Uses of Accounting Information and the Financial Statements Chapter 1 Uses of Accounting Information and the Financial Statements

What Is Accounting? Accounting is an information system that measures, processes, and communicates financial information about an economic entity © Royalty-Free/Corbis Supplies information for reasoned choices among alternative uses of scarce resources in business and economic activities Copyright © Cengage Learning. All rights reserved.

Economic Entity: Business Economic unit that aims to sell goods and services to customers © Royalty-Free/Corbis Provides adequate return to owners Examples: Wal-Mart, Best Buy, Wendy’s Copyright © Cengage Learning. All rights reserved.

Why Is Accounting Important to Business? To achieve business goals To carry on business activities Profitability Liquidity Operating Investing Financing Copyright © Cengage Learning. All rights reserved.

Meeting Business Goals Profitability Is the business earning enough income to attract and hold investment capital? Liquidity Does the business have enough cash to pay debts when they are due? © Royalty Free C Squared Studios/ Getty Images Copyright © Cengage Learning. All rights reserved.

Conducting Business Activities Operating Activities Investing Activities Financing Activities Selling goods and services to customers Employing managers and workers Buying and producing goods and services Paying taxes Buying land, buildings, and equipment Purchasing other resources necessary to operate the business Selling these resources when no longer needed Obtaining capital from creditors Securing loans Gathering funds from owners Repaying creditors Paying returns to owners Copyright © Cengage Learning. All rights reserved.

Performance Measures Indicate whether managers are achieving business goals and whether business activities are well managed © Royalty Free PhotoDisc Collection/ Getty Images Should be crafted in a way that motivates managers to act in the best interests of the owners of the business Copyright © Cengage Learning. All rights reserved.

Performance Measures: Ratios Used to compare a company’s financial performance from one year to the next Helpful when making comparisons among companies Return on Assets = how much is earned on each dollar invested in assets Copyright © Cengage Learning. All rights reserved.

Who Needs Accounting Information? Internal Users External Users Stockholders Creditors Government regulators Employees Managers Management Accounting Information about past performance and what can be expected in the future Financial Accounting Financial statements report on profitability and liquidity to evaluate the success of a business Copyright © Cengage Learning. All rights reserved.

Components of Accounting System Design Record Transactions: Bookkeeping Accounting Analyze & Interpret Information Communicate Information Processing can be done: Manually, By computer, or Using a management information system © Royalty Free C Squared Studios/ Getty Images Copyright © Cengage Learning. All rights reserved.

Importance of Ethics in Financial Reporting Users of reports depend on the good faith of those who prepared the reports Users rely on the accuracy of the reports and the disclosure of all relevant facts © Royalty Free C Squared Studios/ Getty Images Investors make decisions based on the reliability of the reports Copyright © Cengage Learning. All rights reserved.

Sarbanes-Oxley Act Violations can result in criminal penalties Chief executives and chief financial officers of all publicly traded U.S. companies must attest to the accuracy and completeness of their quarterly statements and annual reports filed with the SEC Violations can result in criminal penalties Want to learn more about the legislation? On the Web Sarbanes-Oxley.com Copyright © Cengage Learning. All rights reserved.

Management Responsibility What assurance does management give that a company’s reports are not false or misleading? Research: Find the current year’s annual report for CVS on the company’s website and locate the “Management’s Report.” What language is used? CVS’s SEC Filings On the Web We are responsible for establishing and maintaining effective internal control over financial reporting. . . . the unauthorized acquisition, use or disposition of assets are prevented or timely detected and that transactions are authorized, recorded and reported properly to permit the preparation of financial statements in accordance with GAAP and receipt and expenditures are duly authorized. Copyright © Cengage Learning. All rights reserved.

Who Uses Accounting Information? Management Those With Direct Financial Interests Those With Indirect Financial Interests Finance Investment Operations & Production Marketing Human Relations Accounting Tax Authorities Regulators Labor Unions Customers Economic Planners Investors Creditors Banks Copyright © Cengage Learning. All rights reserved.

If You Were a Manager… Making good financial decisions requires reliable accounting information. Does my company have enough cash? Which products are most profitable? Is the rate of return to owners adequate? © Royalty Free C Squared Studios/ Getty Images Copyright © Cengage Learning. All rights reserved.

Users with Direct Financial Interests Creditors Require financial data to assess whether a company will have the cash to repay debt before making a loan Investors Require financial information to analyze the past success and potential earnings of a business Copyright © Cengage Learning. All rights reserved. © Royalty Free PhotoDisc Collection/ Getty Images

Users with Indirect Financial Interests Tax Authorities – require special tax returns and recordkeeping Regulatory Agencies – publicly traded companies must report periodically to the SEC Labor Unions, Consumer Groups, Customers, and Other Groups – the financial performance and prospects of businesses affect the economy, environment, and public policy © Royalty-Free/Corbis Copyright © Cengage Learning. All rights reserved.

Making an Accounting Measurement What is measured? Business transactions Economic events that affect the financial position of a business Sale of goods Loss from theft Collection of loan Wear and tear on machinery Copyright © Cengage Learning. All rights reserved.

Concept of Money Measure All business transactions are recorded in terms of money. The monetary unit used depends on the country in which the business resides. An exchange rate is used to translate one currency to another for international transactions. Copyright © Cengage Learning. All rights reserved.

Concept of Separate Entity A business is considered distinct from its creditors and customers as well as its owners Business reports & accounts Personal reports & accounts Copyright © Cengage Learning. All rights reserved.

Forms of Business Sole Proprietorship Partnership Corporation One owner Owner takes all profits and losses Owner is liable for all business obligations Two or more owners Partners share in profits and losses One partner can obligate the business to another party Must be dissolved if ownership changes Business unit chartered by the state with articles of incorporation; legally separate from owners (stockholders) Stockholders enjoy limited liability Life of corporation is unlimited Copyright © Cengage Learning. All rights reserved.

The Corporation as a Separate Entity © Royalty-Free/Corbis Copyright © Cengage Learning. All rights reserved.

Organization of a Corporation Stockholders Elect a board of directors and own shares of stock Board of Directors Determines corporate policy, declares dividends, and appoints corporate officers Management Carries out corporate policies and manages the business Copyright © Cengage Learning. All rights reserved.

In a recent survey, 78% of boards Corporate Governance Oversight of a corporation’s management and ethics by the board of directors Ethical practices are in the best interest of the business Companies with codes of ethics tend to have higher stock prices than those without codes Use of audit committees helps ensure that adequate systems are in place to safeguard resources In the News: In a recent survey, 78% of boards of directors established ethical standards for their companies Copyright © Cengage Learning. All rights reserved.

Financial Position Economic resources (cash, inventory, buildings) and the claims against those resources at a particular point in time © Royalty Free PhotoDisc Collection/ Getty Images Economic Resources = Creditors’ Equities + Stockholders’ Equity Copyright © Cengage Learning. All rights reserved.

Building the Accounting Equation Economic Resources = Creditors’ Equities + Stockholders’ Equity In accounting terms… Assets = Liabilities + Stockholders’ Equity The two sides of the equation must always be in balance. Copyright © Cengage Learning. All rights reserved.

Assets Economic resources expected to benefit the company’s future operations Inventory, land, equipment, buildings (physical items) © Royalty-Free/Corbis Cash, accounts receivable (monetary items) Patents, trademarks, copyrights (nonphysical) Copyright © Cengage Learning. All rights reserved.

Liabilities Obligations to pay cash, transfer assets, or provide services to other entities in the future May take the form of accounts payable, taxes payable, loans, or wages owed to employees Liabilities are claims recognized by law Copyright © Cengage Learning. All rights reserved.

Stockholders’ Equity Claims of the owners of a corporation to the assets of the business Stockholders’ Equity Contributed Capital Retained Earnings (RE) Amount that stockholders invest in the business Generated by business operations and kept for use in the business Capital Stock Expenses and dividends decrease RE Revenues increase RE Par value Add’l paid-in capital Copyright © Cengage Learning. All rights reserved.

Communicating Financial Information Four primary financial statements Income Statement Balance Sheet Statement of Retained Earnings Statement of Cash Flows © Royalty-Free/Corbis Copyright © Cengage Learning. All rights reserved.

Income Statement Often considered the most important financial statement Summarizes revenues and expenses over an accounting period Shows whether the goal of profitability was achieved Copyright © Cengage Learning. All rights reserved.

Statement of Retained Earnings Shows changes in retained earnings over an accounting period Use this figure to prepare the balance sheet Net income figure from income statement Copyright © Cengage Learning. All rights reserved.

Shows financial position on a certain date Balance Sheet Shows financial position on a certain date Ending balance of retained earnings from statement of retained earnings Copyright © Cengage Learning. All rights reserved.

Statement of Cash Flows Shows cash inflows and outflows for an accounting period Net income from income statement Matches cash account on balance sheet Copyright © Cengage Learning. All rights reserved.

What Are GAAP? Generally accepted accounting principles (GAAP) encompass the conventions, rules, and procedures necessary to define accepted accounting practice at a particular time. GAAP are constantly growing, changing, and improving Copyright © Cengage Learning. All rights reserved.

GAAP and the Audit Audits are performed to determine that financial statements have been prepared in accordance with GAAP Audits are performed by independent CPAs The CPA renders an opinion about whether the statements present fairly or conform in all material respects to GAAP Copyright © Cengage Learning. All rights reserved.

Organizations That Influence GAAP Financial Accounting Standards Board (FASB) Primary source of GAAP Public Company Accounting Oversight Board (PCAOB) International Accounting Standards Board (IASB) GAAP Securities and Exchange Commission (SEC) American Institute of Certified Public Accountants (AICPA) Governmental Accounting Standards Board (GASB) Copyright © Cengage Learning. All rights reserved.

Professional Conduct Key to the accountant’s reputation for independence and competence The AICPA’s code of professional ethics governs conduct of CPAs Is the accountant honest and candid? Does he or she put aside personal gain in service of the public trust? Integrity Is the accountant impartial and intellectually honest? Objectivity Does the accountant avoid all relationships that impair or appear to impair his or her objectivity? Independence Copyright © Cengage Learning. All rights reserved.

Discussion: Ethics on the Job Carla McDonald is a CPA working on an audit with Trevor Industries. Teresa Wong, the staff accountant with Trevor Industries, invites her and her audit team to dinner at an expensive restaurant and insists on picking up the check. Q. If Carla allows Teresa to pick up the check, has she violated any ethical standard? Why or why not? Copyright © Cengage Learning. All rights reserved.