C HAP TE R Accounting Principles and the Financial Statements Principles of Accounting 12e Needles Powers Crosson © human/iStockphoto 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 – 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 – For accounting purposes, a business organization is a separate entity, distinct not only from its creditors and customers but also from its owners ©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 Financial and Managerial Accounting Accounting is usually divided into financial accounting and managerial - Internal decision - 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 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 ©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 Business Transactions Business transactions are economic events that affect a business’s financial position All business transactions are recorded in terms of money This concept is called money measure 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 ©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 Forms of Business Organization There are three basic forms of business organization that are recognized as separate entities – Sole proprietorship—a business owned by one person The owner takes all the profits or losses of the business and is liable for all its obligations – Partnership—a business that has two or more owners The partners share the profits or losses according to a prearranged formula – 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 ©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 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 ©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 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) ©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 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 – borrowed money such as bank loans – salaries and wages owed to employees – taxes owed to the government – services to be performed ©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 Owner’s Equity (slide 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 ©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 Owner’s Equity (slide 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, this is called net income When expenses exceed revenues, this is called net loss ©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 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 ©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 Income Statement The income statement summarizes the revenues earned and expenses incurred by a business over an accounting period ©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 Statement of Owner’s Equity The statement of owner’s equity shows the changes in owner’s equity over an accounting period ©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 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 ©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 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 ©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 GAAP and the Independent CPA’s Report 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 Many companies of all sizes have their financial statements audited by an independent certified public accountant (CPA) – 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 ©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 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 ©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 Other Organizations That Influence GAAP The Governmental Accounting Standards Board (GASB) 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 The Public Company Accounting Oversight Board (PCAOB) 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 CPAs 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 ©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 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 The Institute of Management Accountants (IMA), the primary professional association of managerial accountants, also has a code of professional conduct ©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 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 ©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 Management, Investors, and Creditors Management is responsible for ensuring that a company meets its goals of profitability and liquidity 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 ©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 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 ©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 Business Goals and Activities 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 ©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 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 ©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 Ethical Financial Reporting Ethics is a code of conduct that addresses the question of whether actions are right or wrong – 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 – 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 ©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 ... These reports, called financial statements, are a central feature of accounting They report on a business’s financial performance makers use information provided by managerial accounting about operating,... 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 ... companies of all sizes have their financial statements audited by an independent certified public accountant (CPA) – An audit is an examination of a company’s financial statements and the accounting