Ch. 1 Accounting Information and Decision Making

Question 1

Accounting

Answer 1

A system of maintaining records of a company’s operations and communicating that info to decision makers.

Question 2

Financial Accounting

Answer 2

Measurement of business activities of a company and communication of those measurements to external parties for decision-making purposes.

Question 3

Financing activities

Answer 3

• Transactions involving external sources of funding.
• 2 types: Investors and creditors
• Measurement category: Liabilities, Stockholders’ Equity, and Dividends

Question 4

Investing activities

Answer 4

• Transactions involving the purchase and sale of: (1) long-term resources such as land buildings, equipment, and machinery (2) any resources not directly related to a company’s normal operations.
• Measurement category: Assets

Question 5

Operating activities

Answer 5

• Transactions involving the primary operations of the company, such as providing products and services to customers and the associated costs of doing so, like utilities, taxes, advertising, wages, rent, and maintenance.
• Measurement category: Revenues and Expenses

Question 6

Corporation

Answer 6

• An entity that is legally separate from its owners.
• Rises external funding by selling shares of ownership (common stock) in the corporation.
• Each share of stock represents a unit of ownership.
• Advantage: Limited liability- stockholders are not held personally responsible for the financial obligations of the corporation.
• Disadvantage: Double taxation- 1st when the company earns it and pays corporate income tax on it, 2nd when stockholders pay personal income tax on dividends.

Question 7

Assets

Answer 7

Resources owned by a company.

• Current/short-term- has to be sold, converted to cash, or liquidated to pay for liabilities within one year. (cash, accounts receivable, supplies, prepaid expenses, inventory, marketable securities, petty cash)
• Long-term- benefits company for more than one year. Property, plant, equipment, long term investments, intangible assets (patents, copyrights, franchises, trademarks), accumulated depreciation (contra asset)

Question 8

Liabilities

Answer 8

Amounts owed to creditors.

• Current/short-term: due within one year (accounts payable, unearned revenue, salaries payable, utilities payable, interest payable)
• Long-term: Notes payable

Question 9

Stockholders’ equity

Answer 9

• Stockholders’ or owners’ claims to resources, which equal the difference between total assets and total liabilities.
• Profits of the company, which add to total resources are claimed solely by stockholders, the owners of the company.

Question 10

Accounting equation

Answer 10

• Equation that shows a company’s resources (assets) equal creditors’ and owners’ claims to those resources (liabilities and stockholders’ equity)

Assets = Liabilities + Stockholders’ equity

or

Assets - Liabilites = Stockholders’ equity

• Assets = resources
• Liabilities = creditors claims
• Stockholders’ Equity = owners claims

Question 11

Revenues

Answer 11

Amounts earned from selling products or services to customers.

Question 12

Expenses

Answer 12

Costs of providing products and services.

Question 13

Net income

Answer 13

Difference between revenues and expenses.

Question 14

Dividends

Answer 14

• Cash payments to stockholders.
• Dividends are not expenses
• They are a distribution of net income in the statement of stockholders Equity.
• Stockholders are not guaranteed regular cash payments from the firm.

Question 15

Sole Proprietorship

Answer 15

• A business owned by one person.
• No outside investment
• Advantage: only taxed once
• Disadvantage: full liability

Question 16

Partnership

Answer 16

• Business owned by 2 or more persons.
• No outside investment
• Advantage: only taxed once
• Disadvantage: full liability

Question 17

Financial statements

Answer 17

Periodic reports published by the company for the purpose of providing information to external users.

Question 18

Income statement

Answer 18

A financial statement that reports the company’s revenues and expenses over an interval of time.

Question 19

Statement of stockholders’ equity

Answer 19

• A financial statement that summarizes the changes in stockholders’ equity over an interval of time.
• The reporting period coincides with the time period covered by the income statement.
• Has 2 components:
• Common Stock: (paid in/contributed capital) external
• Retained Earnings: internal
• Both common stock and retained earnings make up total stockholders’ Equity. This represents the value of the firm to its owners, the stockholders.

Question 20

Retained Earnings

Answer 20

• Cumulative amount of net income earned over the life of the company that has not been distributed to stockholders as dividends.
• R/E = Net income - Dividends
• 3 components: Revenues, Expenses, Dividends

Question 21

Balance Sheet

Answer 21

• A financial statement that presents the financial position of the company on a particular date.
• The financial position of a company is summarized by the basic accoutnting equation.
• This equation provides a fundamental model of business valuation.

Question 22

Statement of cash flows

Answer 22

• A financial statement that measures activities involving cash receipts and cash payments over and interval of time.
• 3 components: operating, investing, and financing cash flows.
• Explains why the cash reported in the balance sheet changed.
• Investors use the relationship between net income and operating cash flows to forecast a company’s future profitability.
• Creditors compare operating cash flows and investing cash flows to asses a company’s ability to repay debt.

Question 23

Generally accepted accounting principles (GAAP)

Answer 23

• The rules of financial accounting
• All companies that sell their stock to the public must follow these rules and must publish financial statements in accordance with those rules.

Question 24

Financial accounting standards board (FASB)

Answer 24

• An independent, private body (sector) that has primary responsibility for the establishment of GAAP in the United States.
• Not all countries follow the same accounting and reporting standards.

Question 25

International accounting standards board (IASB)

Answer 25

• An international accounting standard-setting body responsible for the convergence of accounting standards world wide.
• Wants to eliminate differences in accounting standards around the world
• Global counterpart to FASB
• Developing IFRS (International Financial Reporting Standards) (eye-furs)

Question 26

International financial reporting standards (IFRS)

Answer 26

• The standards being developed and promoted by the International accounting standards board (FASB).
• In 2002, the FASB and IASB signed the Norwalk agreement, formalizing their commitment to convergence of U.S. and international accounting standards.

Question 27

Auditors

Answer 27

• Trained individuals hired by a company as an independent party to express a professional opinion of the accuracy of that company’s financial statements.
• Makes sure management is not “cooking the books”
• Ensures management appropriately applied GAAP.
• They are not employees of the company they are auditing.
• If they find mistakes or fraudulent reporting behavior, auditors require the company to correct all significant info. before issuing financial statements
• Verify internal controls
• Adds credibility to a company’s financial statements.

Question 28

Ethics

Answer 28

A code or moral system that provides criteria for evaluating right and wrong behavior.

Question 29

Sarbanes-Oxley Act (SOX)

Answer 29

Formally titled the Public Company Accounting Reform and Investor Protection Act of 2002

• Provides regulation of auditors and the types of services they furnish to clients, increases accountability of corporate executives, addresses conflicts of interest for securities analysts, and provides for stiff criminal penalties for violators.
• Established a variety of new guidlines related to auditor-client relations and internal control procedures.
• Response to Enron and WoldCom accounting scandals.
• One of the greatest reforms in business practices in U.S. history.

Question 30

Decision usefulness

Answer 30

The ability of the information to be useful in decision making.

Question 31

Relevance

Answer 31

Accounting information that possesses confirmatory value and/or predictive value.

Question 32

Faithful representation

Answer 32

Accounting information that is complete, neutral, and free from material error.

Question 33

Comparability

Answer 33

The ability of users to see similarities and differences between 2 different business activities.

Question 34

Consistency

Answer 34

The use of similar accounting procedures either over time for the same company, or across companies at the same point in time.

Question 35

Verifiability

Answer 35

An agreement among different measures.

Question 36

Timeliness

Answer 36

Information being available to user early enough to allow them to use it in the decision process.

Question 37

Understandability

Answer 37

Users must understand the info within the context of the decision they are making.

Question 38

Cost effectiveness

Answer 38

Financial accounting info is provided only when the benefits of doing so exceed the costs.

Question 39

Materiality

Answer 39

• The impact of financial accounting info on investors’ and creditors’ decisions.
• Unless an item is material in amount or nature-that is, sufficient in amount or nature to affect a decision,-it need not be reported in accordance with GAAP.
• Most companies record assets such as a wastebaskets and staplers as expenses, even though they will benefit the company in the long run.
• Recording a $6 wastebasket as a current expense instead of a long-term asset for a multi-billion dollar company has no impact on investors’ decisions.

Question 40

Economic entity assumption

Answer 40

• All economic events (transactions?) with a particular economic entity (company?) can be identified.
• Only business transactions involving Dell should be reported as part of Dell’s financial accounting info.
• There should be distinction between economic activities of owners and those of the company.

Question 41

Monetary unit assumption

Answer 41

A unit or scale of measurement can be used to measure financial statement elements. (Dollar in U.S)

Question 42

Periodicity assumption

Answer 42

• The economic life of an enterprise (presumed to be indefinite) can be divided into artificial time periods for financial reporting. (monthly, quarterly, annually)
• Relates to timelyness.

Question 43

Going concern assumption

Answer 43

• In the absence of info to the contrary, a business entity will continue to operate indefinitely.
• Historical Cost Principle–measure assets on their original cost.
• If an enterprise was going to cease operations, we would measure assets and liabilities not at their original costs but at their current liquidation values.

Question 44

Business Activities to Measure

Answer 44

• Financing activities
• Investing activities
• Operating activities

Question 45

Net

Answer 45

• Used to describe the difference between 2 amounts
• ie: Net Income (Revenue - Expenses)

Question 46

Other Information Reported to Outsiders

Answer 46

• Management discussion and analysis (MD&A): Management’s views on significant events, trends, and uncertainties pertaining to the company’s operations and resources. Covers internal controls/limits.
• Note disclosures: Offer additional info. either to explain the info. presented in the financial statements or to provide info. not included in the financial statements. (ie: revenues itemized by geographic region)
• Auditor notes

Question 47

Total Liabilities (Total debt)

Answer 47

• Expanding debt levels limit management’s ability to respond quickly and effectively to business situations.
• The “overhanging” debt which involves legal obligation of repayment, restricts management’s ability to engage in new profit-generating activities.
• Failure to pay interest or to repay debt can result in creditors forcing the company to declare bankruptcy and go out of business.

Question 48

Securities and Exchange Commission (SEC) History

Answer 48

• Many blamed financial accounting for the 1929 stock market crash and the ensuing Great Depression of the 1930s.
• Accounting practices and reporting procedures were not well established, providing the opportunity for companies to engage in inaccurate financial reporting to enhance their reported performance.
• This led to many stocks being valued too highly.
• As investors recognized this, their confidence in stock market. They panicked and sold stocks in a frenzy.
• The 1933 Securities Act and 1934 Securities Exchange Act were designed to restore investor confidence in financial accounting.
• 1933 Securities Act: accounting and disclosure requirements for offering securities.
• 1934 Securities Exchange Act: created SEC-requires companies to prepare financial statements.

Question 49

Securities and Exchange Commission (SEC)

Answer 49

• Came from the 1934 Securities Exchange Act
• Congress gave them the power to require companies that publicly trade their stock to prepare periodic financeal statements for distribution to investors and creditors.
• Has power/responsibility for setting accounting and reporting standards for publicly traded companies.
• Primary responsibility is setting accounting standards to the private sector (FASB).
• SEC requires independent outside verification of financial statements of publicly traded companies (Auditors).

Question 50

FASB’s Objectives of Financial Accounting

Answer 50

Financial accounting should provide information that:

1. Is useful to investors and creditors in making decisions.
2. Helps predict cash flows.
3. Tells about economic resources, claims to resources, and changes in resources and claims.

Question 51

FASB’s Conceptual Framework

Answer 51

Decision Usefulness

Pimary Characteristics

• Relavance
• Confirmatory value
• Predictive value
• Faithful Representation
• Completeness
• Neutrality
• Freedome from material error

Enhancing Characteristics

• Comparability and Consistency
• Verifiability
• Timeliness
• Understandability

Constraints

• Cost effectiveness (benefits exceed costs)
• Materiality (recognition threshold)

Question 52

GAAP’s 4 Underlying Assumptions

Answer 52

• Economic Entity assumption
• Monetary Unit assumption
• Periodicity assumption
• Going Concern assumption