Chapter 1 Notes - Summary Fundamental Accounting Principles PDF

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Mgmt 1A Chapter 1—Accoutning in Business Importance of Accounting 

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Accounting is an information and measurement system that identifies, records, and communicates relevant, reliable, and comparable information about an organization’s business activities  Identifying requires selection of relevant transactions and events  Select transactions and events  Recording requires keeping a chronological log of transactions and events measured in dollars  Input, measure, and log  Communicating requires preparing accounting reports (such as financial statements) that we analyze and interpret  Prepare, analyze, and interpret o Most common contact with accounting is through credit approvals, checking accounts, tax forms, and payroll  Recordkeeping (bookkeeping)is the recording of transactions and events, either manually or electronically Users of Accounting Information o Language of business because all organizations set up an accounting information system to communicate data to help people make better decisions o External Information Users  Lenders, shareholders, governments, consumer groups, external auditors, customers  External users are NOT directly involved in running the organization  They have limited access to an organization’s information  Financial accounting—the area of accounting aimed at serving external users by providing them with general-purpose (broad range) financial statements  List of external users and decisions they make  Lenders (creditors)—loan money to an organization. They look for info whether an organization is likely to repay its loans with interest  Shareholders (investors)—owners of a corporation. Use reports to decide to buy, hold, or sell stock  Directors—board of directors that oversee their interests in a company. Info needs similar to shareholders  External (independent) auditors—examine financial statements to verify they are prepared according to generally accepted accounting principles (GAAP)  Nonexecutive employees and labor unions—used to judge the fairness of wages, assess job prospects, and bargain for better wages

Mgmt 1A Regulators—have legal authority over certain activities of organizations o Ex. IRS require filing acct reports for taxes o Ex. Utility boards use acct info to set utility rates  Voters, legislators, and government officials—use info to monitor and evaluate government receipts and expenses  Contributors—use to evaluate the use and impact of donations  Suppliers—judge soundness of a customer before making sale on credit o Internal Information Users  Internal users of accounting info are those directly involved in managing and operating an organization. Use info to help improve efficiency and effectiveness of an organization  Managerial accounting serves the decision-making needs of internal users  Internal reports are designed with the needs of internal users in mind  List of internal users and decisions they make  Research and development managers—need info about projected costs and revenues of any proposed changes in products and services  Purchasing managers—know what, when, and how much to purchase  Human resource managers—info about employees’ payroll, benefits, performance, and compensation  Production managers—use info to monitor costs and ensure quality  Distribution managers—need reports for timely ,accurate, and efficient delivery of products and services  Marketing managers—use reports to target consumers, set prices, and monitor consumer needs, tastes, and price concerns  Service managers—info for costs and benefits of looking after products and services Opportunities in Accounting o Financial  Preparation, analysis, auditing, regulatory, consulting, planning o Managerial  General accounting, cost accounting, budgeting, internal auditing, consulting, controller, treasurer, strategy o Taxation  Preparation, planning, regulatory, investigations, consulting, enforcement, legal services, estate planning o Accounting-related  Lenders, consultants, analysts, traders, directors, underwriters, planners, appraisers, FBI investigators, market researchers, systems designers, merger services, business valuation, forensic accounting, litigation support, entrepreneurs 

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Opportunities in accounting: private > public > government and non-profit and education

Fundamentals of Accounting 

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Ethics o Accounting is meant to provide useful info, which must be trusted o Ethics are beliefs that distinguish right from wrong (good and bad)  The preferred path is a course of action that avoids casting doubt on decisions o Guidelines for making ethical decisions  Identify ethical concerns—use personal ethics to recognize an ethical concern  Analyze options—consider all good and bad consequences  Make ethical decision—choose best option after weighting all consequences Fraud Triangle o The 3 factors a person must exist for a person to commit fraud are opportunity, pressure, and rationalization  Opportunity—a person must envision a way to commit fraud with low risk of getting caught  Pressure—a person needs pressure or incentive to commit fraud  Rationalization—a person who rationalizes fails to see the criminal nature of the fraud pr justifies the action o Prevention is less expensive and more effective than detecting once crime committed o Internal controls are procedures set up to protect company property and equipment, ensure reliable accounting reports, promote efficiency, and encourage adherence to company policies  Ex. good records, physical controls (locks, passwords), and independent reviews Generally Accepted Accounting Principles o Generally Accepted Accounting Principles—GAAP  GAAP governs financial accounting  GAAP aims to make info relevant (users decisions), reliable (trusted by users), and comparable (contrasting organizations) o Securities and Exchange Commission (SEC)—a government agency that has the legal authority to set GAAP  Oversees proper use of GAAP that raise money from public through stocks and debt o Companies that issue stock on US Exchanges  US SEC registrants—companies incorporated in the US  Non-US SEC registrants—companies incorporated under non-US laws o Financial Accounting Standards Board (FASB)—a private-sector group that sets both broad and specific principles for the US GAAP International Standards

Mgmt 1A International Accounting Standards Board (IASB) is an independent group of individuals from many countries that issues International Financial Reporting Standards (IFRS) o If the standards are the same, one company can potentially use a single set of financial statements in all financial markets o For the SEC to change the GAAP to include the individual IFRS standards, the SEC would  Maintain its oversight of FASB, including authority to prescribe accounting principles and standards for US issuers  Contribute to oversight and governance of the IASB through its involvement on the IFRS Foundation Monitoring Board Conceptual Framework and Convergence o The FASB and IASB are attempting to converge and enhance the conceptual framework that guides standard settings  Objectives—to provide info useful to investors, creditors, and others  Qualitative Characteristics—to require info that is relevant, reliable, and comparable  Elements—to define items that financial statements can contain  Recognition and Measurement—to set criteria that an item must meet for it to be recognized as an element, and how to measure that element Principles and Assumptions of Accounting o General—basic assumptions, concepts, and guidelines for preparing financial statements o Specific principles—detailed rules used in reporting business transactions and events o Accounting principles  Measurement principle—cost principle—acct info is based on actual cost. Cost is measured on a cash or equal-to-cash basis. Emphasizes reliability and verifiability, and info based on cost is objective  Objectivity means that info is supported by independent, unbiased evidence  Revenue recognition principles—guidance on when company must recognize revenue. The recognize means to record it.  Revenue is recognized when it is earned  Proceeds from selling products and services need not be in cash  Revenue is measured by the cash received plus the cash value of any other items received  Expense recognition principles—matching—company record expenses incurred to generate the revenue reported  Full disclosure principle—company report the details behind financial statements that would impact users’ decisions (footnotes) o Accounting Assumption  Going-concern assumption—acct info reflects a presumption that the business will continue to operate instead of being closed or sold o

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Mgmt 1A Monetary unit assumption—we can express transactions and events in monetary units  Time period assumption—presumes that the life of a company is divided into time periods, such as months years  Business entity assumption—a business is accounted for separately from other business entities, including its owner. A business entity can take one of 3 forms  Sole proprietorship—business owned by 1 person  Partnership—business owned by 2 or more people o Has agreement about how income and losses shared o LLC—limited liability company—offers the limited liability of a corporation and the tax treatment of a partnership  Corporation—business legally separate from its owners, meaning it is responsible for its own acts and debts o Separate legal status so corporation can conduct business with rights, duties, and responsibilities of a person o Shareholders (owners) are not responsible for acts and debts o Advantage—limited liability o Disadvantage—double taxation—corp. income is taxed and any distribution of income to owners through dividends is taxed o Ownership of all corp. is divided into shares/stocks  One class of stock—common stock Accounting Constraints 

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Materiality constraint—prescribes that only info that would influence decisions of a reasonable person need to be disclosed. Looks at importance and size of amount.  Cost-benefit constraint—prescribes only info with benefits of disclosure greater than the cost of providing it need to be disclosed  Sometimes, conservatism and industry practices are constraints Sarbanes-Oxley (SOX) o Sarbanes-Oxley Act helps curb financial abuses at companies that issue stock to the public. o SOX require public companies apply both accounting oversight and stringent internal controls. The desired results are more transparency, accountability, and truthfulness in reporting transactions o Compliance requires documentation and verification or internal controls 

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Dodd-Frank

Auditors also must verify effectiveness of internal controls Governance systems reduce risk of accounting fraud  System includes owners, managers, employees, board of directions, and other important stakeholders, who work together to reduce the risk of accounting fraud and increase confidence in acct reports

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Dodd-Frank Wall Street Reform and Consumer Protection Act  Promote accountability and transparency in the financial system  Put an end to the notion of “too big to fail”  Protect the taxpayer by ending bailouts  Protect consumers from abusive financial services

Transaction Analysis and the Accounting Equation 

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Accounting system reflects what the company owns and owes o Assets—resources a company owns or controls  Assets are expected to yield future benefits  Receivables—an asset that promises a future inflow of resources  Ex. cash, supplies, equipment, land  Return on assets = (net income / average total assets) o Liabilities—creditors’ claims on assets (claims reflect company obligations to provide assets, products, or services to others)  What company owes to its non-owners in future payments, products, or services  Payables—a liability that promises a future outflow of resources o Equity—owners claim on assets  Equal to assets – liabilities  Also called net assets or residual equity  Owners investments and revenues increase equity, whereas owner withdrawals and expenses decrease equity  Owner investments—resources, such as cash, that an owner puts into the company and are included in account Owner, Capital  Revenues—sales of products or services to customers o Revenue increase equity (via net income) and result from company’s earnings activities (ex. sale of products)  Owner withdrawals—resources that an owner takes from the company for personal use  Expenses—costs necessary to earn revenues o Expenses decrease equity  Net Income—when revenue exceeds expenses o Accounting Equation—Assets = Liabilities + Equity Transaction Analysis o External transactions—exchanges between 2 entities, which yield changes in accounting equation (ex. sale of ad space by Google) o Internal transactions—exchanges within an entity, which may/may-not affect equation o Events—happenings that affect the equation and are reliably measured  Business events—changes in market values of assets and liabilities  Natural events—floods, fires that destroy assets and create losses o 3 types of company operations

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 Services—providing customer service for profit  Merchandisers—buying products and re-selling them for profit  Manufacturers—creating products and selling them for profit Assets include cash, A/R, supplies, and equipment Liabilities is A/P Equity is Capital – withdrawal + revenue – expenses

Financial Statements  

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Income Statement—describes company’s revenue and expenses along with net income/loss over a period of time due to earnings activities Statement of Owners Equity—explains changes in equity from net income and from any owner investments and withdrawals over a period of time o Beginning capital + owner investments + Net income – withdrawals – Net Loss Balance Sheet—describes a company’s financial position (types and amounts of assets, liabilities, and equity) at a point in time o Left side is assets: cash, supplies, and equipment o Upper right—owed to creditors + loans Statement of Cash Flows—identifies cash inflows (receipts) and outflows (payments) over a period of time o Operating activities—cash received (from customers) and paid out (supplies, rent, employees salaries) o Investing—buying and selling assets that are held for long-term use (PPE) o Financing—long-term borrowing and repaying of cash from lenders and cash investments (and withdrawals) from owner o Final cash balance should equal cash from assets in balance sheet...