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Chapter 1 Key Vocabulary - Introduction to Financial Statements

Importance of Accounting

  • Accounting: Information & measurement system for identifying, recording, and communicating an organization
    ’s business activities. (Page 4)

Users of Accounting Information

  • Accounting is the language of business; communicates data for better decisions.
  • External users: Shareholders, Lenders, External auditors, Regulators, Investors. (Page 5)
  • Internal users: Purchasing, HR, Production, R&D, Marketing managers. (Page 5)

Opportunities in Accounting

  • Private accounting: Most opportunities; employees work for businesses.
  • Public accounting: Services like auditing, taxation, and advisory. (Page 6)

Artificial Intelligence in Accounting

  • AI: Software to complete repetitive tasks (e.g., entering invoices and transaction data).
  • Accountants still needed for developing advanced AI systems and analyzing reports/graphics. (Page 7)

Data Analytics in Accounting

  • Identifies meaningful relations and trends.
  • Four basic types:
    1. Descriptive: Summarizes and describes past events.
    2. Diagnostic: Reveals causes of past events.
    3. Predictive: Predicts likely future events.
    4. Prescriptive: Creates action plans to achieve desired future. (Page 8)

Data Visualization

  • Presents data graphically to help understand significance and inform decisions.
  • Tools: Tableau dashboard, including charts, graphs, and imaging to show trends/relations. (Page 9)

Ethics and GAAP

  • Objective C2: Describe the importance of ethics and GAAP. (Page 11)

Ethics – A Key Concept

  • Goal of accounting: Provide useful, trusted information for decisions.
  • Ethics: Beliefs separating right from wrong; accepted standards of good and bad behavior. (Page 11)

Fraud Triangle

  • Three factors for fraud: Opportunity, Pressure, Rationalization.
  • Involves perceived low risk of getting caught, a rationalization, and pressure (e.g., unpaid bills). (Page 12)

Generally Accepted Accounting Principles (GAAP)

  • Governs financial accounting.
  • Aims for information with relevance (affects user decisions) and faithful representation (accurately reflects business results). (Page 13)

Financial Accounting Standards Board (FASB) and the SEC

  • FASB: Sets GAAP.
  • SEC (U.S. government agency): Oversees GAAP by public companies that sell stock and debt. (Page 14)

International Standards (IFRS) and IASB

  • External users demand comparability in a global economy.
  • IASB: Issues International Financial Reporting Standards (IFRS).
  • IFRS identify preferred practices, similar to but sometimes different from U.S. GAAP.
  • FASB and IASB are working to reduce differences. (Page 15)

Conceptual Framework

  • Objectives: Provide useful information to investors, creditors, and others.
  • Qualitative characteristics: Information should have relevance and faithful representation.
  • Elements: Defines items in financial statements.
  • Recognition and Measurement: Criteria for an item to be recognized and how to measure it. (Page 16)

Principles, Assumptions, and Constraint

  • General principles: Assumptions, concepts, guidelines for financial statements.
  • Specific principles: Detailed rules for reporting transactions and events. (Page 17)

Accounting Principles

  • Measurement Principle (Cost Principle): Accounting information is based on actual, objective cost.
  • Expense Recognition Principle (Matching Principle): Expenses incurred to generate revenue are recorded.
  • Full Disclosure Principle: Details that could impact decisions are disclosed in notes.
  • Revenue Recognition Principle:
    1. Recognize revenue when goods or services are provided to customers.
    2. Recognize revenue at an amount expected to be received from the customer. (Page 18)

Accounting Assumptions

  • Monetary Unit Assumption: Transactions/events expressed in monetary units.
  • Business Entity Assumption: A business is accounted for separately from its owner(s).
  • Time Period Assumption: Company life divided into periods (months/years).
  • Going-Concern Assumption: Business is presumed to continue operating. (Page 19)

Accounting Constraints

  • Cost-benefit constraint: Benefits to users must exceed the cost of providing information.
  • Materiality constraint: Information that could influence decisions should be disclosed.
  • Conservatism and industry practices can also be constraints. (Page 20)

Proprietorship, Partnership, and Corporation

  • Major attributes of sole proprietorships, partnerships, corporations, and LLCs. (Page 21)

The Accounting Equation (A1)

  • Definition: \text{Assets} = \text{Liabilities} + \text{Equity}
  • Net Income is a component that affects Equity. (Page 22–23)

Quick Glance: Transaction Effects on Accounting Equation

  • Each transaction affects assets, liabilities, and/or equity to keep the equation balanced.
  • Transaction 1: Investment by Owner (30{,}000)
    • Cash (Asset) \uparrow 30{,}000
    • Common Stock (Equity) \uparrow 30{,}000
  • Transaction 2: Purchase Supplies for Cash (2{,}500)
    • Cash (Asset) \downarrow 2{,}500
    • Supplies (Asset) \uparrow 2{,}500 (Net effect on assets is zero)
  • Transaction 3: Purchase Equipment for Cash (26{,}000)
    • Cash (Asset) \downarrow 26{,}000
    • Equipment (Asset) \uparrow 26{,}000 (Net effect on assets is zero)
  • Transaction 4: Purchase Supplies on Credit (7{,}100)
    • Supplies (Asset) \uparrow 7{,}100
    • Accounts Payable (Liability) \uparrow 7{,}100
  • Transaction 5: Provide Services for Cash (4{,}200)
    • Cash (Asset) \uparrow 4{,}200
    • Revenues (Equity component) \uparrow 4{,}200
  • Transaction 6: Payment of Expenses in Cash (Rent 1{,}000, Salaries 700)
    • Cash (Asset) \downarrow 1{,}700
    • Rent Expense (reduces Equity) \uparrow 1{,}000
    • Salaries Expense (reduces Equity) \uparrow 700
  • Transaction 8: Provide Services and Facilities on Credit (1{,}900 total)
    • Accounts Receivable (Asset) \uparrow 1{,}900
    • Consulting Revenues (Equity) \uparrow 1{,}600
    • Rental Revenue (Equity) \uparrow 300
  • Transaction 9: Receipt of Cash from Accounts Receivable (1{,}900)
    • Cash (Asset) \uparrow 1{,}900
    • Accounts Receivable (Asset) \downarrow 1{,}900 (Net effect on assets is zero)
  • Transaction 10: Payment of Accounts Payable (900)
    • Cash (Asset) \downarrow 900
    • Accounts Payable (Liability) \downarrow 900
  • Transaction 11: Payment of Cash Dividend (200)
    • Cash (Asset) \downarrow 200
    • Dividends (reduces Equity) \uparrow 200

Basic Financial Statements and Their Interrelations (P2)

  • Four main financial statements:
    • Income Statement: Reports revenues and expenses to determine net income or loss for a period.
    • Statement of Retained Earnings: Shows changes in retained earnings (Beginning RE + Net Income – Dividends = Ending RE).
    • Balance Sheet: Reports assets, liabilities, and equity at a point in time.
    • Statement of Cash Flows: Shows cash inflows and outflows (operating, investing, financing activities).
  • Interrelations:
    • Net income from Income Statement increases Equity via Retained Earnings on the Balance Sheet.
    • \text{Ending Retained Earnings} = \text{Beginning Retained Earnings} + \text{Net Income} - \text{Dividends}
    • The Balance Sheet links to the Statement of Cash Flows through cash movements.

Additional Core Concepts for Exam Preparation

  • Return on Assets (ROA) (Analytical Objective A2):
    • Formula: \text{ROA} = \frac{\text{Net Income}}{\text{Average Total Assets}}
    • Interpretation: Measures how efficiently a company uses its assets to generate net income.
  • Concepts: Relevance, faithful representation, and their importance for decision making.
  • Ethical considerations: Trust & integrity in reporting; GAAP's role in consistency and comparability.
  • Accounting equation: Basic idea of how changes in accounts affect the equation across transactions; emphasis on balance after each transaction.
  • Real-world relevance: The framework guides reporting for users such as investors, lenders, regulators, and managers.

Quick Recap: Key Exhibits and Terms

  • Exhibit 1.1: Definition of accounting information system.
  • Exhibit 1.2: Opportunities in accounting (private vs public).
  • Exhibit 1.5: Ethics in accounting.
  • Exhibit 1.6: Conceptual Framework components (Objectives, Qualitative Characteristics, Elements, Recognition and Measurement).
  • Exhibit 1.7: General principles, assumptions, and constraints.
  • Exhibit 1.8: Proprietorship, Partnership, Corporation, LLC attributes.
  • Exhibit 1.9: Summary of Transactions (illustrates the balance in the accounting equation).
  • Exhibit 1.10: Financial Statements and their links (interrelations).

Formulas and Notation Summary

  • Fundamental accounting equation: \text{Assets} = \text{Liabilities} + \text{Equity}
  • Revenue recognition principle (two bullets):
    • Revenue is recognized when goods/services are provided.
    • Recognize revenue for the amount expected to be received.
  • Cost principle and matching principle govern measurement and expense timing.
  • Ending Retained Earnings formula: \text{Ending Retained Earnings} = \text{Beginning Retained Earnings} + \text{Net Income} - \text{Dividends}
  • ROA formula: \text{ROA} = \frac{\text{Net Income}}{\text{Average Total Assets}}