded companies

• AICPA (American Institute of Certified Public Accountants) - Professional association of certified public accountants(CPA

• IRS (Internal Revenue Service) - US government agency that collects and regulations income taxes 

• IASB (International Accounting Standards Board) - The “FASB” of the whole world…except for the US

Ethics - basic moral principles that govern an individual’s behavior, including how an individual conducts himself or herself in a business-related activity

Ethics in Accounting

• SEC and legal punishments

• AICPA and professional sanctions

• Business community and loss of credibility

Technology in Accounting

• Collect vast amounts of data with few mechanical errors, and process and analyze the details. People still exercise judgment when designing the system and making decisions.

Chapter 2: Overview of The Financial Statements

Chapter 2-1 The Financial Statements

Key External Users of Financial Accounting Data

Lenders

• Will the loan be repaid?

• Current Income

• Existing Obligations

• Existing Assets

Investors

• Is the business profitable now?

• What is the potential for the future?

The Financial Statements

Balance Sheet (statement of financial position) 

• Reports resources of a company (assets), the company’s obligations (liabilities), and the difference between what is owned (assets) and what is owed (liabilities), called owner’s equity

• List as a point in time, Resources (Assets), Obligations (Liabilities)

Income Statement (statement of earnings)

• Reports the amount of net income a company earns during a period, with annual and quarterly income statements being the most common.

• For a period of time (such as a year), How much profit did we make?

Statement of Cash Flows 

• Reports the amount of cash collected and paid out by a company in the following types of activities: operating, investing, financing

• For a period of time (such as a year), Where did cash come from? Where did it go?

2.2 - The Balance Sheet 

The Accounting Equation

• Assets = Liabilities + Owner’s Equity 

• Liabilities & Owner’s Equity → Sources of Funding

The Balance Sheet: Assets

• Resources owned or controlled by a company that will provide future benefits (Cash, inventory, buildings, accounts receivable)

The Balance Sheet: Liabilities

• Obligations - that will require probable future sacrifice of economic benefit in the form of the transfer or the providing of services

The Balance Sheet: Owner’s Equity

• How much did the owners initially invest in the business, plus how much profit they have left in the business

• The ownership interest in the company’s assets is computed by subtracting the liabilities from assets - paid-in capital and retained earnings

• Paid-in Capital = Capital Stock = Capital Contribution

What Causes the Owner’s Equity to Increase?

• Additional investments in a business or when the company generates profits that are retained in the business

What Causes the Owner’s Equity to Decrease?

• When owners take back part of their investment and when operations generate a loss instead of a profit

Format of A Balance Sheet 

Assets are always listed first - current assets, then long-term assets

Followed by Liabilities - current liabilities, then long-term liabilities

Owner’s Equity Completes the Balance Sheet - paid-in capital and retained earnings

Limitations of The Balance Sheet

• Often report COST, not MARKET VALUE → some economic assets are not recorded, especially intangible assets

• Book Value of Company ≠ Market Value of Company

2.3 The Income Statement

Difference between Balance Sheet and Income Statement

Balance Sheet - as of right now, what you have vs. what you owe

Income Statement - how much you made in the last month, quarter, year

The Income Statement 

• Revenues - Expenses = Net Income
  

Revenues - the amount of assets created from the sale of goods or services, can also be generated by satisfying liabilities

Expenses - Amount of assets consumed in generating revenue, also caused when liabilities are created in generating revenues

Net Income - an overall measure of a company’s economic performance during a given period

Revenues ≠ Assets & Expenses ≠ Liabilities

• Revenues - one SOURCE of an asset. Other sources are borrowing and owner investment

• Expense - One USE of an asset. Other uses are buying other assets and repaying loans. One way to create a liability. Another way is by borrowing money.

Gross Profit (Gross Margin) = Sales - COGS

Operating Income - reports the results of what a company does daily or its operations

• Sales - COGS - Operating Expense = Operating Income

Net Income = operating income - interest expense - taxes

Earnings (loss) per share (EPS) = net income/number of shares of stock outstanding

The Statement of Retained Earnings

• Beginning Retained Earnings + Net Income for the Period + Dividends Paid during the period = Ending Retained earnings
  

The Expanded Accounting Equations

Assets = Liabilities + Equity

• Equity = Capital Stock + Retained Earnings

• Assets = Liabilities + (Retained Earnings + Capital Stock)

• Retained Earnings = Cumulative Net Income - Cumulative Dividends

• Assets = Liabilities + Capital Stock + Cumulative Net Income - Cumulative Dividends

2.4 - The Statement of Cash Flows

1. Operating Activities - Normal Business Activities

• Collecting cash from customers, Paying for inventory purchases, Paying employees, Paying rent

2. Investing Activities - buying and selling long-term assets - investing in productive capacity

• Buildings, Equipment, Land

3. Financing Activities - Obtaining capital or financing that a business needs to buy the resources needed

• Borrowing money, Repaying Loans, Receiving Cash invested by shareholders, and Paying dividends

How The Financial Statements Tie Together

• Balance Sheet - THE fundamental financial statement - all of the other financial statements simply provide details as to how certain balance sheet accounts changed during the year

• Statement of Retained Earnings - detail how the retained earnings account on the balance sheet changed during the period - remember retained earnings changes with net income and dividends

• The Income Statement - provides details as to how retained earnings change because of revenues and expenses

• Statement of Cash Flows - details how the cash account changed during the period

2.5 - Notes to the Financial Statements

Notes on financial statements - give information about the assumptions and methods used in preparing the financial statements and more details about specific items

Summary of Significant Accounting Policies

• Revenue Recognition, Inventory Methods, Depreciation Methods, Use of Estimates
  

Additional Information About Summary Totals

• Inventory makeup - raw materials, work-in-process, finished goods

• Receivables - gross amount and the allowance for bad debts

• Pension liability - assumptions about interest rates

Disclosure of Information Not Recognized

• Status of legal proceedings and subsequent events

Supplementary Information 

• Business segment information and Domestic/International sales breakdown

2.6 - The External Audit

Do Managers Have an Economic Incentive to LIE - YES

• Make it easier for the company to get loans, boost the share price of the company, and maximize their own earnings-based executive bonuses

The External Audit

What does an external auditor do?

• Independent verification of reported financial statement numbers

• Independent verification of the company’s system of internal control

Which Companies Have Their Financial Statements Audited?

• Private companies that want to assure a banker or potential new investors

• ALL public companies by law, which is enforced by the SEC

Initial Public Offering (IPO) - when a company’s ownership shares are traded on a public stock market

The Qualifications of an External Auditor

• Certification (Certified Public Accountant) - at least 150 semester hours, CPA Exam, Continued training

• Accounting and Business Expertise

• Knowledge of Rules and Regulations regarding Auditing and Financial Reporting

• Independent - cannot have any economic ties with a business that is being audited

Audit report - expresses an opinion about whether the statement fairly presents a company’s financial position, operating results, and cash flows in accordance with GAAP

The Apparent Conflict

• The client pays the auditor

The Counterbalance

• Reputation and Litigation

Most Audit Opinions are “Clean”

• Knowing the auditors are coming keeps the reporting system running smoothly

• A good reporting system is a good business - TRUST

2.7 - Fundamental Accounting Concepts and Assumptions

Fundamental Concepts and Assumptions - TRADITION

• Separate Entity Concept, Assumption of Arm’s-Length Transactions, Cost Principle, Monetary Measurement Concept, Going Concern Assumption

Separate Entity Concept

Assumption of Arm’s-Length Transactions - Most financial statement numbers are based on observed market transaction prices

• What if I bought a machine from my mother

• What if I sold inventory to my brother

• What if the business that owns the television network also owns the basketball team

• RELATED PARTY TRANSACTIONS
  

Cost Principle

• Purchased LAND five years ago for 200,000 

• The current appraised value of LAND is 280,000

• Traditionally, assets are recorded at COSTS

• Some Exceptions: Investment Securities and Assets that have declined in value

• Fair value - the price that would be received to sell an asset in an orderly transaction between market participants

Monetary Measurement Concept - Accountants insist that items that are reported in financial statements should be noted in monetary terms such as US dollars in the US

Going Concern Assumption

How much should a company’s assets be recorded in the balance sheet depends on…

• If there is a plan to collect, sell, or use assets in the normal course of business

• Is there a plan to shut down the  business tomorrow and LIQUIDATE all assets, including inventory, accounts receivable, buildings, and everything else

• Assets are NOT recorded at LIQUIDATION prices