Financial Accounting Chapter 1: Accounting in Action

Activities and Users Associated with Accounting

• Accounting consists of three primary activities:

  • Identification: Selecting the economic events (transactions) relevant to a specific business organization.

  • Recording: Keeping a systematic, chronological diary of events, measured in monetary units. This involves recording, classifying, and summarizing economic transactions.

  • Communication: Distributing accumulated financial information to interested users through standardized accounting reports, known as financial statements. Communication includes analyzing and interpreting reported data:

  • Analysis: Involves using ratios, percentages, graphs, and charts to highlight financial trends and performance.

  • Interpretation: Involves explaining the statistical meaning, value, and limitations of reported accounting data.

• Accounting vs. Bookkeeping:

  • Bookkeeping encompasses only the recording step of economic events.

  • Accounting includes identification, recording, and communication, along with analytical and interpretive tasks.

• Users of Accounting Data:

  • Internal Users: Managers who plan, organize, and run the business operations (e.g., marketing managers, production supervisors, finance directors, and company officers).

  • Finance: Is cash sufficient to pay dividends to stockholders?

  • Marketing: What price should a company charge for a product to maximize net income?

  • Human Resources: Can the company afford to grant employee pay raises this year?

  • Management: Which product line is the most profitable, and should any product lines be eliminated?

  • Managerial Accounting: The field of accounting focused on generating internal financial reports for managerial decision-making.

• External Users: Individuals and organizations outside the company who require financial performance metrics.

  • Investors (Owners): Use financial statements to make decisions about buying, holding, or selling corporate stock.

  • Creditors (Suppliers and Bankers): Evaluate the risk of granting credit or lending funds to the entity.

  • Questions Asked by External Users:

    • Investors: Is the company earning satisfactory income? How does its profitability compare to industry competitors?

    • Creditors: Will the company be able to pay its debts as they come due?

  • Other External Users: Taxing authorities (IRS), regulatory bodies (SEC, FTC), customers, and labor unions.

  • Financial Accounting: The branch of accounting focused on financial reporting for external users.

• Case Study: Clif Bar & Company:

  • Created in 1990 by Gary Erickson and his mother in her kitchen after six months of experimentation.

  • Expanded to approximately $1,000$ employees and named one of Landor's Breakaway Brands®.

  • In 2010, established an Employee Stock Ownership Plan (ESOP), granting employees $20\%$ ownership of the business.

  • Implemented an open-book management program to educate employee-owners on finances.

  • Benefits of open financial access:

  • Marketing: Optimized pricing and product strategies.

  • Finance: Informed debt and equity management.

  • Production: Improved machinery investments and inventory tracking.

  • Human Resources: Accurate compensation evaluation.

  • Employees: Enhanced understanding of performance metrics and higher workplace morale.

• Concept Review (DO IT! 1):

  • The three steps in the accounting process are identification, recording, and communication: True.

  • Bookkeeping encompasses all steps in the accounting process: False (bookkeeping is only the recording activity).

  • Accountants prepare, but do not interpret, financial reports: False (analysis and interpretation are core duties).

  • The two most common types of external users are investors and company officers: False (company officers are internal users; the primary external users are investors and creditors).

  • Managerial accounting activities focus on reports for internal users: True.

Building Blocks of Accounting: Ethics, Principles, and Assumptions

• Ethics in Financial Reporting:

  • Ethics Defined: Standards of conduct by which actions are evaluated as right or wrong, honest or dishonest, fair or unfair.

  • Regulatory Environment: Corporate financial failures (e.g., Enron, WorldCom, HealthSouth, AIG) prompted the passage of the Sarbanes-Oxley Act (SOX) by Congress to reduce unethical behavior and increase top management accountability.

  • Steps for Analyzing Ethical Dilemmas:

  1. Recognize an ethical situation and the underlying ethical issues using personal ethics and organizational codes of conduct.

  2. Identify and analyze the principal elements, including affected stakeholders (parties who gain or suffer harm).

  3. Evaluate legal and moral responsibilities, assess alternatives, and select the most ethical course of action.

• Ethics Case: Dewey & LeBoeuf LLP:

  • Employees at the defunct law firm admitted to creating unissued invoices, manipulating revenue figures, and misleading auditors to conceal cash shortages under pressure from executives.

  • Executives openly discussed these practices in emails, referring to them as "accounting tricks," "cooking the books," and "fake income."

• Generally Accepted Accounting Principles (GAAP):

  • A common set of standards and procedures universally accepted in accounting to ensure standardized financial disclosure.

  • Standard-Setting Bodies:

  • Financial Accounting Standards Board (FASB): Primary private-sector body establishing GAAP in the United States.

  • Securities and Exchange Commission (SEC): US federal agency charged with regulating public financial markets and enforcing accounting standards.

  • International Accounting Standards Board (IASB): Sets International Financial Reporting Standards (IFRS), used across over $115$ countries (including all European Union member states).

• International Insight: The Korean Discount:

  • Historically, South Korean corporate stock traded at lower valuations ("Korean discount") due to opaque accounting practices and discrepancies between reported and actual revenues.

  • Adoption of international accounting standards enhanced transparency, reduced investor uncertainty, and stimulated financial market growth.

• Measurement Principles:

  • Historical Cost Principle (Cost Principle): Dictates that assets must be recorded at their original acquisition cost. Cost remains the benchmark value in subsequent periods.

  • Fair Value Principle: Dictates that assets and liabilities should be reported at fair value (the price received to sell an asset or settle a liability in an orderly transaction).

  • Application Rule: Most assets are recorded under historical cost because cost figures are objective and factual. Fair value is applied primarily to actively traded assets, such as investment securities.

• Accounting Assumptions:

  • Monetary Unit Assumption: Requires that only transaction data capable of being expressed in terms of money be included in accounting records. Non-quantifiable events (e.g., employee health, customer satisfaction) are omitted.

  • Economic Entity Assumption: Mandates that activities of an economic entity be kept strictly separate from the personal activities of its owners and all other entities.

• Forms of Business Ownership:

  • Proprietorship:

  • Owned by one individual.

  • Owner retains all profits, absorbs all losses, and maintains unlimited personal liability for business debts.

  • Separate entity for accounting purposes, but not legally separate from the owner.

  • Partnership:

  • Owned by two or more individuals under a partnership agreement.

  • Partners maintain unlimited personal joint liability for entity obligations.

  • Corporation:

  • Organized as a distinct legal entity under state corporation law, with ownership divided into transferable shares of stock.

  • Stockholders enjoy limited liability (losses are limited to investment amounts).

  • Enjoys indefinite life and continuous existence.

• Concept Review (DO IT! 2):

  • Congress passed SOX to reduce unethical behavior and corporate scandals: True.

  • Primary standard-setting body in the US is FASB: True.

  • Historical cost principle dictates recording assets at cost, but requires fair value updates in later periods if market value rises: False (cost remains the reported basis for most assets).

  • Relevance means financial information matches what actually happened: False (factual accuracy is faithful representation; relevance means information makes a difference in a decision).

  • Business owner's personal expenses must be separated from business accounting: True (Economic Entity Assumption).

  • Combining Kellogg and General Mills activities violates the Economic Entity Assumption.

  • A business organized as a separate legal entity with ownership divided into stock shares is a corporation.

The Basic Accounting Equation and Its Components

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

  • Serves as the core balance framework for recording all economic events.

  • Assets must always equal the sum of Liabilities and Stockholders' Equity.

  • In liquidation proceedings, creditor claims (Liabilities) take absolute legal priority over owner claims (Stockholders' Equity).

• Components Defined:

  • Assets: Resources owned by a business that provide future economic utility or service capacity (e.g., Cash, Accounts Receivable, Supplies, Equipment).

  • Liabilities: Debts, obligations, and claims of creditors against total assets (e.g., Accounts Payable, Notes Payable, Salaries and Wages Payable).

  • Stockholders' Equity: The ownership claim on total business assets; referred to as residual equity (Total Assets minus Total Liabilities):     $\text{Stockholders' Equity} = \text{Assets} - \text{Liabilities}$

• Stockholders' Equity Structure:

  • Common Stock: Total paid-in capital invested by stockholders in exchange for corporate ownership shares.

  • Retained Earnings: Net income retained in the business entity, affected by three factors:

  • Revenues (+): Gross increases in equity resulting from business activities aimed at earning income (e.g., sales, service fees, commissions, interest, dividends, rent). Revenues increase Stockholders' Equity.

  • Expenses (-): The cost of assets consumed or services used in generating revenues (e.g., salaries, rent, utilities, advertising, taxes). Expenses decrease Stockholders' Equity.

  • Dividends (-): Distribution of cash or assets to stockholders. Dividends reduce Retained Earnings and Equity, but are not expenses.

• Expanded Accounting Equation:   $\text{Assets} = \text{Liabilities} + \text{Common Stock} + \text{Revenues} - \text{Expenses} - \text{Dividends}$

• Equity Effects Summary (DO IT! 3):

  • Rent Expense: Classified as an Expense $\rightarrow$ Decreases Equity.

  • Service Revenue: Classified as Revenue $\rightarrow$ Increases Equity.

  • Dividends: Classified as Dividends $\rightarrow$ Decreases Equity.

  • Salaries and Wages Expense: Classified as an Expense $\rightarrow$ Decreases Equity.

Transaction Analysis: Effects of Business Transactions on the Accounting Equation

• Transaction Definition & Decision Rule:

  • Economic events recorded by accountants; can be external (with external parties) or internal (usage of existing supplies).

  • Criterion: An event is recorded only if it alters the financial position (Assets, Liabilities, or Stockholders' Equity) of the business.

• Dual Effect Principle: Every transaction impacts at least two accounting elements, preserving mathematical equality in the accounting equation.

• Detailed Transaction Illustration (Softbyte Inc. - September 2020):

  • Transaction 1: Investment by Stockholders:

  • Ray and Barbara Neal invest $\$15,000$ cash in Softbyte Inc. in exchange for $\$15,000$ of common stock.

  • Impact: Cash (Asset) increases by $+\$15,000$; Common Stock (Equity) increases by $+\$15,000$

  • Transaction 2: Purchase of Equipment for Cash:

  • Softbyte Inc. buys computer equipment for $\$7,000$ cash.

  • Impact: Cash (Asset) decreases by $-\$7,000$; Equipment (Asset) increases by $+\$7,000$

  • Transaction 3: Purchase of Supplies on Credit:

  • Softbyte Inc. buys headsets and accessories for $\$1,600$ on credit from a supplier payable in October.

  • Impact: Supplies (Asset) increases by $+\$1,600$; Accounts Payable (Liability) increases by $+\$1,600$

  • Transaction 4: Services Performed for Cash:

  • Softbyte Inc. receives $\$1,200$ cash for app development services rendered.

  • Impact: Cash (Asset) increases by $+\$1,200$; Revenue (Equity) increases by $+\$1,200$

  • Transaction 5: Purchase of Advertising on Credit:

  • Softbyte Inc. receives a $\$250$ bill from Daily News for website advertising, deferring payment.

  • Impact: Accounts Payable (Liability) increases by $+\$250$; Advertising Expense (Equity) decreases equity by $-\$250$

  • Transaction 6: Services Performed for Cash and Credit:

  • Softbyte Inc. provides $\$3,500$ of services, collecting $\$1,500$ cash and billing customers $\$2,000$ on account.

  • Impact: Cash increases by $+\$1,500$; Accounts Receivable increases by $+\$2,000$; Service Revenue increases by $+\$3,500$

  • Transaction 7: Payment of Cash Expenses:

  • Softbyte Inc. pays $\$600$ rent, $\$900$ employee salaries, and $\$200$ utilities in cash (Total Cash paid: $\$1,700$).

  • Impact: Cash decreases by $-\$1,700$; Rent Expense decreases equity by $-\$600$; Salaries Expense decreases equity by $-\$900$; Utilities Expense decreases equity by $-\$200$

  • Transaction 8: Payment of Accounts Payable:

  • Softbyte Inc. pays its $\$250$ Daily News bill in cash.

  • Impact: Cash decreases by $-\$250$; Accounts Payable decreases by $-\$250$

  • Transaction 9: Receipt of Cash on Account:

  • Softbyte Inc. collects $\$600$ cash from customers previously billed in Transaction 6.

  • Impact: Cash increases by $+\$600$; Accounts Receivable decreases by $-\$600$

  • Transaction 10: Cash Dividend Distribution:

  • Softbyte Inc. pays a $\$1,300$ cash dividend to owners Ray and Barbara Neal.

  • Impact: Cash decreases by $-\$1,300$; Dividends decrease equity by $-\$1,300$

• Summary Balance Sheet Totals for Softbyte Inc.:

  • Assets: Cash ($\$8,050$) + Accounts Receivable ($\$1,400$) + Supplies ($\$1,600$) + Equipment ($\$7,000$) = $\$18,050$

  • Liabilities & Equity: Accounts Payable ($\$1,600$) + Common Stock ($\$15,000$) + Retained Earnings ($\$1,450$) = $\$18,050$

  • Retained Earnings Calculation: Revenue ($\$4,700$) minus Expenses ($\$1,950$) minus Dividends ($\$1,300$) = $\$1,450$

• Tabular Analysis Practice (DO IT! 4 - Virmari & Co., August):

  1. Stock issued for $\$25,000$ cash $\rightarrow$ Cash $+\$25,000$, Common Stock $+\$25,000$

  2. Purchased $\$7,000$ equipment on credit $\rightarrow$ Equipment $+\$7,000$, Accounts Payable $+\$7,000$

  3. Received $\$8,000$ cash for services $\rightarrow$ Cash $+\$8,000$, Service Revenue $+\$8,000$

  4. Paid $\$850$ rent in cash $\rightarrow$ Cash $-\$850$, Rent Expense $-\$850$

  5. Paid $\$1,000$ cash dividend $\rightarrow$ Cash $-\$1,000$, Dividends $-\$1,000$

  • Final Balance Checks:

  • Total Assets: Cash ($\$31,150$) + Equipment ($\$7,000$) = $\$38,150$

  • Total Liabilities + Equity: Accounts Payable ($\$7,000$) + Common Stock ($\$25,000$) + Revenue ($\$8,000$) - Expense ($\$850$) - Dividends ($\$1,000$) = $\$38,150$

Financial Statements and Their Preparation

• The Four Financial Statements:

  1. Income Statement:

  • Reports corporate profitability over a specified time period.

  • Lists revenues first, followed by itemized operating expenses.

  • Net Income results when Revenues exceed Expenses ($\text{Revenues} > \text{Expenses}$).

  • Net Loss results when Expenses exceed Revenues ($\text{Expenses} > \text{Revenues}$).

  • Excludes stock issuances and dividend payouts.

  • Alternative names: Statement of Operations, Earnings Statement, Profit and Loss (P&L) Statement.

  1. Retained Earnings Statement:

  • Summarizes changes in retained earnings over the exact same period as the income statement.

  • Formula:        $\text{Beginning Retained Earnings} + \text{Net Income (or } - \text{Net Loss)} - \text{Dividends} = \text{Ending Retained Earnings}$

  1. Balance Sheet:

  • Reports business assets, liabilities, and equity at a specific point in time (a snapshot date).

  • Lists assets first, followed by liabilities and equity.

  • Total Assets must equal Total Liabilities and Stockholders' Equity.

  1. Statement of Cash Flows:

  • Details cash receipts and cash payments over a specified time period.

  • Categorizes cash activity into Operating Activities, Investing Activities, and Financing Activities.

  • Answers three core questions: Where did cash come from? What was cash used for? What was the net change in cash?

• Interrelationships Among Financial Statements:

  • Net Income calculated on the Income Statement is added to the Retained Earnings Statement.

  • Ending Retained Earnings computed on the Retained Earnings Statement is carried over to the Balance Sheet under Stockholders' Equity.

  • Ending Cash Balance reported on the Balance Sheet matches the final cash balance on the Statement of Cash Flows.

• Triple Bottom Line (3BL) Insight:

  • Evaluates performance across three pillars: People, Planet, and Profit.

  • Asserts that corporate responsibility extends beyond shareholder return to all affected stakeholders.

  • Addresses social equity, worker safety, fair trade, and environmental sustainability.

  • Example: British Petroleum's oil spill caused catastrophic stock price drops, dividend cuts, executive turnover, and severe environmental damage.

• Financial Statement Problem Solving (DO IT! 5 - Flanagan Corporation, Dec 31, 2022):

  • Given: Equipment $\$10,000$; Cash $\$8,000$; Service Revenue $\$36,000$; Rent Expense $\$11,000$; Accounts Payable $\$2,000$; Utilities Expense $\$4,000$; Accounts Receivable $\$9,000$; Salaries Expense $\$7,000$; Notes Payable $\$16,500$; Dividends $\$5,000$.

  • Total Assets = Cash ($\$8,000$) + Accounts Receivable ($\$9,000$) + Equipment ($\$10,000$) = $\$27,000$

  • Net Income = Service Revenue ($\$36,000$) - Rent Expense ($\$11,000$) - Salaries Expense ($\$7,000$) - Utilities Expense ($\$4,000$) = $\$14,000$

  • Stockholders' Equity = Total Assets ($\$27,000$) - Total Liabilities ($\$16,500$ Notes Payable + $\$2,000$ Accounts Payable) = $\$8,500$

Career Opportunities in Accounting

• Major Accounting Fields:

  • Public Accounting: Offers auditing, tax planning, and management consulting services to the public.

  • Private (Corporate) Accounting: Includes working within private businesses in cost accounting, budgeting, system design, and corporate tax compliance.

  • Governmental Accounting: Opportunities in government entities (IRS, FBI, SEC, public universities, municipal administrations).

  • Forensic Accounting: Integrates accounting, auditing, and legal investigation skills to detect fraud, bribery, money laundering, and corporate embezzlement.

• Salary Estimates & Compensation Ranges:

  • Public Accounting (Large Firm):

  • Junior Level ($0-3$ years): $\$63,250 - \$83,250$

  • Senior Level ($4-6$ years): $\$78,500 - \$106,500$

  • Public Accounting (Medium Firm):

  • Junior Level: $\$56,500 - \$67,750$

  • Senior Level: $\$70,500 - \$96,000$

  • Public Accounting (Small Firm):

  • Junior Level: $\$51,500 - \$60,500$

  • Senior Level: $\$63,750 - \$81,500$

  • Corporate Accounting (Large Company):

  • Junior Level: $\$53,750 - \$69,500$

  • Senior Level: $\$68,750 - \$87,750$

  • Executive Corporate Positions:

  • Chief Financial Officer (CFO): Large Company $\$207,000 - \$465,750$ | Small-to-Medium Company $\$105,250 - \$208,750$

  • Corporate Controller: Large Company $\$140,000 - \$224,750$ | Small-to-Medium Company $\$92,000 - \$161,250$

  • Tax Manager: Large Company $\$112,000 - \$158,250$ | Small-to-Medium Company $\$88,000 - \$124,750$

International Financial Reporting Standards (IFRS) Impact

• Similarities Between GAAP and IFRS:

  • Fundamental double-entry recording mechanisms are identical across both frameworks.

  • Both prioritize transparency, reporting clarity, and meeting investor/creditor decision-making needs.

  • Share common business ownership formats (proprietorships, partnerships, corporations).

• Key Differences Between GAAP and IFRS:

  • Standard-Setting: US GAAP is governed by the FASB; IFRS is governed by the IASB.

  • Approach: IFRS is considered more principles-based (simpler, broader rules); US GAAP is more rules-based (highly detailed, specific operational guidelines).

  • Sarbanes-Oxley Mandates: SOX internal control verification applies specifically to publicly traded entities on US exchanges.

• IFRS Self-Test Concepts:

  • Single high-quality international accounting standards benefit mergers and acquisitions, global financial markets, and multinational operations (claiming US GAAP is universally superior is incorrect).

  • The Sarbanes-Oxley Act determines internal control standards for US publicly traded companies.

  • IFRS is principles-based and less rules-based than GAAP.