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Learning Objectives

1.Describe the four assumptions made when communicating accounting information.

2.Describe the purpose and structure of an income statement and the terms and principles used to create it.

3.Describe the purpose and structure of a balance sheet and the terms and principles used to create it.

Learning Objectives

4. Describe the purpose and structure of a statement of retained earnings and how it links the income statement and the balance sheet.

5. Describe the purpose and structure of a statement of cash flows and the terms and principles used to create it.

Learning Objectives

6. Describe the qualitative characteristics that make accounting information useful.

7. Describe the conceptual framework of accounting.

LO I

Beginning Assumptions

Accounting

is the process of identifying, measuring, and

communicating economic information to permit informed judgments and decisions. Put more simply, accounting is the “language of business.”

The Assumptions

The assumptions to accomplish the process of accounting are: 1 2

• Economic Entity • This assumption states that the financial activities of a business can be separated from the financial activities of the business’s owner. • Time Period • Accountants assume that economic information can be meaningfully captured and communicated over short periods of time.

3

• Monetary Unit • Accountants assume that the dollar is the most effective means to communicate economic activity.

4

• Going Concern • Accountants assume that a company will continue to operate into the foreseeable future.

LO2

Reporting Profitability: The Income Statement

?

One of the first questions any business wants to know is whether they are making money or are

profitable

. These answers can be found in the

Income Statement.

The Income Statement and Terms

An income statement reports a company’s

revenues and expenses .

Matching principle – Expenses should be recorded in the period resources are used to generate revenues Revenue – An increase in resources resulting from the sale of goods or services Terms Expense – A decrease in resources resulting from the sale of goods or services Revenue recognition principle – A revenue should be recorded when a resource has been earned

Basic Structure of the Income Statement

Revenues – Expenses = Net Income or Net Loss Reported over a specific period, like for the year ended December 31, 2012

Income Statement Example

Exhibit 1-1

LO3

Reporting Financial Position: The Balance Sheet

?

An important issue for any business is its current financial position. What does the business own? What does it owe?

These answers can be found in the

Balance Sheet.

Reporting Financial Position: The Balance Sheet and Related

Asset:

An economic resource that is objectively measurable, that results from a transaction, and that will provide future economic benefit.

Terms

Liability:

An obligation of a business that results from a past transaction and will require the sacrifice of economic resources at some future date.

Equity:

The difference between a company’s assets and liabilities and represents the share of assets that are claimed by the company’s owners.

Cost principle:

The principle that assets should be recorded and reported at the cost paid to acquire them.

Contributed capital:

The resources that investors contribute to a business in exchange for an ownership interest.

Retained earnings:

Profits generated through operations that are retained in the business.

Basic Structure of the Balance Sheet

ACCOUNTING EQUATION Assets = Liabilities + Equity Reported at a given time or date

Balance Sheet Example

Exhibit 1-2

LO4

Reporting Equity: The Statement of Retained Earnings

A statement of retained earnings shows the change in a company’s retained earnings over a specific period of time.

Basic Structure of the Statement of Retained Earnings

Statement of Retained Earnings Example

Exhibit 1-3

Relationship Among Financial Statements

The Statement of Retained Earnings links the income statement and the balance sheet.

End of Class

LO5

Reporting Cash Flows: The Statement of Cash Flows

?

A business needs to answer questions about the management of cash: • Where does a company get its cash?

• Where does its cash go? • Will there be enough cash to pay bills?

These answers can be found in the

Statement of Cash Flows.

Reporting Cash Flows: The Statement of Cash Flows

The details of cash inflows and outflows for a business are reported on a statement of cash flows in the following three sections: Operating Activities Investing Activities Financing Activities

Basic Structure of the Statement of Cash Flows

Statement of Cash Flows Example – Exhibit 1-5

LO6

Qualitative Characteristics of Accounting Information

Understandability Relevance Reliability Comparability The ability of accounting information to “be comprehensible to those who have a reasonable understanding of business…and are willing to study the information with reasonable diligence.” The capacity of accounting information to make a difference in decisions.

The extent to which accounting information can be depended upon to represent what it purports to represent, both in description and in number.

The ability to use accounting information to compare or contrast the financial activities of different companies.

Qualitative Characteristics (Continued)

Consistency Materiality Conservatism The ability to use accounting information to compare or contrast the financial activities of the same entity over time.

The threshold at which a financial item begins to affect decision making.

The manner in which accountants deal with uncertainty regarding economic situations.

LO7

The Conceptual Framework

The grammar or terms, explaining financial accounting language in this chapter, are more formally known as components of the conceptual framework of accounting.

The conceptual framework of accounting is the collection of concepts that guide the manner in which accounting is practiced.

Terms Used to Identify and Describe Economic Term Information Definition Reported on the Asset Liability A resource of a business An obligation of a business Balance sheet Balance sheet Equity Balance sheet Contributed Capital Retained Earnings Revenue The difference between assets and liabilities Equity resulting from contributions from owners Equity resulting from profitable operations An increase in assets resulting from selling a good or providing a service Balance sheet Balance sheet and statement of retained earnings Income Statement Expense Dividend A decrease in assets resulting from selling a good or providing a service A distribution of profits to owners Income Statement Statement of retained earnings

Principle Revenue recognition Matching Cost Principles Used to Measure Economic Information Definition

Revenues are recorded when they are earned.

Ramification

The receipt of cash is not required to record a revenue.

Expenses are recorded in the time period when they are incurred to generate revenues.

For many assets, the cost of the asset must be spread over the periods that it is used. Assets are recorded and maintained at their historical costs.

Except in a few cases, market values are not used for reporting asset values.

Assumptions Made When Communicating Economic Information Assumption Economic entity Monetary unit Time period Going concern Definition Ramification

The financial activities of a business can be accounted for separately from the business's owners.

We do not have to worry that the financial information of the owner is mixed with the financial information of the business.

The dollar, unadjusted for inflation, is the best means of communicating accounting information in the United States.

All transactions in foreign currencies are converted to dollars.

Accounting information can be communicated effectively over short periods of time.

Most businesses prepare quarterly and annual financial statements.

The company for which we are accounting will continue its operations indefinitely.

If an entity is not selling its assets, then the cost principle is appropriate.

Qualitative Characteristics of Accounting Information

Term Definition Ramification Understandability Relevance Accounting information should be comprehensible by those willing to spend a reasonable amount of time studying it.

Users must spend a reasonable amount of time studying accounting information for it to be understandable.

The capacity of accounting information to make a difference in decisions.

Information should have predictive or feedback value and should be timely.

Qualitative Characteristics of Accounting Information

(continued) Term Definition Ramification Reliability Comparability The extent to which accounting information can be depended upon to represent what it purports to represent, both in description and in number.

The ability to use accounting information to compare or contrast the financial activities of different companies.

Information should be free from error, a faithful representation, and neutral.

Entities must disclose the accounting methods that they use so that comparisons across companies can be made.

Qualitative Characteristics of Accounting Information

(Continued) Terms Consistency Materiality Definition Ramifications Accounting information should be comparable across different time periods within a company.

An entity should use the same accounting methods year to year and disclose when they change methods.

The threshold over which an item could begin to affect decisions.

When an amount is small enough, normal accounting procedures are not always followed.

Qualitative Characteristics of Accounting Information

(Continued) Terms Conservatism Definition When uncertainty exists, accounting information should present the least optimistic alternative.

Ramifications An entity should choose accounting techniques that guard against overstating revenues or assets.

Financial Statements Used to Communicate Economic Information Statement Balance sheet Income statement Purpose Shows a company’s assets, liabilities, and equity at a specific point in time. Shows a company’s revenues and expenses over a specific period of time.

Structure Links to Other Statements Assets = Liabilities + Equity Revenue Expenses = Net Income/ Loss The balance in retained earnings comes from the statement of retained earnings.

The balance in cash should agree with the ending cash balance on the statement of cash flows. Net income/loss goes to the statement of retained earnings to compute retained earnings.

Financial Statements Used to Communicate Economic Information (continued) Statement Statement of retained earnings Statement of cash flows Purpose Structure Shows the changes in a company’s retained earnings over a specific period of time.

Shows a company’s inflows and outflows of cash over a specific period of time.

Beginning Retained Earnings +/- Net Income/Loss Dividends = Ending Retained Earnings Operating Cash Flows +/ Investing Cash Flows +/ Financing Cash Flows = Net change in cash Links to Other Statements Ending retained earnings goes to the balance sheet.

The ending cash balance on the statement of cash flows should agree with the balance in cash on the balance sheet.

End of Chapter 1