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Accounting What the Numbers Mean CHAPTER 1: Accounting Present and Past Marshall, McManus, and Viele 11th Edition 1-2
Learning Objectives After studying this chapter you should understand and be able to: LO 1-1: Explain the definition of accounting. LO 1-2: Identify who the users of accounting information are and explain why they find accounting information useful. LO 1-3: Identify the variety of professional services that accountants provide. LO 1-4: Summarize the development of accounting from a broad historical perspective. LO 1-5: Explain the role that the Financial Accounting Standards Board (FASB) plays in the development of financial accounting standards. LO 1-6: Generalize about how financial reporting standards evolve. LO 1-7: Identify the key elements of ethical behavior for a professional accountant. LO 1-8: Summarize the reasons for the FASB s Conceptual Framework project. LO 1-9: Summarize the objective of general purpose financial reporting. LO 1-10: Describe the plan of the book. 1-3
What is Accounting? Accounting is the process of: Learning Objective 1-1: Explain the definition of accounting. 1-4
Users and Uses of Accounting User Information Decision/Informed Judgment Made Management Planning, directing, and controlling Investors/Shareholders Assessing amounts, timing, and uncertainty of future cash returns on their investment Creditors/Suppliers Assessing probability of collection and the risk of late (or non-) payment Employees Planning for retirement and future job prospects Securities and Reviewing for compliance of all Exchange Commission required information Learning Objective 1-2: Identify who the users of accounting information are and explain why they find accounting information useful. 1-5
Professional services that accountants provide include: Financial Accounting Financial accounting generally refers to the process that results in the preparation and reporting of financial statements for an entity. Financial accounting is primarily externally oriented and concerned with the historical results of an entity s performance. Learning Objective 1-2: Identify who the users of accounting information are and explain why they find accounting information useful. 1-6
Professional services that accountants provide include: Managerial Accounting/ Cost Accounting Managerial accounting is concerned with the use of economic and financial information to plan and control many of the activities of the entity and to support the management decisionmaking process. Cost accounting relates to the determination and accumulation of product, process, or service costs. Learning Objective 1-3: Identify the variety of professional services that accountants provide. 1-7
Professional services that accountants provide include: Auditing Public Accounting Public accounting firms and individual Certified Public Accountants (CPAs) provide auditing services and issue an independent auditor s report. An independent auditor s report usually contains four brief paragraphs and states whether the financial statements are prepared in conformity with generally accepted accounting principles. An auditor s report can be unqualified (a clean opinion) or qualified. Learning Objective 1-3: Identify the variety of professional services that accountants provide. 1-8
Professional services that accountants provide include: Internal Auditing Internal auditors are professional accountants who perform functions much like those of an external auditor. However, internal auditors are employed in industry rather than public accounting. Learning Objective 1-3: Identify the variety of professional services that accountants provide. 1-9
Professional services that accountants provide include: Governmental and Not-for-Profit Accounting Governmental units (e.g., municipal, state, and federal agencies) and notfor-profit entities (e.g., universities, hospitals, and religious organizations) require the same accounting functions to be performed as do other accounting entities. Learning Objective 1-3: Identify the variety of professional services that accountants provide. 1-10
Professional services that accountants provide include: Income Tax Accounting Tax practitioners often develop specialties in the taxation of individuals, partnerships, corporations, trusts and estates, or international tax law issues. Learning Objective 1-3: Identify the variety of professional services that accountants provide. 1-11
How Has Accounting Developed? Mesopotamians record tax receipts on clay tablets. 3000 B.C. Learning Objective 1-4: Summarize the development of accounting from a broad historical perspective. 1-12
How Has Accounting Developed? Luca Pacioli published the first textbook describing a comprehensive doubleentry bookkeeping system. 3000 B.C. 1494 Learning Objective 1-4: Summarize the development of accounting from a broad historical perspective. 1-13
How Has Accounting Developed? The industrial revolution of the 19 th century generated the need for large amounts of capital to finance the enterprises that supplanted individual craftsmen. 3000 B.C. 1494 1800 s This need resulted in the corporate form of organization and the need to provide investors with reports showing the financial position and the results of operations. Learning Objective 1-4: Summarize the development of accounting from a broad historical perspective. 1-14
How Has Accounting Developed? 3000 B.C. 1494 1800 s 1900 s Accounting professionals in this country organized themselves in the early 1900 s and worked hard to establish certification laws, standardized audit procedures, and other attributes of a profession. Learning Objective 1-4: Summarize the development of accounting from a broad historical perspective. 1-15
How Has Accounting Developed? Between 1932 and 1934, the American Institute of Accountants and the New York Stock Exchange agreed on five broad principles of accounting. 3000 B.C. 1494 1800 s 1900 s 1932 to 1934 1933 & 1934 The Securities Act of 1933 and the Securities Exchange Act of 1934 gave the Securities and Exchange Commission (SEC) the authority to establish accounting principles for companies whose securities had to be registered with the SEC. Learning Objective 1-4: Summarize the development of accounting from a broad historical perspective. 1-16
How Has Accounting Developed? Although the SEC has the authority to establish accounting principles, the standard-setting process has been delegated to other organizations over the years. 3000 B.C. 1494 1800 s 1900 s 1932 to 1934 1933 & 1934 1939 to 1959 The Committee on Accounting Procedure of the American Institute of Accountants issued 51 Accounting Research Bulletins that dealt with accounting principles. Learning Objective 1-4: Summarize the development of accounting from a broad historical perspective. 1-17
How Has Accounting Developed? The Financial Accounting Foundation (FAF) was created and established the Financial Accounting Standards Board (FASB) as the authoritative standard-setting body within the accounting profession. 3000 B.C. 1494 1800 s 1900 s 1932 to 1934 1933 & 1934 1939 to 1959 1973 The FASB has issued 168 Statements of Financial Accounting Standards that have established standards of accounting and reporting for particular issues. Learning Objective 1-5: Explain the role that the Financial Accounting Standards Board (FASB) plays in the development of financial accounting standards. 1-18
How Has Accounting Developed? 3000 B.C. 1494 1800 s 1900 s 1932 to 1934 1933 & 1934 1939 to 1959 1973 2002 The Sarbanes-Oxley Act of 2002 created the five-member Public Company Accounting Oversight Board (PCAOB), which has the authority to set and enforce auditing, attestation, quality control, and ethics standards for public companies. Learning Objective 1-5: Explain the role that the Financial Accounting Standards Board (FASB) plays in the development of financial accounting standards. 1-19
How Has Accounting Developed? Effective July, 2009, however, all FASB standards were superseded by the FASB Accounting Standards Codification (FASB Codification). Essentially, the FASB Codification reorganized divergent sources of U.S. GAAP in a more accessible and researchable format. The FASB Codification now represents a single source of U.S. GAAP. Learning Objective 1-5: Explain the role that the Financial Accounting Standards Board (FASB) plays in the development of financial accounting standards. 1-20
How do financial reporting standards evolve? Standards for Other Types of Accounting: Managerial/Cost Accounting Cost Accounting Standards Board (CASB) for government contracts Auditing/Public Accounting Auditing Standards Board (part of AICPA) State and Local Governments Governmental Accounting Standards Board (GASB) Learning Objective 1-6: Generalize about how financial reporting standards evolve. 1-21
How do financial reporting standards evolve? International Accounting Standards The goal of the International Accounting Standards Board (IASB) is to develop a single set of high-quality, understandable, enforceable and globally accepted financial reporting standards based upon clearly articulated principles. The IASB has issued 41 IASs and 15 IFRSs. Learning Objective 1-6: Generalize about how financial reporting standards evolve. 1-22
Ethics and the Accounting Profession Integrity Independence Objectivity Competence Learning Objective 1-7: Identify the key elements of ethical behavior for a professional accountant. 1-23
The Conceptual Framework In the mid-1970 s, the Financial Accounting Standards Board (FASB) began creating the Statements of Financial Accounting Concepts (SFAC) in an effort to define the underlying concepts of accounting principles and financial reporting practices. Statements of Financial Accounting Concepts (SFACs) describe concepts and relationships that underlie financial accounting standards. Learning Objective 1-8: Summarize the reasons for the FASB s Conceptual Framework project. 1-24
Concepts Statement No. 8 The Objective of General Purpose Financial Statements Individual firms or entities External Users Historical cost Benefits exceed costs Timely information Notes and disclosures Accrual accounting Does not measure value of the firm Evolving Learning Objective 1-9: Summarize the objectives of financial reporting for business enterprises. 1-25
The Plan of this Book: This text is divided into two main parts: Chapters 2 through 11, which compose the first part of the book, are devoted to financial accounting topics. The remaining chapters, Chapters 12 through 16, provide an in-depth look at managerial accounting. Learning Objective 1-10: The Plan of the Book 261-26
End of Chapter 1 1-27
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Accounting What the Numbers Mean CHAPTER 2: Financial Statements and Accounting Concepts/Principles Marshall, McManus, and Viele 11th Edition 1-29
Learning Objectives After studying this chapter you should understand and be able to: LO 2-1: Explain what transactions are. LO 2-2: Identify and explain the kind of information reported in each financial statement and describe how financial statements are related to each other. LO 2-3: Explain the meaning and usefulness of the accounting equation. LO 2-4: Explain the meaning of each of the captions on the financial statements illustrated in this chapter. LO 2-5: Identify and explain the broad, generally accepted concepts and principles that apply to the accounting process. LO 2-6: Discuss why investors must carefully consider cash flow information in conjunction with accrual accounting results. LO 2-7: Identify and explain several limitations of financial statements. LO 2-8: Describe what a corporation s annual report is and why it is issued. 1-30
Financial Statements Transactions are economic interchanges between entities that are accounted for and reflected in financial statements. Learning Objective 2-1: Explain what transactions are. 1-31
Financial Statements Transactions Procedures for sorting, classifying, and presenting (bookkeeping) Selection of alternative methods of reflecting the effects of certain transactions (accounting) An entity s financial statements are the end product of a process that starts with transactions between the entity and other organizations and individuals. Financial Statements Learning Objective 2-1: Explain what transactions are. 1-32
Accounts Cash Account Accounts Receivable Account Accounts Payable Account Transactions are summarized in accounts. Accounts are used to organize like-kind transactions. Account balances are then used in the preparation of financial statements. Learning Objective 2-1: Explain what transactions are. 1-33
Financial Statements Required Disclosure Financial position at the end of the period Earnings for the period Cash flows during the period Investments by and distributions to owners during the period Financial Statement that Satisfies Requirement Balance Sheet Income Statement Statement of Cash Flows Statement of Changes in Owners' Equity In addition to the financial statements, the annual report will probably include several accompanying notes or explanations of the accounting policies used and detailed information about many of the amounts and captions shown in the financial statements. Learning Objective 2-2: Identify and explain the kind of information reported in each financial statement and describe how financial statements are related to each other. 1-34
Balance Sheet Elements Assets represent the amount of resources owned by the entity. Liabilities are amounts owed to other entities. Equity is the ownership right of the owner(s) of the entity in the assets that remain after deducting the liabilities. Learning Objective 2-3: Explain the meaning and usefulness of the accounting equation. 1-35
Balance Sheet Presents the balances in an entity's accounts at a given point in time Assets = Liabilities + Equity Learning Objective 2-3: Explain the meaning and usefulness of the accounting equation. 1-36
Balance Sheet Current assets are those assets that are likely to be converted into cash or used to benefit the entity within one year. Plant and equipment includes longterm assets that will benefit the entity over several years. Learning Objective 2-4: Explain the meaning of each of the captions on the financial statements illustrated in this chapter. 1-37
Balance Sheet Long-term liabilities are those liabilities that will not be repaid within one year of the balance sheet date. Current liabilities are those liabilities that are to be paid within one year. Learning Objective 2-4: Explain the meaning of each of the captions on the financial statements illustrated in this chapter. 1-38
Income Statement The income statement shows the net income (or net loss) for the period of time under consideration. Revenues result from the entity s operating activities (e.g., selling merchandise). Costs and expenses are incurred in generating revenues and operating the entity. Notice that the statement starts with net sales and that the various expenses are subtracted to arrive at net income Learning Objective 2-4: Explain the meaning of each of the captions on the financial statements illustrated in this chapter. 1-39
Income Statement Income taxes are shown after all the other income statement items have been reported. Earnings per share of common stock outstanding is reported as a separate item at the bottom of the income statement because of its significance in evaluating the market value of a share of common stock. Learning Objective 2-4: Explain the meaning of each of the captions on the financial statements illustrated in this chapter. 1-40
Paid-In Capital: Statement of Changes in Stockholders' Equity MAIN STREET STORE, INC. Statement of Changes in Stockholders Equity For the Year Ended August 31, 2017 Beginning balance $ 0 1.Common stock, par value, $10; 50,000 shares authorized, 10,000 shares issued and outstanding 100,000 Additional paid-in capital 90,000 Balance, August 31, 2017 $190,000 Retained Earnings: Beginning balance $ 0 Net income for the year 18,000 Less: Cash dividends of $.50 per share (5,000) Balance, August 31, 2017 $ 13,000 Total stockholders equity $203,000 This financial statement shows the detail of stockholders' equity and explains the changes that occurred in the components of stockholders' equity during the year. Learning Objective 2-4: Explain the meaning of each of the captions on the financial statements illustrated in this chapter. 1-41
Statement of Cash Flows The purpose of this financial statement is to identify the sources and uses of cash during the year. Cash Flows from Operating Activities: MAIN STREET STORE, INC. Statement of Cash Flows For the Year Ended August 31, 2017 Net income $ 18,000 Add (deduct) items not affecting cash: Depreciation expense 4,000 Increase in accounts receivable (80,000) Increase in merchandise inventory (170,000) Increase in current liabilities 67,000 Net cash used by operating activities $(161,000) Cash Flows from Investing Activities: Cash paid for equipment $ (40,000) Cash Flows from Financing Activities: Cash received from issue of long-term debt $ 50,000 Cash received from sale of common stock 190,000 Payment of cash dividend on common stock (5,000) Net cash provided by financing activities $ 235,000 Net increase in cash for the year $ 34,000 Learning Objective 2-4: Explain the meaning of each of the captions on the financial statements illustrated in this chapter. 1-42
Time-Line Model Learning Objective 2-4: Explain the meaning of each of the captions on the financial statements illustrated in this chapter. 1-43
Financial Statement Relationships The arrow indicates that net income affects retained earnings, which is a component of stockholders' equity. Learning Objective 2-4: Explain the meaning of each of the captions on the financial statements illustrated in this chapter. 1-44
Financial Statement Relationships Learning Objective 2-4: Explain the meaning of each of the captions on the financial statements illustrated in this chapter. 1-45
Financial Statement Relationships If assets equal $300,000 and liabilities equal $125,000, what is stockholders' equity? Balance Sheet Stockholders' Assets = Liabilities + Equity 320,000 = 117,000 +? Learning Objective 2-4: Explain the meaning of each of the captions on the financial statements illustrated in this chapter. 1-46
Financial Statement Relationships If assets equal $320,000 and liabilities equal $117,000, what is stockholders' equity? Balance Sheet Stockholders' Assets = Liabilities + Equity 320,000 = 117,000 + 203,000 Stockholders' equity equals $203,000 ($320,000 - $117,000) Learning Objective 2-4: Explain the meaning of each of the captions on the financial statements illustrated in this chapter. 1-47
Financial Statement Relationships Now, suppose that total assets increase $10,000 during the year and total liabilities decrease $3,000 during the year. Balance Sheet Assets = Liabilities + Stockholders' Equity 320,000 117,000 203,000 10,000 (3,000)? 330,000 114,000? What is stockholders' equity at the end of the year? Learning Objective 2-4: Explain the meaning of each of the captions on the financial statements illustrated in this chapter. 1-48
Financial Statement Relationships Stockholders' equity must have increased by $13,000. Since stockholders' equity was $203,000 at the beginning of the year, it must be $216,000 at the end of the year. Balance Sheet Assets = Liabilities + Stockholders' Equity 320,000 117,000 203,000 10,000 (3,000) 13,000 330,000 114,000 216,000 Learning Objective 2-4: Explain the meaning of each of the captions on the financial statements illustrated in this chapter. 1-49
Balance Sheet Cash Account Accounts receivable Merchandise inventory Equipment Accumulated depreciation Short-term debt Accounts payable Other accrued liabilities Long-term debt Stockholders' equity Cash on hand and in the bank Amounts due from customers Definition Cost of merchandise acquired and not yet sold Cost of equipment purchased and used in business Portion of the cost of equipment that is estimated to have been used up in the process of operating the business Amounts borrowed that will be repaid within one year of the balance sheet date Amounts due to suppliers Amounts owed to various creditors Amounts borrowed from banks or other creditors that will not be repaid within one year from the balance sheet date Residual claim of owners, computed as "assets minus liabilities" Learning Objective 2-4: Explain the meaning of each of the captions on the financial statements illustrated in this chapter. 1-50
Captions Net sales Cost of goods sold Gross profit Selling, general, and administrative expenses Income Statement Explanation Amount of sales of merchandise to customers, less the amount of customer returns of merchandise Represents the total cost of merchandise removed from inventory and delivered to customers as a result of sales Difference between net sales and cost of goods sold; Represents the seller's maximum amount of "cushion" from which all other expenses of the business must be deducted before it is possible to have net income Represents the operating expenses of the entity Income from operations Represents one of the most important measures of the firm's activities Interest expense Represents the cost of using borrowed funds Income taxes Shown after all of the other income statement items have been reported because income taxes are a function of the firm's income before taxes Net income per share of A significant item in evaluating the market value of a share common stock of common stock; Often referred to as "earnings per outstanding share" or EPS Learning Objective 2-4: Explain the meaning of each of the captions on the financial statements illustrated in this chapter. 1-51
Statement of Changes in Stockholders' Equity Captions Paid-in capital Common stock Additional paid-in capital Retained earnings Dividends Explanation Represents the total amount invested in the entity by the owners Reflects the number of shares authorized by the corporation's charter, the number of shares issued to stockholders, and the number of shares still held by the stockholders Difference between the total amount invested by the owners and the par value or stated value of the stock Represents the cumulative net income of the entity that has been retained for use in the business Distributions of earnings to the owners Learning Objective 2-4: Explain the meaning of each of the captions on the financial statements illustrated in this chapter. 1-52
Statement of Cash Flows Captions Cash flows from operating activities Depreciation expense Increase in accounts receivable Increase in merchandise inventory Increase in current liabilities Cash flows from investing activities Cash flows from financing activities Explanation Shown first; Net income is the starting point for this measure of cash generation Added back to net income because it is subtracted to arrive at net income, but does not require the use of cash Deducted because it reflects sales revenues, included in net income, but not yet received in cash Deducted because cash was spent to acquire the increase in inventory Added because cash has not yet been paid for the products and services that have been received during the current fiscal period Shows the cash sources and uses related to long-lived assets Shows the cash sources and uses related to transactions with creditors and stockholders Learning Objective 2-4: Explain the meaning of each of the captions on the financial statements illustrated in this chapter. 1-53
Accounting Concepts and Principles Accounting Entity Every economic entity can be separately identified and accounted for. Now Future Going Concern Concept The presumption that the entity will continue to operate in the future it s not being liquidated. Unit of Measurement Only transactions denominated in dollars (currency) are recorded in the accounting records. Cost Principle Transactions are recorded at their original cost to the entity as measured in dollars. Learning Objective 2-5: Identify and explain the broad, generally accepted concepts and principles that apply to the accounting process. 1-54
Accounting Concepts and Principles Objectivity The accountants desire to have a given transaction recorded in the same way in all situations. Accounting Period The period of time selected for reporting results of operations and changes in financial position. Matching Concept All expenses incurred to generate that period s revenues be deducted from the revenues earned. Accrual Accounting Recognize revenue at the point of sale and recognize expenses when incurred, even though the cash receipt or payment may occur at another time. Learning Objective 2-5: Identify and explain the broad, generally accepted concepts and principles that apply to the accounting process. 1-55
Accounting Concepts and Principles Consistency Provides meaningful trend comparisons over several years. Full Disclosure Circumstances and events that make a difference to financial statement users should be disclosed. Materiality The benefit of increased accuracy should outweigh the cost of achieving the increased accuracy. Conservatism When in doubt, make judgments and estimates that result in lower profits and asset valuations. Learning Objective 2-5: Identify and explain the broad, generally accepted concepts and principles that apply to the accounting process. 1-56
Accrual Accounting Vs. Cash Flows Revenue Recognition -Timing is the Key Accrual accounting recognizes: Revenue when revenue is earned, at the point of sale of services or products. Expenses when they are incurred. Cash flow recognizes: Revenue when payment is received for services rendered or products sold. Expenses when they are paid. Learning Objective 2-6: Describe why investors must carefully consider cash flow information in conjunction with accrual accounting results. 1-57
Limitations of Financial Statements Financial statements report only quantitative economic data. Qualitative economic variables are usually subjective in value and cannot be quantified in terms of dollars and cents that can be verified. They do not reflect qualitative economic variables, such as the value of the management team or the employees morale. How do the terms quantitative and qualitative differ? Learning Objective 2-7: Identify and describe several limitations of financial statements. 1-58
Limitations of Financial Statements Historical Cost Concept Assets are usually valued at the cost of the Asset when acquired. Matching Concept Estimates are acceptable provided there is a basis for them. The balance sheet does not report market values or replacement cost of the assets. Many estimates are used, such as warranty costs, depreciation, and pension expense. Learning Objective 2-7: Identify and describe several limitations of financial statements. 1-59
The Corporation s Annual Report The annual report is distributed to shareholders (and others). It contains the financial statements, together with the report of the external auditor s examination of the financial statements. It also contains Management s Discussion and Analysis (MD&A). Learning Objective 2-8: Describe what a corporation s annual report is and why it is issued. 1-60
End of Chapter 2 1-61