Financial Accounting

FINANCIAL ACCOUNTING Robert Libby Patricia A. Libby Daniel G. Short Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc...

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FINANCIAL ACCOUNTING Robert Libby Patricia A. Libby Daniel G. Short

Irwin/McGraw-Hill

© The McGraw-Hill Companies, Inc., 2001

Chapter 1

Financial Statements and Business Decisions Irwin/McGraw-Hill

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The Objectives of Financial Accounting Financial statements are the primary means of communicating financial information to parties outside the business organization. Balance Sheet Income Statement

Stakeholders Irwin/McGraw-Hill

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Business Background Business owners (called investors or stockholders) look for two sources of possible gain: Sell ownership interest in the future for more than they paid.

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Receive a portion of the company’s earnings in cash (dividends).

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Business Background Creditors lend money to a company for a specific length of time and gain by charging interest on the money loaned. Loan

Dana’s Diner

Interest Irwin/McGraw-Hill

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Understanding Business Operations Manufacturers either make the parts needed to produce its products or buy the parts from suppliers. Manufacturer

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Product

Customer

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Understanding Business Operations All businesses have an accounting system that . . .

Collects and processes financial information about an organization.

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Business managers (internal)

Reports information to decision makers. Investors (external)

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Understanding Business Operations Accounting System

Financial Accounting System (preparation of four basic financial statements).

Managerial Accounting System (preparation of detailed plans, forecasts and reports).

External Decision Makers (investors, creditors, suppliers, customers, etc.).

Internal Decision Makers (managers throughout the organization).

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Information Conveyed in Financial Statements The four basic financial statements . . . Statement of Cash Flows

Balance Sheet

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Statement of Retained Earnings

Income Statement

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Information Conveyed in Financial Statements Most companies prepare financial statements at the end of the quarter (called quarterly reports) and the end of the year (called annual reports). 2001

X Irwin/McGraw-Hill

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Let’s look at MAXIDRIVE CORP.’s financial statements.

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MAXIDRIVE CORP. Balance Sheet At December 31, 20A (In thousands of dollars) Assets Cash $ 4,895 Accounts receivable 5,714 Inventories 8,517 of entity Plant 1. andName equipment 7,154 (the separate-entity assumption) 981 Land Total assets of statement $ 27,261 2. Title Liabilities and Stockholders' Equity 3. Specific date Liabilities

(financial snapshot at a specific Accounts payable $ 7,156 point in time) Notes payable 9,000 4. Unit measure Total liabilities $ 16,156 (thousands of dollars) Stockholders' Equity Contributed capital Retained earnings Total stockholders' equity Total liabilities and stockholders' equity

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$ 2,000 9,105 11,105 $ 27,261 © The McGraw-Hill Companies, Inc., 2001

The Balance Sheet Body Body of of the the Statement Statement Assets Assets ●● Economic Economicbenefits benefitsowned ownedby bythe thebusiness businessas asaaresult resultof ofpast past

transactions. transactions.

Liabilities Liabilities ●● Debts Debtsor orobligations obligationsof ofthe thebusiness businessthat thatresult resultfrom frompast past

transactions. transactions.

Stockholders’ Stockholders’ Equity Equity ●● Amount Amountof offinancing financingprovided providedby byowners ownersof ofthe thebusiness businessand and

operations. operations.

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The Balance Sheet Basic Accounting Equation Assets Assets

== Liabilities Liabilities ++ Stockholders’ Stockholders’ Equity Equity

Economic resources =

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Sources of financing . . . Liabilities: from creditors Equity: from stockholders.

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Assets are listed by their ease of conversion into cash.

MAXIDRIVE CORP. Balance Sheet At December 31, 20A (In thousands of dollars) Assets Cash $ 4,895 Accounts receivable 5,714 Inventories 8,517 Plant and equipment 7,154 Land 981 Total assets $ 27,261 Liabilities and Stockholders' Amount of cashEquity in the company’s bank Cash Liabilities account. Accounts payable $ 7,156from prior Accounts Amounts owed by customers Notes payablesales. receivable

9,000

Total liabilities Partial and completed but unsold$ 16,156

Inventories

Stockholders' product. Equity Contributed $ 2,000 Plant and capital Factories and production machinery. Retained earnings 9,105 equipment Total stockholders' equity 11,105

Land on whichequity factories are located. Total liabilitiesProperty and stockholders' $ 27,261 Irwin/McGraw-Hill

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MAXIDRIVE CORP. Balance Sheet At December 31, 20A (In thousands of dollars) Assets Cash Accounts receivable Accounts Amounts Inventories owed to suppliers for prior payable purchases. Plant and equipment Notes Amounts owed Land on written debt payable contracts. Total assets Liabilities and Stockholders' Equity Liabilities Accounts payable

$ 4,895 5,714 8,517 7,154 981 $ 27,261

$ 7,156

Notes payable

9,000

Total liabilities

$ 16,156

Stockholders' Equity Contributed capital Retained earnings Total stockholders' equity

$ 2,000 9,105 11,105

Total liabilities and stockholders' equity Irwin/McGraw-Hill

$ 27,261

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MAXIDRIVE CORP. Balance Sheet At December 31, 20A (In thousands of dollars) Assets Cash Accounts receivable Inventories Plant and equipment Land Total assets Liabilities and Stockholders' Equity Contributed Amounts invested in theLiabilities business by Accounts payable capital stockholders.

Retained earnings

Notesnot payable Past earnings distributed to Total liabilities stockholders.

$ 7,156 9,000 $ 16,156

Stockholders' Equity Contributed capital Retained earnings Total stockholders' equity

$ 2,000 9,105 11,105

Total liabilities and stockholders' equity Irwin/McGraw-Hill

$ 4,895 5,714 8,517 7,154 981 $ 27,261

$ 27,261

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MAXIDRIVE CORP. Balance Sheet At December 31, 20A (In thousands of dollars) Assets

Use $ on the first item in a group and on the group total.

Cash Accounts receivable Inventories Plant and equipment Land Total assets Liabilities and Stockholders' Equity Liabilities Accounts payable

$ 4,895 5,714 8,517 7,154 981 $ 27,261

$ 7,156

Notes payable

9,000

liabilities Assets = LiabilitiesTotal + Stockholders’ Equity Stockholders' Equity Contributed capital Retained earnings Total stockholders' equity

$ 2,000 9,105 11,105

Total liabilities and stockholders' equity Irwin/McGraw-Hill

$ 16,156

$ 27,261

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MAXIDRIVE CORP. Income Statement For the Year Ended December 31, 20A (In thousands of dollars) Revenues Sales revenue $ 37,436 1. Name of entity Expenses 2. Title of statement 3. Specific sheet, this Cost of goodsdate sold(Unlike the balance $ 26,980 statement covers a specified period of time.) Selling, general and administrative 3,624 4. Unit measure (in thousands of dollars) Research and development 1,982 Interest expense 450 Total expenses 33,036 Pretax income Income tax expense Net income Irwin/McGraw-Hill

$ 4,400 1,100 $ 3,300

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MAXIDRIVE CORP. Income Statement For the Year Ended December 31, 20A The income statement is divided into (In thousands of dollars)

three major captions.

! Revenues "

#

Sales revenue $ 37,436 Expenses Cost of goods sold $ 26,980 Selling, general and administrative 3,624 Research and development 1,982 Interest expense 450 Total expenses 33,036 Pretax income Income tax expense Net income

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$ 4,400 1,100 $ 3,300

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MAXIDRIVE CORP. Income Statement For the Year Ended December 31, 20A (In thousands of dollars) Revenues Sales revenue $ 37,436 Expenses Revenues are earnings from the sale of goods Cost of goods sold $ 26,980 or services. Selling, general and administrative 3,624 Research andisdevelopment 1,982 Revenue recognized in the period in which Interest expense 450 goods and services are sold, not necessarily period in which cash is received. 33,036 Totalthe expenses Pretax income Income tax expense Net income Irwin/McGraw-Hill

$ 4,400 1,100 $ 3,300

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The Income Statement

!Revenues Earnings from the sale of goods or services.

When will the revenue from this transaction be recognized? $1,000 sale made on May 25th.

May 2001 Irwin/McGraw-Hill

X

Cash from sale collected on June 10th.

X

June 2001 © The McGraw-Hill Companies, Inc., 2001

The Income Statement

!Revenues Earnings from the sale of goods or services.

When will the revenue from this transaction be recognized? $1,000 revenue recognized in May May 2001 Irwin/McGraw-Hill

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MAXIDRIVE CORP. Expenses are theIncome dollar amount of resources used Statement up by the to earn revenues during a period. Forentity the Year Ended December 31, 20A (In thousands of dollars) An expense is recognized in the period in which goods and services are used, not necessarily Revenues the period in which cash is paid. Sales revenue $ 37,436 Expenses Cost of goods sold $ 26,980 Selling, general and administrative 3,624 Research and development 1,982 Interest expense 450 Total expenses 33,036 Pretax income Income tax expense Net income Irwin/McGraw-Hill

$ 4,400 1,100 $ 3,300

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MAXIDRIVE CORP. Income Statement For the Year Ended December 31, 20A (In thousands of dollars) Revenues Cost of The cost of the products sold this goods sold period. Sales revenue $ 37,436 Expenses Selling, Operating expenses not directly related Cost of goods sold $ 26,980 general and to production. Selling, general and administrative 3,624 administrative Research and development 1,982 Research and Expenses incurred to develop new Interest expense 450 development products. Total expenses 33,036 Interest The cost of using borrowed funds. Pretax income $ 4,400 expense Incometax tax expense 1,100 Income Income taxes on current period’s pretax Netexpense income $ 3,300 income. © The McGraw-Hill Companies, Inc., 2001 Irwin/McGraw-Hill

The Income Statement

" Expenses The dollar amount of resources used up by the entity to earn revenues during a period.

When will the expense for this transaction be recognized? May 11 paid $75 cash for newspaper ad.

X May 2001 Irwin/McGraw-Hill

Ad appears on June 8th.

X

June 2001 © The McGraw-Hill Companies, Inc., 2001

The Income Statement

" Expenses The dollar amount of resources used up by the entity to earn revenues during a period.

When will the expense for this transaction be recognized? Advertising expense recorded in June.

May 2001 Irwin/McGraw-Hill

June 2001 © The McGraw-Hill Companies, Inc., 2001

MAXIDRIVE CORP. Income Statement For the Year Ended December 31, 20A (In thousands of dollars) Revenues Sales revenue $ 37,436 Expenses Cost of goods sold $ 26,980 Selling, general and administrative 3,624 Research and development 1,982 Interest expense 450 revenues exceed expenses, TotalWhen expenses 33,036 Pretax income we report net income. Income tax expense Net income Irwin/McGraw-Hill

$ 4,400 1,100 $ 3,300

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MAXIDRIVE CORP. Income Statement For the Year Ended December 31, 20A (In thousands of dollars) Revenues Sales revenue $ 37,436 Expenses Cost of goods sold $ 26,980 Selling, general and administrative 3,624 Research and development 1,982 Interest expense 450 Total expenses 33,036 Pretax income $ 4,400 When exceed revenues, 1,100 Income taxexpenses expense we report net loss. Net income $ 3,300 Irwin/McGraw-Hill

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Statement of Retained Earnings Income of the enterprise. e d i v i D

s d n

Stockholders Irwin/McGraw-Hill

by

Re tai en ne ter d pri se

Retained Earnings © The McGraw-Hill Companies, Inc., 2001

MAXIDRIVE CORP. Statement of Retained Earnings For the Year Ended December 31, 20A (In thousands of dollars) Retained earnings, January 1, 20A $ 6,805 Net income for 20A 3,300 1. Name of entity Dividends for 20A (1,000) 2. Title of statement Retained December 31,statement, 20A $ 9,105 3. Specificearnings, date (Like the income this statement covers a specified period of time.) 4. Unit measure (in thousands of dollars)

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MAXIDRIVE CORP. Statement of Retained Earnings For the Year Ended December 31, 20A (In thousands of dollars) Retained earnings, January 1, 20A Net income for 20A Dividends for 20A Retained earnings, December 31, 20A

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$ 6,805 3,300 (1,000) $ 9,105

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Notes ✔Notes provide supplemental information about the financial condition of a company. ✔Three types . . . ➊Describe accounting rules applied. ➋Present additional detail about an item on the financial statements. ➌Provide additional information about an item not on the financial statements. Irwin/McGraw-Hill

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Responsibilities for the Accounting Communication Process Effective communication means that the recipient understands what the sender intends to convey.

Decision makers need to understand accounting measurement rules. Irwin/McGraw-Hill

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Generally Accepted Accounting Principles (GAAP) Securities Act of 1933 Securities and Exchange Act of 1934

The Securities and Exchange Commission (SEC) has been given broad powers to determine measurement rules for financial statements.

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Generally Accepted Accounting Principles (GAAP) The SEC has worked closely with the accounting profession to work out the detailed rules that have become known as GAAP.

Currently, the Financial Accounting Standards Board (FASB) is recognized as the body to formulate GAAP.

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Generally Accepted Accounting Principles (GAAP) Companies are interested in GAAP because methods of reporting can have the following economic consequences . . .

! Affect the selling price of stock. " Affect the amount of bonuses received by managers and other employees. # Cause a loss of competitive advantage.

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Management Responsibility and the Demand for Auditing To ensure the accuracy of the company’s records management: ➊ Maintains a system of controls. ➋ Hires an outside independent auditor. ➌ Board of directors review these two safeguards.

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Independent Auditors $ Auditors express an opinion as to the fairness of the financial statement presentation. $ Independent auditors have responsibilities that extend to the general public. Irwin/McGraw-Hill

Overall, I believe these financial statements are fair.

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Independent Auditors An audit involves . . . $Examining the financial reports to ensure compliance with GAAP. $Examining the underlying transactions incorporated into the financial statements. $Expressing an opinion as to the fairness of presentation of financial information. Irwin/McGraw-Hill

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Ethics, Reputation, and Legal Liability The American Institute of Certified Public Accountants requires that all members adhere to a professional code of ethics.

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Ethics, Reputation, and Legal Liability A CPA’s reputation for honesty and competence is his/her most important asset.

Like physicians, CPAs have liability for malpractice. Irwin/McGraw-Hill

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End of Chapter 1

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