ENVIRONMENT OF ACCOUNTING

1. ENVIRONMENT OF ACCOUNTING GAAP

2. NATURE OF ACCOUNTING • An information system designed to : Collect, Process, and Report economic data to interested parties to assist them in making decisions • Areas of accounting • Financial Accounting = external decision makers (investors and creditors) • Management Accounting = internal decision makers • Specialized areas • Tax Accounting • Regulatory Accounting “Accounting is the language of business”

3. “FINANCIAL STATEMENT PACKAGE” • Formal financial statements • Footnotes • Supplementary information • Attestation reports

4. FORMAL FINANCIAL STATEMENTS • Income statement • Balance sheet • Statement of stockholders’ equity • Retained earnings • Statement of cash flows

5. INCOME STATEMENTStatement of Earnings • Report on the operations of the entity • Listing of Revenues, Gains, Expenses, & Losses • Covers a period of time

6. STATEMENT OF FINANCIAL POSITIONBalance Sheet • Report on the financial position of the entity • Listing of Assets, Liabilities, & Owners’ Equity items • A specific point in time

7. STATEMENT OF STOCKHOLDERS’ EQUITY“Retained earnings” • Report on the changes in Retained Earnings • Covers a period of time • Link between the Balance Sheet & Income Statement

8. STATEMENT OF CASH FLOWS • Report on financial activities of the entity • Shows the changes in cash (and cash equivalents) • Covers a period of time

9. OTHER INFORMATION • Footnotes • Refers to a specific item or section • Supplementary information • All additional disclosures

10. ATTESTATION REPORTS • Management report • Report of the audit committee • Report of the independent auditor (CPA)

11. BASIC ACCOUNTING EQUATION[Corporation] Assets = Liabilities + Stockholders’ Equity Contributed (Paid-in) Capital Retained Earnings Par Value Excess Over Par Net Income (+) Net loss (-) Dividends (-) Declared Revenues & Gains (+) Expenses & Losses (-)

12. Issuing Stock to Investors After getting the business plan approved, Simon and Sue opened a Cup-A-Jo Coffee franchise by investing equipment worth $60,000 and cash totaling $300,000 in exchange for common stock. Assets increase by $360,000. Shareholders’ equity increases by $360,000. @Cambridge Business Publishers, 2009

13. Obtaining a Bank Loan Acting on behalf of Cup-A-Jo Coffee, Simon obtained a $90,000 bank loan to be repaid equally at the end of each year for 8 years at 7% annual interest. Assets increase by $90,000. Liabilities increase by $90,000. @Cambridge Business Publishers, 2009

14. Purchase of Franchise Cup-A-Jo acquired franchise rights for an 8-year period at a cost of $240,000 paid in cash. Because the franchise rights represent future economic benefits, the cost is an asset. Assets increase by $240,000, and Assets decrease by $240,000. @Cambridge Business Publishers, 2009

15. Balance Sheet after Pre-Opening Events @Cambridge Business Publishers, 2009

16. Buying Inventory Cup-A-Jo purchased $84,000 of inventory consisting of coffee, tea, cream, flavoring, etc., on credit due in 30 days. Assets increase by $84,000. Liabilities increase by $84,000. Beginning balances @Cambridge Business Publishers, 2009

17. Selling to Customers Cup-A-Jo sold coffee during the year for $305,000. Of this amount, Cup-A-Jo collected $270,000. The balance is still owed at December 31. The cost of the coffee sold was $70,000. Assets increase by $305,000 and decrease by $70,000—a net increase of $235,000. Shareholders’ equity increases by $305,000, and decreases by $70,000—a net increase of $235,000. @Cambridge Business Publishers, 2009

18. RELATIONSHIP OF FINANCIAL STATEMENTS Balance Sheet 12-31-x1 Balance Sheet 12-31-x2 Income Statement For Year 2 Revenues - Expenses = Net Income (or Loss) Assets Liabilities Owners’ equity Assets Liabilities Owners’ equity Statement of Retained Earnings For Year 2 Balance 1-1-x2 (+/-) Net income or loss - Dividends = Balance 12-31-x2

19. GENERALLY ACCEPTEDACCOUNTING CONCEPTS • Reasons for Generally Accepted Accounting Principles (GAAP) • Entities influencing GAAP GAAP

20. GAAP • Generally Accepted Accounting Principles (GAAP) • The guidance U.S. companies currently use to measure and report performance • Is very flexible • Allows management judgment • Different methods of measurement allowed Who prepares a company’s financial statements? Management @Cambridge Business Publishers, 2009

21. GAAP FAQs • Why did GAAP arise? • To mutually benefit the capital market participants who use financial statements • To help evaluate risk and return • To give confidence to users that information helps make better decisions • Created by Financial Accounting Standards Board (FASB) • Overseen by the Securities and Exchange Commission (SEC) • SEC has the ultimate power to set accounting standards @Cambridge Business Publishers, 2009

22. International Accounting Standards • Attempt to harmonize accounting standards through creation of International Financial Reporting Standards (IFRS) • Some countries are using IFRS • European Union converted in 2005 • Recent impact on U.S. • Late 2007, U. S. SEC voted to allow foreign registrants to file financial statements with the U.S. using IFRS • Previously required to use or reconcile to U.S. GAAP 22 @Cambridge Business Publishers, 2009

23. Proposed SEC Roadmap for IFRS #-Staggered adoption possible based on earliest adoption in 2015 or 2016. 23

24. OBJECTIVES OF FINANCIAL STATEMENTS • Help investors and creditors make rational investment, credit, and related decisions • Assess the amounts, timing, and uncertainty of future cash flows • Information about the economic resources of the entity, claims to those resources, and changes in those resources “ALLOCATION OF ECONOMIC RESOURCES”

25. USERS OF FINANCIAL STATEMENTSAssumptions • Reasonable knowledge of business and economic activities • Willing to study the information with reasonable diligence Statement of Financial Accounting Concepts No. 1, “Objectives of Financial Reporting by Business Enterprises”

26. Relevance Predictive value Feedback value Timeliness Reliability Verifiability Neutrality Representational faithfulness Comparability Consistency QUALITIES OF ACCOUNTING INFORMATION

27. ENVIRONMENTAL ASSUMPTIONS • Separate Entity • Continuity (Going Concern) • Time Period (Periodic Measurement) • Unit of Measure (Monetary)

28. IMPLEMENTATION PRINCIPLES • Cost/Exchange Transactions • Revenue Realization • Matching • Full Disclosure

29. Accounting Information Constraints • Materiality • GAAP applies only to economic events significant enough to affect a user’s decision • Conservatism • Applied when trade-offs between qualities are needed • A reaction to uncertainty • When in doubt, financial statements should • Understate assets • Overstate liabilities • Delay recognition of revenues • Accelerate recognition of expenses @Cambridge Business Publishers, 2009

30. Assets Liabilities Equity (Owners’) Investments by Owners Distributions to Owners Revenues Expenses Gains Losses Comprehensive Income ELEMENTS OF FINANCIAL STATEMENTS

31. Claims against resources (Liabilities) Remaining claims accruing to owners (Owner’s Equity) BALANCE SHEET Resources (Assets)

32. BALANCE SHEET ELEMENTS • Assets • Economic resources with probable future value • Controlled by management • Resulting from past transactions • Liabilities • Probable future sacrifices of economic benefits (debts/obligations) • Require transfer of assets • Terms of obligations are specified • Result from past transactions • Equity • Residual interest in the assets of the entity • “Net assets” • Represents the “investment” by owners

33. Assets Current Assets Long-term Investments Property, Plant, and Equipment Intangible Assets Other Assets Liabilities Current Liabilities Long-term Liabilities Stockholders’ Equity Contributed Capital Retained Earnings Other Items BALANCE SHEET CLASSIFICATIONS

34. BALANCE SHEET • Liquidity - length of time until assets are converted to cash or until a liability must be paid • Solvency – the ability of a firm to meet its debts as they come due • Financial flexibility - ability of company to manage its cash flows (deal with emergencies or take advantage of unexpected opportunities)

35. THE INCOME STATEMENT • Describes a company’s operating performance for a specified period of time

36. INCOME STATEMENTELEMENTS • Revenues • Inflows of assets (settlement of liabilities) • From delivery or production of goods or rendering of services • Gains • Increases to equity • From peripheral or incidental transactions • Expenses • Outflows of assets (incurrance of liabilities) • Consumption or expiration of assets in an attempt to generate revenue • Losses • Decreases in equity • From peripheral or incidental transactions • Earnings per share • Basic • Fully diluted

37. INCOME STATEMENT“Multiple-Step” • Operations section • Gross margin (Sales - Cost of goods sold) • Operating expenses • Other items (“nonoperating”) • “Special items” • Net income - “the bottom line” • Earnings per share

38. INCOME STATEMENT“Multiple-Step” • Items within “Income from continuing operations” • Unusual OR infrequent gains and losses • Below “Income from continuing operations” • Discontinued Operations • Extraordinary items (unusual AND infrequent)

39. Income Statement (Multiple-Step) Operations Other Special items

40. Which Basis of Accounting is Used? • Cash basis • Financial effects are recorded in financial statements when cash is received or paid • Accrual basis • Financial effects are recorded without regard to the timing of the cash flows • Accounts that exist under accrual basis • Accounts receivable • Amounts customers owe for items purchased • Accounts payable • Amount the company owes for credit purchases @Cambridge Business Publishers, 2009

41. Revenue Principle Revenue should be recognized in the financial statements when . . • It is earned, and … • It is realized or realizable (measurable)

42. REVENUE RECOGNITION POINTS Recognition before delivery Recognition at delivery Recognition after delivery Design and production, construction in progress, minerals discovered Goods completed and ready for sale, contract complete Delivery of product or service Cash collected for goods or services Right of return expires Percentage-of completion method Production method Point of sale method Installment method Right of return expiration method Completed contract method Cost recovery method RELEVANCE RELIABILITY

43. Matching • Once revenues are determined, the expenses incurred in attempting to generate the revenue should be recognized. • As revenues are earned, certain assets are consumed and services are used.

44. Expense Classification • Direct • Period • Allocated

45. BUSINESS CYCLE Collect cash from customer Customer receives item Purchase materials Convert materials into finished product Ship product & invoice customer Receive order from customer Inspect product Store product in warehouse

46. EXPENDITURES vs. EXPENSES Assets as of Jan. 1, 1998 Expenditures during 1998 Direct association with revenue Expenses of 1998 Yes Example: Cost of goods sold No Association with activities Yes Example: Office expenses No Association with future Yes No Assets as of 12-31-98 Example: Obsolete merchandise

47. STATEMENT OF CASH FLOWS

48. Nature of Statement Reports on Financial Activity Covers a period of time (fiscal period) Explains changes in cash balance Cash and equivalents Highly liquid short-term investments Treasury bills, Money-market funds Objectives of Statement Prediction of future cash flows Evaluation of financial management Determine ability to pay interest and dividends Explain relationship of net income to changes in cash balance STATEMENT OF CASH FLOWS

49. STATEMENT OF CASH FLOWComponents • Cash flow from Operating Activities • Result from creation of revenues and expenses • Items that affect the Income Statement • Cash flow from Investing Activities • Result from increases or decreases in long-term assets • Cash flow from Financing Activities • Result from transactions with creditors or investors • Generate funds needed to launch or sustain the business

50. CASH FLOW FROM OPERATIONS • Operating Sources of Cash • Collections from customers • Receipts of interest • Receipts of dividends • Operating Uses of Cash • Payments to suppliers • Payments to employees • Payments for interest • Payments for income taxes