Transcript Document

Chapter 1:
Accounting
as a Form of
Communication
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What is Business?
Activities necessary to provide members of
an economic system with goods and
services. Business entities are organized to
earn a profit.
 Examples of business entities

– Sole Proprietorship
– Partnership
– Corporation

Nonbusiness entities - also deliver goods
and services, but are established with goals
other than profit maximization.
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The Nature of Business Activity

Business activites can be classified into 3 major
categories.
 Operating Activities: Operating Activities focus on
the primary goal of the organization, usually to
deliver products or services. Includes revenue
and expense activity (see Income Statement
discussed later in this chapter).
 Investing Activities: from buying and selling
operational assets like buildings and equipment.
 Financing Activities: from borrowing money and
issuing stock to owners.
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Financial Information Users

Financial statements used by a variety of groups.
– Equity investors: purchase shares of stock,
which represent ownership in the company.
The financials are used by investors to analyze
management’s decisions.
– Debt investors (creditors): provide capital
through loans. The financials are used by
creditors to assess likelihood of default.
– Management: uses other companies financials
to asses the competition.
– Others, including government bodies, labor
unions, employees, use financials to assess the
financial status of the company.
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Financial Statements
Financial statements report the
company activity during the year and
the financial condition of the company at
the end of the year.
 The required financial statements are:
– Balance Sheet
– Income Statement
– Statement of Stockholders’ Equity
– Statement of Cash Flows

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The Balance Sheet
The balance sheet reports the financial
position at a point in time (end of the
quarter or year).
 The balance sheet is divided into three
major categories:
– Assets
– Liabilities
– Stockholders’ equity

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The Balance Sheet
The balance sheet is represented by the
fundamental accounting equation:
Assets = Liabilities + Stockholders’ Equity
A =
L
+
SE
 The effects of all described business
transactions may be represented in this
formula.

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The Balance Sheet (B/S)



Assets - represent future benefit to the
company, and are classified in order of
liquidity (current assets; property, plant and
equipment; long-term investments)
Liabilities - represent obligations of the
company, and are classified according to
payment date (current liabilities, long-term
liabilities)
Stockholders’ equity - represents the residual
claims of the owners, and is classified based
on source (contributed capital and retained
earnings)
(Expanded discussion in Chapter 2)
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B/S Assets

Current assets include
– Cash: checking and savings accounts; petty
cash.
– Accounts receivable: amounts owed to a
company from its customers.
– Notes receivable: similar to A/R but usually has
an interest component.
– Supplies: products on hand to be used by the
company (ex: office supplies).
– Inventory: products on hand designated for sale
to customers.
– Prepaid expenses: amounts paid for future
expenses.
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B/S Assets

Property, plant, and equipment are assets
that are used in the production of goods and
services. These productive assets are longterm in nature, and include the following:
– Land: property upon which the productive
facilities are located.
– Building: the physical structure of the
company’s operations.
– Machinery and Equipment: include
operating machinery, vehicles, computers,
copy machines, etc.
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B/S Assets

Long-term investments are assets acquired by
the company to provide long-term benefits to the
company. Long-term investments include:
– Long-term notes receivable owed to the
company (from customers or others).
– Investments in stock of other companies:
held for expectation of dividends and/or stock
price increase.
– Investment in bonds of other companies: held
for expectation of dividends and/or stock price
increase.
– Other assets, like land, held for the long term.
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B/S Assets

Intangible assets are long-lived assets that
have no physical substance. Examples
include:
– Patents: legal claim to produce and sell a
product.
– Copyrights: legal claims to books, art,
music and other created works.
– Goodwill: recognized when one company
buys another company, and the purchase
price is greater than the fair value of the
identifiable net assets.
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B/S Liabilities

Current liabilities are obligations expected to
be paid (or services expected to be
performed) within the next year or operating
cycle. The elimination of the current liabilities
requires the use of current assets (most
commonly cash). Examples include:
– Accounts payable: owed to suppliers
– Wages payable: owed to employees
– Interest payable: owed to banks
– Short-term notes payable
– Current maturities of long-term debt
– Unearned revenues: owed to customers
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B/S Liabilities

Long-term liabilities are obligations expected to
require payments beyond the current year.
Examples of long-term liabilities include:
– Notes payable: amounts owed to banks and
other creditors beyond the current year.
– Mortgage payable: amounts owed to
mortgage company beyond the current year.
– Bonds payable: amounts owed to investors
holding bond investments issued by the
company, where payments of principal and
interest are beyond the current year.
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B/S: Stockholders’ Equity
Stockholders’ Equity consists of the following
components:
–Contributed Capital
–Retained Earnings
Contributed Capital
– Common stock: shares of stock issued to owners
to reflect ownership.
– Additional paid in capital: excess amounts
contributed by shareholders for various activities
(APIC will be discussed more in Chapter 11).
– These are contributions from the shareholders.
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B/S: Stockholders’ Equity
Retained Earnings (RE)
– Retained earnings represent the excess earnings
retained in the company after dividends have
been paid to shareholders.
– This measures the equity generated by the
company for the shareholders.
– Retained earnings is increased by net income
and decreased when dividends are distributed to
the owners.
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B/S: Stockholders’ Equity
Retained Earnings (RE) Formula
(changes in Retained Earnings only,
due to Net Income and Dividends):
REB egin + NI -
Div = REEnd
Stockholders’ Equity (SE) Formula
(changes in Common Stock and Retained Earnings):
SEBegin + Issue CS + NI - Div = SEEnd
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The Income Statement (I/S)
The income statement shows the
components of net income in detail.
 Revenues represent the inflow of assets
(or decrease in liabilities) due to a
company’s operating activities.
 Expenses represent the outflow of assets
(or increases in liabilities) due to a
company’s operating activities.
 The general formula for the I/S is:
Revenues - Expenses = Net Income

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The Income Statement Format
Operating revenues
Sales
Fees earned
Other revenues
Less: Operating expenses
Cost of goods sold
Wage expense
Rent expense
Selling expense
Depreciation expense
Other expenses
Net Income
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The Statement of Cash Flows

Cash flows from operating activities:
– Collections from sales, rent, interest, etc.
– Cash paid to suppliers and employees, and for
rent, selling activities, interest, and taxes etc.
 Cash flow from investing activities:
– Proceeds from sale of investment securities,
land, buildings, equipment, etc.
– Purchase of investment securities, land,
buildings, equipment, etc.
 Cash flow from financing activities:
– Proceeds from issuance of notes, debt, sale of
equity, etc.
– Payments on notes, debt, dividends, etc.
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Relationships Among the
Financial Statements
Ending
Balance Sheet
Beginning
Balance Sheet
Assets
(Cash)
=
Statement of
Cash Flows
Income
Statement
=
Liabilities
Liabilities
+
Equity
Assets
(Cash)
+
Statement of
Stockholders’ Equity
(Statement of RE)
Equity
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GAAP
The basic principles are the foundation for
Generally Accepted Accounting
Principles (GAAP). Some of the
principles are discussed in Chapter 1:
– Economic entity
– Cost principle
– Going concern
– Time period assumption
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Economic Entity
A company is assumed to be a separate
economic entity that can be identified
and measured.
 This concept helps determine the scope
of financial statements.
 Some business own subsidiaries, and
the subsidiaries are a separate
economic entity from the parent, even
though they might have combined
reporting.

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Cost Principle
Historical cost is the input price paid
when asset originally purchased.
 For example, land and property used in
a company’s operations are all valued
at original cost.
 Companies may adjust historical cost,
for activities like depreciation and
losses, but original cost is still a major
factor in external financial reporting.

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Going Concern
The life of an economic entity is
assumed to be indefinite.
 Assets, defined as having future
economic benefit, require this
assumption.
 Allocation of costs to future periods is
supported by the going concern
assumption.

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Time Period Assumption
This principle requires that companies
report in discrete time periods, like
months, quarters and years.
 This allows the companies to send out
interim reports, and inform shareholders
of the activities of the company.

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Regulations and Standards
The Securities and Exchange Commission
(SEC) governs financial reporting for
publicly traded companies. Congress and
other regulatory agencies have influence
with the SEC.
 The Financial Accounting Standards
Board (FASB) is responsible for the
promulgation of generally accepted
accounting principles (GAAP) for financial
statements. The FASB accepts input from
all interested parties, including
accountants, corporations, academics,
and governmental entities.

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Opportunities In Accounting
Financial - Preparer, Auditor,
Investigator, Consulting
 Managerial - Controller, Treasurer,
Internal Auditor, Cost Accountant
 Taxation - Preparer, Investigator,
Consulting, Enforcement, Estate Planner
 Related - Lenders, Consultants, Analysts,
Traders, Underwriters, Appraisers, FBI
Investigators, Litigation Support

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Professional Reputation and Ethics

Ethical behavior is in the long-run interest of
managers, stockholders, and auditors.
 Many companies, universities, and
professional organizations have enacted
increased emphasis on ethics.
 Auditors’ reputations are integral to their ability
to perform their duties. High ethical conduct is
imperative to their continued success.
 A number of companies, and their auditors,
have been exposed in recent years for their
fraudulent financial reporting: Enron,
WorldCom, HealthSouth, Xerox, Rite Aid, and
Quest.
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Sarbanes-Oxley Act
Passed by Congress in 2002, in
response to a series of corporate
scandals.
 Requires principal executive and
financial officers to certify a number of
statements regarding the financials.
 Places additional responsibilities on
management to ensure that adequate
internal controls are in place.

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