CHAPTER 1 Accounting Information: Users and Uses LEARNING OBJECTIVES 1. Describe the purpose of accounting and explain its role in business and society.

• Accounting is a service activity designed to assist individuals and organizations in deciding how to allocate scarce resources and reach their financial objectives.

• Accounting is used to accumulate, measure, and communicate economic data about organizations and to assist in the decision-making process.

2. Identify the primary users of accounting information.

• The primary users of accounting information are lenders, investors, management, and other interested individuals and organizations.

• Management accounting deals primarily with the internal accounting functions of planning, implementing, and control.

• Financial accounting is concerned with reporting business activities and results to external parties.

• The objectives of both areas of accounting are measurement and communication of information for decision-making purposes.

3. Describe the environment of accounting, including the effects of generally

accepted accounting principles, international business, ethical considerations, and technology. • Accounting functions in a dynamic environment.

The principles of accounting have evolved over time to meet the changing demands of the business environment.

They are therefore not absolute. Only if they prove useful do they become generally accepted. Accounting principles provide comparable data for external users and

need to be applied with judgment. • Since the 1930s, several organizations have been involved in the

development of accounting principles in the United States. The American Institute of Certified Public Accountants (AICPA), the

Securities and Exchange Commission (SEC), and the Financial Accounting Standards Board (FASB) are among the most prominent.

The FASB is currently the primary standard-setting body for accounting principles in the private sector.

• Accounting is practiced in an international environment.

Accounting Information: Users and Uses

Accounting procedures in the United States sometimes must be modified to accommodate foreign operations.

Attempts are being made to establish consistent and comparable accounting practices throughout the world, primarily through the efforts of the International Accounting Standards Board (IASB).

• Ethical considerations affect society. Ethical considerations are particularly important for accountants, who have

a special responsibility to the public. CPAs have adopted standards of conduct to guide them in the

performance of their duties. • Technology has changed the way accounting information is accumulated and

analyzed. What once occupied a large part of an accountant’s time is now done

quickly by computers, thereby freeing the accountant to be involved in more productive tasks.

Technology has not removed the accountant from the decision-making process.

Accounting judgment is still essential. 4. Analyze the reasons for studying accounting.

• Knowing how to use accounting information will help individuals make better decisions in their personal life as well as in their employment.

• Whatever the job, it is likely that accounting information plays a part. • Knowing where information comes from, how it is accumulated, and how it is

best used will result in better decision making. CHAPTER REVIEW OUTLINE

I. WHAT’S THE PURPOSE OF ACCOUNTING? (p. 5) A. Bookkeeping 1. The preservation of a systematic, quantitative record of an activity. 2. Without bookkeeping, business is impossible.

B. An accounting system is used by a business to: 1. Analyze transactions.

2. Handle routine bookkeeping tasks. 3. Structure information so it can be used to evaluate the performance and health of the business.

C. Accounting provides quantitative, financial information about economic entities that is intended to be useful in making economic decisions. 1. Quantitative—deals with numbers. 2. Financial—focuses on just the financial dimension of business. 3. Useful—supported by a long tradition of theory (theoretical conceptual framework).

Chapter 1 4. Decisions—past information can only be useful if it impacts decisions about the future.

D. Accounting Assists in the Decision-Making Process 1. Clearly identify the issue or question.

2. Gather and analyze facts. 3. Identify and consider alternative courses of action. 4. Reach a decision. 5. Outcome always has an element of chance.

E. An accounting system provides information about a specific economic entity in a form that can be used to make knowledgeable financial decisions.

1. Economic entity—individual, business enterprise, or nonprofit organization.

a. Business—operated to make a profit for its owners. b. Nonprofit organization—provides services effectively and efficiently.

2. Provides a way for entities to track their activities and measure results.

F. The Relationship of Accounting to Business 1. Business—the activities involved in the production and distribution of goods and services.

2. Accounting records and reports the financial effects of business activities. 3. One common business activity is the acquisition and use of monetary

resources (capital). a. Sources of capital include: (1) Investors (owners), (2) Creditors (lenders), and (3) The business itself (retained earnings). b. Uses of resources:

(1) To buy land, buildings, and equipment; (2) To purchase materials and supplies; (3) To pay employees; and (4) To meet any other operating expenses involved in the production and marketing of goods and services.

c. When the product or service is sold, additional resources (revenues) are generated. These revenues are used to:

(1) Pay loans; (2) Pay taxes; (3) Buy new materials, equipment, and other items needed to continue the operations of the business; or (4) Distribute to the owners a return on their investment.

4. Accountants play two roles with regard to business activities: a. They measure and communicate (report) the results of business

activities through a process know as the accounting cycle, which involves:

(1) Analyzing,

Accounting Information: Users and Uses (2) Recording, (3) Classifying, (4) Summarizing, and (5) Reporting the transactions of the business.

b. They advise managers as to how to structure business activities in order to accomplish the goals of the firm, those goals being:

(1) Generate profit, (2) Minimize costs, (3) Efficiently provide services, etc.

II. WHO USES ACCOUNTING INFORMATION? (p. 9)

A. Internal Reports 1. Used by management, those who direct the business’s day-to-day operations.

2. Management accounting focuses on the information needed for: a. Planning, b. Implementing plans, and c. Controlling costs.

3. Managers and executives have access to specialized accounting information not available to outsiders.

4. Other decisions made using management accounting include: a. Whether to produce a product internally or purchase it from an outside supplier (outsource), b. What prices to charge, and c. Which costs seem excessive.

B. External Reports

1. Included in the firm’s annual report. 2. Report financial information to external parties who have an economic interest in the business. 3. Information is provided in the form of general-purpose financial statements

and special reports required by government agencies. The main financial statements generated by financial accounting are: a. Balance sheet—reports the company’s resources, obligations, and the owners’ equity. b. Income statement—reports the company’s net income (net loss) during a period (difference between revenues and expenses). c. Statement of cash flows—reports the amount of cash collected by, and paid out for, operating, investing, and financing activities.

C. Lenders 1. Lenders (creditors) want to repaid, with interest. 2. Many lenders (like banks) use companies’ financial statements to make decisions about commercial loans because the statements help them predict the future ability of the company to repay the loan.

Chapter 1

D. Investors 1. Investors want information to help them estimate how much cash return to

expect in the future if they invest in a company now. 2. Financial statements, along with a knowledge of business plans, market forecasts, and management character, help investors assess these future cash flows.

E. Management 1. Company goals are often stated in terms of financial accounting numbers, such as a target of sales growth of 5%.

2. Net income is frequently used to calculate management bonuses. 3. Managers use financial statement information to pinpoint areas of

weakness.

F. Other Users of Financial Information 1. Suppliers and customers.

a. Interested in long-term staying power of a company. b. Financial statements help them to assess these prospects.

2. Employees. a. Bonuses often based on financial statement data. b. Used to evaluate ability to keep long-term obligations (e.g., pensions and retirement benefits). c. Used in contract negotiations between labor unions and management.

3. Competitors. a. Help identify strategic opportunities for marketing. b. Help determine where you are stronger or weaker than competition.

4. Government agencies. a. SEC monitors statements of publicly traded companies to be sure that investors have sufficient information to make informed investment decisions. b. International Trade Commission monitors imports to determine if they are harming U.S. companies through unfair trade practices. c. Justice Department evaluates whether companies are earning excess monopolistic profits.

5. The press. a. May help reporters with background information about a company. b. A surprising accounting announcement might cause a reporter to want to know more about a company’s operations.

III. WITHIN WHAT KIND OF ENVIRONMENT DOES ACCOUNTING OPERATE? (p. 13)

A. Accounting functions in a dynamic environment, being influenced by changing technological, political, and economic factors.

1. Recent accounting “scandals” have led to greater government involvement in the development of accounting rules and oversight of the accounting industry.

Accounting Information: Users and Uses

B. The Significance and Development of Accounting Standards 1. Reasonable people can disagree on how to handle accounting for certain

situations. 2. It is necessary that external users understand the rules and assumptions

used by companies when constructing financial statements. 3. In most countries there is a committee or board that establishes the

accounting rules for that country. C. The Financial Accounting Standards Board

1. In the United States, financial accounting standards are set by the FASB. 2. It is comprised of seven full-time members selected from professional

accounting, business, government, and academia. 3. One-third of its budget comes from donations from the accounting

profession and from businesses; the rest comes from sales of publications and other services.

4. It is not a government agency, but a private body established and supported by the joint efforts of the U.S. business community, financial analysts, and practicing accountants.

5. While it has no legal power to enforce the standards it sets, it gets its authority to establish rules from the SEC.

6. It must walk a fine line between constant improvement of accounting practices to provide more full and fair information for external users and practical constraints on financial disclosure to appease businesses.

7. Seeks consensus by requesting written comments and sponsoring public hearings on proposed standards.

8. The end result of this process is a set of accounting rules described as generally accepted accounting principles (GAAP).

D. Other Organizations

1. Securities and Exchange Commission. a. Created by Congress to regulate U.S. stock exchanges, its job is to make sure investors are provided with full and fair information about publicly traded companies. b. Has specific legal authority to establish financial accounting standards for companies soliciting investment funds from the American public. c. In recent history, the SEC generally has refrained from using this

authority and has instead supported the FASB in setting U.S. accounting standards.

d. HOWEVER, the Sarbanes-Oxley Act of 2002, has placed the SEC in a position of greater responsibility and authority regarding financial reporting practices and corporate governance. (1) Act is largely a reaction to the accounting “fiascos” of the early

2000s. (2) Act created the Public Company Accounting Oversight Board.

2. American Institute of Certified Public Accountants (AICPA). a. A CPA is someone who has:

(1) Taken a minimum number of college-level accounting classes,

Chapter 1 (2) Passed the exam administered by the AICPA, and (3) Met other requirements set by his or her state.

b. CPAs work in accounting, law, business, academia, etc. c. CPA firms also hire specialists in law, information technology, finance, etc. d. CPA firms provide a variety of services including audits of a company’s financial statements to ensure reliability.

3. Internal Revenue Service. a. Government agency that prescribes the rules and regulates the collection of tax revenues in the United States. b. Tax rules differ from financial accounting guidelines.

(1) Tax rules are designed to tax income when the tax can be paid. (2) Tax rules provide concrete rules to minimize inefficient arguing

between taxpayers and the IRS. c. Because each has different rules designed for different purposes, companies must maintain two sets of books—one for financial accounting and one for tax accounting.

4. International business. a. Business has expanded on a worldwide basis.

(1) U.S. companies have operating divisions in foreign countries. (2) U.S. companies have extensive transactions with foreign

companies. b. Accounting practices among countries vary widely. c. The International Accounting Standards Board (IASB)

(1) Formed in 1973 to develop worldwide accounting standards. (2) Includes representatives from the eight major accounting standard-

setting boards around the world (including the U.S.). (3) Issues IFRS: International Financial Reporting Standards.

(4) To date, the SEC has not recognized IASB standards and still requires foreign companies to comply with U.S. accounting standards through statements prepared under U.S. GAAP (or

alternatively by providing a reconciliation between IASB GAAP and U.S. GAAP results).

(5) Resistant in conceding to IASB standards has been observed in other countries/stock exchanges outside of just the U.S./NYSE.

E. Ethics in Accounting 1. There have been several notable incidents within the last few years

involving management falsification of accounting data and auditors being negligent, or even complicit, in not detecting such misrepresentations. a. This has resulted in erosion of the public’s confidence in auditors as

ethical and competent in carrying out their perceived responsibility of ensuring that such events do not occur.

b. Correspondingly, and as described earlier in these outlines, this has also resulted in increased regulatory involvement in accounting profession, as well as having prompted an analogous increase of

Accounting Information: Users and Uses

“policing” from within its own ranks (i.e., Auditing Standards Board, etc.).

c. Former SEC Chairman Arthur Levitt’s landmark 1998 speech: “The Numbers Game”. (1) With the hindsight of the financial failures of the early 2000s, this

speech turned out to be somewhat “prophetic” in nature. (2) Speech dealt with several major accounting techniques being used

to manage earnings to expectations rather than report the actual results of a company’s operations.

(3) The implementation of such techniques is the product of pressure upon management from various parties interested in an entity’s performance, with such pressure leading to questionable manipulation of the flexibility inherent in the practice of accounting; in other words, “accounting hocus pocus” replaces judgments based on sound ethical principles.

2. The AICPA has a Code of Professional Conduct. a. Its key principles are integrity, objectivity, and judgment. b. Members who knowingly violate the code are subject to disciplinary action.

F. Technology

1. Allows companies to easily and inexpensively gather vast amounts of information about individual transactions. 2. Allows large amounts of data to be compiled quickly and accurately,

significantly reducing the likelihood of errors. 3. Lenders and investors have the ability to receive and process large

amounts of data. 4. Technology has not replaced judgment.

a. People must still analyze complex business situations and input the results into the computer. b. People must still analyze what comes out of the computer.

IV. SO, WHY SHOULD I STUDY ACCOUNTING? (p. 20)

A. Everyone Makes Financial Decisions 1. Buying versus leasing, budgeting, investing, financing expenses. 2. Accounting information allows you to evaluate your employer’s short-term

and long-term potential. 3. Your future job responsibilities may require knowledge of accounting in

areas like sales, production, quality control, or human resources. B. Ignoring the value of accounting information puts you at a disadvantage.

Chapter 1

DESCRIPTION OF ILLUSTRATIONS IN TEXT

Exhibit 1, p. 6 Functions of an Accounting System Exhibit 2, p. 7 The Decision-Making Process Exhibit 3, p. 8 Activities Common to Business Organizations Exhibit 4, p. 9 Output of the Accounting Cycle BOXED ITEMS/ BUSINESS ENVIRONMENT ESSAYS Boxed Item, pp. 18-19 The Secrets to Doing Well in an Accounting Class Essay, p. W1-W2 The Evolution of Accounting?

TOPICAL OVERVIEW OF END-OF-CHAPTER ASSIGNMENTS

Topics Questions Exercises Discussion JC* 1. Purpose and role of accounting 1-5 1-3 16,19,20,21 2. Primary users of accounting 6 4-8 16,17,21

information 3. Environment of accounting 15 a. GAAP 7-9 9,10 23 b. International business 10 11 18 c. Ethical considerations 11 12 d. Technology 12 22 4. Reasons to study accounting 13 13,14 *JC = JUDGMENT CALLS

Accounting Information: Users and Uses

ASSIGNMENT CLASSIFICATIONS

Each exercise, problem, and case is listed with its estimated completion time as well as its level of difficulty: E=easy, M=moderate, D=difficult.

Difficulty Estimated Time Exercise Description Level (Minutes) 1-1 The role and importance of accounting E 5 1-2 Bookkeeping is everywhere E 10 1-3 Accounting information and decision making E 10 1-4 Allocation of limited resources E 5 1-5 Users of financial information E 5 1-6 Structuring information for use in evaluation E 10 1-7 Investing in the stock market E 5 1-8 Management versus financial accounting E 10 1-9 The role of the SEC E 10 1-10 Why two sets of books? E 10 1-11 Career opportunities in accounting E 10 1-12 Differences in accounting across borders E 10 1-13 Ethics in accounting E 10 1-14 Challenges to the accounting profession E 10 1-15 Why do I need to know accounting? E 10 Analytical Assignments Difficulty EstimatedTime Description Level (Minutes) Discussion 1-16 To lend or not to lend—that is the question E 10 1-17 Information needs to remain competitive E 10 1-18 International happenings E 10 1-19 Is better accounting the solution to all of life’s E 10 problems? 1-20 We don’t have time for good accounting! E 10 1-21 Is the proposed electricity rate increase fair? E 10 Judgment Call 1-22 You decide: How much education is necessary for an accountant? 1-23 You decide: Should the Emerging Issues Task Force be allowed to have members of large corporations sit on their committee and vote on accounting issues that are facing today’s companies, or should it be left to the accounting firms?

Chapter 1 Real Company Analysis 1-24 Wal-Mart E 15 1-25 General Motors E 15 International 1-26 Should the SEC choose the FASM or the IASB? M 15 Ethics Case 1-27 Disagreement with the boss M 15 Writing Assignments ```1-28 The language of business M 60 1-29 Visiting an accounting professional M 60

CHAPTER 2 Financial Statements: An Overview LEARNING OBJECTIVES 1. Understand the basic elements, uses, and limitations of the balance sheet.

• The balance sheet provides a summary of the financial position of a company at a particular date.

• It lists a company’s assets, liabilities, and owners’ equity. • For a corporation, owners’ equity consists of directly invested funds as well as

retained earnings. • A classified balance sheet facilitates, by showing the composition of assets

and liabilities as either current or long-term, useful analyses - such as to the liquidity of a firm for instance - by statement users.

• To facilitate analysis, is usually prepared on a comparative basis. • The biggest limitation of the balance sheet is that it does not reflect the

current value/worth of a company. 2. Understand the basic elements and uses of the income statement.

• The income statement shows, over a given period of time, the major sources of revenues generated and the expenses associated with those revenues.

The difference between revenues and expenses is net income or net loss. The income statements of corporations must also include earnings per

share. • Investors find net income useful in evaluating the health and performance of a

business. • As with the balance sheet, categorization of revenues and expenses on the

income statement helps to facilitate more useful analyses by statement users. • To facilitate analysis, is usually prepared on a comparative basis. • Comprehensive income, of which net income is a part, is a broader measure

of the change in a company’s overall wealth during a given period. • A Statement of Retained Earnings links the income statement to the balance

sheet by reflecting net income as a part of retained earnings. 3. Understand the categories and uses of the statement of cash flows and see how

the primary financial statements tie together. • The statement of cash flows shows the significant cash inflows (receipts) and

cash outflows (payments) of a company for a period of time. • Cash inflows and outflows are classified according to operating, investing,

and financing activities.

Financial Statements: An Overview

• Articulation refers to the relationship between an operating statement (the income statement or statement of cash flows) and comparative balance sheets, whereby the information contained in the operating statement helps explain the changes in balance sheet items from one period to the next.

4. Recognize the need for financial statement notes and identify the types of

information included in the notes. • The notes to the financial statements contain additional information not

included in the financial statements themselves. • The notes:

explain the company’s accounting assumptions and practices, provide details of financial statement summary numbers and additional

disclosure about complex events, and report supplementary information required by the SEC and the FASB. 5. Describe the purpose of an audit report and the incentives the auditor has to

perform a good audit. • An audit report is issued by an independent CPA firm attesting to the

conformity of a set of financial statements with generally accepted accounting principles (GAAP).

• CPA firms have an economic incentive to perform credible audits in order to preserve their reputations and to avoid lawsuits.

6. Explain the fundamental concepts and assumptions that underlie financial

accounting. • Certain fundamental concepts underlie the practice of accounting.

First, a business must be accounted for as an economic entity separate from the personal affairs of the owners and separate from other businesses.

Second, the transactions are assumed to be arm’s-length, so that the negotiated prices reflect true market values at the dates of the transactions.

Third, transactions are recorded at historical cost (though this may be modified in some instances to provide a more “relevant”, market-based figure).

Fourth, only those transactions and events that can be measured in monetary terms are reported.

Fifth, the accounting entity is assumed to be a going concern.

CHAPTER REVIEW OUTLINE

I. THE FINANCIAL STATEMENTS (p. 30) A. General Purpose Financial Statements

1. Primary financial statements. a. Used by investors, creditors, managers, etc. b. Answers basic questions:

(1) What is the company’s current financial status?

Chapter 2 (2) What were the company’s operating results for the period? (3) How did the company obtain and use cash during the period?

2. Balance sheet (statement of financial position) reports the resources of a company (assets), the company’s obligations (liabilities), and the difference between what is owned and owed, called owners’ equity.

3. Income statement (statement of earnings) reports the amount of net income earned by a company during a period. The income statement is the accountant’s best effort at measuring the company’s economic performance.

4. Statement of cash flows reports the amount of cash collected and paid out by a company in its operating, investing, and financing activities.

B. The Balance Sheet

1. Assets. a. Economic resources owned or controlled by a company. b. Include cash, accounts receivable, inventory, land, buildings, equipment, and intangible items (each measured in monetary terms).

2. Liabilities. a. Obligations to pay cash, transfer other assets, or provide services to someone else. b. Include accounts payable, notes payable, and mortgages payable. c. Measuring liabilities in monetary terms is one of the accountant’s biggest challenges.

3. Owners’ equity. a. The remaining (residual) claim against the company's assets after all of the liabilities have been deducted. b. Represents the net assets (total assets minus total liabilities) available after all obligations have been satisfied. c. Ownership of a company can be:

(1) One person (sole proprietorship), (2) A small group (partnership), or (3) A diffuse group of owners (corporation).

d. Owners of a corporation are called stockholders (shareholders). They receive stock certificates (evidence of shares) that can be:

(1) Privately traded among owners, (2) Privately sold to new owners, or (3) Publicly traded on an organized stock exchange. e. Owners’ equity is increased when: (1) Owners make additional investments in the business, or (2) When business generates profits that are retained within the business. f. Owners’ equity is decreased when: (1) Dividends are distributed to stockholders of a corporation. (2) Operations generate a loss instead of a profit.

g. Retained earnings for a corporation is the amount of accumulated earnings that have not been distributed to the owners.

Financial Statements: An Overview

h. Capital stock for a corporation is the portion of owners’ equity contributed by owners in exchange for shares of stock. i. Total owners’ equity = Capital stock + Retained earnings.

4. The accounting equation. a. Assets = Liabilities + Owners’ equity. b. Assets are equal to the claims against the assets. c. Double-entry accounting is a system of recording transactions in a way

that maintains the equality of the accounting equation. 5. The format of a balance sheet.

a. Reports a company’s financial position at a point in time (a snapshot). b. Is the accounting equation in financial statement form.

6. Classified and comparative balance sheets. a. A classified balance sheet distinguishes between current and long-term assets. b. Current assets. (1) Cash and other assets expected to be converted to cash within a year.

(2) Generally listed in decreasing order of liquidity (liquidity measures how easily assets can be converted to cash), cash is listed first.

c. Long-term assets (land, buildings, equipment) are those assets a company needs in order to operate over an extended period of time. d. Liabilities are also classified as current or long-term. (1) Current liabilities are debts expected to be paid within a year. (2) Long-term liabilities are debts expected to be paid in more than one year. e. Comparative financial statements are statements prepared for the current year and preceding year so that users can identify significant changes.

7. Limitations of a balance sheet. a. Does not reflect current value or worth of a company. (1) Assets are recorded at their purchase cost, not current market value (the price that would be paid to buy the same asset today). (2) Not all economic assets are included in the balance sheet (such as intangible factors outside the accounting process). b. The book value of a company (the amount of owners’ equity) is usually less than the company’s market value (market price per share times the number of shares of stock outstanding).

C. The Income Statement 1. Shows the results of a company’s operations over a period of time

(month, quarter, or year). 2. Summarizes the revenues generated and the costs incurred (expenses) to generate those revenues.

3. Net income (net loss) is the difference between revenues and expenses. 4. Revenues.

a. The amount of assets created through business operations.

Chapter 2

b. When goods are sold or services performed, the resulting revenue is in the form of an inflow of cash or accounts receivable. c. Since this increase in total assets is not tied to any liability obligation, the assets belong to the owners and thus represent an increase in owners’ equity.

5. Expenses. a. The amount of assets consumed through business operations. b. The costs incurred in normal business operations to generate revenues. c. Generally represent a decrease in assets and in equity.

6. Net income (or net loss). a. An overall measure of the company's performance. b. Reflects the company’s accomplishments (revenues) in relation to its efforts (expenses) during a particular period of time. c. Revenues - Expenses = Net income (if expenses exceed revenues, then net loss). d. Revenue is a “gross” concept; income (or loss) is a “net” concept.

7. The format of an income statement. a. Revenues are listed first. b. Expenses are often divided into three categories. (1) Cost of goods sold—the cost of the inventory items that were sold.

Sales - Cost of goods sold = Gross profit (margin). (2) Operating expenses are the costs of running normal business operations. Gross profit - Operating expenses = Operating income. (3) Nonoperating expenses have no connection with the nature of the

business operations. Interest and income taxes are the most common.

c. Gains (losses) refer to money made or lost on activities outside the normal business activities of a company. d. Factors which arise from changes in market conditions unrelated to company operations may still impact a company’s performance. These

items are excluded from the income statement and listed in a separate measure of “comprehensive income.” Examples include: (1) Changes in foreign currency exchange rates for a multinational company with subsidiaries operating all over the world.

(2) Changes in the value of certain investment securities. (3) Changes in the value of certain derivative financial instruments.

e. Earnings (loss) per share (EPS). (1) Computed by dividing current period net income (earnings or loss) by the number of shares of stock outstanding during the period.

(2) EPS tells the owner of a single share of stock how much of the net income for the year belongs to him or her. f. Companies usually show the comparative results for two or more periods. This allows users to evaluate how profitable the enterprise was during the current period as compared with earlier periods.

Financial Statements: An Overview

D. The Statement of Retained Earnings 1. Identifies changes in retained earnings from one accounting period to the next. 2. Beginning retained earnings + Net income for the period - Dividends paid = Ending retained earnings balance.

a. Net income results in an increase in net assets and corresponding increase in retained earnings (owners’ equity). b. Dividends reduce net assets with a corresponding reduction in retained earnings (owners’ equity).

3. Retained earnings is NOT cash. 4. Sometimes, corporations present the more detailed statement of

stockholders’ equity which includes changes in capital stock (contributed capital) as well as changes in retained earnings.

E. The Statement of Cash Flows 1. Shows the cash inflows (receipts) and cash outflows (payments) of an

entity during a period of time. 2. Companies receive cash by:

a. Selling goods or providing services, b. Selling other assets, c. Borrowing, and d. Receiving cash contributions from owners.

3. Companies use cash to: a. Pay current operating expenses such as wages, utilities, and taxes;

b. Purchase equipment, buildings, land, and expand operations; c. Repay loans; and d. Pay their owners a return on the investments that have been made.

4. Classifies cash flow items according to three main activities—operating, investing, and financing.

a. Operating activities are those that are part of the company’s day-to- day business operations. (1) Major operating cash inflow is cash receipts from selling goods or providing services. (2) Major operating cash outflows include payments to purchase inventory and to pay operating expenses.

b. Investing activities are those associated with buying and selling long- term assets. c. Financing activities are those whereby cash is obtained from or repaid

to owners and (long-term) creditors.

F. How the Financial Statements Tie Together 1. The three primary financial statements are interrelated and tie together. 2. Articulation.

a. Refers to the relationship between an operating statement (the income statement or statement of cash flows) and comparative balance sheets.

Chapter 2

b. An item on the operating statement helps explain the change in an item on the balance sheet from one period to the next. c. Refer to Exhibit 12, p. 45. (1) Beginning cash from 2007 balance sheet is added to the net increase or decrease in cash (from the statement of cash flows) to derive the cash balance as reported on the 2008 balance sheet. (2) The retained earnings balance as reported on the 2008 balance sheet comes from the beginning retained earnings balance (2007 balance sheet) plus net income for the period (from the income statement) less dividends paid.

II. NOTES TO THE FINANCIAL STATEMENTS (p. 46) A. Information in Addition to the Primary Financial Statements

1. Tell about the assumptions and methods used in preparing the financial statements. 2. Provide more detail about specific items.

B. Four General Types of Financial Statement Footnotes 1. Summary of significant accounting policies.

a. Accounting involves making assumptions, estimates, and judgments. b. Sometimes there is more than one acceptable method of accounting. c. Information about which accounting policies and practices are used is provided in the notes.

2. Additional information about the summary totals found in the financial statements.

a. For large companies, one summary number in the financial statements can represent many individual items. b. The notes provide additional detail.

3. Disclosure of important information that is not recognized in the financial statements.

a. Recognition. (1) Boil down all estimates and judgments into one number and report only that one number in the financial statements. (2) The key assumptions and estimates are described in the notes. b. Disclosure. (1) Items are not included in the statement but explained in the notes. (2) The accepted way to convey information when the information is too uncertain to be recognized.

4. Supplementary information required by the FASB or the SEC.

a. Both the FASB and SEC require supplementary information that must be reported in the financial statement notes. b. For example, the FASB requires disclosure of quarterly financial information and of business segment information.

Financial Statements: An Overview

III. THE EXTERNAL AUDIT (p. 47) A. Why an Audit?

1. Because poor financial performance can lower a company's stock price, make loans harder to get, or reduce the amount that managers receive in bonuses, owners and managers have an incentive to report the most favorable results possible. 2. Financial statements would not be reliable unless reviewed by an independent external firm. 3. In the United States, financial statements are usually audited by an independent certified public accountant (CPA).

B. Audit Report 1. The financial statements are the responsibility of the company’s management. The CPA's responsibility is to express an opinion on these financial statements. 2. Expresses whether the statements fairly present a company’s financial position, operating results, and cash flows in accordance with GAAP.

a. Although not a guarantee of accuracy, an audit provides added assurance that the statements are not misleading. b. Despite the inherent “conflict of interest” which might exist because

auditors are paid by the companies they are auditing, CPA firms still have other economic incentives to perform credible audits.

(1) CPA firms want to maintain a reputation for doing high-quality audits and are reluctant to risk their reputation by signing off on a questionable set of financial statements.

(2) Investors who lose money may claim they relied on misleading financial statements certified by an external auditor. Such lawsuits frequently involve substantial damages.

IV. FUNDAMENTAL CONCEPTS AND ASSUMPTIONS (p. 49) A. Accounting Model comprises the basic accounting assumptions, concepts, principles, and procedures that determine the manner of recording, measuring, and reporting a company’s transactions. B. The Separate Entity Concept

1. An entity is the organizational unit for which accounting records are maintained.

2. The separate entity concept holds that the activities of an entity should be kept separate from those of its owners.

C. The Assumption of Arm’s-Length Transactions 1. Transactions a. Exchange of goods or services between entities as well as the borrowing and lending of money. b. Events having an economic impact on a business, such as the loss of value of equipment due to obsolescence or fire.

Chapter 2

c. Provide the data that are included in accounting records and reports. 2. Arm’s-length transactions

a. Business dealings between independent, rational parties who are looking out for their own interests. b. Without this assumption, the numbers in the financial statements may not reflect true transactional values.

D. The Cost Principle 1. To ensure objective measurements, accountants record transactions at

historical cost, the amount originally paid or received for goods and services in arms’-length transactions.

2. Historical cost is assumed to represent the fair market value of the item at the date of the transaction because it reflects the actual use of resources by independent parties.

3. Historical cost may, in certain instances that are highly justified based on the increased relevancy of the information provided, be modified to reflect current market values.

E. The Monetary Measurement Concept

1. Accountants record only those economic activities of an entity that can be measured in monetary terms. 2. All transactions are recorded in monetary terms whether cash is involved or not (the unit of measure in the United States is the dollar).

3. The listed values may not be the same as the actual market values. a. Because of the cost principle. b. Some economic assets are not recorded because they are too difficult or impossible to measure in monetary amounts.

F. The Going Concern Assumption

1. An entity will continue to exist for the foreseeable future. 2. Allows accountants to record assets at what they are worth to a company in normal use, rather than what they would sell for in a liquidation sale.

DESCRIPTION OF ILLUSTRATIONS IN TEXT Exhibit 1, p. 32 Common Assets Exhibit 2, p. 33 Common Liabilities Exhibit 3, p. 33 Sources of Owners’ Equity Exhibit 4, p. 34 Elements of the Accounting Equation Exhibit 5, p. 36 Classified Balance Sheets for Safeway Exhibit 6, p. 38 Book Value and Market Value for the Ten Largest U.S. Firms Exhibit 7, p. 40 Top Ten U.S. Companies, Ranked by Net Income Exhibit 8, p. 40 Adapted Comparative Income Statements for Safeway Exhibit 9, p. 42 Illustrated Statement of Retained Earnings for Safeway Exhibit 10, p. 44 Cash Flows Exhibit 11, p. 44 Statement of Cash Flows for the Safeway, Inc. Exhibit 12, p. 45 How the Financial Statements Tie Together Exhibit 13, p. 47 Safeway’s Note Disclosure