financial accounting and its environment chapter 1

Financial Accounting Financial Accounting and Its Environmentand Its Environment

Chapter 1

Major Types of AccountingMajor Types of Accounting

• Financial accounting provides information to decision makers who are external to the business.– Examples include present and future

shareholders, present and future creditors, and government regulators.

Major Types of AccountingMajor Types of Accounting

• Managerial accounting provides information to decision makers who are internal to the business.– This information is not published to

people outside of the business.

Major Types of AccountingMajor Types of Accounting

• Tax accounting involves tax compliance and tax planning.– Tax compliance involves the

calculation of the company's tax liability after the transactions for a year have been completed.

Major Types of AccountingMajor Types of Accounting

• Tax accounting involves tax compliance and tax planning.– Tax planning involves the

consideration of a transaction before it has taken place in order to determine tax consequences.

Major Types of AccountingMajor Types of Accounting

• Accounting Information Systems – The processes and procedures

required to generate accounting information.

Major Types of AccountingMajor Types of Accounting

• Nonbusiness Organization Accounting – Deals with the accounting needs of

organizations which do not attempt to earn a profit, such as hospitals, colleges, and churches.

Overview of Financial AccountingOverview of Financial Accounting

FinancialStatements

DecisionMakers

PastTransactions andOther Economic

Events

FinancialAccounting

Process

The Financial Accounting ProcessThe Financial Accounting Process

• Categorize past transactions and events.

• Measure attributes of those transactions and events.

• Record and summarize the measurements.

The Financial Accounting ProcessThe Financial Accounting Process

• The initial valuation of a transaction is generally not changed in the future.– This original measurement is called

the historical cost.

Primary Financial StatementsPrimary Financial Statements

• The end result of the accounting process is the preparation of the following:– Balance sheet– Income statement– Statement of cash flows

The Balance Sheet The Balance Sheet

• The balance sheet shows a firm's assets, liabilities, and owners' equity at one point in time.

The Balance Sheet The Balance Sheet

• Assets are valuable resources that a firm owns.

• Liabilities are obligations to convey something of value in the future.

The Balance Sheet The Balance Sheet

• Owners' equity is a residual amount, calculated by subtracting liabilities from assets.– If assets are $300 and liabilities are

$50, then owner's equity must equal $250.

The Balance SheetThe Balance Sheet

Assets Liabilities and Owners’ Equity

Cash 5,000 LiabilitiesAccounts receivable 7,000 Accounts payable 8,000Inventory 10,000 Notes payable 2,000Equipment 7,000 Total liabilities 10,000

Owners’ equity 19,000Total assets 29,000 Total liabilities and

owners’ equity 29,000

The Income Statement The Income Statement

• The income statement summarizes a firm's revenues and expenses for a period of time.

The Income Statement The Income Statement

• Revenues are inflows of assets from providing goods and services to customers.

• Expenses are the costs incurred to generate revenues.

The Income Statement The Income Statement

• If revenues exceed expenses, then the result is net income.

• If expenses exceed revenues, then the result is a net loss.– If expenses are $500 and revenues

are $400, then there is a net loss of $100.

The Income StatementThe Income Statement

RevenuesSales 63,000

ExpensesCost of goods sold 35,000General and administrative 20,000Tax 3,000

Total expenses 58,000Net income 5,000

The Statement of Cash Flows The Statement of Cash Flows

• The statement of cash flows summarizes a firm's inflows and outflows of cash over a period of time.

The Statement of Cash Flows The Statement of Cash Flows

• The statement has three sections.– Operating activities—deal with a

company's operations.– Investing activities—deal with a

company's long-term asset transactions.

– Financing activities—deal with a company's long-term debt activities and activities involving shareholders.

The Statement of Cash FlowsThe Statement of Cash Flows

Distinguishing Between Financial StatementsDistinguishing Between Financial Statements

• The balance sheet reports its components as of one moment in time.

• The income statement and the statement of cash flows cover a period of time.

Notes to the Financial StatementsNotes to the Financial Statements

• Clarify and expand upon the material presented in the body of the statements.

Notes to the Financial StatementsNotes to the Financial Statements

• They are an integral part of a set of financial statements.– An example is a note which explains

a company's inventory pricing policies or the methods used to depreciate fixed assets.

Annual ReportsAnnual Reports

• Annual reports include the following:– Descriptions of significant events

that occurred during the year.– Commentary on future plans and

strategies.– A discussion and analysis by

management of the year’s results.

Users of Financial Statements and the Decisions They MakeUsers of Financial Statements and the Decisions They Make

• Present and potential owners (investors) assess and compare the prospects of alternative investments.

Present and Potential Owners Evaluate Two VariablesPresent and Potential Owners Evaluate Two Variables

• Expected return—the increase in the investor's wealth that is expected over the investment's time horizon.

• Risk—the uncertainty surrounding estimates of expected return.

Users of Financial Statements and the Decisions They MakeUsers of Financial Statements and the Decisions They Make

• Shareholders must decide whether to buy, hold, or sell shares in the firm.

• Creditors must decide whether to extend credit and on what terms.

Other Users of Financial Statements Other Users of Financial Statements

• Financial analysts and advisors• Customers• Employees and labor unions• Regulatory authorities

Generally Accepted Accounting PrinciplesGenerally Accepted Accounting Principles

• The most widely used set of accounting principles is called generally accepted accounting principles (GAAP).

• GAAP is currently set by the Financial Accounting Standards Board (FASB).

Generally Accepted Accounting PrinciplesGenerally Accepted Accounting Principles

• The FASB uses a due-process procedure in setting standards.– Ensures that all interested parties

are given an opportunity to have input into the standard-setting process.

FASB’s Due Process Procedures

FASB’s Due Process Procedures

Placement onAgenda

Issuance of an Invitationto Comment or a

Discussion Memorandum

PublicHearings

Issuance of anExposure Draft

PublicHearings

Issuance of a Statementof Financial Accounting

Standard

Two sources of FASB's authority:Two sources of FASB's authority:

• The acceptance of its rulings by the business community and the accounting profession

• The delegation by the Securities and Exchange Commission of its legislative authority to determine GAAP for large, publicly held corporations

Groups Involved in Setting Accounting StandardsGroups Involved in Setting Accounting Standards

The Role of AuditingThe Role of Auditing

• Independent certified public accountants (CPAs) often perform audits in order to enhance the credibility of the statements. – Only a CPA may perform an audit.

The Role of AuditingThe Role of Auditing

• The wording of the audit report is very specific about what the audit does and does not do.

The Role of AuditingThe Role of Auditing

• Auditors follow generally accepted auditing standards (GAAS) in the conduct of the audit.

The Role of AuditingThe Role of Auditing

• GAAS are standards developed by the accounting profession to provide guidance in the performance of an audit.

The Role of AuditingThe Role of Auditing

• An audit is not a guarantee of the correctness of the financial statements.

The Role of AuditingThe Role of Auditing

• Auditors do not certify the financial statements.– The audit report notes in the second

paragraph that an audit provides reasonable, but not absolute, assurance that financial statements are free of material error.

The Role of AuditingThe Role of Auditing

• The most desirable audit opinion is the unqualified opinion.

Auditing RelationshipsAuditing Relationships

Shareholders/Board of Directors

Company Management

Financial Statements

GAAP

CPA Firm

AuditOpinion

Consequences of the Choice of Accounting PrinciplesConsequences of the Choice of Accounting Principles

• The FASB's primary objective is to select accounting principles that provide useful information to financial statement readers.

Consequences of the Choice of Accounting PrinciplesConsequences of the Choice of Accounting Principles

• Accounting principles have implementation costs.– They can affect the wealth of

managers and firms via compensation plans, debt contracts, and political costs.

– Managers consider these economic consequences when selecting accounting principles.

Compensation PlansCompensation Plans

• A compensation plan may tie managers' compensation to earnings, and therefore, the managers might choose principles which will enhance earnings.

Debt ContractsDebt Contracts

• The use of accounting principles which increase reported net income can reduce the chances of contract violation.

Political CostsPolitical Costs

• A firm might choose accounting principles which will minimize reported income in order to keep government regulation and taxation to a minimum.

Two Roles of Financial AccountingTwo Roles of Financial Accounting

• The primary objective of accounting is to provide useful information to those who make business and economic decisions.

• A secondary objective of accounting is to help develop and enforce contracts.

Ethics in AccountingEthics in Accounting

• Accountants have a significant responsibility to the public because the public relies upon financial statements in order to make business decisions.

Ethics in AccountingEthics in Accounting

• It is imperative that accountants follow the highest ethical principles in order to keep that public trust in the profession.

Ethics in AccountingEthics in Accounting

• The American Institute of Certified Public Accountants (AICPA) has a Code of Professional Conduct which emphasizes CPAs' obligation to serve the public interest.

Financial Accounting Financial Accounting and Its Environmentand Its Environment

End of Chapter 1