Understanding Principles of Accounting

Chapter Outline
 What Is Accounting and Who Uses
Accounting Information?
 Who Are Accountants and What Do They
Do?
 Tools of the Accounting Trade
 Financial Statements
 Analyzing Financial Statements
 What Is Accounting and Who Uses
Accounting Information?
 Accounting is a comprehensive system for
collecting, analyzing and communicating
financial information
 Bookkeeping is the recording of transactions
 What Is Accounting and Who Uses
Accounting Information?
• Accounting
information system
(AIS) is an organized
means by which
financial information is
identified, measured,
recorded and retained
for use in accounting
statements and
management reports
Users of Accounting Information
 Business Managers use it to develop goals and
plans, set budgets, and evaluate future prospects
 Employees and Unions use it to plan for and
receive compensation and benefits
 Investors and Creditors use it to estimate returns
to stock holders, determine growth prospects,
and decide whether a firm is a good credit risk
 Government Regulatory Agencies rely on it to
fulfill their duties toward the public
 What is a Controller?
Person who manages all of a
firm’s accounting activities
(chief accounting officer
 Who Are Accountants and
What Do They Do?
 Financial Versus Managerial Accounting
 Financial accounting system is concerned with
external information users: consumer groups,
unions, stock holders and government agencies
It regularly prepares income statements and
balance sheet, as well as other financial reports
published for share holders and the public
These documents focus on the activities of the
company as a whole rather than on individual
departments or divisions
Who Are Accountants and
What Do They Do?
 Managerial (or Management) accounting system
serves internal users
 Managers at all levels need information to make
departmental decisions, monitor projects, , plan
future activities
 To make products or operations improvement
engineers must know certain costs
 To set performance goals, sales people need past
sales data organized by geographic regions
 Purchasing agents use information on materials cost
to negotiate terms with suppliers
 What is an Audit?
Systematic examination of a
company’s accounting system
to determine whether its
financial reports fairly
represent its operations
What is GAAP (or Generally Accepted
Accounting Principles)?

Accepted rules and

procedures
governing the
content and form of
financial report
The Accounting Equation

Assets = Liabilities + Owners’ Equity

 The Accounting Equation
 Asset is any economic resource expected to benefit a firm or an
individual who owns it
 Assets include land, buildings, equipment, inventory and due to
the company (account receivable)
 Liability is a debt owned by a firm to an outside organization or
individual
 Owners’ equity is the amount of money that owners would
receive if they sold all of a firm’s assets and paid all of its liabilities
 Assets – Liabilities = Owners’ equity
 Owners’ equity consists of two sources of capital
 The amount that the owner originally invested
 Profits earned by and reinvested in the company
 The Accounting Equation
 When a company operates profitably its assets
increase faster than its liabilities
 Owners’ equity will increase if profits are
retained in the business instead of paid out as
dividends to stock holders
 Owners’ equity will also increase if if owners
invest more of their money to increase assets
 Owners’ equity can shrink if the company
operates at a loss or if owners withdraw assets
What is Double-Entry Accounting?
Bookkeeping system that
balances the accounting
equation by recording the dual
effects of every financial
transaction
 if business buys inventory by cash you
decrease cash and increase inventory
 If you invest more cash in your
business you increase the company’s
cash and increase your owners’ equity
 Financial Statements
 Also known as a statement of financial position, is a kind
of “snapshot” of where a company is, financially
speaking, at one moment in time.
 The balance sheet includes all the elements in the
accounting equation, showing the balance between assets
on one side and liabilities and owners’ equity on the other.
 Every company prepares a balance sheet at least once a
year, most often at the end of the calendar year, January 1
to December 31.
The fiscal year, any 12 consecutive months, is used by
many business and government bodies.
 Financial Statements
• Assets
• There are three types:
– Current Asset—asset that can or will be converted into cash within
the following year.
» Liquidity—ease with which an asset can be converted into cash.
» Nonliquid Assets—Includes marketable securities which vary in
liquidity and three other forms:
• accounts receivable—amount due from a customer who
has purchased goods on credit
• merchandise inventory—cost of merchandise that has been
acquired for sale to customers and is still on hand
• prepaid expense—expense that is paid before the
upcoming period in which it is due
 Financial Statements
Fixed Asset—asset with long-term use or value
» depreciation—process of distributing the cost of an asset over
its life
– Intangible Asset—nonphysical asset that has economic value in the
form of expected benefits.
» goodwill—amount paid for an existing business above the value
of its other assets
•  Liabilities are the debts that a business has incurred and appear after
assets because they are claims against the assets as shown in the
accounting equation: Assets = Liabilities + Owners’ Equity
– Current Liability—debt that must be paid within the year.
– Account Payable—current liabilities consisting of bills owed to
suppliers, plus wages and taxes due within the upcoming year.
– Long-Term Liability—debt that is not due for more than one year.
 Financial Statements
• Owners' Equity is the owners’ investment in a business.
This is also the section that shows a corporation’s
retained earnings, the portion of shareholders’ equity
earned by the company, but not distributed to its
owners in the form of dividends.
– Common Stock
– Paid-In Capital—additional money, above proceeds from
stock sale, paid directly to a firm by its owners.

• Retained Earnings—earnings retained by a

firm for its use rather than paid as dividends
 Financial Statements
a.Income Statements—financial statement listing a firm’s annual
revenues and expenses so that a bottom line shows annual profit
or loss. If the balance sheet is a “snapshot,” the income statement
is a “movie.”
i. Revenues—funds that flow into a business from the sale of goods or
services.
ii.Cost of Goods Sold—total cost of obtaining materials for making the
products sold by a firm during the year.
iii.Gross Profit (or Gross Margin)—revenues obtained from goods sold
minus cost of goods sold.
iv.Operating Expenses—costs, other than the cost of goods sold, incurred
in producing a good or service.
v.Operating Income—gross profit minus operating expenses.
1. net income (or net profit or net earnings)—gross profit minus operating expenses
and income taxes
 Financial Statements
 Statement of cash flows describes a firm’s
yearly cash receipts and cash payments.
Three activities:
 Cash Flows from Operations
 Cash Flows from Investing
 Cash Flows from Financing
 Financial Statements
 Cash Flows from Operations:
 Cash transactions involved in buying and
selling goods and services
 It reveals how much of the year’s income
results from main line of business
 Depreciation amount must be added back to
cash although it is an expense in
determining net income because it did not
reduce cash
 Financial Statements
 Cash Flows from Investing
 This section reports net cash used in or provided by
investing
 It includes cash receipts and payments from buying and
selling stocks, bonds, property, equipment, and other
productive assets
 These sources of cash are not the company’s main line of
business
 Cash Flows from Financing:
 Reports net cash from all financing activities
 It includes cash inflows from borrowing or issuing stock as
well as outflows for paying dividends and repayment of
borrowed money
An Internal Financial Statement:
What is the Budget?
 A detailed statement of estimated receipts and
expenditures for a period of time in the future.
 The budget is probably the most crucial internal
financial report.
 Most companies use their budgets for internal
planning, controlling, and decision-making.
 Although the accounting staff coordinates the
budget process, many different employees
contribute to creating and updating the budget.
 Analyzing Financial Statements

• Organizations and individuals use financial

statements to spot problems and opportunities.
• Managers and outsiders use them to evaluate a
company’s performance in relation to the
economy, the
• competition, and past performance. To
perform this analysis, most users look at
historical trends and key ratios.