Financial Accounting Ch. 1-3

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information system that identifies, records, and communicates the economic events of an organization
annual report
report prepared by corporate management that presents financial information and an independent auditor’s report
Resources owned by a business
Auditor’s report
A report prepared by an independent outside auditor stating the auditor’s opinion as to the fairness of the presentation of the financial position and results of operations and their conformance with generally accepted accounting standards.
Balance sheet
A financial statement that reports the assets and claims to those assets at a specific point in time.
Basic accounting equation
Assets = Liabilities + Stockholders’ Equity.
Certified Public Accountant (CPA)
An individual who has met certain criteria and is thus allowed to perform audits of corporations.
Common stock
total amount paid in by stockholders for the shares they purchase.
Comparative statements
A presentation of the financial statements of a company for more than one year.
A business organized as a separate legal entity having ownership divided into transferable shares of stock.
Payments of cash from a corporation to its stockholders.
The cost of assets consumed or services used in the process of generating revenues.
Income statement
A financial statement that presents the revenues and expenses and resulting net income or net loss of a company for a specific period of time.
The debts and obligations of a business. Liabilities represent the amounts owed to creditors.
Management discussion and analysis (MD&A)
A section of the annual report that presents management’s views on the company’s ability to pay near-term obligations, its ability to fund operations and expansion, and its results of operations.
Net income
The amount by which revenues exceed expenses.

Net Income = Revenues > Expenses

Net loss
The amount by which expenses exceed revenues.

Net Loss = Expenses > Revenue

Notes to the financial statements
Notes that clarify information presented in the financial statements, as well as expand upon it where additional detail is needed.
A business owned by two or more persons associated as partners.
Retained earnings
The amount of net income retained in the corporation.
Retained earnings statement
A financial statement that summarizes the amounts and causes of changes in retained earnings for a specific period of time.
The increase in assets that result from the sale of a product or service in the normal course of business.
Sarbanes-Oxley Act (SOX)
Regulations passed by Congress in 2002 to try to reduce unethical corporate behavior.
Sole proprietorship
A business owned by one person.
Statement of cash flows
A financial statement that provides financial information about the cash receipts and cash payments of a business for a specific period of time.
Stockholders’ equity
The owners’ claim on total assets.
Classified balance sheet
A balance sheet that contains a number of standard classifications and sections.
Ability to compare the accounting information of different companies because they use the same accounting principles.
The approach of choosing an accounting method, when alternatives exist, that will least likely overstate assets and net income.
Use of the same accounting principles and methods from year to year within a company.
Cost principle
An accounting principle that states that companies should record assets at their cost.
Current assets
Cash and other resources that companies expects to convert to cash or use up within one year or the operating cycle, whichever is longer.
Current liabilities
Obligations that a company reasonably expects to pay within the next year or operating cycle, whichever is longer.
Current ratio measures
ability of company to pay short-term debt-paying
Debt to total assets ratio measures
Measures the percentage of assets financed by creditors.

higher percentage of dept financing , the riskier the business

Earnings per share (EPS) measures
the net income earned on each share of common stock.
Economic entity assumption
An assumption that every economic entity can be separately identified and accounted for.
Financial Accounting Standards Board (FASB)
The primary accounting standard-setting body in the United States
Free cash flow measures
provides insight into a company’s cash gnerating ability
Full disclosure principle
Accounting principle that dictates that companies disclose circumstances and events that make a difference to financial statement users.
Generally accepted accounting principles (GAAP)
A set of rules and practices, having substantial authoritative support, that the accounting profession recognizes as a general guide for financial reporting purposes.
Going concern assumption
The assumption that the company will continue in operation for the foreseeable future.
Intangible assets
Assets that do not have physical substance.
International Accounting Standards Board (IASB)
An accounting standard-setting body that issues standards adopted by many countries outside of the United States.
The ability of a company to pay obligations that are expected to become due within the next year or operating cycle.
Liquidity ratios
Measures of the short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash.
Long-term investments
(1) investments in stocks and bonds of other corporations that companies hold for more than one year, and
(2) long-term assets, such as land and buildings, not currently being used in the company’s operations.
Long-term liabilities (Long-term debt)
Obligations that a company expects to pay after one year
The constraint of determining whether an item is large enough to likely influence the decision of an investor or creditor.
Monetary unit assumption
An assumption that requires that only those things that can be expressed in money are included in the accounting records.
Operating cycle
The average time required to go from cash to cash in producing revenues.
Profitability ratios
Measures of the operating success of a company for a given period of time.
Property, plant, and equipment
Assets with relatively long useful lives that companies use in operating the business and are not intended for resale.
Public Company Accounting Oversight Board (PCAOB)
The group charged with determining auditing standards and reviewing the performance of auditing firms.
An expression of the mathematical relationship between one quantity and another; may be expressed as a percentage, a rate, or a proportion.
Ratio analysis
Expresses the relationship among selected items of financial statement data.

Expresssed in terms of either percentage, a rate or a simple proportion

The quality of information that indicates the information makes a difference in a decision.
The quality of information that gives assurance that it is free of error, is factual, and is neutral.
Securities and Exchange Commission (SEC)
The agency of the U.S. government that oversees U.S. financial markets and accounting standard-setting bodies.
The ability of a company to pay interest as it comes due and to repay the balance of debt at its maturity.
Solvency ratios
Measures of the ability of the company to survive over a long period of time.
Statement of stockholders’ equity
A financial statement that presents the factors that caused stockholders’ equity to change during the period, including those that caused retained earnings to change.
Time period assumption
An assumption that the life of a business can be divided into artificial time periods and that useful reports covering those periods can be prepared for the business.
Working capital measures
short-term ability to pay obligatons

positive working capital – indicates likelihood that it will pay liabilities

negative working capital – indicates that a company might not be able to pay creditors and may be forced into bankruptcy

An individual accounting record of increases and decreases in specific asset, liability, stockholders’ equity, revenue or expense items.
Accounting information system
The system of collecting and processing transaction data and communicating financial information to interested parties.
Accounting transactions
Events that require recording in the financial statements because they affect assets, liabilities, or stockholders’ equity.
Chart of accounts
A list of a company’s accounts.
The right side of an account.
The left side of an account.
Double-entry system
A system that records the dual effect of each transaction in appropriate accounts.
General journal
The most basic form of journal.
General ledger
A ledger that contains all asset, liability, stockholders’ equity, revenue, and expense accounts.
The procedure of entering transaction data in the journal.
An accounting record in which transactions are initially recorded in chronological order.
The group of accounts maintained by a company.
The proces of transferring journal entries to the ledger accounts.
T account
The basic form of an account.
Trial balance
A list of accounts and their balances at a given time.
order to complete financial statements
1. Income Statement
2. Retained Earnings Statement
3. Balance Sheet
4. Statement of Cash Flows
primary forms of business organization
• Sole proprietorship
• Partnership
• corporation
Advantages of Sole proprietorship
•simple to establish
•owner controlled
•tax advantages that are more favorable than a corporation
Disadvantages of Sole proprietorship
•owner personally liable for all business debts
•financing may be difficult
•transfer of ownership may be difficult
Advantages of partnership
•simple to establish
•shared control
•broader skills and resources
•tax advantages that are more favorable than a corporation
Disadvantages of partnership
•owners personally liable for all business debts
• transfer of ownership may be difficult
Advantages of corporation
•easier to transfer ownership
•easier to raise funds
•lower legal liability – no personal liability for stockholders
Disadvantages of corporation
•unfavorable tax treatment resulting in higher taxes paid by stockholders
purpose of financial statements
provide inputs for decision making
two types of users of financial statements are
internal users
external users
all businesses are involved in the following types of activity
Financing activities
Cash is often obtained from outside sources to start or expand a business.
Investing activities
Purchase of resources a company needs to operate the business
Operating activities
begin once business has assets it needs from the other two activities.
primary sources of financing activities
1. Borrowing money
2. Issuing shares of stock
Accounting Information is communicated through which documents
Income Statement
Retained Earnings Statement
Balance Sheet
Statement of Cash Flows
Components of Annual Report
• Financial statements
• Management discussion and analysis
• Notes to financial statements
• Auditor’s report
internal users of financial statements
are within the organization … marking, management, human resources
external users of financial statements
outside organization… investors, creditors, IRS, SEC, customers, labor unions
Earnings per share (EPS) computed as
net income
minus preferred stock dividends
divided by the average number of common shares outstanding during the year.

expressed in dolar value

Working Capital computed as
Current Assets minus Current Liabilities

expressed in Proportion 1.44:1

Current ratio computed as
current assets divided by current liabilities.

expressed in Proportion 1.44:1

Debt to total assets ratio computed as
total liabilities divided by total assets

expressed as a percentage

Free cash flow computed as
Cash provided by operations
minus capital expenditures
minus cash dividends

expressed in dolar value

for financial information to be useful, it should possess:
• relevance
• reliability
• comparability
• consistency
Assumptions in Financial Accounting are
• Monetary unit assumption
• Economic entity assumption
• Time period assumption
• Going concern assumption
• Cost principle
• Full disclosure principle
constraints in financial reporting
• Materiality
• Conservatism
Balance Sheet Classifications
• Current Assets
• Long-term investments
• Property, plant and equipment
• Intangible assets
• Current liabilities
• Long-term liabilities
• Stockholder’s equity
Statement of cash flows
presents information about cash inflows and outflows from
1. Operating activities
2. Investing activities
3. Financing activities
Asset entry effects
debit- increase
credit – decrease
normal balance – debit
liabilities entry effects
debit – decrease
credit – increase
normal balance – credit
normal balance
on the side where the increase in account is recorded
common stock entry effects
debit – decrease
credit – increase
normal balance – credit
retained earnings entry effects
debit – decrease
credit – increase
normal balance – credit
dividends entry effects
debit- increase
credit – decrease
normal balance – debit
Revenue entry effects
debit – decrease
credit – increase
normal balance – credit
Expense entry effects
debit- increase
credit – decrease
normal balance – debit
journal contributes to the recording process by
1. disclosing in one place the complete effect of a transaction
2. provides a chronological record of transactions
3. helps prevent or locate errors because debit and credit amounts can be readily compared
basic steps in the accounting process
1. analyze each transaction in terms of it’s effect on accounts
2. enter the transaction into the journal
3. transfer the journal information to accounts in the ledger
accounts types with debit normal balance
accounts types with credit normal balance
common stock
retained earnings
Categories: Financial Accounting