1. 1 Accounting Principles and the Financial Statements
C H A P T E R
Accounting Principles and the Financial Statements
Principles of Accounting
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2. LEARNING OBJECTIVES
LO1: Define accounting, and explain the concepts underlying accounting measurement.
LO2: Define financial position, and state the accounting equation.
LO3: Identify the four basic financial statements and their interrelationships.
LO4: Explain how generally accepted accounting principles (GAAP) and international financial reporting standards (IFRS) relate to financial statements and the independent CPA’s report, and identify the organizations that influence GAAP.
LO5: Identify the users of accounting information, and identify business goals, activities, and performance measures.
LO6: Explain the importance of ethics in financial reporting.
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3. SECTION 1: CONCEPTS
Accounting measurement: measuring business activities by recording data about them for future use
Business transactions: economic events that affect a business’s financial position
Money measure: the concept that all business transactions are recorded in terms of money
Separate entity: the concept that a business organization is distinct from its owners, creditors, and customers
Assets: economic resources that are expected to benefit the company’s future operations
Liabilities: a business’s obligations to pay cash, transfer assets, or provide services to other entities in the future
Owner’s equity: the claims by the owner of a business to the assets of the business; sometimes said to equal net assets
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4. 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.
As shown on the next slide, accounting is a link between business activities and decision makers.
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5. Accounting as an Information System
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6. Financial and Managerial Accounting
Accounting is usually divided into financial accounting 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 a central feature of accounting. They report on a business’s financial performance.
Internal decision makers use information provided by managerial accounting about operating, investing, and financing activities.
It provides managers and employees with information about how they have done in the past and what they can expect in the future.
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7. Financial and Managerial Accounting
It is important to distinguish accounting from bookkeeping and management information systems.
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.
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8. Accounting Measurement
To make an accounting measurement, the accountant must answer four basic questions:
What is measured?
When should the measurement be made?
What value should be placed on what is measured?
How should what is measured be classified?
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9. Business Transactions
Business transactions are economic events that affect a business’s financial position.
A transaction can be an exchange of value (a purchase, sale, payment, collection, or loan) between two or more parties.
A transaction also can be an economic event that does not involve an exchange, such as losses from fire, flood, explosion, and theft; physical wear and tear on machinery and equipment, and the day-by-day accumulation of interest.
To be recorded, a transaction must relate directly to a business entity.
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10. Money Measure
All business transactions are recorded in terms of money. This concept is called money measure.
The monetary unit a business uses depends on the country in which the business resides. In the United States, the basic unit of money is the dollar.
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 terms of another.
The next slide illustrates the exchange rates of several currencies in dollars.
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11. Examples of Foreign Exchange Rates
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12. Separate Entity
For accounting purposes, a business organization is a separate entity, distinct not only from its creditors and customers but also from its owners.
It should have its own set of financial records, and its records and reports should refer only to its own affairs.
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13. Forms of Business Organization (slide 1 of 2)
Three basic forms of business organization are recognized as separate entities.
Sole proprietorship—a business owned by 1 person
The owner takes all the profits or losses of the business and is liable for all its obligations.
Partnership—a business with 2 or more owners
The partners share the profits or losses according to a prearranged formula.
A partnership must be dissolved if a partner leaves or dies.
The partners have unlimited liability, which can be avoided by organizing as a limited liability partnership.
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14. Forms of Business Organization (slide 2 of 2)
Corporation—a business unit chartered by the state and legally separate from its owners
The owners are called stockholders because their ownership is represented by shares of stock.
The stockholders do not directly control the corporation’s operations but elect a board of directors to run the corporation for their benefit.
Stockholders enjoy limited liability, which means that their risk of loss is limited to the amount they paid for their shares.
Stockholders can sell their shares without dissolving the corporation, so the life of a corporation is unlimited.
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15. Number and Receipts (Revenues) of U. S
Number and Receipts (Revenues) of U.S. Proprietorships, Partnerships, and Corporations
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17. 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
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18. Concepts Underlying Financial Position
In accounting terminology, economic resources are called assets and creditors’ equities are called liabilities, so the equation can be written:
Assets = Liabilities + Owner’s Equity
This equation is known as the accounting equation
(A = L + OE).
The two sides of the equation must always be equal, or “in balance,” as shown on the next slide.
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19. The Accounting Equation
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20. Assets
Assets are the economic resources that are expected to benefit the company’s future operations. They include:
monetary items (cash and money owed to the company by customers)
nonmonetary, physical items (inventories, land, buildings, equipment)
nonphysical items (rights granted by patents, trademarks, and copyrights)
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21. Liabilities
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 (called accounts payable)
borrowed money such as bank loans
salaries and wages owed to employees
taxes owed to the government
services to be performed
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22. 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
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23. 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, the difference is called net income.
When expenses exceed revenues, the difference is called net loss.
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24. ©2014 Cengage Learning. All Rights Reserved
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25. SECTION 2: ACCOUNTING APPLICATIONS
Describe the income statement
Describe the statement of owner’s equity
Describe the balance sheet
Describe the statement of cash flows
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26. 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.
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27. Income Statement
The income statement summarizes the revenues earned and expenses incurred by a business over an accounting period.
Many people consider it the most important financial report because it shows whether a business achieved its profitability goal—that is, whether it earned an acceptable income.
To show the period to which the statement applies, it is dated “For the [Month/Year] Ended [Date]”
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28. Income Statement for Roland Consultancy
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29. Statement of Owner’s Equity
The statement of owner’s equity shows the changes in owner’s equity over an accounting period.
Owner’s equity is affected by investments in the business by the owner, net income (or loss), and withdrawals by the owner.
The net income or loss on the statement of owner’s equity comes from the income statement.
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30. Statement of Owner’s Equity for Roland Consultancy
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31. 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.
For this reason, it is often called the statement of financial position.
The date on the balance sheet is a single date, whereas the dates on the other three statements cover a period of time.
The amount of the owner’s capital account on the balance sheet comes from the ending balance on the statement of owner’s equity.
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32. Balance Sheet for Roland Consultancy
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33. Statement of Cash Flows
The statement of cash flows focuses 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
Cash flows from investing activities
Cash flows from financing activities
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34. Statement of Cash Flows for Roland Consultancy
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35. Relationships Among the Financial Statements
As shown on the next slide, the statement of cash flows is related directly to the other three financial statements.
Net income comes from the income statement.
Withdrawals—and investments by the owner—come from the statement of owner’s equity.
The other items in the statement represent changes in the balance sheet accounts.
The heading at the top of each statement identifies the company and the kind of statement.
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36. Income Statement, Statement of Owner’s Equity, Balance Sheet, and Statement of Cash Flows for Roland Consultancy
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37. ©2014 Cengage Learning. All Rights Reserved
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38. Generally Accepted Accounting Principles
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.
They encompass the conventions, rules, and procedures necessary to define accepted accounting practice at a particular time.
They evolve to meet the needs of decision makers, and they change as circumstances change or as better methods are developed.
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39. GAAP and the Independent CPA’s Report
Many companies of all sizes have their financial statements audited by an independent certified public accountant (CPA).
Independent means that the CPA is not an employee of the company being audited and has no financial or other compromising ties to it.
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.
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40. Large International Certified Public Accounting Firms
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41. Organizations That Issue Accounting Standards
Two organizations issue accounting standards that are used in the United States:
The Financial Accounting Standards Board (FASB) has been designated by the Securities and Exchange Commission (SEC) to issue Statements of Financial Accounting Standards.
The International Accounting Standards Board (IASB) issues international financial reporting standards (IFRS). The SEC allows foreign companies to use these standards in the United States.
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42. Other Organizations That Influence GAAP (slide 1 of 2)
Many other organizations influence GAAP:
The Governmental Accounting Standards Board (GASB) is a separate but related body to the FASB that 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. In some cases the rules conflict with good accounting practice, but they are important nonetheless.
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43. Other Organizations That Influence GAAP (slide 2 of 2)
The Public Company Accounting Oversight Board (PCAOB) is a governmental body that 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 certified public accountants.
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.
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44. 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.
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45. Professional Conduct
The Institute of Management Accountants (IMA), the primary professional association of managerial accountants, has a code of professional conduct that emphasizes that these accountants have a responsibility:
To be competent in their jobs
To keep information confidential unless authorized or legally required to disclose it
To maintain integrity and avoid conflicts of interest
To communicate information objectively, without bias
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46. ©2014 Cengage Learning. All Rights Reserved
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47. SECTION 3: BUSINESS APPLICATIONS
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
Ethics: a code of conduct that addresses the question of whether actions are right or wrong
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48. 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.
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49. Management
Management is responsible for ensuring that a company meets its goals of profitability and liquidity.
To make good decisions, owners and managers need answers to such questions as:
What were the company’s earnings during the past quarter?
Is the rate of return to the owners adequate?
Does the company have enough cash?
Which products or services are most profitable?
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50. Users with a Direct Financial Interest
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. They study a company’s cash flow to determine its liquidity.
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51. Users with an Indirect Financial Interest
Tax authorities—federal, state, and local
Regulatory agencies—such as the SEC for publicly traded corporations
Labor unions
Advisors of investors and creditors
Consumer groups, customers, the general public
Economic planners—such as the President’s Council of Economic Advisers
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52. Governmental and Not-for-Profit Organizations
These include hospitals, universities, professional organizations, and charities.
Their functions include:
raising funds from investors, creditors, taxpayers, and donors
deploying scarce resources
planning how to pay for operations and to repay creditors on a timely basis
reporting their financial performance to legislators, boards, and donors
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53. 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
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54. Business Goals and Activities
All businesses pursue their goals by 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; repaying creditors; paying a return to owners
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55. Business Goals and Activities
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56. The effectiveness of financial analysis depends on:
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.
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57. ©2014 Cengage Learning. All Rights Reserved
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58. Ethical Financial Reporting
Ethics is a code of conduct that addresses the question of whether actions are right or wrong.
Ethics is especially important in preparing financial reports because users must be able to trust that the reports are accurate and disclose all relevant facts.
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.
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59. Ethical Financial Reporting
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.
It requires chief executives and chief financial officers of all publicly traded U.S. companies to swear that, based on their knowledge, their quarterly statements and annual reports filed with the SEC are accurate and complete.
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60. ©2014 Cengage Learning. All Rights Reserved
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