1 - 1 © 2002 prentice hall business publishing introduction to financial accounting, 8th...

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© 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8th Edition Horngren, Sundem, and Elliott

Introduction to Financial Accounting

8th EditionPowerPoint Presentation

Slides prepared by:

Eddie Metrejean, MTAX, CPAThe University of Mississippi

Images provided by New Vision Technology1-800-387-0732

nvtech.com

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Chapter 1

Accounting: The Languageof Business

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Learning ObjectivesAfter studying this chapter, you should be able to: Explain how accounting information assists in making

decisions. Describe the components of the balance sheet. Analyze business transactions and relate them to changes

in the balance sheet. Classify operating, investing, and financing activities in

a cash flow statement.

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Learning ObjectivesAfter studying this chapter, you should be able to: Compare features of proprietorships, partnerships, and

corporations. Describe auditing and how it enhances the value of

financial information. Distinguish between public and private accounting. Evaluate the role of ethics in the accounting process.

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Introduction Accounting - a process of identifying, recording,

summarizing, and reporting economic information to decision makers in the form of financial statements

Financial accounting - focuses on the specific needs of decision makers external to the organization, such as stockholders, suppliers, banks, and government agencies

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The Nature of Accounting The accounting system is a series of steps

performed to analyze, record, quantify, accumulate, summarize, classify, report, and interpret economic events and their effects on an organization and to prepare the financial statements.

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The Nature of Accounting Accounting systems are designed to meet the

needs of the decision makers who use the financial information.

Every business maintains some type of accounting system.• These accounting systems may be very complex or

very simple, but the real value of any accounting system lies in the information that the system provides.

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Accounting as an Aid toDecision Making

Accounting information is useful to anyone who makes decisions that have economic results.• Managers want to know if a new product will be

profitable.• Owners want to know which employees are

productive.• Investors want to know if a company is a good

investment.• Legislators want to know how a proposed law will

affect budgets.• Creditors want to know if they should extend credit,

how much to extend, and for how long.

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Accounting as an Aid toDecision Making

Accounting helps in decision making by showing where and when money has been spent, by evaluating performance, and by showing the implications of choosing one plan instead of another.

Fundamental relationships in the decision-making process:

EventAccountant’sanalysis and

recording

Financialstatements

Users

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Financial and Management Accounting

The major distinction between financial and management accounting is the users of the information.• Financial accounting serves external users,

such as investors, creditors, and suppliers.• Management accounting serves internal

users, such as top executives, management, and administrators within organizations.

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The primary questions about an organization’s success that decision makers want to know are:

What is the financial picture of the organization on a given day?

How well did the organization do during a given period?

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Accountants answer these primary questions with three major financial statements.• Balance sheet – shows financial picture on a given

day• Income statement – shows performance over a given

period• Statement of cash flows – shows performance over a

given period

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Annual report - a document prepared by management and distributed to current and potential investors to inform them about the company’s past performance and future prospects• The annual report is one of the most common

sources of financial information used by investors and managers.

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The annual report usually includes:• A letter from corporate management• A discussion and analysis by management of recent

economic events• Footnotes that explain many elements of the financial

statements in more detail• The report of the independent auditors• A statement of management’s responsibility for

preparation of the financial statements• Other corporate information

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In many cases, annual reports take a long time to produce and are not widely available to people who want them.• The Internet allows companies to have a Web site

where they provide direct access to the annual report.

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The Balance Sheet The balance sheet shows the financial position of

a company at a particular point in time.• The balance sheet is sometimes referred to as the

statement of financial position or the statement of financial condition.

The left side lists assets – the right side lists liabilities and owners’ equity

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The Balance Sheet The balance sheet equation:

Assets = Liabilities + Owners’ Equity

or

Owners’ Equity = Assets - Liabilities

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The Balance Sheet Elements of the balance sheet:

• Assets - resources of the firm that are expected to increase or cause future cash flows (everything the firm owns)

• Liabilities - obligations of the firm to outsiders or claims against its assets by outsiders (debts of the firm)

• Owners’ Equity - the residual interest in, or remaining claims against, the firm’s assets after deducting liabilities (rights of the owners)

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The Balance SheetSTEVENS COMPANY

Balance SheetJune 30, 2002

Assets LiabilitiesCurrent assets: Current liabilities: Cash $ 4,525 Accounts payable $ 9,800 Accounts receivable 2,040 Wages payable 3,765

Total current assets $ 6,565 Total liabilities $13,565Plant assets: Land $ 9,755 Equipment 6,500 Owner’s Equity Total plant assets 16,255 Hamilton, capital 9,255

Total liabilities andTotal assets $22,820 owner’s equity $22,820

============= =============

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Balance Sheet Transactions

The balance sheet is affected by every transaction that an entity encounters.

Each transaction has counterbalancing entries that keep total assets equal to total liabilities and owners’ equity, i.e., the balance sheet equation and the balance sheet must always be balanced.

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Balance Sheet Transactions A balance sheet could be prepared after every

transaction, but this practice would be awkward and unnecessary.• Therefore, balance sheets are usually prepared

monthly or on some other periodic schedule.

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Transaction Analysis Transactions are recorded in accounts, which are

summary records of the changes in particular assets, liabilities, or owners’ equity.

The account balance is the total of all entries to the account.

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Transaction Analysis For each transaction, the accountant determines:

• Which specific accounts are affected• Whether the account balances are increased or

decreased• The amount of the change in each account

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Transaction AnalysisSome definitions to remember: Inventory - goods held by a firm for resale to customers Account payable - a liability that results from the

purchase of goods or services on account Compound entry - a transaction that affects more than

two accounts Creditor - one to whom money is owed Debtor - one who owes money

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Introduction to Statementof Cash Flows

Companies do three basic things.• They invest in assets to conduct business.• They raise money to finance these assets.• They use the assets and the money they raise to

operate the business.

These transactions can be classified into one of three categories – operating, investing, and financing activities.

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Operating activities – include sale and purchase of goods and payment of items such as rent, taxes, and interest

Investing activities – include acquiring and selling assets and securities held for investment purposes

Financing activities – include obtaining resources from owners and creditors and repaying amounts borrowed

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The statement of cash flows gives a direct picture of where cash came from and where cash went.

Preparation of the statement of cash flows• List the activities that increased (inflow) or decreased

(outflow) cash.• Place each inflow or outflow into the proper

categories.

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Types of Ownership Three basic forms of ownership:

• Sole proprietorships

• Partnerships

• Corporations

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Types of Ownership

Sole Proprietorship A separate organization with a single owner

Tend to be small retail establishments and individual professional or service business

The sole proprietorship is an individual entity that is separate and distinct from the personal activities of the owner.

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Types of Ownership

Partnership An organization that joins two or more individuals

who act as co-owners

Dentists, doctors, attorneys, and accountants tend to conduct their activities as partnerships.

The partnership is an individual entity that is separate and distinct from the personal activities of each of the partners.

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Types of Ownership

Corporation An “artificial entity” created under state laws

Corporations have limited liability - corporate creditors have claims against corporate assets only.• Individual investors are at risk only up to the amount

they have invested in the corporation. Creditors cannot hold investors liable for the corporation’s debts.

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Types of Ownership

Corporation Owners are called shareholders or stockholders.

Publicly owned vs. privately owned corporations• Public - Shares in the ownership are sold to the public

on a stock exchange; the corporation can have many thousands of shareholders.

• Private - Shares in the ownership are owned by families, small groups of shareholders, or a single shareholder and are not sold to the public.

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Types of Ownership Management by the owners:

• Sole proprietorship - The owner is an active manager in day-to-day operation of the business.

• Partnership - Partners are usually active managers in day-to-day operations of the business.

• Corporation - Shareholders usually do not participate in the day-to-day operations of the business – shareholders elect a board of directors who hires a management team.

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Advantages and Disadvantages of Forms of Ownership

Corporations Advantages

• Limited liability• Easy transfer of ownership - shares of stock can be

bought and sold easily on stock exchanges• Ease of raising ownership capital because of many

potential stockholders• Continuity of existence - life of the corporation

continues even if its ownership changes

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Corporations Disadvantages

• Possibility of double taxation - corporation pays tax at the entity level and its owners pay taxes on distributions of earnings to them

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Proprietorships and Partnerships Advantages

• No taxation at the entity level - income of sole proprietorship and partnership is attributed to the owners as individual taxpayers

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Proprietorships and Partnerships Disadvantages

• Unlimited liability - creditors of the business can look to the owners’ personal assets for repayment

• Not easy to transfer ownership• Not easy to raise ownership capital with few owners• No continuity of existence - changes in ownership

terminate the proprietorship or partnership

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Accounting for Owners’ EquityProprietorships and Partnerships vs. Corporations Owners’ equities for proprietorships and

partnerships are called capital. Owners’ equity for a corporation

is called stockholders’ equity or shareholders’ equity.

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Accounting for Owners’ Equity In a corporation, the total capital investment

actively invested by the owners is called paid-in capital.

Paid-in capital consists of two parts:• Capital stock at par value• Paid-in capital in excess of par value

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The Meaning of Par Value Par value (stated value) - a dollar amount printed

on each stock certificate• Stock is usually issued and sold at more than par

value.

Paid-in capital in excess of par value - the difference between the total amount received for the stock (issue price or sales price) and the par value

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The Meaning of Par Value The following formulas show the components of

total paid-in capital:

Total paid-incapital

Capital stockat par

Paid-in capitalin excess of par= +

Capital stockat par = x

Number ofshares issued

Par valueper share

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The Meaning of Par Value The following formulas show the components of

total paid-in capital:

Paid-in capitalin excess of par

Capital stockat par


= –

= xNumber of

shares issuedAverage issueprice per share


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The Meaning of Par Value Par value was originally a measure of protection

for investors because it established a minimum legal liability of a stockholder.• The creditors would be assured that the corporation

would have at least a minimum amount of ownership capital because the investors agreed to invest at least par value.

Capital stock is sometimes called common shares or common stock.

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The Meaning of Par Value Some investors purchase stock directly from the

corporation (as in the previous discussion).• The company records cash received and records the

par value and paid-in capital in excess of par.

Usually, stock transactions involve two or more individuals.• In that case, the corporation does not record anything

except the change in ownership.

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Stockholders and theBoard of Directors

In the corporate form of business, management activities and ownership activities are kept separate.

The board of directors is the link between the owners (stockholders) and the actual managers.• The board has the responsibility to ensure that

management acts in the interests of the stockholders.

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The relationship among owners, managers, and the board of directors:

Stockholders

Board ofDirectors

Managers

Elect

Appoint

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The board of directors is elected by the stockholders.

Management is appointed by the board of directors

Therefore, the interests of both the stockholders and management are usually represented on the board of directors.

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Credibility and the Role of Auditing

Corporate management prepares the financial statements.• In some cases, management may have incentives to

make the company’s performance look better than it actually is.

Investors must be able to rely on the financial statements to show an accurate picture of the company.

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Credibility and the Role of Auditing

One way to solve the credibility problem is to introduce an honorable, expert third party.• The auditor examines the information that managers

use to prepare the financial statements and provides assurances about the credibility of the statements.

• These assurances should make the investors more comfortable about using the information to guide their investing activity.

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The Certified Public Accountant Providing credibility to financial statements

requires individuals who have:• The technical knowledge to assess financial

statements and determine their quality• The reputation for integrity and independence that

assures they will honestly tell interested parties if management has not produced fair financial statements

The accounting profession has such individuals.

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The Certified Public Accountant Certified public accountant (CPA) - earns the

designation by a combination of education, qualifying experience, and the passing of a two-day written national examination

The CPA exam covers four major areas:• Auditing• Accounting theory• Business law• Accounting practice (taxes, cost accounting, etc.)

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The Certified Public Accountant American Institute of Certified Public

Accountants (AICPA) - principal professional association in the private sector that regulates the quality of the public accounting profession• The AICPA prepares and grades the CPA exam.

Each state has its own regulations concerning the qualifications for taking the CPA exam and for earning the right to practice as a CPA.

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The Auditor’s Opinion Audit - an examination of transactions and

financial statements made in accordance with generally accepted auditing standards (GAAS) developed primarily by the AICPA

An audit includes tests of the accounting records, internal control systems, and other audit procedures as deemed necessary.

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The Auditor’s Opinion The audit is described in the auditor’s opinion

(independent auditor’s report).• The auditor’s opinion is included

with the financial statements of the organization being examined.

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The Accounting Profession The most common way to classify accountants is

to divide them into public accountants and private accountants.• Public accountants - accountants whose services are

offered to the general public on a fee basis• Private accountants - all other accountants, including

those who work for businesses, government agencies, and other not-for-profit organizations

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The Accounting Profession Public Accounting Firms:

• Services offered include auditing, preparing income tax returns, and management consulting.

• Firms vary in size and services offered.– Small proprietorships perform mostly income tax returns

and monthly “write-up” work (bookkeeping).

– Large partnerships perform many different types of accounting and consulting services. Some of these firms have thousands of partners and offices in many different countries.

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The Accounting ProfessionThe “Big-Five” accounting firms: Andersen Deloitte & Touche Ernst & Young KPMG Peat Marwick PricewaterhouseCoopers

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Professional Ethics Members of the AICPA must follow a code of

professional conduct which is especially concerned with competence, confidentiality, integrity, and objectivity.• CPAs have consistently been perceived as having

high ethical standards.

Ethics extend beyond public accounting.• Members of the Institute of Management Accountants

are expected to follow their own code of ethics.

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Other Opportunities for Accountants

Many accountants start their careers in public accounting and move to positions in business or government.• Accounting provides an excellent opportunity for

gaining broad knowledge which, in turn, provides excellent opportunities for upward movement within organizations.

Accounting is ranked as the most important course in business programs for future managers.

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