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Financial Accounting
Financial Accounting measures and records business transactions and provides financial statements for external users (investors, creditors, and stockholders) that are based on GAAP. It is mandatory.
GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (GAAP)
Expected return refers to the increase in the investors wealth that is expected over the
investments time horizon. This wealth increase is comprised of two parts: (1) increases in the market value of the investment and (2) dividends (periodic cash
distributions from the firm to its owners). Both of these sources of wealth depend on
the firms ability to generate cash. Accordingly, financial statements can improve decision making by providing information that helps current and potential investors estimate a firms future cash flows.
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1Risk
expected implies that the return is not guaranteed. Financial statements help investors assess risk by providing information about the historical pattern of past income and cash flows. Creditors: The lending decision involves two issues: whether or not credit should be extended, and the specification of a loans terms. For example, consider a bank loan officer evaluating a loan application. The officer must make decisions about the
amount of the loan, interest rate, payment schedule, and collateral. Because
repayment of the loan and interest will rest on the applicants ability to generate cash, lenders need to estimate a firms future cash flows and the uncertainty surrounding those flows. Although investors generally take a long-term view of a
firms cash generating ability, creditors are concerned about this ability only during
the loan period. Lenders are not the only creditors who find financial statements useful. Suppliers often sell on credit, and they must decide which customers will or will not honor their obligations.
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Other Users
A variety of other decision makers find financial statements helpful. Some of these decision makers and their decisions include the following: 1. Financial analysts and advisors. Many investors and creditors seek expert advice
when making their investment and lending decisions. These experts use financial
statements as a basis for their recommendations. 2. Customers. The customers of a business are interested in a stable source of supply. They can use financial statements to identify suppliers that are financially sound. 3. Employees and labor unions. These groups have an interest in profitability of firms that employ them. 4. Regulatory authorities. Capital Market Authority (CMA) is a prominent example. Its responsibility is to ensure that capital markets operate smoothly. To help achieve this, corporations are required to make full and fair financial disclosures. The CMA regularly reviews firms financial statements to evaluate the adequacy of their
disclosures.
management.
The conflict of interest in this situation is apparent. As a result, the financial statements of all corporations reporting to the CMA must be audited. Audits are required because they enhance the credibility of the financial statements. The financial statements of many privately held businesses are also subject to an audit. Banks, for example, require many loan applicants to submit audited financial statements so that lending decisions can be based on credible financial information.
The auditor (CPA) examines the information used by managers to prepare the
financial statements and attests to the credibility of the statements.
Financial Statements
Financial statements are the end result of the financial accounting process. Firms prepare three major financial statements: the balance sheet, the income statement, and the statement of cash flows. Balance Sheet (Statement of Financial Position): Snapshot of assets, liabilities, and owners equity at a given point in time.
Accounts receivable are amounts owed to Newton Company by its customers; these have value because they represent future cash inflows. Inventory is merchandise acquired that is to be sold to customers. Newton expects its inventory to be converted into accounts receivable and ultimately into cash. Finally, equipment enables Newton to operate its business.
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Liabilities are obligations of the business to convey something of value in the future. Newtons balance sheet shows two liabilities. Accounts payable are
profits). The income statement summarizes the earnings generated by a firm during
a specified period of time. Income statements contain at least two major sections: revenues and expenses: Revenues are inflows of assets from providing goods and services to customers. Newtons income statement contains one type of revenue: sales to customers. This includes sales made for cash and sales made on credit. Expenses are the costs incurred to generate revenues. Newtons income statement
includes three types of expenses. Cost of goods sold is the cost to Newton of the
merchandise that was sold to its customers. General and administrative expenses include salaries, rent, and other items. Tax expense reflects the payments that Newton must make to the taxing authorities.
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The difference between revenues and expenses is net income (or net loss if expenses are greater than revenues). The Newton Company Income Statement For the Year Ended December 31, 2000 Revenues Sales Expenses Cost of goods sold General and administrative Tax Total expenses Net Income 63,000 35,000 20,000 3,000 58,000 5,000
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The Newton Company Statement of Cash Flows For the Year Ended December 31, 2000 Cash flows from operating activities: Cash received from customers Cash paid to suppliers Taxes paid Cash flows from investing activities: Purchase of equipment Cash flows from financing activities: (2,000) 61,000 (37,000) (3,000)
1,100
Net borrowings
Net increase in cash Cash at beginning of year Cash at end of year
1,000
100 4,900 5,000
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Annual Report
All large firms, and many smaller ones, issue their financial statements as part of a larger document referred to as an annual report. In addition to the financial