978-1133939283 Chapter 1 Lecture Note Part 2

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Section 2: Accounting Applications

Accounting Applications

Describe the income statement

Describe the statement of owner’s equity

Describe the balance sheet

Describe the statement of cash ows

Lecture Outline

0. There are four basic nancial statements that are interrelated.

0. Income statement (also known as the statement of earnings or the prot and loss

statement)

00. Shows revenues earned and expenses incurred for a period of time

00. Indicates prot or loss for an accounting period

0. Statement of owner’s equity (also known as the capital statement)

00. Shows changes in the owner’s capital account over a period of time

0. Balance sheet (also known as the statement of nancial position)

00. Usually prepared as of the last day of the accounting period to show the

organization’s nancial position (or status) as of that specic date

00. Reects the accounting equation in its structure

0. Statement of cash ows

00. Presents signicant nancing, investing, and operating activities

(cash-generating and cash-using activities) during a given period

I0. GAAP are the conventions, rules, and procedures that dene acceptable accounting

practice at a particular time.

A0. CPAs perform independent audits of businesses’ nancial statements.

B0. An audit results in a professional opinion as to whether the nancial statements

are in accordance with GAAP.

III0. Organizations that issue accounting standards

A. The FASB is responsible for developing GAAP.

B0. The IASB sets international accounting standards.

IV. Other organizations that inuence GAAP

A0. The PCAOB is a governmental body created by the Sarbanes-Oxley Act to regulate

the accounting profession.

B0. The AICPA inuences GAAP through advisory committees.

C0. The SEC sets its own standards for companies whose securities are listed on the

stock exchanges.

D0. The GASB was established to issue accounting standards for state and local

governments.

E0. IRS guidelines are established to collect taxes but play an inuential role in the

establishment of accounting practices.

V0. It is important for CPAs to conform to their code of professional ethics, because the

public relies on them for the following:

0. Integrity

0. Objectivity

0. Independence

0. Due care

E0. Management accountants have a code of professional ethics that addresses

competence, condentiality, integrity, and objectivity.

or posted to a publicly accessible website, in whole or in part.

Chapter 1: Accounting Principles and the Financial Statements Instructor’s Manual, p. 2

Summary

Accountants communicate their information through nancial statements. The four basic

statements are the income statement, the statement of owner’s equity, the balance sheet,

and the statement of cash ows.

The income statement, whose components are revenues and expenses, is perhaps the

most important nancial statement. Its purpose is to measure a business’s protability

during a given period of time. The net income or net loss is used to update retained earnings

on the statement of retained earnings. Net income (loss) also appears on the statement of

cash ows.

The statement of owner’s equity is a calculation of the changes in owner’s capital during

the accounting period. Owner’s capital at the beginning of the period is the rst item on the

statement, followed by an addition for net income and a deduction for owner’s withdrawals.

The ending gure is transferred to the owner’s equity section of the balance sheet.

The balance sheet shows the nancial position of a business on a specic date. The

resources used in the business are called assets, debts of the business are called

liabilities, and the owner’s nancial interest in the business is called owner’s equity.

Changes that occur in these accounts are reected in the statement of cash ows.

The statement of cash ows provides users with information about the business’s

liquidity by disclosing all important nancing, investing, and operating activities that

a<ected its cash balance during the accounting period. Cash ows are the inows and

outows of cash into and out of a business. Financing activities may include issuing or

repaying debt. Investing activities may include selling a building or investing in stock.

Operating activities include receipts from customers and payments to suppliers and others

in the ordinary course of the business’s main operations.

Every nancial statement has a three-line heading. The rst line gives the name of the

company, the second line gives the name of the statement, and the third line gives the

relevant dates (the date of the balance sheet or the period of time covered by the other

three statements).

Generally accepted accounting principles (GAAP) are the conventions, rules, and

procedures that dene acceptable accounting practice at a particular time. They arise from

wide agreement on the theory and practice of accounting at a given time. These principles

change continually as business conditions change and practices improve.

The nancial statements of publicly held corporations are prepared by management but

audited by a licensed professional, called a certi$ed public accountant (CPA), so that the

statements can be made more believable to the users. Before the audit (examination) can

take place, however, the CPA must be independent of (without nancial or other ties to) the

client. On completion of the audit, the CPA reports whether the audited statements are

“presented fairly in all material respects” and are “in conformity with generally accepted

accounting principles.” Because estimates and interpretations are made in the application of

GAAP, auditors must employ their professional judgment in rendering an opinion.

The Financial Accounting Standards Board (FASB), an independent body, is the

authoritative body in the development of GAAP. The FASB issues Statements of Financial

Accounting Standards.

Spurred by the growth of nancial markets worldwide, the International Accounting

Standards Board (IASB) develops international accounting standards.

The Public Company Accounting Oversight Board (PCAOB) is a governmental body

created by the Sarbanes-Oxley Act to regulate the accounting profession.

or posted to a publicly accessible website, in whole or in part.

Chapter 1: Accounting Principles and the Financial Statements Instructor’s Manual, p. 3

The American Institute of Certi$ed Public Accountants (AICPA), the professional

association of CPAs, inuences accounting practice through the activities of its senior

technical committees.

The Securities and Exchange Commission (SEC) is an agency of the federal government

that has the legal power to set and enforce accounting practices for companies whose

securities are traded by the general public.

The Governmental Accounting Standards Board (GASB) was established in 1984 and is

responsible for issuing accounting standards for state and local governments.

The Internal Revenue Service (IRS) has its own set of rules that govern the assessment

and collection of taxes. These rules, while sometimes contrary to GAAP, are an important

inuence on accounting practice.

or posted to a publicly accessible website, in whole or in part.

Chapter 1: Accounting Principles and the Financial Statements Instructor’s Manual, p. 4

Professional ethics is the application of a code of conduct to the practice of a profession.

The accounting profession has developed a code that is intended to guide the accountant in

carrying out his or her responsibilities to the public. In conformity with the AICPA’s code for

CPAs, the accountant must act with integrity, objectivity, independence, and due care.

00. Integrity means the accountant is honest, regardless of consequences.

00. Objectivity means the accountant is impartial and intellectually honest in performing

his or her job.

00. Independence means the accountant avoids all relationships that could impair, or

even appear to impair, his or her objectivity, such as owning stock in a company being

audited.

00. Due care means carrying out professional responsibilities with competence and

diligence.

The Institute of Management Accountants (IMA) has a code of professional ethics,

which stipulates that managerial accountants are to be competent in their jobs, to keep

information condential, to maintain integrity and avoid conicts of interest, and to

communicate information objectively and without bias.

Relevant Examples and Exhibits

Exhibit 5 Financial Statement Relationships

Exhibit 6 Income Statement for Roland Consultancy

Exhibit 7 Statement of Owner’s Equity for Roland Consultancy

Exhibit 8 Balance Sheet for Roland Consultancy

Exhibit 9 Statement of Cash Flows for Roland Consultancy

Exhibit 10 Income Statement, Statement of Owner’s Equity, Balance Sheet and

Statement of Cash Flows for Roland Consultancy

Exhibit 11 Large International Certied Public Accounting Firms

Teaching Strategy

Explain the purpose of each nancial statement and discuss how each is used by various

user groups’ in evaluating a company’s protability and liquidity. Then refer to Exhibit 10 in

the text as you discuss how these statements interrelate. For example, students need to

know why the income statement must be prepared rst. Point out the common elements

that appear on more than one statement. Stress that it is the ending owner’s equity that

appears on the balance sheet. Distinguish between a specic date and a period of time.

Since the assets and liabilities of a business are changing from moment to moment, it is

necessary to choose a cuto< date on which to measure them.

Distinguish between net income on the income statement and net cash ows from operating

activities on the statement of cash ows.

Explain that GAAP are constantly evolving and are not like laws of science. Explain that

GAAP are designed to “accurately measure the performance of businesses” and that the

accountant, contrary to a common misconception, should not attempt to make a company

look better on paper than it really is. Emphasize that GAAP are guidelines that require

interpretation; they are not a rigid set of rules.

or posted to a publicly accessible website, in whole or in part.

Chapter 1: Accounting Principles and the Financial Statements Instructor’s Manual, p. 5

Be sure to explain that an audit report does not state whether the audited company is a

good investment; it states only whether its nancial statements are “presented fairly” in

accordance with GAAP. Also discuss the importance of independence. Explain that an audit

provides only reasonable, not absolute, assurance because it relies on test results from a

sample of transactions.

An interesting discussion involves distinguishing between GAAP and tax law (Internal

Revenue Code). Point out that the objective of tax law is to raise revenue for the

government, not to accomplish the logical measurement of business income.

Explain the importance of ethics within the accounting profession and the possible

consequences of being in violation of the professional code. The key terms integrity,

objectivity, independence, and due care can help illustrate the concept. Describe some

situations that typically create ethical dilemmas for accountants.

Section 3: Business Applications

Business Applications

Protability

Liquidity

Ethics

Lecture Outline

0. Three major groups use accounting information.

0. Management (internal users)

0. Outsiders with a direct nancial interest

00. Present or potential investors

00. Present or potential creditors

0. People, organizations, and agencies with an indirect nancial interest

00. Tax authorities

00. Regulatory agencies

a. Securities and Exchange Commission (SEC)

00. Other groups (labor unions, nancial advisers, economic planners, etc.)

0. Government and not-for-prot organizations also use nancial information.

II0. A business is an economic unit that aims to sell goods and services to customers at

prices that will provide an adequate return to its owners.

0. Goals

00. Protability—earning a suGcient return to maintain owner interest

00. Liquidity—having enough cash to pay debts as they come due

0. Activities

00. Operating—selling goods and services to customers, employing managers

and workers, buying and producing goods and services; and paying taxes

00. Investing—spending the capital a company receives in productive ways that

help it achieve its objectives

00. Financing—obtaining funds to begin operations and to continue operating

0. Performance measures

00. Performance measures relate to achieving goals and assessing the

management of business activities.

or posted to a publicly accessible website, in whole or in part.

Chapter 1: Accounting Principles and the Financial Statements Instructor’s Manual, p. 6

2. Financial analysis is the evaluation and interpretation of the nancial

statements and related performance measures.

30. Performance measures must be crafted to motivate managers to make

decisions that are in the best interest of the business.

I0. Ethical nancial reporting

0. Ethics is a code of conduct that addresses whether actions are right or wrong.

00. Ethics in the preparation of nancial reports is important, because users of

these reports must depend on the good faith of the people involved in their

preparation.

00. The intentional preparation of misleading nancial statements is called

fraudulent nancial reporting.

00. Fraudulent nancial reporting can result from the distortion of records,

falsied transactions, or the misapplication of various accounting principles.

00. The motivation for fraudulent nancial reporting could be to inate the

perceived value of a business, meet stockholders’ and nancial analysts’

expectations, obtain nancing, or receive personal gain.

Summary

Basically, three groups use accounting information: management, outsiders with a direct

nancial interest, and outsiders with an indirect nancial interest.

00. If a business is to survive, management must achieve protability and liquidity. The

company also has other goals, such as improving its products and expanding

operations. Management directs the company toward these goals by making the right

decisions.

00. Present or potential investors and present or potential creditors are considered outside

users with a direct nancial interest in a business. Investors use nancial statements

to assess the strength or weakness of the company, whereas creditors examine the

nancial statements to determine the company’s ability to repay loans at the

appropriate time.

00. Society as a whole, through its government oGcials and public groups, may be viewed

as a nancial statement user with an indirect nancial interest in a business.

Specically, society includes (a) tax authorities, (b) regulatory agencies, and (c) other

groups (such as labor unions and nancial analysts). The Securities and Exchange

Commission (SEC), a regulatory agency, has extensive reporting requirements for

public companies.

Managers in government and not-for-prot organizations such as hospitals, universities,

professional organizations, and charities also make extensive use of nancial information. In

addition to nancing, investing, and operating activities, these organizations have reporting

responsibilities to authoritative bodies that hold them accountable for their nancial

performance.

A business is an economic unit that aims to sell goods and services to customers at prices

that will provide an adequate return to its owners. The two major goals of all businesses are

protability and liquidity. Pro$tability is the ability to earn enough income to attract and

hold investment capital. Liquidity is the ability to have suGcient cash to pay debts as they

fall due. Businesses pursue their goals by engaging in (1) operating activities, which

include selling goods and services to customers, employing managers and workers, and

buying and producing goods and services; (2) investing activities, which involve spending

the capital a company receives in ways to help it achieve its objectives; and (3) $nancing

activities, which include obtaining funds to begin and sustain operations.

or posted to a publicly accessible website, in whole or in part.

Chapter 1: Accounting Principles and the Financial Statements Instructor’s Manual, p. 7

Financial Analysis uses nancial statements to determine how well a business is

managed. An important function of accounting is to provide performance measures,

which indicate whether managers are achieving their business goals and whether the

business activities are well managed. Financial ratios can provide information on both how

nancial statement items relate to each other and allow for comparisons from one period to

the next.

Ethics is the code of conduct that helps individuals in their everyday life distinguish right

from wrong. Ethics is especially important in preparing nancial reports, because users of

these reports must depend on the good faith of the people involved in their preparation. The

intentional preparation of misleading nancial statements is called fraudulent $nancial

reporting. It can result from the distortion of records, falsied transactions, or the

misapplication of various accounting principles.

In 2002, Congress passed the Sarbanes-Oxley Act to regulate nancial reporting in public

corporations. This legislation requires the chief executives and chief nancial oGcers of all

publicly traded U.S. companies to attest to the accuracy and completeness of the quarterly

statements and annual reports that their companies le with the SEC.

Relevant Examples and Exhibits

Exhibit 12 The Users of Accounting Information

Exhibit 13 Business Goals and Activities

Teaching Strategy

An interesting way to present learning objective 5 is to ask students to name the many users

of nancial information while you keep a list on the board (or overhead transparency, etc.).

Students should know that the list in Exhibit 12 of the text, although ambitious, is not

exhaustive. At the same time, you may want to ask them why each user would seek a

company’s nancial information and whether each user is more interested in assessing

protability or liquidity.

Making the distinction between direct and indirect users, and between internal and external

users, is helpful. Ask students how they have used accounting information.

Case 1 provides a good foundation for discussing business goals and activities. This sets the

stage for a discussion of accounting and how it helps businesses achieve goals and perform

activities. Figure 2 in the text illustrates business goals and activities. Distinguish between

protability and liquidity and explain why a business must maintain both if it is to survive.

The key components of the AICPA’s denition of accounting are “useful,” “nancial

information,” and “decisions.”

Be sure to mention management’s responsibility for ethical nancial reporting, including the

denition of fraudulent nancial reporting and the signicance of the Sarbanes-Oxley Act.

Short Exercise 1 can be used in class to test students’ knowledge of terminology. Case 5

emphasizes the importance of cash ows and the goal of liquidity.

or posted to a publicly accessible website, in whole or in part.

Chapter 1: Accounting Principles and the Financial Statements Instructor’s Manual, p. 8

Student Engagement Tactics

1. Divide the class into small groups. One quick way to form groups is to divide the

number of students in class by three or four (the most e<ective group size for this

activity). Ask students to count o< from 1 to the maximum number of groups. Remind

them not to forget their number. Have students get together by number after you

give complete instructions. It will encourage a speedy transition, as this activity has a

time limit.

2. Assign one of the learning tools. (If one of the problems was done for homework, use

another one in this activity; it will reinforce learning.)

3. The rst group to correctly complete the task wins. As the groups complete the task,

mark their completion time. (You may want to gather and keep their responses until

the time limit has expired. See Step 4.) The time limit is 25 minutes. If, for some

reason, no group has the correct response in 25 minutes, give them additional time

as deemed appropriate.

4. The winning group could present the correct responses to the entire class using a

solution transparency and answer student questions. You may prefer to debrief this

activity if time is limited. If you have retained group responses, quickly check them to

determine where additional review may be needed.

5. Reward each of the winning group members with one or two extra quiz points,

fun-size candy bars, novelty erasers, or other small prizes.

or posted to a publicly accessible website, in whole or in part.