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Introduction to Financial Accounting

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by: Merritt

Introduction to Financial Accounting Acc100

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These notes cover material from the first week
Intro to Financial Accounting
Luke Rhyner
Class Notes




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This 12 page Class Notes was uploaded by Merritt on Monday January 18, 2016. The Class Notes belongs to Acc100 at University of Wisconsin - Madison taught by Luke Rhyner in Spring 2016. Since its upload, it has received 28 views. For similar materials see Intro to Financial Accounting in Accounting at University of Wisconsin - Madison.


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Date Created: 01/18/16
Introduction to Financial Statements – Chapter One Introduction to Financial Statements  Forms of Business Organizations o Sole proprietorship o Partnership o Corporation  Users and Uses of Financial Information o Internal users o External users o Ethics in financial reporting  Business Activities  o Financing o Investing o Operating  Communicating with Users o Income statement o Retained earnings statement o Balance sheet o Statement of cash flows o Interrelationships of statements o Other elements of an annual report Describe the primary forms of business organization  Sole Proprietorship o Simple to establish o Owner controlled o Tax advantages  Partnership o Simple to establish o Shared control o Broader skills and resources o Tax advantage  Corporation o Easier to transfer ownership  Investors in a corporation receive shares of stock to indicate their ownership  claim. Buying stock in a corporation is often more attractive than investing in a  partnership because shares of stock are easy to sell. o Easier to raise funds  Individuals can become stockholders by investing relatively small amounts of  money. o No personal liability Corporate stockholders generally pay higher taxes but have no personal legal liability.  Easier to raise funds o Corporation o Corporation  Tax advantages  Simple to establish  o Sole proprietorship o Sole proprietorship o Partnership o Partnership  Easier to transfer ownership  No personal legal liability o Corporation Users and Uses of Financial Statements The purpose of financial information is to provide inputs for decision­making.  Accounting is the information system that identifies, records, and communicates the economic  events of an organization to interested users. o Users of accounting information can be divided into two groups  Internal users  External users  Internal Users o Internal users of accounting information are managers who plan, organize, and run a  business  Marketing managers  Finance directors  Production supervisors  Company officers  External Users o Investors (owners) use accounting information to make decisions to buy, hold, or sell stock. o Creditors (such as suppliers and bankers) use accounting information to evaluate the risks of selling on credit or lending money  Why does the form of organization matter for accounting?  Public investors make investments in publicly traded corporations through capital markets, and therefore have more difficulty requesting information from management.  Conversely, users of financial information from sole proprietorships, partnerships, and privately held corporations can more easily request financial information directly from owners and managers. o Therefore, the accounting rules and regulations differ for public vs. private companies. Only corporations can be publicly held.  What are the benefits to the company and to the employees of making the financial statements available to all employees?  The marketing department will make better decisions about products to offer and prices to charge.  The finance department will make better decisions about debt and equity financing and how much to distribute in dividends  The production department will make better decisions about when to buy new equipment and how much inventory to produce.  The human resources department will be better able to determine whether employees can be given raises.  All employees will be better informed about the basis on which they are evaluated, which will increase employee morale.  How might accounting help you?  You will need to understand financial reports in any business with which you are associated   Ethics in Financial Reporting  Sarbanes-Oxley Act (SOX) – To reduce unethical corporate behavior and decrease the likelihood of future corporate scandals o To provide measures that help ensure that fraud will not occur.  What happened as a result of SOX? o Management must now sign off on the accuracy of financial information o Increase independence of auditors  Many judgements in Financial Reporting o Rules and Principles related to Recognition o Management estimates in Measurement  Management Incentives can lead to unethical decisions  What benefits does a sound accounting system provide to a not- for-profit organization?  It helps to ensure that money is used in the way that donors intended.  It assures donors that their money is not going to waste and thus increases the likelihood of future donations.  Business Activities  All businesses are involved in three types of activity – financing, investing, and operating o The accounting information system keeps track of the results of each of the various business activities.  Financing Activities o The two primary sources of outside funds for corporations are:  Borrowing money (debt financing)  Take out a loan at a bank  Borrow money directly from investors by issuing debt securities called bonds. o Persons or entities to whom one owes money are its creditors o Amounts owed to creditors – in the form of debt or other obligations – are called liabilities  Specific names are given to a different types of liabilities, depending on their source  Issuing (selling) shares of stock in exchange for cash (equity financing)  Common stock is the term used to describe the total amount paid in by stockholders for the shares they purchase   Creditor claims must be paid before stockholders’ claims   Dividends – Cash payments to stockholders  Investing Activities o Once the company has raised enough cash through financing activities, it uses that cash in investing activities.  Investing activities involve the purchase of the resources a company needs in order to operate.  Resources owned by a business are called assets o Cash is one of the more important assets owned by any business  If a company has excess cash that it does not need for a while, it might choose to invest in securities (stocks or bonds) of other corporations.  Operating Activities – Usually involves assets with shorter lives (longer-lived assets are usually purchased through investing activities) o Revenue – The increase in assets or decrease in liabilities resulting from the sale of goods or the performance of services in the normal course of business.  Sources of revenue common to many businesses are sales revenue, service revenue, and interest revenue.  Inventory: goods (assets) available for future sales to customers  Account Receivable: right to receive money in the future o Expenses: The costs of assets consumed or services used in the process of generating revenues.  Costs of goods sold (such as the cost of ingredients  Selling expenses (such as the cost of salespersons’ salaries  Marketing expenses (such as the cost of advertising)  Administrative expenses (such as the salaries of administrative staff, and telephone and heating costs incurred at the corporate office)  Interest expense (amounts of interest paid on various debts)  Income taxes (corporate taxes paid to the government)   Net Income = Revenues > Expenses  Net Loss = Expenses > Revenues   Accounts Payable: obligations to pay for goods/services purchased on credit  Interest payable  Wages payable  Sales taxes payable  Property taxes payable  Income taxes payable   Summary  Forms of Business Organization o Sole Proprietorship o Partnership o Corporation  Accounting and Users of Financial Statements o Accounting: How companies communicate financial information/business activity to various user groups o Internal Users: Those who run a business o External Users: Anyone outside of business   All businesses are involved in 3 types of activity – which the accounting information systems keeps track of o Financing o Investing o Operating  Classify each item based on its economic characteristics  Cost of renting property – Expense  Truck purchased – Asset  Notes payable – Liability  Issuance of ownership shares – Common stock  Amount earned from performing service – Revenue  Amounts owned to suppliers - Liabilities  ------------------------------------------------------------------------------------------ ------------------------------------------------  Components of Annual Reports  Financial Statements – form the backbone of financial accounting o Assets, liabilities, expenses and revenues are presented in 4 different financial statements  Income Statement  To show how successfully your business performed during a period of time, you report its revenues and expenses in an income statement  Retained Earnings Statement  To indicate how much of previous income was distributed to you and the other owners of your business in the form of dividends, and how much was retained in the business to allow for future growth, you present a retained earnings statement  Balance Sheet  To present a picture at a point in time of what your business owns (its assets) and what it owes (its liabilities), you prepare a balance sheet  Statement of Cash Flows  To show where your business obtained cash during a period of time and how that cash was used, you present a statement of cash flows  Income Statement o Reports revenues and expenses and resulting net income/loss of the company’s operations for a period of time o Investors/creditors are use past net income to predict future net income  Relates to a company’s stock price  Helps creditors determine if company has ability to repay in the future  Cash received from issuing stock or borrowing are NOT revenues  Dividends paid are NOT expenses   Retained Earnings Statement o Retained earnings is the net income retained in the corporation  Retained earnings statement shows the amounts and causes of changes in retained earnings for a specific time period  By monitoring the retained earnings statement, financial statement users can evaluate dividend payment practices o Any money paid in dividends reduces a company’s ability to repay its debts  Balance Sheet o The balance sheet reports assets and claims to assets at a specific point in time  Claims to assets are subdivided into two categories  Claims of creditors (liabilities)  Claims of owners (stockholders’ equity)  Basic Accounting Equation – Assets = Liabilities + Stockholders’ Equity  Financing – Raising funds (Assets) to build a business with  What were the two alternatives to raise funds? o Borrowing money (creates a liability) o Issuing stock in the company (increasing equity)  Statement of Cash Flows  The primary purpose of a statement of cash flows is to provide financial information about the cash recipients and cash payments of a business for a specific period of time o The statement of cash flows reports the cash effects of a company’s operating, investing, and financing activities  The statement shows the net increase or decrease in cash during the period, and the amount of cash at the end of the period o Users are interested in the statement of cash flows because they want to know what is happening to a company’s most important resource  Where did cash come from during the period?  How was cash used during the period?  What was the change in the cash balance during the period?  Interrelationships of Statements  The retained earnings statement uses the results of the income statement o Net income is added to the beginning amount of retained earnings to determine ending retained earnings  The balance sheet and retained earnings statement are interrelated o The ending amount on the retained earnings statement is the retained earnings amount on the balance sheet  The statement of cash flows relates to information on the balance sheet o The ending amount of cash shown on the statement of cash flows must agree with the amount of cash on the balance sheet  Expanded Accounting Equation  Equity = Assets/gains in business not attributable to debt o Investments from stockholders o Value retained in business through operations  Retained Earnings = Same as retained earnings statement   Example:  Saira’s Maid Service began the year with total assets of $120,000 and stockholders’ equity of $40,000. During the year the company earned $90,000 in net income and paid $20,000 in dividends. Total assets at the end of the year were $215,000. Assuming the company did not issue any more stock during the year, how much was stockholders’ equity at the end of the year?  $110,000 – The sum of the beginning balance of stockholder’s equity (40,000) plus net income (90,000) less the dividends paid (20,000) during the period results in the ending balance of $110,000).  In what sequence are financial statements usually prepared?  Income statement, retained earnings statement, balance sheet, and statement of cash flows.  If total liabilities decreased by $15,000 and stockholders’ equity increased by $5,000 during a period of time, then total assets must change by what amount and direction during that same period?  $10,000 decrease – Assets = liabilities + stockholders’ equity, can be used to determine the answer: $15,000 + $5,000 = $10,000  The balance sheet…  Reports the assets, liabilities, and stockholders’ equity at a specific rate.  U.S. companies that are publicly traded must provide its shareholders with an annual report. What is included?  Financial statements  A management discussion and analysis section  Notes to the Financial statements  An independent auditor’s report   Management Discussion & Analysis (MD&A)  Includes company’s views on: o Ability to pay near-term obligations o Ability to fund operations and expansion o It’s results of operations  Involves several subjective estimates and opinions  Notes to the Financial Statements  The notes to the financial statements clarify the financial statements, and provide additional detail  Information in not necessarily quantifiable (numeric) o Often includes descriptions of accounting policies and methods utilized to prepare the statements  Auditor’s Report  An auditor’s report is prepared by an independent outside auditor  States 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 principles (GAAP) o An auditor is an accounting professional who conducts an independent examination of a company’s financial statements  Only accountants who meet certain criteria and attain their Certified Public Accountant (CPA) license requirements may perform audits o If the auditor is satisfied that the financial statements provide a fair representation of the company’s financial position and results of operations in accordance with generally accepted accounting principles, then the auditor expresses an unqualified opinion  State whether each of the following items is most closely associated with the management discussion and analysis (MD&A), the notes to the financial statements, or the auditor’s report  Descriptions of significant accounting policies – Notes  Unqualified opinion – Auditor’s report  Explanations of uncertainties and contingencies – Notes  Description of ability to fund operations and expansion – MD&A  Description of results of operations – MD&A  Certified public accountant (CPA) – Auditor’s report  Before you invest, you should evaluate the income statement, retained earnings statement, balance sheet, and statement of cash flows  What should these financial statements tell you? o You would probably be most interested in the income statement because it tells about past performance and thus gives an indication of future performance. The retained earnings statement provides a record of the company’s dividend history. The balance sheet reveals the relationship between assets and liabilities. The statement of cash flows reveals where the company is getting and spending its cash. This is especially important for a company that wants to grow.  Many agree that there is a need for one set of international accounting standards due to  Multinational corporations  Mergers and acquisitions  Information technology  Financial markets  IFRS  Principles based  Developed by the International Accounting Standards Board (IASB)  Non – US. Companies do not have to comply with SOX  U.S. GAAP  Rules based  Developed by the Financial Accounting Standards Board (FASB)  SOX applies to large public companies on U.S. exchanges  _________________________________________________________________ ____________________  Describe the primary forms of business organization  A sole proprietorship is a business owned by one person. A partnership is a business owned by two or more people associated as partners. A corporation is a separate legal entity for which evidence of ownership is provided by shares of stock  Identify the users and uses of accounting information  Internal users are managers who need accounting information to plan, organize, and run business operations. The primary external users are investors and creditors. Investors (stockholders) use accounting information to help them decide whether to buy, hold, or sell shares of a company’s stock. Creditor’s (suppliers and bankers) use accounting information to assess the risk of granting credit or loaning money to a business.     Explain the three principle types of business activity  Financing activities involve collecting the necessary funds to support the business. Investing activities involve acquiring the resources necessary to run the business. Operating activities involve putting the resources of the business into action to generate a profit.  Describe the content and purpose of each of the financial statements  An income statement presents the revenues and expenses of a company for a specific period of time. A retained earnings statement summarizes the changes in retained earnings that have occurred for a specific period of time. A balance sheet reports the assets, liabilities, and stockholder’s equity of a business at a specific date. A statement of cash flows summarizes information concerning the cash inflows (receipts) and outflows (payments) for a specific period of time.  Explain the meaning of assets, liabilities, and stockholders’ equity and state the basic accounting equation  Assets are resources owned by a business. Liabilities are the debts and obligations of the business. Liabilities represent claims of creditors on the assets of the business. Stockholders’ equity is subdivided into two parts: common stock and retained earnings. The basic accounting equation is Assets = Liabilities + Stockholders’ Equity  Self – Test Questions  Which statement about users of accounting information is incorrect? a) Management is considered an internal user b) Taxing authorities are considered external users c) Present creditors are considered external users d) Regulatory authorities are considered internal users  Net income will result during a time period when: a) Assets exceed liabilities b) Assets exceed revenues c) Expenses exceed revenues d) Revenues exceed expenses  Which statement presents information as of a specific point in time? a) Income statement b) Balance sheet c) Statement of cash flows d) Retained earnings statement  Which financial statement reports assets, liabilities, and stockholders’ equity? a) Income statement b) Retained earnings statement c) Balance sheet d) Statement of cash flows  Stockholders’ equity represents: a) Claims of creditors b) Claims of employees c) The difference between revenues and expenses d) Claims of owners  As of December 31, 2014, Stoneland Corporation has assets of $3,500 and stockholders’ equity of $1,500. What are the liabilities for Stoneland Corporation as of December 31, 2014?  $1,500 (Using the accounting equation, liabilities can be computed by subtracting stockholders’ equity from assets, or $3,500 - $2,000 = $1,500)  If total liabilities decreased by $15,000 and stockholders’ equity increased by $5,000 during a period of time, then total assets must change by what amount and direction during that same period?  $10,000 decrease (Assets = Liabilities + Stockholders’ Equity, can be used to determine the answer: ($15,000) + $5,000 = (10,000)             


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