Principles of financial accounting 12e by needles crosson chapter 01

Concepts Underlying Accounting Measurement Accounting is an information system that measures, processes, and communicates financial information about a business or other economic ent

Concepts Underlying Accounting Measurement

 Accounting is an information system that

measures, processes, and communicates financial information about a business or other economic

entity.

– An economic entity is a unit that exists independently,

such as a business, hospital, or governmental body.

– Bookkeeping is the process of recording financial

transactions and keeping financial records It is mechanical and repetitive and is usually handled by computers.

– Management information systems (MIS) consist of the interconnected business subsystems, including accounting, that provide the information needed to run a business.

– For accounting purposes, a business organization is a

separate entity , distinct not only from its creditors and customers but also from its owners.

Financial and Managerial Accounting

- External decision

makers use financial

accounting to

evaluate how well a

business has achieved

its goals.

 These reports, called

financial statements , are

 It provides managers and

employees with information about how they have done

 Accounting is usually divided into

financial accounting and managerial

accounting

Business Transactions

 Business transactions are economic

events that affect a business’s financial position.

 All business transactions are recorded in

terms of money This concept is called

money measure

 In international transactions, exchange

rates must be used to translate from

one currency to another An exchange rate is the value of one currency in

Forms of Business Organization

 There are three basic forms of business organization

that are recognized as separate entities.

– Sole proprietorship —a business owned by one person

 The owner takes all the profits or losses of the business

and is liable for all its obligations.

– Partnership —a business that has two or more owners

 The partners share the profits or losses according to a

Concepts Underlying Financial Position

 Financial position refers to a company’s economic resources, such as cash,

inventory, and buildings, and the claims

against those resources at a particular

time Another term for claims is equities.

 Every company has two types of equities: creditors’ equities, such as bank loans,

and owner’s equity The sum of these

equities equals a company’s resources:

Economic Resources = Creditors’ Equities +

Owner’s Equity

 Assets are the economic resources

that are expected to benefit the

company’s future operations They

– nonphysical items (rights granted by

patents, trademarks, and copyrights)

 Liabilities are a business’s present

obligations to pay cash, transfer assets,

or provide services to other entities in

the future They include:

– amounts to suppliers for goods or services bought on credit

– borrowed money such as bank loans

– salaries and wages owed to employees

– taxes owed to the government

– services to be performed

Owner’s Equity

(slide 1 of 2)

 Owner’s equity represents the claims

by the owner of a business to the

assets of the business.

– Theoretically, owner’s equity is what would

be left if all liabilities were paid

– It is sometimes said to equal net assets

– We can define owner’s equity this way:

Owner’s Equity = Assets − Liabilities

Owner’s Equity

(slide 2 of 2)

– Owner’s equity is affected by the owner’s

investment in and withdrawals from the business and by the business’s revenues and expenses.

 Owners’ investments are assets that the owner puts

into the business.

 Withdrawals are assets that the owner takes out of the

business.

 Revenues are increases in owner’s equity that result

from operating a business.

 Expenses are decreases in owner’s equity that result

from operating a business.

 When revenues exceed expenses, this is called net

income

 When expenses exceed revenues, this is called net loss .

Financial Statements

 Four major financial statements are

used to communicate accounting

information: the income statement,

the statement of owner’s equity, the

balance sheet, and the statement of

cash flows.

Income Statement

 The income statement summarizes

the revenues earned and expenses

incurred by a business over an

accounting period.

Statement of Owner’s Equity

 The statement of owner’s equity

shows the changes in owner’s equity

over an accounting period.

Balance Sheet

 The purpose of a balance sheet is to

show the financial position of a

business on a certain date, usually the end of a month or year.

Statement of Cash Flows

on liquidity, that is, balancing the inflows

and outflows of cash to enable the

business to operate and pay its bills when they are due.

– Cash flows are the inflows and outflows of

cash into and out of a business.

– The statement of cash flows is organized

according to three major business activities:

 Cash flows from operating activities

GAAP and the Independent CPA’s Report

 To ensure that financial statements are

understandable to their users, a set of

generally accepted accounting principles (GAAP) has been developed to provide

guidelines for financial accounting.

 Many companies of all sizes have their financial

statements audited by an independent

certified public accountant (CPA)

– An audit is an examination of a company’s financial statements and the accounting systems, controls, and records that produced them It ascertains that the

statements were prepared in accordance with GAAP.

Organizations That Issue Accounting

Standards

 Two organizations issue accounting

standards that are used in the United

– The International Accounting Standards

Board (IASB) issues international financial reporting standards (IFRS) The SEC allows foreign companies to use these standards in the

Other Organizations That Influence GAAP

 The Governmental Accounting Standards Board

(GASB) issues accounting standards for state and local

governments.

 The Internal Revenue Service (IRS) interprets and

enforces the tax laws that specify the rules for determining

taxable income

 The Public Company Accounting Oversight Board

(PCAOB) has wide powers to determine the standards that

auditors must follow.

 The American Institute of Certified Public Accountants

(AICPA) is the primary professional organization of CPAs.

 The Securities and Exchange Commission (SEC) is a

governmental agency that has the legal power to set and

enforce accounting practices for companies whose securities

are offered for sale to the general public.

Professional Conduct

 The code of professional ethics of the American

Institute of Certified Public Accountants governs the

conduct of CPAs The code requires CPAs to act with:

– Integrity —be honest and candid and subordinate personal gain to service and the public trust.

– Objectivity —be impartial and intellectually honest. – Independence —avoid all relationships that impair

or appear to impair objectivity.

– Due care —carry out professional responsibilities

with competence and diligence.

 The Institute of Management Accountants (IMA) ,

the primary professional association of managerial

Decision Makers: The Users of

Accounting Information

 The people who use accounting

information to make decisions fall into three categories: managers (internal

users), outsiders who have a direct

financial interest in the business, and

outsiders who have an indirect financial interest.

Management, Investors, and Creditors

 Management is responsible for ensuring that

a company meets its goals of profitability and liquidity.

 Investors —owners and stockholders—have a

direct financial interest in the success of their companies

 Creditors —those who lend money or deliver

goods or services before being paid—are

interested mainly in whether a company will have the cash to pay interest charges and to repay the debt on time

Business Goals and Activities

 A business is an economic unit that aims

to sell goods and services at prices that

will provide an adequate return to its

owners.

 The two major goals of all businesses are:

– Profitability —the ability to earn enough

income to attract and hold investment capital – Liquidity —the ability to have enough cash to pay debts when they are due

Business Goals and Activities

engaging in the following activities:

– Operating activities —buying, producing, and selling goods and services; hiring managers

and other employees; paying taxes – Investing activities —buying resources for

operating the business, such as land, buildings, and equipment; selling those resources when

no longer needed – Financing activities —obtaining capital from creditors and from the company’s owners;

Financial Analysis

 Financial analysis is the use of financial statements to determine that a business

is well managed and is achieving its goals.

 The effectiveness of financial analysis

depends on:

– Performance measures : Profitability is

commonly measured in net income, and

liquidity is commonly measured by cash flows.

– Financial ratios : The ratio of earnings to total

assets can be used to assess profitability, and

the ratio of cash flows to total assets can be

used to assess liquidity.

Ethical Financial Reporting

 Ethics is a code of conduct that addresses the

question of whether actions are right or wrong.

– The intentional preparation of misleading

financial statements is called fraudulent reporting and can result from distortion of records, falsified transactions, and

misapplication of various accounting principles – In response to the accounting scandals at

Enron Corporation and WorldCom, the

Sarbanes-Oxley Act of 2002 was passed.

 It regulates the financial reporting of public

companies and their auditors.