CH1

1. Accounting

Financial accounting is concerned with the preparation of highly condensed,

standardized financial reports for use by interested parties outside the organization.
Financial markets depend on financial accounting information, the competency and
integrity of accountants who prepare it, and the governance processes that oversee its
production and delivery to investors, creditors, the press and regulatory agencies.
Managerial accounting concerns itself with the preparation of reports for use by
managers within a firm.
Enterprises need corporate governance practices in place so they choose appropriate
GAAP and so their Boards hear, and react appropriately, to concerns of the CFO (chief
finanancial officer) and other accountants hired by management to prepare and audit
financial statements.

2.Financial Statements

Income statement:Presents the results of operating activities for a period of

time,How well is the enterprise doing? Is it profitable?sometimes called the
profit and loss statement
Balance Sheet:Lists the enterprise's assets (economic resources), its
liabiltities (obligations) and the owners' residual interest at a point in
time.sometimes called the statement of financial position
Statement of Equity:Shows the increases in equity from operating profits and
new investment and distribution of assets to owners.Are owners withdrawing
resources or investing more resources?The statement of owner's equity reports
the change in owner's equity over the accounting period and explains the change in
net assets of the enterprise.

Cash Flow Statement:Reports the change in cash and the cash inflows and
outflows from operating, financing and investing activities for a period of
time.Does the enterprise generate enough cash to be self-sustaining? If not,
where does it get cash to survive? If it generates excess cash, how does it
use it?

Cash was used to pay dividends and to acquire equipment. cash was received when
bonds and common shares were issued.
In general, the typical sources and uses of cash for any firm are
SOURCES:

Operations (revenues from selling goods and services net of expenses)

Investing activities (selling off long term assets)

Financing activities (long term borrowings or selling more shares)

USES

Operations (only if cash expenses exceed cash revenues)

Investing activities (buying more long term assets)

Financing activities (retiring debt or shares or paying dividends)

Thus, the cash flow statement helps explain changes in various items on the
comparative balance sheet. This statement relates also to the income statement in
that it shows how operations affected cash for the period.

3.Balance Sheet
The balance sheet, sometimes called the statement of financial position, is a listing of
a firm's assets, liabilities, and owners' equity on a given date (these terms are
explained below) It is important for you to realize that the balance sheet of a firm
changes with every single transaction, so that when we formally draw up a balance
sheet we are depicting the firm's financial position at one fleeting instant in time.
The total assets always equal the sum of the creditors' and owners' equities. This
balancing is sometimes described as the accounting equation or the balance sheet
equation, and it shows that all of the assets of the corporation are attributed to
claims of its creditors and owners.This relationship can be shown as follows:

A. Asset
Assets are the economic resources of the business that can usefully be expressed in
monetary terms.Some assets-such as land, buildings, and equipment-may have
readily identifiable physical characteristics. Others may simply represent claims
for payment or services, such as amounts due from customers (accounts
receivable) or prepayments for future services (for example, prepaid insurance). As a
convenience to the reader of the balance sheet, the assets are usually listed in
an established order, with the most liquid assets (cash, receivables, supplies, and so
on) preceding the more permanent assets (land, buildings, and equipment).The
simplest way of defining an asset is a thing of value owned.
Current assets include cash and assets that are expected to be turned into cash, or
sold, or consumed within approximately one year from the date of the balance sheet.
Cash, temporary investments in securities, accounts receivable from customers, and
inventories are the most common current assets. Non-current assets, typically held
and used for several years, include land, buildings, equipment, patents, and long-term
investments in securities.

B.Liabilities
Liabilities, or creditors' equity, are the obligations, or debts, that the firm must pay in
money or services at some time in the future. Therefore, they represent creditors'
claims on the firm's assets. in the order that they will come due. Short-term liabilitiessuch as notes payable given for money borrowed for relatively short periods, accounts
payable to creditors, and salaries owed employees-are shown first. Below the shortterm liabilities, the long-term debt is presented. Long-term debt items such as
mortgages and bonds payable will normally not be repaid in full for several
years.Although most liabilities are payable in cash, some may involve the performance
of services. A magazine publisher, for example, may receive advance payments for
three- or five-year subscriptions.
Current liabilities include liabilities that are expected to be paid within one year. Notes
payable to banks, accounts payable to suppliers, salaries payable to employees, and
taxes payable to governments are examples. Non-current liabilities and shareholders'
equity are a firm's longer term sources of funds.

C. Owners' Equity
owners' equity is a residual claim- a claim to the assets remaining after the debts to
creditors have been discharged. If the business is a limited company (corporation),

then we use the term shareholders' equity instead of owners' equity. The shareholders'
equity
generally
comprises two
parts:
contributed
capital
and
retained
earnings.Contributed capital reflects the funds invested by shareholders for an
ownership interest. The Hayes brothers, who own all of the shares in Lazy Boards Inc.
have contributed $500,000 for this one hundred percent interest in the firm. When a
business is incorporated, owners invest in the business by purchasing shares of the
corporation. Changes in share capital (the owners' investment) and changes in
retained earnings (accumulated net income less accumulated dividends, distribution
of assets to shareholders of a corporation) are reported separately for corporations.

Owners' equity can be increased by contributions from owners and by

revenue. It can be decreased by withdrawals and expenses. Only revenue and
expenses are used in determining net income.
a.Retained earnings

Retained earnings represent the earnings realized by a firm since its formation in
excess of dividends distributed to shareholders. In other words, retained earnings are
earnings reinvested by management for the benefit of shareholders.Management
directs the use of a firm's assets so that, over time, more assets are received than are
given up in obtaining them. This increase in assets, after any claims of creditors,
belongs to the firm's owners. Most firms reinvest a large percentage of the assets
generated by earnings for replacement of assets and growth rather than paying
dividends.Since there are no retained earnings or accumulated losses reflected in Lazy
Boards equity section, we can surmise that this is a start-up balance sheet before
operations commenced. Once a firm has earnings (net income) the accumulated effect
is shown as Retained Earnings.

4. Cash Basis & Accrual Basis

determining net income (Revenue - Expenses) on the accrual basis, revenue is
recognized when earned rather than when cash is collected, and expenses are
recognized when goods and services are used rather than when they are paid for.
The timing difference between the two methods occurs because revenue recognition is
delayed under the cash basis until customer payments arrive at the company. Similarly,
the recognition of expenses under the cash basis can be delayed until such time as a
supplier invoice is paid. To apply these concepts, here are several examples:

Revenue recognition. A company sells $10,000 of green widgets to a customer in

March, which pays the invoice in April. Under the cash basis, the seller recognizes the sale
in April, when the cash is received. Under the accrual basis, the seller recognizes the sale
in March, when it issues the invoice.

Expense recognition. A company buys $500 of office supplies in May, which it pays
for in June. Under the cash basis, the buyer recognizes the purchase in June, when it pays
the bill. Under the accrual basis, the buyer recognizes the purchase in May, when it
receives the supplier's invoice.

Cash Basis:

Revenue is recorded when cash is received from customers, and expenses

are recorded when cash is paid to suppliers and employees. the cash basis is only available
for use if a company has no more than $5 million of sales per year. It is easiest to account
for transactions using the cash basis, since no complex accounting transactions such as
accruals and deferrals are needed. Given its ease of use, the cash basis is widely used in
small businesses. However, the relatively random timing of cash receipts and expenditures
means that reported results can vary between unusually high and low profits.

Accrual Basis:The

accrual basis income statement reports revenue and

expenses on a comparable basis from year to year and from business to business:

revenue is recognized when the business delivers the goods or provides the
services, regardless of when customers pay (provided ultimate collection is
reasonably assured); and

expenses (costs of earning the revenue) are 'matched' in the same accounting
period, regardless of when suppliers, employers or taxing authorities and others
are paid.

Accounting entity-each business venture is a separate unit, accounted for separately.

Historical cost-assets are reported at acquisition prices and are not adjusted upward.
Objectivity-where possible, recording of transactions should be supported by verifiable evidence.
Going concern-the assumption is made in accounting that a business will continue indefinitely.
Measuring unit-conventional accounting statements are expressed in money amounts, unadjusted
for changes in the value of the dollar.