Introduction To Financial Accounting: 8th Edition

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Introduction to Financial
Accounting
8th Edition
PowerPoint Presentation
Slides prepared by:

Eddie Metrejean, MTAX, CPA
The University of Mississippi
Images provided by New Vision Technology
1-800-387-0732
nvtech.com
© 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8th Edition Horngren, Sundem, and Elliott
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Chapter 1
Accounting: The Language

of Business
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Learning Objectives
After 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 Objectives
After 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 to
Decision 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 to
Decision 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:
Accountant’s
Financial
Event analysis and Users
statements
recording
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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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Accounting
 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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Accounting
 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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Accounting
 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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Accounting
 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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Accounting
 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 Sheet

STEVENS COMPANY
Balance Sheet
June 30, 2002
Assets Liabilities
Current 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 $13,565

Plant assets:
Land $ 9,755
Equipment 6,500 Owner’s Equity
Total plant assets 16,255 Hamilton, capital 9,255
Total liabilities and
Total 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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 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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Some 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 Statement
of 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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of Cash Flows
 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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of Cash Flows
 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.
Even if the shareholder has > 50% of shares he might
not be among the managers
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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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Forms of Ownership
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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Forms of Ownership
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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Forms of Ownership
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’ Equity

Proprietorships 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 following formulas show the components of
total paid-in capital:
Total paid-in Capital stock Paid-in capital

= +
capital at par in excess of par
Capital stock Number of Par value

= x
at par shares issued per share
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 The following formulas show the components of
total paid-in capital:
Paid-in capital Total paid-in Capital stock

= –
in excess of par capital at par
Total paid-in Number of Average issue

= x
capital shares issued price per share
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 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.
 Capitalstock is sometimes called common shares

or common stock.
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 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 the

Board 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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Board of Directors
 The relationship among owners, managers, and
the board of directors:
Stockholders
Elect
Board of
Directors
Appoint
Managers
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Board of Directors
 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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 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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 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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 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 “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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1-1

Slides prepared by:

Accounting: The Language

 Financial accounting - focuses on the specific

The Nature of Accounting

The Nature of Accounting

 Every business maintains some type of

Financial and Management

Financial and Management

What is the financial picture of the organization

How well did the organization do during a given

Financial and Management

Financial and Management

Financial and Management

Financial and Management

The Balance Sheet

 The left side lists assets – the right side lists

The Balance Sheet

Assets = Liabilities + Owners’ Equity

The Balance Sheet

The Balance Sheet

Total current assets $ 6,565 Total liabilities $13,565

Balance Sheet Transactions

 Each transaction has counterbalancing

Balance Sheet Transactions

 These transactions can be classified into one of

 Tend to be small retail establishments and

 The sole proprietorship is an individual entity that

 Dentists, doctors, attorneys, and accountants tend

 The partnership is an individual entity that is

 Corporations have limited liability - corporate

Advantages and Disadvantages of

Advantages and Disadvantages of

Advantages and Disadvantages of

Advantages and Disadvantages of

Accounting for Owners’ Equity

Accounting for Owners’ Equity

 Paid-in capital consists of two parts:

The Meaning of Par Value

 Paid-in capital in excess of par value - the

The Meaning of Par Value

Total paid-in Capital stock Paid-in capital

Capital stock Number of Par value

The Meaning of Par Value

Paid-in capital Total paid-in Capital stock

Total paid-in Number of Average issue

The Meaning of Par Value

 Capitalstock is sometimes called common shares

The Meaning of Par Value

 Usually, stock transactions involve two or more

Stockholders and the

 The board of directors is the link between the

Stockholders and the

Stockholders and the

Credibility and the Role of

 Investors must be able to rely

Credibility and the Role of

The Certified Public Accountant

 The accounting profession has such individuals.

The Certified Public Accountant

The Certified Public Accountant

 Each state has its own regulations concerning the

The Auditor’s Opinion