Principles of financial accounting 12e by needles crosson chapter 01

C HAP TE R

1

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 1 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 2 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.