Financial Accounting: Chapter Notes

Financial Accounting: Chapter Notes

Businesses combine resources, labor, and capital to create these products and services. Owners and managers direct the business and make the operating decisions to help make the company successful. Accounting is essential to businesses because it provides the owners and managers with feedback on how well the business is operating. The accounting process gathers financial information and communicates it to seers so that these users (owners, creditors) can make decisions about how to proceed with business operations. Accounting, therefore, is a decision- making tool.

The Basic Structure of Accounting All businesses and individuals need and use accounting to keep track of financial transactions. A transaction is at the heart of the accounting process. Whenever a financial exchange occurs between people or businesses, the accounting process measures and records that economic event as a transaction. Examples: When someone is paid to provide a service (such as mowing a lawn), an accounting transaction has occurred. The exchange is be;men the service provider (mower) and the service requester (lawn owner).

If the provider (one person) is mowing another person’s lawn, then a transaction is recorded between the two individuals. If, however, the mowing is provided by a lawn care service to a nursing home, then the transaction is between two businesses. Any two parties can create a transaction with each other. The textbook begins the story of accounting by identifying the users of accounting information. The act of incorporating a transaction into the company’s financial accounting system creates a permanent record of the transaction.

We use the accounting information contained in the accounting records both to evaluate current activities and to make future decisions. When the managers off business provide an external report of the transactions conducted by the business, we call this financial accounting. If the managers use the accounting numbers to make internal decisions, this is called management accounting. This introductory course focuses on financial accounting; therefore, we will focus on how managers report their operations to external parties. Many outside users take an interest in how well a company is doing.

External users may be investors, creditors, the government (IRS, federal, state, and local), and other interested parties like unions, consumer groups, and the general public (potential customers). Given all the interested parties and all the information that could be provided, the accounting profession formed a governing body to determine what, and how, accounting information should be reported and disclosed. The Financial Accounting Standards Board (FAST) is the private sector rule-making body that determines how accounting is practiced.

Caps (Certified Public Accountants) make sure that the rules set down by the FAST re being followed by the reporting businesses. International Financial Reporting Standards (FIRS) are also becoming important as U. S. Generally Accepted Accounting Principles (GAP) is converging with International Reporting requirements. Although beyond the scope of this primer, more references will be made to International Reporting requirements as you progress further into the field of financial accounting.

Forms of Business Organization Businesses usually fall into three major organizational types: proprietorships, partnerships, and corporations. In a proprietorship, a single owner hires people to conduct a needed service. Examples include a dentist, a lawyer, a CPA or the proprietor of a lawn care service. A group of owners may form a partnership. Some of the large CPA firms, doing over a billion dollars of business, were partnerships for many years. Recently these firms have become professional associations in order to limit the individual liability of the partners.

However, being a partnership for tax purposes can have some real advantages, and many businesses continue to keep that form. Most businesses eventually become corporations. Corporations can start or main small but often they become huge, owned by many stockholders and are clearly the largest and most powerful business form. Some corporations are larger than most countries. Wall-Mart and Exxon/Mobil have revenues of over $300 billion, which would rank them with the top ten largest countries in the world. Almost all of the examples in the textbook are of corporations.

Types of Buss nesses Businesses can provide many different types of services and activities. Here are some examples. Manufacturing Companies: A manufacturing firm transforms basic resources into finished goods. These companies add value y taking simple inputs, such as labor and materials, and combining them to create a complex product like an automobile. Success is measured by the ability of the manufacturer to sell the complex product for more than the cost of the inputs. Examples are Boeing, Caterpillar, and Ford.

Merchandising Companies: A merchandising firm moves the product from the manufacturer to the ultimate consumer. The product does not change very much while the merchandising firm holds it. For example, in the automobile business, Ford Motor Company is the manufacturer, while the local Ford dealership is the merchandising company. The difference between the types of businesses above is that manufacturing companies change raw materials into usable products, while merchandising companies leave the product essentially unchanged. Wall-Mart and Target are large merchandising firms.

Wholesalers: Wholesalers are a specific type of merchandiser. Wholesalers move (distribute) products from manufacturers to dealers or retailers. They make profits by converting large quantities of product into small, usable packages that customers can buy from retail outlets. For example, a restaurant might buy hundreds of pounds of beef from a wholesaler and then prepare it in individual portions to sell to customers. Service Companies: Service companies also provide a value-added service to consumers. Value-added service means that customers pay individuals for improving their quality of life.

Health care, legal services, insurance services, and the government are examples of service companies. Service companies form the largest part of the U. S. Economy. For example, the “big four” accounting firms (PricewaterhouseCoopers, KEMP, Dolomite & Touché Tomcats, and Ernst and Young) employ hundreds of thousands of individuals while selling essentially no physical products. The combined revenues of the big 4 accounting firms is approaching $100 billion and employ over 600,000 professionals worldwide. The service industry is the fastest growing segment of the economy.

Most professionals are in service businesses–they do not create physical products; rather, they improve the quality of living for the population. The Internet has increased the growth of service companies because of the need and desire for more information. Generally Accepted Accounting Principles (GAP) GAP is the set of accounting rules that the FAST has set down for the financial reporting of business transactions. Advanced accounting courses review many GAP issues in detail. This course introduces some basic principles and concepts that are widely used and understood.

Before discussing the accounting model, let us review a few basic concepts that apply to most accounting transactions. BASIC CONCEPTS Entity: To make sense, accounting must define the entity. Accounting is related to specific entities (proprietorships, partnerships, corporations). Reliable: A recorded transaction can only be meaningful if the source documents are reliable, dependable and trustworthy. Relevant: Provides dieback and predictive value on a timely basis. Cost Principle: Transactions are recorded at their actual Or historical cost.

Accountants record the amount paid, not how much something “should” be worth. Note, however, that most initial transactions reflect the market value of the transaction. That market price is designated as the cost (historical cost). Fair Value: Sometimes GAP requires items to be reported at fair value in financial statements. Fair value is the amount that could be received to sell the item in an orderly manner. Going Concern: To meaningfully measure accounting transactions, accountants assume, in absence of evidence to the contrary, that a business will continue to operate for the foreseeable future.

Therefore the business is called “a going concern. ” Businesses that are currently bankrupt or liquidating require special accounting treatments not ordinarily used by healthy, continuing businesses. Stable Monetary Unit: We assume that dollars in the future are comparable to dollars today. If inflation becomes a serious problem, this assumption can lose its meaning. In summary, these concepts are at the foundation of meaningful accounting numbers, and we Ely upon them for the accounting process to work properly.

The Accounting Equation To begin the process of recording and then reporting accounting transactions, we need a model that captures the events we are trying to measure. The accounting model is represented by the accounting equation, and it is a powerful tool we use to measure, record, classify, and report accounting transactions. The accounting equation allows all the complexities of accounting to be condensed into a few simple concepts. The accounting equation states: Assets = Liabilities + Owner’s Equity Remember that accounting is related to entities.

The accounting equation shows that assets of the entity are financed by two sources: creditors and owners. Once we understand each of the terms, the model makes more sense. Also, note that accounting is based upon one algebraic equation with three variables. Students need to know basic algebra and be able to add, subtract, multiple, and divide to learn accounting. Assets: Assets are economic resources owned or controlled by a business entity. Assets must have a future economic benefit for the business that owns them. An asset like a truck that a business uses to haul its product is clear and measurable.

A river that runs by a equines that allows for the discharge of excess water is clearly an asset, but is not owned or controlled by the business entity; therefore, it is not recorded by accounting in the business books. Common examples of assets are cash, inventory (goods held for the purpose of resale), and productive fixed assets (such as cars, buildings, and computers). Assets can also be intangible, such as patents, copyrights, and trademarks. The key to measuring and recording an asset is that the business entity has a current benefit by owning these resources in the future.

Liabilities: Liabilities are claims against the assets of a equines. Liabilities are obligations of the business entity, encumbrances, or debts, meaning that outsiders control the terms of repayment. A business will eventually have to use its assets to pay off these debts. Common examples are: accounts payable (amounts owed for the purchase of inventory’), bank loans, and bonds payable (long-term obligations owed to investors who want a fixed return on their money). Owner’s Equity: Owners’ equity equals assets – liabilities (net assets).

It represents the increase in net assets by financing provided by owners and by earnings from the business operations. If we take our assets and subtract our liabilities, what remains is the equity in our business. To illustrate, if a company has assets of and liabilities of then equity is Simply put, if a company pays off its creditors, the remaining amount ($20,000,000) represents the equity of the business. In accounting, owners equity does not reflect the value of the business; it is simply the amount left over from subtracting liabilities from assets.

To better understand how the model works, we will go through several examples of accounting transactions. Journal entries, introduced in Chapter 2, are used to illustrate how the equines accounts for transactions. An Example of a Proprietorship Business Entity, LIMO Company In this lesson, we illustrate the creation of a proprietorship. (Starting in Chapter 5, almost all examples will be of corporations. ) Imagine a rural community that has a number of tourist attractions. Pat Johnson, an entrepreneur, decides to form a limousine service business (which we will call LIMO Co. To take visitors to these nearby attractions. In June XX, Pat invests SSL 0,000 of her personal savings in the business. She sets up a business checking account that is separate from her arsenal checking account and transfers the SSL 0,000. The primary operating asset Of the business will be a vehicle to carry tourists to the local fishing lodge or ski resort. Therefore, Pat decides to purchase a minivan so that it can carry skis in winter and camping supplies in summer. (Note: this example problem will be continued and built upon in subsequent Lessons).

The minivan selected costs $30,000 and the business borrows $25,000 from the local bank to finance the purchase. Accountants record transactions as journal entries. Learning how to make journal entries is one of the key incepts in learning accounting. To reflect the previous transactions, we make the following accounting journal entries: 1. The business records the investment of $10,000 by the owner. Journal Entry for Owner Contribution to the Business: Debit Credit Cash $10,000 Owner’s Equity $1 0,oho Explanation: TO record a capital contribution to the firm.

An explanation Of the transaction and journal entry form: The first line (Cash for $10,000) is a referred to as a debit to “Cash. ” The word debit simply means left side, and in this case means that LIMO Co. Is recording an increase in its cash balance from zero to $10,000. The second line (Owner’s Equity for $10,000) is a credit to an account called “owner’s equity’ (alternatively, owners’ capital). The work credit simply means right side. This credit to Owner’ Equity implies that the business owner is the source of the cash; it is not owed to outsiders.

The two accounts are in balance, and the accounting model shows assets (Cash) equals liabilities and owner’s equity: Assets Liabilities Equity 10,000 Owners’ Equity From the accounting equation, note that assets, to the left of the equal sign, have debit (left-hand side) balances, and liabilities and owner’s equity, to the eight of the equal sign, have credit (right-hand side) balances. Assets have Debit Balances Liabilities have Credit Balances Owners’ Equity has Credit Balances Assets In Accounting, each account is a unit of information tracked by the accounting system.

Accountants use a visual T account (looks like a T) to represent the information. Information entered on the left in the T account is a debit, and information entered on the right is a credit. If we created two T-accounts, as the textbook illustrates, they would appear as follows: Cash These T-accounts show the debit on the left and the credits on the right. So the normal balance we would expect to see in asset accounts is a debit, and the normal balance of owner’s equity is a credit.

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