CHAPTER
1
Accounting Principles and
the Financial Statements
Principles of
Financial
Accounting
12e
Needles
Powers
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Concepts Underlying Accounting Measurement
 Accounting is an information system that measures,
processes, and communicates financial information about a
business or other economic entity.
– An economic entity is a unit that exists independently, such as a
business, hospital, or governmental body.
– Bookkeeping is the process of recording financial transactions and
keeping financial records. It is mechanical and repetitive and is
usually handled by computers.
– Management information systems (MIS) consist of the
interconnected business subsystems, including accounting, that
provide the information needed to run a business.
– For accounting purposes, a business organization is a separate
entity, distinct not only from its creditors and customers but also
from its owners.
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Financial and Managerial Accounting
 Accounting is usually divided into financial
accounting and managerial accounting.
- External decision makers
use financial accounting
to evaluate how well a
business has achieved its
goals.
 These reports, called financial
statements, are a central
feature of accounting. They
report on a business’s financial
performance.
- Internal decision makers
use information provided
by managerial
accounting about
operating, investing, and
financing activities.
 It provides managers and
employees with information
about how they have done in
the past and what they can
expect in the future.
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Business Transactions
 Business transactions are economic events that
affect a business’s financial position.
 All business transactions are recorded in terms of
money. This concept is called money measure.
 In international transactions, exchange rates must
be used to translate from one currency to another.
An exchange rate is the value of one currency in
terms of another.
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Forms of Business Organization
 There are three basic forms of business organization that
are recognized as separate entities.
– Sole proprietorship—a business owned by one person
 The owner takes all the profits or losses of the business and is
liable for all its obligations.
– Partnership—a business that has two or more owners
 The partners share the profits or losses according to a
prearranged formula.
– Corporation—a business unit chartered by the state
and legally separate from its owners
 The owners are called stockholders because their ownership is
represented by shares of stock.
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Concepts Underlying Financial Position
 Financial position refers to a company’s economic
resources, such as cash, inventory, and buildings,
and the claims against those resources at a
particular time. Another term for claims is equities.
 Every company has two types of equities:
creditors’ equities, such as bank loans, and owner’s
equity. The sum of these equities equals a
company’s resources:
Economic Resources = Creditors’ Equities + Owner’s Equity
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Assets
 Assets are the economic resources that are
expected to benefit the company’s future
operations. They include:
– monetary items (cash and money owed to the company
by customers)
– nonmonetary, physical items (inventories, land,
buildings, equipment)
– nonphysical items (rights granted by patents,
trademarks, and copyrights)
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Liabilities
 Liabilities are a business’s present obligations to
pay cash, transfer assets, or provide services to
other entities in the future. They include:
– amounts to suppliers for goods or services bought on
credit
– borrowed money such as bank loans
– salaries and wages owed to employees
– taxes owed to the government
– services to be performed
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Owner’s Equity
(slide 1 of 2)
 Owner’s equity represents the claims by the
owner of a business to the assets of the business.
– Theoretically, owner’s equity is what would be left if all
liabilities were paid.
– It is sometimes said to equal net assets.
– We can define owner’s equity this way:
Owner’s Equity = Assets − Liabilities
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Owner’s Equity
(slide 2 of 2)
– Owner’s equity is affected by the owner’s investment in
and withdrawals from the business and by the business’s
revenues and expenses.
 Owners’ investments are assets that the owner puts into the
business.
 Withdrawals are assets that the owner takes out of the business.
 Revenues are increases in owner’s equity that result from
operating a business.
 Expenses are decreases in owner’s equity that result from
operating a business.
 When revenues exceed expenses, this is called net income.
 When expenses exceed revenues, this is called net loss.
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Financial Statements
 Four major financial statements are used to
communicate accounting information: the income
statement, the statement of owner’s equity, the
balance sheet, and the statement of cash flows.
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Income Statement
 The income statement summarizes the revenues
earned and expenses incurred by a business over
an accounting period.
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Statement of Owner’s Equity
 The statement of owner’s equity shows the
changes in owner’s equity over an accounting
period.
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Balance Sheet
 The purpose of a balance sheet is to show the
financial position of a business on a certain date,
usually the end of a month or year.
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Statement of Cash Flows
 The statement of cash flows focuses on liquidity,
that is, balancing the inflows and outflows of cash
to enable the business to operate and pay its bills
when they are due.
– Cash flows are the inflows and outflows of cash into
and out of a business.
– The statement of cash flows is organized according to
three major business activities:
 Cash flows from operating activities
 Cash flows from investing activities
 Cash flows from financing activities
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GAAP and the Independent CPA’s Report
 To ensure that financial statements are understandable to
their users, a set of generally accepted accounting
principles (GAAP) has been developed to provide
guidelines for financial accounting.
 Many companies of all sizes have their financial statements
audited by an independent certified public accountant
(CPA).
– An audit is an examination of a company’s financial statements
and the accounting systems, controls, and records that produced
them. It ascertains that the statements were prepared in
accordance with GAAP.
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Organizations That Issue Accounting
Standards
 Two organizations issue accounting standards that
are used in the United States:
– The Financial Accounting Standards Board (FASB) has
been designated by the Securities and Exchange
Commission (SEC) to issue Statements of Financial
Accounting Standards.
– The International Accounting Standards Board (IASB)
issues international financial reporting standards
(IFRS). The SEC allows foreign companies to use these
standards in the United States.
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Other Organizations That Influence GAAP
 The Governmental Accounting Standards Board (GASB) issues
accounting standards for state and local governments.
 The Internal Revenue Service (IRS) interprets and enforces the tax
laws that specify the rules for determining taxable income.
 The Public Company Accounting Oversight Board (PCAOB) has
wide powers to determine the standards that auditors must follow.
 The American Institute of Certified Public Accountants (AICPA)
is the primary professional organization of CPAs.
 The Securities and Exchange Commission (SEC) is a
governmental agency that has the legal power to set and enforce
accounting practices for companies whose securities are offered
for sale to the general public.
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Professional Conduct
 The code of professional ethics of the American Institute of Certified
Public Accountants governs the conduct of CPAs. The code requires
CPAs to act with:
– Integrity—be honest and candid and subordinate personal gain to
service and the public trust.
– Objectivity—be impartial and intellectually honest.
– Independence—avoid all relationships that impair or appear to
impair objectivity.
– Due care—carry out professional responsibilities with competence
and diligence.
 The Institute of Management Accountants (IMA), the primary
professional association of managerial accountants, also has a code of
professional conduct.
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Decision Makers: The Users of
Accounting Information
 The people who use accounting information to
make decisions fall into three categories:
managers (internal users), outsiders who have a
direct financial interest in the business, and
outsiders who have an indirect financial interest.
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Management, Investors, and Creditors
 Management is responsible for ensuring that a
company meets its goals of profitability and
liquidity.
 Investors—owners and stockholders—have a direct
financial interest in the success of their companies.
 Creditors—those who lend money or deliver goods
or services before being paid—are interested
mainly in whether a company will have the cash to
pay interest charges and to repay the debt on time.
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Business Goals and Activities
 A business is an economic unit that aims to sell
goods and services at prices that will provide an
adequate return to its owners.
 The two major goals of all businesses are:
– Profitability—the ability to earn enough income to
attract and hold investment capital
– Liquidity—the ability to have enough cash to pay
debts when they are due
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Business Goals and Activities
 All businesses pursue their goals by engaging in
the following activities:
– Operating activities—buying, producing, and selling
goods and services; hiring managers and other
employees; paying taxes
– Investing activities—buying resources for operating
the business, such as land, buildings, and equipment;
selling those resources when no longer needed
– Financing activities—obtaining capital from creditors
and from the company’s owners; repaying creditors;
paying a return to owners
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Financial Analysis
 Financial analysis is the use of financial
statements to determine that a business is well
managed and is achieving its goals.
 The effectiveness of financial analysis depends on:
– Performance measures: Profitability is commonly
measured in net income, and liquidity is commonly
measured by cash flows.
– Financial ratios: The ratio of earnings to total assets
can be used to assess profitability, and the ratio of cash
flows to total assets can be used to assess liquidity.
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Ethical Financial Reporting
 Ethics is a code of conduct that addresses the question of
whether actions are right or wrong.
– The intentional preparation of misleading financial
statements is called fraudulent reporting and can result
from distortion of records, falsified transactions, and
misapplication of various accounting principles.
– In response to the accounting scandals at Enron
Corporation and WorldCom, the Sarbanes-Oxley Act
of 2002 was passed.
 It regulates the financial reporting of public companies and
their auditors.
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.