Chapter 1

A Framework for Financial

Accounting

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 Accounting Information
• Managerial accounting: information provided for internal users
o Has no rules and regulations like US GAAP, but uses various models
o Can use historical data, but also uses projections about the future
o For decision makings for the future, not past
• Financial accounting: information provided for external users
o Follows rules and regulations, e.g. US GAAP, IFRS or any other Country GAAP

OUR FOCUS external users

in this class
Internal users

external users

2
Source: Spiceland 3e, modified by M Kregar
 Framework for Financial Accounting

Investors:
Buying/Selling Stock
Creditors: Lending
money

• Financing Activities
• Investing Activities
Financial • Operating Activities
Statements

3 Source: Spiceland 3e, modified by M Kregar

 Use of Financial Accounting Information in Investing
and Lending Decisions – Does it really matter?
No better single piece of company information better explaining
stock price performance than Financial Accounting NET INCOME!

& other
information

How to allocate resources?

To which company – run efficiently and profitable?
Risk – Return profile of the company?
Financial condition of the company?

4 Source: Spiceland 3e, modified by M Kregar

 Measuring Business Activities

 Financing activities: transactions the company

has with investors and creditors

 Investing activities: transactions involving the

purchase and sale of resources that provide
benefit for several years

 Operating activities: transactions that relate to

the primary operations of the company

5 Source: Spiceland 3e
Exercise Question

Problem 1-1A

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 Balance Sheet &
Basic Accounting Equation
1. Bring $100,000 cash and in turn receive 100,000 shares at par $1
2. Ask Bank to give you a loan of $100,000 and to repay over the next 5 years
3. Buy and pay in cash some equipment for $75,000 to start your operations
Assets Liabilities
+100,000
Cash + 100,000 - 75,000 125,000 Creditor/Bank +100,000 100,000
Equipment +75,000 75,000
Equity
Investors/Shares +100,000 100,000

Total Assets 200,000 Total Liabilities 200,000

&Equity
Assets = Liabilities + Stockholders’ Equity
200,000 = 100,000 + 100,000
7 Resources= claims to resources by creditor and owners $ 100,000 each
 Basic Accounting Equation
Assets = Liabilities + Stockholders’ Equity
200,000 = 100,000 + 100,000
Resources= claims to resources by BOTH - creditors and owners

Assets - Liabilities = Stockholders’ Equity

200,000 - 100,000 = 100,000

Assets - Liabilities = Net Assets = Stockholders’ Equity

200,000 - 100,000 = 100,000 = 100,000

Stockholders’ Claim
Note: Basic Accounting Equation  Fundamental Model of Business Valuation
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 Income Statement – Net Income
All Stockholders wish that their ‘Claim’ on ‘Net Assets’ does increase
over time  Company has to make profits!
Assume: Cash Sales 50,000 and expenses paid by in cash 20,000
Income Statement
Revenues 50,000
– Expenses 20,000
= NET INCOME 30,000
Assets Liabilities
125,000
Cash +50,000 Creditor/Bank 100,000
- 20,000 155,000
Equipment 75,000 Equity
Investors/Shares 100,000
Retained Earnings 30,000 130,000
Total Assets 230,000
Total Liab.&Eq. 230,000
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 Distribution to Owners - Dividend
Stockholders wish to receive some cash distribution over time
 Company pays Dividends
Assume: Cash Dividend of $10,000 is paid to all Stockholders

Assets Liabilities
155,000
Cash -10,000 Creditor/Bank 100,000
145,000
Equipment 75,000 Equity
Investors/Shares 100,000
Retained Earnings 30,000
-10,000 120,000
Total Assets 220,000 Total Liab.&Eq. 220,000
Assets = Liabilities + Stockholders’ Equity
220,000 = 100,000 + 120,000
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 Business Activities and Their Measurement

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Exercise Question

Problem 1-2A

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 Communicating Through Financial Statements
Primary financial statements

Income statement

Statement of stockholders’ equity

Balance sheet

Statement of cash flows

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 Income Statement
The INCOME STATEMENT reports, for a certain interval of time, the net
assets generated through business operations (revenues), the net assets
consumed (the expenses), and the difference, which is called net income. (best
effort to measure economic performance)

if Revenues < Expenses

 NET LOSS

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 Statement of Stockholders’ Equity
Summarizes the changes in stockholders’
equity over an interval of time
Stockholders’ Equity = Common Stock + Retained Earnings

Note: Dividends are cash distributions and reducing Retained Earnings,

but NOT an EXPENSE

15 Source: Spiceland 3e
 Balance Sheet
The BALANCE SHEET reports, as of a certain point in time, the resources of a
company (the assets), the company’s obligations (the liabilities), and the equity
of the owners.  The Financial Position on a particular date – ‘SnapShot’

Assets = Liabilities + Stockholders’ Equity

Assets - Liabilities = Net Assets = Stockholders’ Equity

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40,000 - 14,000 = 26,000 = 26,000
 Statement of Cash Flows

Measures activities involving cash receipts and

cash payments over an interval of time

Can be classified into three categories

Operating Investing Financing

cash flows cash flows cash flows

17 Source: Spiceland 3e
 Statement of Cash Flows

18
Source: Spiceland 3e
 Links among Financial
Statements

19 Source: Spiceland 3e
 Other Information Reported to Outsiders
A. Accounting estimates and judgments are outlined in the NOTES
DISCLOSURES to the financial statements. In addition, the notes contain
supplemental information as well as information about items not included
in the financial statements (Notes are an integral part of financial
statements)

B. Auditors issue an AUDITOR’S OPINION (qualified, unqualified, no opinion,

unqualified with explanatory language, adverse) about the fairness of the
statements and their adherence to proper accounting principles.

The financial statements and accompanying notes – all certified

by the auditor’s opinion - are the primary mode of
communicating financial information to external users
C. Management Discussion and Analysis (MD&A) includes Mgmt’s views
on events, trends and uncertainties related to the company’s operations and
resources
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Exercise Questions

Problem 1-3A

Problem 1-4A

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The SEC and US GAAP
The Securities and Exchange Commission (SEC) was created by
the 1933/1934 Securities Acts to protect the interests of investors
by ensuring full and fair disclosure, as result of the 1929 market
crash.
 It requires public companies to furnish audited financial
statements (10-K), and other periodic information about significant
events (8-K)
It was given specific legal authority to establish accounting
standards for companies desiring to publicly issue shares in the United
States.
The SEC has generally allowed the private-sector organizations to
make the accounting standards in the United States  commonly referred
to as Generally Accepted Accounting Principles (GAAP).
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 The FASB
The Financial Accounting Standards Board (FASB) is currently
recognized as the private-sector body responsible for the
establishment of U.S. accounting standards, but the authority
remains with the SEC
The FASB was organized in 1973, replacing the Accounting Principles
Board (APB) due to lack of credibility and too much influence by accountants

7 full-time board members are drawn from a variety of

backgrounds—auditing, corporate accounting, financial services, and
academia.
The official source of U.S. GAAP is called the
FASB Accounting Standards Codification (ASC).
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International Accounting Standards Board
 Similar to FASB, IASB develops proposals, circulates these among
interested organizations, receives feedback, and then issues a final
pronouncement.

 Board members are representatives from the United States, the United
Kingdom, France, Sweden, China, Australia, South Africa, Brazil, and Japan.

 Accounting standards issued by the IASB are referred to as International

Financial Reporting Standards (IFRS) if issued since 2001, and
International Accounting Standards (IAS) if issued prior to 2001.

 In 2008 the SEC began allowing non-U.S. companies with shares trading on
U.S. stock exchanges to issue their financial reports using IASB standards.
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Practice Quiz Question
In 1973, the following private-sector
body was organized to set accounting
standards in the United States:

a. The Financial Accounting Foundation

b. The Securities and Exchange Commission
c. The FASB
d. The Accounting Principles Board

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Practice Quiz Question
Primary responsibility for GAAP and
public reporting currently rests with
the

a. SEC
b. FASB
c. Congress
d. AICPA

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