Unformatted text preview: Chapter 1 | 1, 2, and 6 Define Accounting:
o Accounting is a service activity. Its function is to provide quantitative information, primarily financial in nature,
about economic entities that are intended to be useful in making economic decisions – in making reasoned choices
among alternative course of action. Accounting information is used in making decisions about how to allocate scarce resources. Although accountants place much emphasis on reporting what has already occurred, this past information is
intended to be useful in making economic decisions about the future. Describe the functions performed by accountants:
o Accountants analyze and interpret financial information, prepare financial statements, conduct audits, design
accounting systems, prepare special business and financial studies, prepare forecasts and budgets, and provide tax
services. Accountants observe many events/activities and identify and measure in financial terms (dollars) those
events considered evidence of economic activity. (Often, these three functions are collectively referred to as
analyze.) The purchase and sale of goods and services are economic events. Next, the economic events are recorded, classified into meaningful groups, and summarized. Accountants report on economic events (or business activity) by preparing financial statements and
special reports. Often accountants interpret these statements and reports for various groups such as
management, investors, and creditors. Interpretation may involve determining how the business is
performing compared to prior years and other similar businesses. User of Accounting Information:
o Stakeholders: All parties interested in the financial health of the company (have something at stake). Internal Users: Are stakeholders who make decisions that directly affect the internal operations of the
enterprise. External Users: Are stakeholders who make decisions concerning their relationship to the enterprise. Stockholder vs Stakeholder:
o Stockholders and creditors are two of the outside parties who need financial accounting
information. These outside parties decide on matters pertaining to the entire company,
such as whether to increase or decrease their investment in a company or to extend credit
to a company. External Investors:
o Creditors: Need information about the profitability and stability of the company to decide whether to lend money to
the company and, if so, what interest rate to charge.
o Investors: Both existing stockholders and potential investors, need information concerning the safety and
profitability of their investment. Differentiate between financial and managerial accounting:
o Management Accounting: is concerned primarily with financial reporting for internal users, especially
management. (Internal) (Accounting standards: Flexible) (As needed)
o Financial Accounting: Focuses on the development and communication of financial information for external users.
(Accounting standards: US GAAP or IFRS) (Annual/Quarterly) Primarily for external use (although management also uses them for certain internal issues) Helps users in determining whether a company’s operations are profitable enough to justify additional
funding. Stockholders and creditors are two of the outside parties who need financial accounting information. Helps users in determining how risky a company’s operations are in order to determine what rate of return
is necessary to compensate capital providers for the investment risk. Identify several organizations that have a role in the development of financial accounting standards.
o Several organizations are influential in the establishment of generally accepted accounting principles (GAAP) for
businesses or governmental organizations: American Institute of Certified Public Accountants (AICPA) The American Institute of Certified Public Accountants (AICPA) is the professional organization of
practicing certified public accountants (CPAs) in the United States. It publishes the monthly journal, the Journal of Accountancy. The AICPA is responsible for preparing and grading the Uniform CPA Examination. The AICPA continues to influence the establishment of accounting standards. The American Accounting Association (AAA) is an organization of accounting professors. It sponsors national and regional meetings where accounting professors discuss technical research
and share innovative teaching techniques and materials. The AAA publishes a number of academic journals, including The Accounting Review and
Accounting Horizons. Professional organization of CPAs. Many of these CPAs are in public accounting practice.
Continues to influence the development of accounting standards and practices. Two of its
committees—the Accounting Standards Committee and the Auditing Standards Committee—are
particularly influential in providing input to the Financial Accounting Standards Board (the current
rule-making body) and to the Securities and Exchange Commission and other regulatory agencies.
Financial Accounting Standards Board (FASB) Independent, 7 member, replaced the Accounting Principles Board. The FASB is the private sector organization now responsible for the development of new financial
accounting standards in the US, has no legal authority. Members are required to sever all connections with their firms or institutions prior to assuming
membership on the Board. Members are appointed for 5-year terms and are eligible for reappointment to one additional term. Appointment of new Board members is done by the Financial Accounting Foundation (FAF). The FAF serves somewhat like a board of directors overseeing the FASB. The FAF is also responsible for selecting and supporting members of the Governmental
Accounting Standards Board (GASB). The major functions of the FASB are to study issues and to establish accounting standards. These standards are published as Accounting Standards Updates. The FASB has also issued Statements of Financial Accounting Concepts that provide a
framework within which specific accounting standards can be developed. The various FASB pronouncements are referred to as U.S. Generally Accepted Accounting
Principles (GAAP). Prior to 2009, finding a specific accounting rule on a specific topic involved a primitive hunt-andpeck strategy. You would need to search among the various types of pronouncements. In July 2009, all the FASB pronouncements that make up U.S. GAAP were compiled in the FASB
Accounting Standards Codification (ASC). The FASB Accounting Standards Codification (ASC) is today the single repository of U.S.
GAAP standards. Governmental Accounting Standards Board (GASB) Was established with a full-time chairperson and four part-time members. The GASB issues statements on accounting and financial reporting in the governmental area. This organization is the private sector organization now responsible for the development of new
governmental accounting concepts and standards. The GASB also has the authority to issue interpretations of these standards.
Securities and Exchange Commission (SEC) The SEC was created by an act of Congress in 1934. Its primary role is to regulate the issuance and trading of securities by corporations to the general
public. It requires companies to furnish various financial statements, and other periodic information about
significant events. The SEC requires companies to have their external financial statements audited by independent
accountants. Is a government agency that administers important acts dealing with the interstate sale of securities
(stocks and bonds). The SEC has the authority to prescribe accounting and reporting practices for companies under its
jurisdiction. This includes virtually every major US business corporation. SEC has adopted a policy of working closely with the accounting profession, especially the FASB,
in the development of accounting standards.
The SEC indicates to the FASB the accounting topics it believes the FASB should address. In addition to the SEC’s rules and interpretive releases, the SEC staff issues Staff Accounting
Bulletins that represent practices followed by the staff administering SEC disclosure requirements. The auditors of SEC-required financial information must be registered and periodically inspected
by the Public Company Accounting Oversight Board (PCAOB). American Accounting Association (AAA) Consisting largely of accounting educators, has sought to encourage research and study at a
theoretical level into the concepts, standards, and principles of accounting.
Financial Executives Institute (FEI) An organization whose members are primarily financial policy-making executives. Many of its members are chief financial officers (CFOs – in charge of the accounting activity) of
very large corporations. The role of the CFO has evolved in recent years from number cruncher to strategic planner. FEI is very effective in representing the views of the private financial sector to the FASB and to
the Securities and Exchange Commission and other regulatory agencies.
Institute of Management Accountants (IMA) An organization with approximately 70,000 members, consisting of management accountants in
private industry, CPAs, and academics. Primary focus of the organization is on the use of management accounting information for internal
decision making. Management accountants prepare the financial statements for external users. Thus, through its
Management Accounting Practices (MAP) Committee and other means, the IMA provides input
on financial accounting standards to the Financial Accounting Standards Board and to the
Securities and Exchange Commission and other regulatory agencies.
Internal Revenue Service (IRS) The Internal Revenue Service (IRS) has the primary goal of equitably collecting revenue. Although not the same, there are many areas where tax and financial accounting are closely
International Accounting Standards Board (IASB) The international nature of business requires companies to be able to make their financial
statements understandable to users all over the world. In an attempt to harmonize conflicting standards, the International Accounting Standards Board
(IASB) was formed in 1973 to develop worldwide accounting standards. Similar to FASB, IASB develops proposals, circulates these among interested organizations,
receives feedback, and then issues a final pronouncement. Board members are representatives from the United States, the United Kingdom, France, Sweden,
China, Australia, South Africa, Brazil, and Japan. Accounting standards issued by the IASB are referred to as International Financial Reporting
Standards (IFRS) if issued since 2001, and International Accounting Standards (IAS) if issued
prior to 2001.
In 2008 the SEC began allowing non-U.S. companies with shares trading on U.S. stock exchanges
to issue their financial reports using IASB standards.
Appendix A in your textbook contains a summary of differences between U.S. GAAP and IFRS. The SEC is considering whether to allow U.S. companies to use IASB standards, rather than
FASB standards, in the financial reports that they provide to their U.S. stockholders. If this happens, the FASB may cease to exist. The SEC “work plan” does not envision a U.S. switch to IFRS until 2016 at the earliest, although
some standards have already converged. Business Entity Concept:
o For accounting purposes, each business organization or entity has an existence separate from its owner(s), creditors,
employees, customers, and other businesses. Accounting records of the business entity, the activities of each business should be kept separate from the
activities of other businesses and from the personal financial activities of the owner(s). Identify and describe the three basic forms of business organizations:
o Single Proprietorship: Unincorporated business owned by an individual and often managed by that same person. Single
proprietors include physicians, lawyers, electricians, and other people in business for themselves. No legal formalities are necessary to organize such businesses, and usually business operations can begin
with only a limited investment. Owner is solely responsible for all debts of the business.
o Partnership: Unincorporated business owned by two or more persons associated as partners. Many small retail establishments and professional practices, such as dentists, physicians, attorneys, and
many CPA firms, are partnerships. A partnership begins with a verbal or written agreement. Each partner may be held liable for all the debts of the partnership and for the actions of each partner
within the scope of the business.
o Corporation: A business incorporated under the laws of a state and owned by a few stockholders or thousands of
stockholders. Almost all large businesses and many small businesses are incorporated. The corporation is unique in that it is a separate legal business entity. The owners of the corporation are stockholders, or shareholders. They buy shares of stock, which are units of ownership, in the corporation. Should the corporation
fail, the owners would only lose the amount they paid for their stock. The corporate form of business protects the personal assets of the owners from the
creditors of the corporation. Stockholders do not directly manage the corporation. They elect a board of directors to represent their
interests. The board of directors selects the officers of the corporation, such as the president and vice
presidents, who manage the corporation for the stockholders. Three types of activities performed by business organizations:
o Service Companies: Perform services for a fee. This group includes accounting firms, law firms, and dry cleaning
o Merchandising Companies: Purchase goods that are ready for sale and then sell them to customers. Merchandising companies include
auto dealerships, clothing stores, and supermarkets.
o Manufacturing Companies: Buy materials, convert them into products, and then sell the products to other companies or to the final
consumers. Manufacturing companies include steel mills, auto manufacturers, and clothing manufacturers. Describe the content and purposes of the income statement, statement of retained earnings, balance sheet, and
statement of cash flows:
o Income Statement (aka Earnings statement): Financial statement that reflects the company’s profitability (ability to generate income) for a stated period
of time. Measure profitability for a period (month or year) by comparing revenues (inflows of assets/cash)
with the expenses incurred to produce these revenues. Expenses are measured by the assets surrendered or consumed in serving customers. If the revenues of a period exceed the expenses of the same period, net income results. Net Income = Revenues – Expenses Net Income is often called the earnings of the company. When expenses exceed revenues, the business has a net loss, and it has
operated unprofitably. o Revenues (or delivery fees) generated by serving customers for July
totaled USD 5,700.
Expenses for the month amounted to USD 3,600.
Metro’s net income (Revenues – Expenses) for July was USD 2,100. Statement of Retained Earnings: Retained earnings are the profits or net income that a company chooses to keep rather than
distribute it to the shareholders (retained earnings represent undistributed net income | Net income –
dividends Shows the change in retained earning between the beginning and end of a period (i.e. a month or a year). Explains the changes in retained earnings between two balance sheet dates. These changes usually consist of the addition of net income (or deduction of net loss) and the
deduction of dividends (means by which a corporation rewards its stockholders (owners) for
providing it with investment funds | dividend is a payment (usually of cash) to the owners of the
business; it is a distribution of income to owners rather than an expense of doing business.) Corporations are not required to pay dividends and, because dividends are not an expense,
they do not appear on the income statement.
The effect of a dividend is to reduce cash and retained earnings by the amount paid out. Then, the
company no longer retains a portion of the income earned but passes it on to the stockholders. Organized on June 1, Metro did not earn any revenues or incur any expenses during June. So
Metro’s beginning retained earnings balance on July 1 is zero.
Metro then adds its USD 2,100 net income for July.
Since Metro paid no dividends in July, the USD 2,100 would be the ending balance of
Next, Metro carries this USD 2,100 ending balance in retained earnings to the balance sheet If there had been a net loss, it would have deducted the loss from the beginning balance
on the statement of retained earnings. For instance, if during the next month (August) there is a net loss of $500, the
loss would be deducted from the beginning balance in retained earnings of USD
2,100. The retained earnings balance at the end of August would be USD 1,600. Dividends could also have affected the Retained Earnings balance. To give a more realistic illustration, assume that (1) Metro Courier, Inc.’s net income for August was actually USD
1,500 (revenues of USD 5,600 minus expenses of USD 4,100) (2) The company declared and paid dividends of USD 1,000. Then,
Metro’s statement of retained earnings for August would be: o Balance Sheet (aka Statement of financial position): Reflects a company’s solvency (ability to pay debts) and financial position. | Reports, as of a certain point
in time, the resources of a company (the assets – things of value owned by a business/also called
resources), the company’s obligations (the liabilities – debts owed by business), and the equity of the
owners (stockholder equity). That specific moment is the close of business on the date of the balance sheet. o Assets of chart: Metro’s assets ($38,700) consist of cash, accounts receivable (amounts due from
customers for services previously rendered), trucks, and office equipment. Liabilities of chart: Metro’s liabilities consist of accounts payable (amounts owed to suppliers for
previous purchases) and notes payable (written promises to pay a specific sum of money) totaling USD
6,600. Stockholder equity of chart: Metro’s stockholders’ equity consists of (1) USD 30,000 paid for shares of
capital stock (shows the amount of the owners’ investment in the corporation) and (2) retained earnings
(consists of the accumulated net income of the corporation minus dividends distributed to stockholders.)
of USD 2,100.
Statement of Cash Flows: Shows the cash inflows and outflows for a company over a period of time. | The amount of cash generated
and consumed by a company through the following three types of activities: O Operating (include the cash effects of transactions and other events that enter into the
determination of net income.) Financing (include the cash effects of transactions and other events involving creditors and
owners (stockholders). Investing (include business transactions involving the acquisition or disposal of long-term assets
such as land, buildings, and equipment) activities. These determine the company’s cash it has available to pay its bills when due Normally, a firm prepares a statement of cash flows for the same time period as the income statement. The following statement, however, shows the cash inflows and outflows for Metro Courier, Inc.,
since it was formed on 2010 June 1. Thus, this cash flow statement is for two months. Basic Accounting Equation and describe relationship to balance sheet:
o A company's equity would equal its total assets if it hypothetically had no liabilities | Assets = Equities | Assets =
Liabilities + Stockholders Equity / Assets = Debt + Equity The balance between assets, liability, and equity makes sense when applied to a more
straightforward example, such as buying a car for $10,000. In this case, you might use a $5,000 loan
(debt), and $5,000 cash (e...
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