environment of accounting

Fin Acctg Concepts - 1

ENVIRONMENT OF ACCOUNTING

GAAP


NATURE OF ACCOUNTING

An information system designed to : Collect, Process, and Report economic data to interested parties to assist them in making decisions

Areas of accounting– Financial Accounting = external decision makers

(investors and creditors)– Management Accounting = internal decision makers– Specialized areas

• Tax Accounting• Regulatory Accounting

“Accounting is the language of business”


“FINANCIAL STATEMENT PACKAGE”

Formal financial statements

Footnotes

Supplementary information

Attestation reports


FORMAL FINANCIAL STATEMENTS

Income statement

Balance sheet

Statement of stockholders’ equity– Retained earnings

Statement of cash flows


INCOME STATEMENTStatement of Earnings

Report on the operations of the entity

Listing of Revenues, Gains, Expenses, & Losses

Covers a period of time


STATEMENT OF FINANCIAL POSITION

Balance Sheet Report on the financial position of

the entity

Listing of Assets, Liabilities, & Owners’ Equity items

A specific point in time


STATEMENT OF STOCKHOLDERS’ EQUITY

“Retained earnings”

Report on the changes in Retained Earnings


Link between the Balance Sheet & Income Statement


STATEMENT OF CASH FLOWS

Report on financial activities of the entity

Shows the changes in cash (and cash equivalents)



OTHER INFORMATION

Footnotes– Refers to a specific item or section

Supplementary information– All additional disclosures


ATTESTATION REPORTS

Management report

Report of the audit committee

Report of the independent auditor (CPA)


BASIC ACCOUNTING EQUATION[Corporation]

Assets = Liabilities + Stockholders’ Equity

Contributed(Paid-in)

Capital

Retained Earnings

Net Income (+)Net loss (-) Dividends (-)

Declared

Revenues & Gains (+) Expenses & Losses (-)

ParValue

ExcessOverPar


Issuing Stock to Investors

@Cambridge Business Publishers, 2009

After getting the business plan approved, Simon and Sue opened a Cup-A-Jo Coffee franchise by investing equipment worth $60,000 and cash totaling $300,000 in exchange for common stock.

Assets = Liabilities +Shareholders'

EquityCash Equipment Intangible Assets Loan Payable Common Stock

300,000 60,000 360,000

Assets increase by $360,000.Shareholders’ equity increases by $360,000.


Obtaining a Bank Loan


Acting on behalf of Cup-A-Jo Coffee, Simon obtained a $90,000 bank loan to be repaid equally at the end of each year for 8 years at 7% annual interest.



90,000 90,000

Assets increase by $90,000. Liabilities increase by $90,000.


Purchase of Franchise


Cup-A-Jo acquired franchise rights for an 8-year period at a cost of $240,000 paid in cash.



-240,000 240,000

Assets increase by $240,000, andAssets decrease by $240,000.

Because the franchise rights represent future economic benefits, the cost is an asset.


Balance Sheet after Pre-Opening Events




300,000 60,000 360,000 90,000 90,000-240,000 240,000 150,000 60,000 240,000 90,000 360,000

450,000 = 90,000 + 360,000

Assets Liabilities & Shareholders' EquityCash $150,000 Liabilities Equipment 60,000 Loan payable $ 90,000Intangible Assets 240,000 Shareholders' Equity

Common Stock 360,000

Total assets $450,000 Total liab. & shareholders' equity $450,000


Buying Inventory


Cup-A-Jo purchased $84,000 of inventory consisting of coffee, tea, cream, flavoring, etc., on credit due in 30 days.

Assets increase by $84,000.Liabilities increase by $84,000.

Beginning balances

Assets = Liabilities + Shareholders' Equity

CashAccounts

Rec. InventoryEquip-ment

Accum. Deprec.

Intang. Assets

Accts. Pay.

Taxes Payable

Loan Payable

Common Stock

Retained Earnings

150,000 0 0 60,000 0 240,000 0 0 90,000 360,000 0

84,000 84,000


Selling to Customers


Cup-A-Jo sold coffee during the year for $305,000. Of this amount, Cup-A-Jo collected $270,000. The balance is still owed at December 31. The cost of the coffee sold was $70,000.

Assets increase by $305,000 and decrease by $70,000—a net increase of $235,000. Shareholders’ equity increases by $305,000, and

decreases by $70,000—a net increase of $235,000.

Assets = Liabilities + Shareholders' Equity

CashAccounts

Rec. InventoryEquip-ment

Accum. Deprec.

Intang. Assets

Accts. Pay.

Taxes Payable

Loan Payable

Common Stock

Retained Earnings

150,000 0 0 60,000 0 240,000 0 0 90,000 360,000 0270,000 35,000

-70,000

305,000 -70,000

Fin Acctg Concepts - 18RELATIONSHIP OF FINANCIAL

STATEMENTS

AssetsLiabilitiesOwners’ equity

AssetsLiabilitiesOwners’ equity

Revenues - Expenses=

Net Income (or Loss)

Balance 1-1-x2(+/-) Net income or loss - Dividends = Balance 12-31-x2

Income StatementFor Year 2

Statement of Retained EarningsFor Year 2

Balance Sheet12-31-x1

Balance Sheet12-31-x2


GENERALLY ACCEPTEDACCOUNTING CONCEPTS

Reasons for Generally Accepted Accounting Principles (GAAP)

Entities influencing GAAPGAAP


GAAP

Generally Accepted Accounting Principles (GAAP)– The guidance U.S. companies currently use to

measure and report performance– Is very flexible

•Allows management judgment•Different methods of measurement allowed


Who prepares a company’s

financial statements?

Management


GAAP FAQs

Why did GAAP arise?– To mutually benefit the capital market

participants who use financial statements– To help evaluate risk and return– To give confidence to users that information

helps make better decisions Created by Financial Accounting Standards Board

(FASB)• Overseen by the Securities and Exchange

Commission (SEC)SEC has the ultimate power to set accounting

standards@Cambridge Business Publishers, 2009


International Accounting Standards

Attempt to harmonize accounting standards through creation of International Financial Reporting Standards (IFRS)

Some countries are using IFRS– European Union converted in 2005

Recent impact on U.S.– Late 2007, U. S. SEC voted to allow foreign

registrants to file financial statements with the U.S. using IFRS•Previously required to use or reconcile to

U.S. GAAP


22


Proposed SEC Roadmap for IFRS

#-Staggered adoption possible based on earliest adoption in 2015 or 2016.

23


OBJECTIVES OF FINANCIAL STATEMENTS

Help investors and creditors make rational investment, credit, and related decisions

Assess the amounts, timing, and uncertainty of future cash flows

Information about the economic resources of the entity, claims to those resources, and changes in those resources

“ALLOCATION OF ECONOMIC RESOURCES”


USERS OF FINANCIAL STATEMENTSAssumptions

Reasonable knowledge of business and economic activities

Willing to study the information with reasonable diligence

Statement of Financial Accounting Concepts No. 1, “Objectives of Financial Reporting by Business Enterprises”


QUALITIES OF ACCOUNTING INFORMATION

Relevance– Predictive value– Feedback value– Timeliness

Reliability– Verifiability– Neutrality– Representationa

l faithfulness

Comparability

Consistency


ENVIRONMENTAL ASSUMPTIONS

Separate Entity

Continuity (Going Concern)

Time Period (Periodic Measurement)

Unit of Measure (Monetary)


IMPLEMENTATION PRINCIPLES

Cost/Exchange Transactions

Revenue Realization

Matching

Full Disclosure


Accounting Information Constraints

Materiality– GAAP applies only to economic events significant

enough to affect a user’s decision Conservatism

– Applied when trade-offs between qualities are needed

– A reaction to uncertainty– When in doubt, financial statements should

• Understate assets• Overstate liabilities• Delay recognition of revenues• Accelerate recognition of expenses



ELEMENTS OF FINANCIAL STATEMENTS

Assets

Liabilities

Equity (Owners’)– Investments by

Owners– Distributions to

Owners

Revenues Expenses Gains Losses Comprehensive

Income


BALANCE SHEET

Resources (Assets)

Resources (Assets)

Claims against resources (Liabilities)

Claims against resources (Liabilities)

Remaining claims accruing to owners

(Owner’s Equity)

Remaining claims accruing to owners

(Owner’s Equity)


BALANCE SHEET ELEMENTS Assets

– Economic resources with probable future value– Controlled by management– Resulting from past transactions

Liabilities– Probable future sacrifices of economic benefits

(debts/obligations)– Require transfer of assets– Terms of obligations are specified– Result from past transactions

Equity– Residual interest in the assets of the entity– “Net assets”– Represents the “investment” by owners


BALANCE SHEET CLASSIFICATIONS

Assets– Current Assets– Long-term

Investments– Property, Plant,

and Equipment– Intangible

Assets– Other Assets

Liabilities– Current Liabilities– Long-term

Liabilities

Stockholders’ Equity– Contributed Capital– Retained Earnings– Other Items


BALANCE SHEET

LiquidityLiquidity - length of time until assets are converted to cash or until a liability must be paid

Solvency – the ability of a firm to meet its debts as they come due

Financial flexibilityFinancial flexibility - ability of company to manage its cash flows (deal with emergencies or take advantage of unexpected opportunities)


THE INCOME STATEMENT

Describes a company’s operating performance for a specified period of time


INCOME STATEMENTELEMENTS

Revenues– Inflows of assets (settlement of liabilities)– From delivery or production of goods or rendering of

services Gains

– Increases to equity– From peripheral or incidental transactions

Expenses– Outflows of assets (incurrance of liabilities)– Consumption or expiration of assets in an attempt to

generate revenue Losses

– Decreases in equity– From peripheral or incidental transactions

Earnings per share– Basic – Fully diluted


INCOME STATEMENT“Multiple-Step”

Operations section– Gross margin (Sales - Cost of goods

sold)– Operating expenses

Other items (“nonoperating”) “Special items” Net income - “the bottom line” Earnings per share


INCOME STATEMENT“Multiple-Step”

Items within “Income from continuing operations”

•Unusual OR infrequent gains and losses

Below “Income from continuing operations”

•Discontinued Operations•Extraordinary items (unusual AND

infrequent)


Income Statement (Multiple-Step)

Operations

Other

Specialitems


Which Basis of Accounting is Used?

Cash basis– Financial effects are recorded in financial

statements when cash is received or paid Accrual basis

– Financial effects are recorded without regard to the timing of the cash flows

– Accounts that exist under accrual basis• Accounts receivable

Amounts customers owe for items purchased• Accounts payable

Amount the company owes for credit purchases



Revenue Principle

Revenue should be recognized in the financial statements when . .

It is earned, and …

It is realized or realizable (measurable)


REVENUE RECOGNITION POINTS

Design and production,construction in progress,minerals discovered

Goods completedand ready for sale,contract complete

Delivery ofproduct or

service

Cash collectedfor goods or

services

Right ofreturn expires

Recognition before delivery

Recognition after delivery

Recognitionat delivery

Percentage-ofcompletion method

Productionmethod

Completedcontractmethod

Pointof salemethod

Installment method

Costrecovery method

Right ofreturn

expiration method

RELEVANCE RELIABILITY


Matching

Once revenues are determined, the expenses incurred in attempting to generate the revenue should be recognized.

As revenues are earned, certain assets are consumed and services are used.


Expense Classification

Direct

Period

Allocated


BUSINESS CYCLECollect cash

from customer

Purchase materials

Convert materialsinto finished product

Inspect product

Store productin warehouse

Receive orderfrom customer

Ship product& invoice customer

Customerreceives item


EXPENDITURES vs. EXPENSES

Assets as ofJan. 1, 1998

Expendituresduring 1998

Directassociation

withrevenue

Assets as of12-31-98

Associationwith

activities

Associationwith

future

No

No

Expenses of 1998Yes

Yes

Yes

No

Example: Cost of goods sold

Example: Office expenses

Example: Obsolete merchandise



Nature of Statement Reports on Financial

Activity Covers a period of

time (fiscal period) Explains changes in

cash balance Cash and equivalents

– Highly liquid short-term investments

– Treasury bills, Money-market funds

Objectives of Statement Prediction of future

cash flows Evaluation of financial

management Determine ability to

pay interest and dividends

Explain relationship of net income to changes in cash balance


STATEMENT OF CASH FLOWComponents

Cash flow from Operating Activities– Result from creation of revenues and

expenses– Items that affect the Income Statement

Cash flow from Investing Activities– Result from increases or decreases in long-

term assets

Cash flow from Financing Activities– Result from transactions with creditors or

investors– Generate funds needed to launch or

sustain the business


CASH FLOW FROM OPERATIONS

Operating Sources of Cash– Collections from customers– Receipts of interest– Receipts of dividends

Operating Uses of Cash– Payments to suppliers– Payments to employees– Payments for interest– Payments for income taxes


CASH FLOW FROM INVESTING

Investing Uses of Cash– Acquisition of Operating Assets– Acquisition of Investments

Investing Sources of Cash– Proceeds from sale of Operating

Assets– Proceeds from sale of Investments


CASH FLOW FROM FINANCING

Financing Sources of Cash – Proceeds of borrowings– Proceeds from issuing stock

Financing Uses of Cash– Payment of debt– Purchase of treasury stock– Payment of cash dividends


NONCASHINVESTING & FINANCING

ACTIVITIES Investing or Financing which DO NOT

DIRECTLY INVOLVE CASH, but which could involve cash.

These transactions are usually “short-cut” methods used to reduce the cost of investing or financing activities

Examples:– Acquiring plant assets by issuing long-

term debt– Converting debt into equity (common

stock)


CASH FLOW FROM OPERATIONSIndirect Method

Net income

Adjustments for noncash items included in net income– Depreciation or amortization (additions to net income)– Gains (deducted from net income)– Losses (added to net income)

Adjustments for changes in working capital items– Current assets

• Increases = deductions from net income• Decreases = additions to net income

– Current liabilities• Increases = additions to net income• Decreases = deductions from net income

environment of accounting

Documents

entitylisting of assets

statement of cash flowsreport

cambridge business publishers

financial activities

cash equivalentscovers

cash totaling

business plan

year period