needles powers crosson principles of accounting 12e accounting principles and the financial...

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Principles of Accounting

12e

Accounting Principles and the Financial Statements1

C H A P T E R

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LEARNING OBJECTIVES

©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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.

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

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.


Accounting as an Information System


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 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.


Accounting is usually divided into financial accounting and managerial accounting.

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.


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?


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.


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.


Examples of Foreign Exchange Rates


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.


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.


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.


Number and Receipts (Revenues) of U.S. Proprietorships, Partnerships, and Corporations


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


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.


The Accounting Equation


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)


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


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, the difference is

called net income. When expenses exceed revenues, the difference is

called net loss.


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


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.– 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]”


Income Statement for Roland Consultancy


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.


Statement of Owner’s Equity for Roland Consultancy


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.


Balance Sheet for Roland Consultancy


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


Statement of Cash Flows for Roland Consultancy


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.


Income Statement, Statement of Owner’s Equity, Balance Sheet, and Statement of Cash Flows for Roland Consultancy


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.


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.


Large International Certified Public Accounting Firms


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.


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.


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.


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.


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


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


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

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?


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.


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


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


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



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


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.– 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.


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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