Accounting & Finance

Chapter 1

Uses of
Accounting
Information and
the Financial
Statements

Multimedia Slides by: Gail A. Mestas, MAcc, New Mexico State University

Accounting

… is an information system that
measures
processes
communicates
financial information
about an identifiable, economic entity

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Company. All rights reserved. 1–2

Accounting

…supplies the information
decision makers need to make
reasoned choices
among alternative uses of
scarce resources
in the conduct of business and
economic activities


Accounting …

• Is a link between business activities and
decision makers
– Decision makers use accounting
information to make informed decisions
about available alternatives
• Measures business activities by
recording data about them for future
use
• Is communicated to decision makers
through reports

Accounting as an Information System
Input Output

Accounting System


Business Goals, Activities, and
Performance Measures

• Business
– An economic unit that aims to sell goods
and services to customers at prices that
will provide an adequate return to its
owners


Business Goals

• Profitability
– The ability to earn enough income to
attract and hold investment capital
• Liquidity
– Having enough cash available to pay debts
when they are due


Business Activities

• Financing Activities
• Investing Activities
• Operating Activities


Financing Activities

• Activities associated with obtaining
adequate funds, or capital, to begin and
continue operations
– Owner investments
– Paying a return to owners
– Obtaining loans from creditors
– Repaying amounts to creditors, plus
interest

Investing Activities

• Activities associated with spending
funds to begin and continue operations
– Buying resources such as land, buildings,
and equipment needed in the operation
of the business
– Selling these resources when no longer
needed


Operating Activities

• Activities associated with the course of
running a business
– Selling goods and services
– Employing managers and workers
– Buying goods and services
– Paying taxes


Performance Measures

• Indicators
– Used to determine whether
1. Managers are achieving their business goals
2. Business activities are well managed
• Include
– Earned income
– Cash flow
– Ratio of expenses to revenue
– Ratio of money owed to total resources
controlled


Financial and Management Accounting

• Accounting’s role is divided into two
categories
1. Management accounting
2. Financial accounting
• The functions of both categories
overlap
• Primary difference between the two is
the principal users of the information

Management Accounting

• Focuses on internal decision makers
– Managers and employees
• Reporting format is flexible and based
on the type of information needed, such
as budgets and sales forecasts
• Used to report past performance and
expected future performance


Financial Accounting

• Focuses on external decision makers
– Stockholders
– Banks and other creditors
– Government regulators
• Financial information of company is
reported in the financial statements
– Used to report directly on goals of
profitability and liquidity

Bookkeeping versus Accounting

Bookkeeping Accounting
– Repetitive, – Bookkeeping a small
mechanical process part of accounting
of recording financial – Includes design of an
transactions and information system
keeping financial to meet users’ needs
records
– Goals include the
analysis,
interpretation, and
use of information


Decision Makers

… fall into three categories

1. Those who manage a business
– Finance
– Investment
– Operations and Production
– Marketing
– Human Resources
– Information Systems
– Accounting

Decision Makers (cont’d)

2. Those with a Direct Financial Interest
– Investors
– Creditors
3. Those with an Indirect Financial Interest
– Tax Authorities
– Regulatory Agencies
– Labor Unions
– Financial Advisors
– Customers
– Economic Planners

Management

• Managers are internal users of accounting
information
– Make key decisions using accounting information
– Basic management functions require accounting
information for decision making
• Financing the business
• Investing resources
• Producing goods and services
• Marketing goods and services
• Managing employees
• Providing information to decision makers


Users With a Direct Financial Interest

… are external users of accounting
information
• Investors
– Put money into a business in order to
make money (by purchasing and selling
stocks and receiving dividends)
– Use financial statements to judge the
prospects for profitable investments


Users With a Direct
Financial Interest (cont’d)

• Creditors
– Loan money to a business in order to make
money (by charging interest)
– Use financial statements to judge whether
a company will have enough cash to
• Pay interest charges
• Repay debt at appropriate time


Users With an Indirect
Financial Interest
… are external users of accounting
information
• Tax authorities
– Use accounting information to determine amount
of tax due
– Procedures for tax reporting mandated by law
• Government regulatory agencies
– Federal, state, and local levels
– Securities and Exchange Commission (SEC)
• Regulates the issuing, buying, and selling of stocks in
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the Houghton Mifflin

Users With an Indirect
Financial Interest (cont’d)

• Other groups
– Labor unions
– Those advising investors and creditors
• Financial analysts and advisors
• Brokers
• Underwriters
• Lawyers
• Financial press
– Consumer groups
– Customers
– General public
– Economic planners

Government and Not-for-Profit
Organizations
• Include
– Hospitals
– Universities
– Professional organizations
– Charities

• Have the same categories of decision makers as
profit-oriented organizations
– Managers
– Those with a direct financial interest
– Those with an indirect financial interest


Business Transactions

… are economic events that affect the
financial position of a business entity

– Involve an exchange of value
• Purchase
• Sale
• Payment
• Collection
– Events that have the same effect as an exchange
of value
• Loss from fire, flood, theft
• Physical wear and tear on equipment
• Accumulation of interest

Money Measure

• Recording of all business transactions
in terms of money
• Money is the only factor common to all
business transactions
• Basic unit of money determined by the
country in which business resides
• Exchange rates are used to translate
transactions from one currency to
another

Separate Entity

• A business is distinct from its
– Owner(s)
– Creditors
– Customers
• Its financial records and reports should
refer only to its own financial affairs


Forms of Business Enterprises

• Three basic forms of business
enterprises
– Sole proprietorship
– Partnership
– Corporation


Sole Proprietorships

• Business owned by one person
– The owner
• Receives all profits or losses
• Is liable for all obligations of the business

• Not incorporated
• Life of business ends when the owner
– Decides to stop operating business
– Dies
– Is incapacitated

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Partnerships

• Business owned by more than one person
– The partners share all profits or losses according
to an agreed upon formula
– At least one partner is liable for all obligations of
the business
• Not incorporated
• Life of business ends when
– Ownership changes
• A partner leaves the business or dies
• A new partner is admitted


The Corporation as a
Separate Entity

• Legally and economically separate from its
owners
– Business unit chartered by the state and legally
separate from owners (incorporated)
– Owners (stockholders) do not directly control
operations
– Elected board of directors run the corporation
– Owners’ risk of loss limited to amount paid for
shares of stock – owners are not liable for the
obligations of the business

Financial Position

The economic resources that belong
to a company
and the claims against those resources
at a point in time

Economic Resources = Equities


Developing the Accounting Equation

Economic Resources = Equities
Two types of equities
Creditor’s equities and owner's equities,
therefore,

Assets Liabilities
Economic Resources = Creditor’s Equities
+ Owner’s Equities
In accounting terminology
Economic resources are called assets
Creditor’s equities are called liabilities

Accounting Equation

Assets = Liabilities + Owner’s Equity
Two sides of equation are always in balance
• Assets
– Economic resources owned by a company that are expected
to benefit future operations
• Liabilities
– Obligations of a business to pay cash, transfer assets, or
provide services to other entities in the future
– Represent claims of creditors to the assets of the business
• Owner’s Equity
– Represents the claims by owners to the assets of the
business

Owner’s Equity

• Equals the residual interest in a company’s
assets after deducting all liabilities
• Also called residual equity or net assets
• Defined by rearranging the accounting
equation

Assets = Liabilities + Owner’s Equity
Owner’s Equity = Assets – Liabilities

Transactions That Affect Owner’s Equity

• Owner’s investments
– Assets the owner puts into the business
• Owner’s withdrawals
– Assets the owner takes out of the business
• Revenues
– Increases in owner’s equity that result from
operating a business
• Expenses
– Decreases in owner’s equity that result from
operating a business


Illustrative Transactions for Shannon Realty

Effects of Transactions
on the Accounting Equation


Owner’s Investments
1. Deposited $50,000 in a bank account in the name of
Shannon Realty
Assets = Liab. + Owner’s Equity
John Shannon,
Cash Capital
1.+$50,000 +$50,000

A = $50,000 L + OE = $50,000

Notice that the accounting equation
Assets = Liabilities + Owner's Equity, or
A = L + OE,
is always in balance


Purchase of Assets with Cash
2. Purchased a lot for $10,000 and a small building on a lot
for $25,000
John Shannon,
Cash Land Building Capital
1. $50,000 $50,000
2. -35,000 + $10,000 +$25,000
bal. $15,000 $10,000 $25,000 $50,000

A = $50,000 L + OE = $50,000

This transaction only affects one side of the
accounting equation – Assets
Whenever a transaction affects only one side
of the accounting equation, the total on each
side of the equal sign remains unchanged

Purchase of Assets
by Incurring a Liability
3. Purchased office supplies for $500 on credit

John Shannon,
Cash Supplies Land Building A/P Capital
1. $50,000 $50,000
2. -35,000 $10,000 $25,000
3. +$500 +$500
bal. $15,000 $500 $10,000 $25,000 $500 $50,000

A = $50,500 L + OE = $50,500


Payment of a Liability
4. Paid $200 of the $500 owed for supplies

John Shannon,
1. $50,000 $50,000
2. -35,000 $10,000 $25,000
3. $500 $500
4. -200 -200
bal. $14,800 $500 $10,000 $25,000 $300 $50,000

A = $50,300 L + OE = $50,300


Revenues
5. Earned and received a commission of $1,500 in cash

John Shannon,
1. $50,000 $50,000
2. -35,000 $10,000 $25,000
3. $500 $500
4. -200 -200
5. +1,500 +1,500
bal. $16,300 $500 $10,000 $25,000 $300 $51,500

A = $51,800 L + OE = $51,800


Revenues
6. Earned a commission of $2,000 to be received at a later
date
John Shannon,
Cash A/R Supplies Land Building A/P Capital
1. $50,000 $50,000
2. -35,000 $10,000 $25,000
3. $500 $500
4. -200 -200
5. 1,500 1,500
6. +$2,000 +2,000
bal. $16,300 $2,000 $500 $10,000 $25,000 $300 $53,500

A = $53,800 L + OE = $53,800


Collection of Accounts Receivable
7. Received $1,000 from client for commission earned earlier
in the month
John Shannon,
1. $50,000 $50,000
2. -35,000 $10,000 $25,000
3. $500 $500
4. -200 -200
5. 1,500 1,500
6. $2,000 2,000
7. +1,000 -1,000
bal. $17,300 $1,000 $500 $10,000 $25,000 $300 $53,500

A = $53,800 L + OE = $53,800


Expenses
8. Paid $1,000 to rent equipment for office

John Shannon,
1. $50,000 $50,000
2. -35,000 $10,000 $25,000
3. $500 $500
4. -200 -200
5. 1,500 1,500
6. $2,000 2,000
7. 1,000 -1,000
8. -1,000 -1,000
bal. $16,300 $1,000 $500 $10,000 $25,000 $300 $52,500

A = $52,800 L + OE = $52,800


Expenses
9. Paid $400 in wages to part-time helper

John Shannon,
1. $50,000 $50,000
2. -35,000 $10,000 $25,000
3. $500 $500
4. -200 -200
5. 1,500 1,500
6. $2,000 2,000
7. 1,000 -1,000
8. -1,000 -1,000
9. -400 -400
bal. $15,900 $1,000 $500 $10,000 $25,000 $300 $52,100

A = $52,400 L + OE = $52,400


Expenses
10. Recorded utilities expense of $500 incurred in December
but not yet paid
John Shannon,
1. $50,000 $50,000
2. -35,000 $10,000 $25,000
3. $500 $500
4. -200 -200
5. 1,500 1,500
6. $2,000 2,000
7. 1,000 -1,000
8. -1,000 -1,000
9. -400 -400
10. +300 -300
bal. $15,900 $1,000 $500 $10,000 $25,000 $600 $51,800

A = $52,400 L + OE = $52,400

Owner’s Withdrawals
11. Withdrew $600 in cash from Shannon Realty and
deposited it in a personal account
John Shannon,
1. $50,000 $50,000
2. -35,000 $10,000 $25,000
3. $500 $500
4. -200 -200
5. 1,500 1,500
6. $2,000 2,000
7. 1,000 -1,000
8. -1,000 -1,000
9. -400 -400
10. 300 -300
11. -600 -600
bal. $15,300 $1,000 $500 $10,000 $25,000 $600 $51,200

A = $51,800 L + OE = $51,800

Communications Through Financial
Statements

• Four Major Financial Statements
– Income Statement
– Statement of Owner’s Equity
– Balance Sheet
– Statement of Cash Flows


Income Statement

• Summarizes revenues earned and
expenses incurred over a period of time
• Dated “For the Month Ended …”
• Purpose to measure a company’s
performance over a period of time
• Shows whether or not a company
achieved its profitability goal

Income Statement (cont’d)

• Considered by many to be most important
financial statement
• Also called the capital statement
• First financial statement to be prepared in a
sequence
• Net income figure used to prepare statement
of owner’s equity


Income Statement Date reflects
revenues and
expenses incurred
over a period of time
Shannon Realty
Income Statement
For the Month Ended December 31, 20xx

Revenues
Commissions earned $3,500
Expenses
Equipment rental expense $1,000
Wages expense 400
Utilities expense 300
Total expenses 1,700
Net income $1,800

Net income figure used to prepare
Copyright © Houghton Mifflin statement of owner’s equity

Statement of Owner’s Equity

• Shows changes in owner’s equity over
a period of time
• Uses net income figure from income
statement
• End of period balance in Capital
account used to prepare balance sheet


Date reflects changes in John Shannon,
Capital, over a period of time
Shannon Realty
For the Month Ended December 31, 20xx

John Shannon, Capital, December 1, 20xx $ 0
Add: Investments by John Shannon $50,000
Net income for the month 1,800 51,800
Subtotal 51,800
Less: Withdrawals by John Shannon 600
John Shannon, Capital, December 31, 20xx $51,200

Ending balance of John
Shannon, Capital, used to Net income figure from
prepare the balance sheet income statement


Balance Sheet

• Shows the financial position of a company on
a certain date
• Dated as of a certain date
• Also called the statement of financial position
• Presents view of business as holder of assets
that are equal to the claims against those
assets
• Claims consist of liabilities and owner’s equity

Balance Sheet Date reflects account
balances as of a
certain date

Shannon Realty
Balance Sheet
December 31, 20xx

Assets Liabilities

Cash $15,300 Accounts payable $ 600
Accounts receivable 1,000
Supplies 500 Owner’s Equity
Land 10,000
Building 25,000 John Shannon, Capital 51,200

Total liabilities
Total assets $51,800 and owner’s equity $51,800

Balance in Cash
account used in John Shannon, Capital, from
statement of cash statement of owner’s equity
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flows Mifflin

Statement of Cash Flows

• Shows cash flows into and out of a
business over a period of time
• Focuses on whether the business met
its liquidity goal
• Explains how the Cash account
changed during the period

Statement of Cash Flows Date reflects
Shannon Realty cash flows over
Statement of Cash Flows a period of
For the Month Ended December 31, 20xx time
Cash flows from operating activities
Net income $ 1,800
Adjustments to reconcile net income to net cash
flows from operating activities
Increase in accounts receivable ($1,000)
Begins
Increase in supplies (500) with net
Increase in accounts payable 600 (900) income
Net cash flows from operating activities $ 900
from
Cash flows from investing activities
Purchase of land ($10,000) income
Purchase of building (25,000) statement
Net cash flows from investing activities (35,000)
Cash flows from financing activities
Investments by John Shannon $50,000
Withdrawals by John Shannon (600)
Net cash flows from financing activities 49,400
Net increase (decrease) in cash $15,300
Cash at beginning of month 0
Cash at end of month
Cash at end of month $15,300
same as Cash account
balance on balance sheet

Generally Accepted Accounting
Principles (GAAP)

• The conventions, rules, and procedures
necessary to define accounting practice
at a particular time
• Developed to provide guidelines for
financial accounting
• Are altered as better methods evolve or
circumstances change


Financial Statements, GAAP, and the
Independent CPA’s Report (Audit)
Financial Statements Audit
• Summary of financial affairs of a • Examination of a company's
business financial statements

• Prepared by management of • Prepared by independent
company certified public accountant
(CPA)
• Management has an interest in • CPA should have no
company performance; not compromising ties with
independent company
• Should be prepared in • Ascertains that financial
accordance with GAAP statements prepared in
accordance with GAAP

• Implies that investors and
creditors can rely on financial
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Ethics

… is the code of conduct that applies to
everyday life

• Addresses whether actions are right or wrong
• Ethical actions are the product of individual
decisions
• Certain actions may be unethical but not
illegal

Professional Ethics

… is the code of conduct that applies to
the practice of a profession

• Accountants have a responsibility to their
employers, clients, and society to uphold
highest ethical standards
• AICPA and each state have adopted codes of
professional conduct for certified public
accountants

Ethical Principles

• Integrity
– Requires honesty, frankness, and placing service
and public trust before personal gain

• Objectivity
– Requires impartiality and intellectual honesty

• Independence
– Requires that an accountant avoid all relationships
that impair, or appear to impair, his or her
objectivity

Institute of Management Accountants
(IMA)

• Code of Professional Conduct for
Management Accountants
– Emphasizes:
• Competence
• Confidentiality
• Integrity
• Independence
• Objectivity


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