ACC821 Notes | Fall 2020

Chapter 1: Introduction to Financial Accounting

First 10 slides are not covered.

Financial
Accounting

Management
Accounting
Accounting

Tax Accounting

The Complete set of Financial Statements include:

- Balance Sheet or Statement of Financial Position
- Income Statement or Statement of Activities
- Cash Flow Statement
- Owners’ Equity Statement
- Notes and Disclosures

Accounting in the USA: They follow the US GAAP Standard, Generally Accepted Accounting
Principle (written by FASB). While in Europe or the Middle East they follow the IFRS
Standard, International Financial Reporting Standard (written by IASB).

Auditing is implemented to give credibility to the financial statements, usually by an external

audit.
- Auditing in the USA follows the US GAAS, Generally Accepted Auditing Standard
- Auditing in Europe follows the ISA, International Standard on Auditing

I always Start preparing my statements by preparing the IS, from it I take the NI and put it in RE
hence I prepare my BS second.

Characteristics of a Financial Statement:

- Assumption 1: Faithful Representation:
The auditors will give a reasonable assurance (never absolute) that the financial statements are
free of material misstatements (no evidence/material enough to deceive or change the decision of
the management / people in charge)
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- Assumption 2: Historical Cost and Economic Entity:

Or historical Unit Assumption, it’s related to the conservatism philosophy: Record future Losses
but not gains.
For example, if a land I bought for 1M$ is now worth 10M$, I won’t show this gain in my
statement, but I may disclose it in my notes. Once I sell the land, the 10M$ profit may be record.

But my losses (expected) are always shown as a provision in my statements.

Economic Entity: There’s a clear separation between the company and the owners. I don’t record
the owners personal expenses on the company

- Assumption 3: Monetary Unit Assumption:

No entry shall be made that doesn’t have a monetary nature. In other word I only record what
has already been made in the past. Anything in the future is and will not be a part of it. (Here we
disregard the provision mentioned above because the loss made is connected to a past
asset/operation)

- Assumption 4: Consistency and Comparison:

Follow the same standard and principles in all my statements so I am able to compare it and have
it all consistent.

- Assumption 5: Going Concern:

Simply put, it’s the concern about the firm’s Continuity for the next year at least (Dec-Dec).
We have a going concern problem (won’t be able to continue operations) when for example my
Short-term Liabilities are bigger than my ST Assets hence, I won’t be able to meet my ST
Obligations.
The auditor should mention in my notes the going concern problem, because if I publish my
statements and then just one month later, I face a problem, investors might lose money. That is
why when it’s mentioned that the company might face some problems the investors will take
some precautions.

Primary users of Financial Statements: External Users like investors and Stakeholders…

Characteristics and Elements of a Balance Sheet:

All the Accounts in the BS are permanent

The Golden Formula: Asset=Liabilities+ Equity

- Assets are what the company owns, they can be Current (easily transformed
into cash in less than 1 year like Cash, AR and inventory) or the are long-term
and usually I don’t sell them like land and equipment
- Liabilities are what the company owes to external parties
- Equity is what the company owes to the shareholders
- Owners’ Equity: The Original Owners, 3endoun 7essa men l assets-liabilities
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- Stockholder Equity: All stockholders, and they only receive relative to their
portion of stocks

End OE=Beg OE+ ¿−Dividends

Also Same for RE: But when there’s no new capital injection OE=RE

Characteristics and Elements of an Income Statement:

IS Accounts are temporary because at the end of the year I remove everything and start from 0
whereas the BS I record everything I have till the moment.

The Golden Formula: Revenues−Expenses=Net Income

- Revenues: What we generate

- Expenses: Recurring whereas Capitalized (LT) assets are non-recurring

There is no relationship between cash and profit.

- That’s why Revenues are recorded when earned. That means when we sell a product
or deliver a service, I record it regardless if I receive cash.
- Expenses are recorded when incurred

Example:
*When I sell a fridge and receive cash: My assets (cash) increase, and my Sales revenues
as well
*When I sell a fridge and don’t receive cash: My Account Receivables and Sales
Revenues increase
*When I have salaries to pay they are removed from either Cash or AP, and I record
Salaries Expenses

Characteristics and Elements of a Cash Flow Statement:

- Operating Activities: includes the Current assets and liabilities like selling
products or cost incurred to operate
- Investing Activities: When I want to increase my profit, so I buy LT Assets
- Financing Activities: in the form of LT Liabilities (Debt: Loans or Bonds) or
Equity Account (Stocks)

Agencies and their roles:

- SEC: Securities and Exchange Commission: The federal agency with ultimate
authority to determine the rules for preparing statements for companies whose stock
is sold to the public, the rule enforcers
- FASB: Financial Accounting Standards Board: The group in the private sector
with authority to set accounting standards, the rule makers
- AICPA: American Institute of Certified Public Accountants: The professional
organization for CPA, the CPA regulators
- IASB: International Accounting Standards Board: The organization formed to
develop worldwide accounting standards
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- PCAOB: Public Company Accounting Oversight Board: a 5-member body

created by an act of Congress in 2002 to set auditing standards

Additional Notes:
- A corporation is made out of shares so it can issue stocks and all the profit goes first
to Retained Earning whereas a Partnership (2 or more owners), all the profit goes to
the partners not (RE) and they are directly liable for the losses

- RE: Accumulation of Losses and Profits over the years

- Note Receivable: Less than 1 year but there’s a binding agreement, more liquid

- AR: Not binding

- I start in my BS with the most liquid accounts like Current Asset

- My Net Income goes to RE and then if the company decides to pay out dividend it
can

- Dividend doesn’t decrease NI, it decreases RE

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Chapter 2: Financial Statements and the Annual Report

Financial Statements: BS, IS …
Annual Report: A big report that includes the financial statements as part of it. It includes
everything from A-Z. it is prepared every year

Primary Objective of Financial Reports Secondary Objective of Financial Reports

Extend Credit, Borrow, should we invest, take A = L + OE
a loan, start a new business, new stock?

Characteristics of Financial Reports:

1- Understandable: Should be prepared as if people with now background can understand
it, easy to read.
2- Relevant: The information make sense
3- Reliable: I can make proper decisions based on the information
4- Comparable
5- Consistent
6- Materiality: Will the error I found in the statement make a difference in the solution?
In a company there’s a materiality driver: it drives the whole operation, it can be TA, TE, TR, NI

We have 3 Levels of Materiality:

- Level 1: Overall Materiality: decided by an audit manager or top

management
For TA, TE, TE it’s up to 0.5%
For NI it’s up to 5%
Here, I will assume OM is 1M$ based on some algorithms

- Level 2: Planning / Performing Materiality: 50% - 75% of OM

If it is a controlled environment, I will be less conservative and more tolerant and vice
versa. I will not dig in detail, so I put my materiality at 75% (0.75 x 1M = 750K) so
anything with an error of more than 750k$ is material and I raise the flag

- Level 3: Summary of Unadjusted Difference: 5% - 10% of OM

Anything below the SUD, I ignore it. It’s immaterial

Now I group all the errors in excel

Excel Debit Credit
Purchase Increased by 350K
Depreciation Decreased by 200K
Revenues Decreased by 400
All of these fall between SUD and Planning Materiality, I sum them up (+ and -) and if
the sum is below SUD I ignore them, Above Planning Materiality I raise a flag. Once an
error is adjusted, I directly remove it from my excel. (? Or if above SUD I raise it)
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I have Cash, I buy inventory and sell it on account (AR) then they will pay me in cash: a Cycle

Working Capital = CA – CL

Liquidity Ratio: Current Ratio: CA / CL

- A ratio of 1.4 or 1.5 is good. A ratio of 1.97 is highly liquid which is not good
meaning I have a lot of unused cash

Profit Margin: NI / Operating Revenue

(No need for CF, Stop on financial statement for a real company)