September 9, 2013
Accounting is the information system which records, summarizes, and reports the
underlying economic conditions of an entity.
Financial accounting is used to report this information to external parties
[managerial accounting is to use this information internally].
Financial statements are management’s report to owners.
3 profit-seeking entities:
Sole proprietorship simple to establish, owner controlled
Unlimited liability (no legal separation).
All profits and losses belong to owner, report income on tax returns.
Business ends if owner dies, can sell it.
Easy and inexpensive to operate. No reporting requirements.
Partnership simple to establish, shared control, broader skills and resources
Two or more owner-managers.
Want a formal agreement covering $ contributions, workload,
Each partner’s net income reported on his or her personal tax form. No tax
General Partners: have unlimited liability (person A and B legally
Limited Partners: limited involvement, limited liability (LLP at the end of
Ends if the partners die or dissolve it, can try to sell your portion.
Corporation Easier to transfer ownership, easier to attract investors, no personal
liability, tax advantages possible.
Separate legal entity from owners. Owners called shareholders. Limited
liability. Can only lose investment, not personal assets.
Taxed separately from owners: corporate income tax. Tax deferral if
income not paid out but double taxation.
Indefinite life: owners can sell their shares, doesn’t affect operations.
Most complex (and expensive) to operate: More regulations, but easier to
raise additional capital.
Corporate Organization: Slide 8.
IPO (initial public offer): when public company first offers shares. Shares bought on
stock exchange do not “affect” corporation.
Public companies must provide financial information publicly, private companies do not.
Private corporations are not necessarily small.
The amount initially invested by shareholders is called equity. Equity in a house: down payment. Liability is the mortgage, asset is the house. Increase
in value of home (renos, etc.) is an increase in equity.
Financial statements or reports
Accounting system is reporting and summarizing information
Reports prepared by management
For Internal users and External users
Or more frequent
Or reports with different levels of details
Who What Where
Creditors (Lent $$) If it can be repaid Financial statements
Cashflow, profit, earnings,
types of assets
Shareholders Profitability share price,
if dividends are distributed,
Financial statements cannot be bent like a CV have to meet standards, be
Annual report reliable sooner information is released, the less reliable it is.
GAAP: generally accepted accounting principles (not rules)
Set of accounting recommendations and guidelines used to prepare
September 11, 2013
Balance Sheet Components: 1. Assets: future economic benefit to company cash, receivables, inventory,
2. Liabilities: future obligations of company payables, bank loans, mortgages
3. Equity: amount invested by owners share capital, retained earnings (dividends
are payouts to owners)
Income statement based on the concept of accrual accounting is the best measure
-Recognizes the difference between when a sale is made and when the cash is
Or when an expense is incurred when it is paid
Statement of Cash Flow
Shows the cash inflows and outflows during the same period as the income
statement but class…[slide 34]
Responisbility for Financial Statements
1. Management: Statement of Management’s Responsibility, Management
Discussion & Analysis in the annual report
September 16, 2013
Statement of Earnings comes first on a Financial Statement, because it has all of the
Operating expenses are usually ordered with larger/more important expenses first.
Management undertakes 3 types of activities:
I.e. there are 3 different types of expenses.
Gross margin = cost of sales/sales
Net profit margin = net earnings/sales
Payout margin = payout/net earnings
Debt to equity = current liabilities + long-term debt/shareholder’s equity
Current ratio (liquidity) = current assets/current liabilities Current assets are listed in order of liquidity.
1-Sided Accounting (Your Bank Account)
Bank statement is a summary of all deposits to & withdrawals from your bank
Doesn’t tell you where your money comes from
Need a better approach
Transactions are events that must be recorded in FS. 2 Types:
External: between co. & outside party. Involves an exchange of assets, liabilities
Internal: within the co. IF event results in a financial impact that you can measure
with reasonable accuracy.
Double Entry Bookkeeping
Account: an individual listing or record of changes in a specific asset, liability, or
Transactions affect two (or more) accounts and we adjust all accounts affected.
Your bank account – need to track where $ goes (what it is spent on) when you
withdraw to get a useful report.
Assets = Liability + Equity
Assets [TTTT] Liabilities + Equity [TTTTT]
Individual T Accounts
Create a T account for each account. 1 side of the T increases the account. The
other side decreases it.
They will normally have the balance (debit/left-hand side, credit/right hand side)
the same as the Balance Sheet T account.
Assets: debit balance.
Liabilities and Equity: credit balance.
Increases in an account are recorded on the same side as its normal balance.
Increases in assets are debits. Increases in L & E are credits.
Decreases are the opposite. A decreases credits, L&R decreases dr.
Net Earnings and Equity
Net Earnings not paid out become Retained Earnings
Things that increase net earnings therefore increase retained earnings: Revenue Things that decrease Net Earnings decrease Retained Earnings: Expenses
The set of earnings explains the changes in retained earnings, that balances the
Revenues, Expenses & T Accounts
If increases in revenue increase equity, increases should be credits (decreases dr.)
If increases in expenses decrease equity, increases should be debits (decreases cr.)
Revenues normally have Cr balances.
Expenses normally have Dr balances.
After all transactions are recorded in the T accounts prepare a summary listing of
the accounts: Trial Balance
List accounts from assets, thru liabilities & equity to revenue and expenses
2 columns: Debit and Credit balances
Totals are equal (Balance)
Cash Flow Statement
Cash flow statement does not come from the T accounts.
Prepared by analyzing the transactions on the balance sheet and income statement.
How much did cash increase or decrease?
Was it an Operating, Financing, or Investing Activity?
GAAP: Generally Accepted Accounting Principals
So far everything has been cash accounting.
Recall: GAAP uses Accrual Accounting to measure performance
Accrual Accounting recognizes the difference between when the transaction
occurs and when the cash is received or paid.
Results in additional accounts on the B/S & ST of E and requires decision about
when to record some transactions (what new accounts?).
Qualitative Characteristics of Accounting Information
o Timely, predictive value, confirmatory value
o Representational faithfulness, substance over form, neutrality, prudence,
3 Basic Principals of GAAP
1. Accrual Accounting
a. Revenues and expenses recognized based on performance not when the
2. Revenue Recognition a. Revenue should be matched to the period it was earned. Revenue is earned
form operations (not selling shares to investors)
b. Tradeoff between timely info and reliability
c. Has revenue been earned?
i. Has the co. performed the majority of the things it has to do for the
ii. Can the amount be reasonably measured?
iii. Is there reasonable assurance that the amount will be collected?