Exam 1: Ch. 1 & 2 Formulas and Other Info Flashcards
the 2 primary functions of financial accounting
- measure business activities of a company
- communicate information about those activities to investors, creditors, and other external parties for decision-making purposes
financial activities vs. investing activities vs. operating activities
- financial activities include transactions a company has with investors and creditors, such as issuing stock and borrowing money from a local bank
- investing activities include transactions involving the purchase and sale of resources that are expected to benefit the company for several years, such as the purchase of equipment
- operating activities include transactions that relate to the primary operations of the company, such as providing products and services to customers and the associated costs of doing so, like rent, salaries, utilities, taxes, and advertising
advantages and disadvantages of a corporation vs. a partnership or sole proprietorship
- potential advantage of corporation: being legally separate from owners means stockholders have limited liability (prevents stockholders from being held personally responsible for the financial obligations of the corporation– can’t lose their personal assets if the business fails)
- potential disadvantage of corporation: double taxation - the company pays corporate income taxes on income it earns, and stockholders pay personal income taxes when the company distributes that income as dividends to them
- potential disadvantage of sole proprietorship/partnership: must have necessary resources to start/finance the business, the ability to borrow money, and will not have limited liability (meaning owners and partners are held personally responsible for the activities of the business)
the accounting equation
Assets (resources) = Liabilities (creditors’ claims to resources) + stockholders’ equity (owners’ claims to resources) ….. A = L + SE
net income equation
net income = revenues - expenses … NI = R - E
the 4 primary financial statements
(prepared in this order because numbers from the previous one are used in the next one:)
1. income statement
2. statement of stockholders’ equity
3. balance sheet
4. statement of cash flows
What does an income statement show?
Whether the company was able to generate enough revenue to cover the expenses of running the business AND the companies’ stock price performance AND can help predict future profitability
stockholders’ equity equation
stockholders’ equity = common stock + retained earnings … SE = CS + RE
common stock equation
common stock = assets - liabilities - retained earnings … CS = A - L - RE
ending retained earnings equation
ending retained earnings = beginning retained earnings + net income - dividends … (E)RE = (B)RE + NI - D
2 sources of equity
(Selling) common stock is a company’s external source of equity. Retained earnings - or profits/earnings in excess of dividends paid - are a company’s internal source of equity.
Income statement vs. balance sheet
An income statement is like a video (shows events over time). A balance sheet is like a photo (shows events at a point in time).
How investors and creditors assess a company
- Investors use the relationship between net income (revenues minus expenses) and operating cash flows (cash flows from revenue and expense activities) to forecast a company’s future profitability.
- Creditors compare operating cash flows and investing cash flows to assess a company’s ability to repay debt.
The 1933 Securities Act and 1934 Securities Exchange Act did what 3 things?
- set forth accounting and disclosure requirements
- created the SEC (Securities and Exchange Commission)
- requires publicly traded companies to prepare periodic financial statements for investors and creditors
What did/does the SEC do?
- They delegated responsibility for setting accounting standards to the private sector (currently the FASB), but it can force a change in any standard at any time.
- They require auditors to verify the financial statements of publicly traded companies to ensure management has appropriately applied GAAP.
Financial accounting should provide information that: (3 things)
- is useful to investors and creditors in making decisions
- helps to predict cash flows
- tells about economic resources (assets), claims to resources (liabilities and stockholders’ equity), and their changes over time
____________ has the responsibility of applying accounting standards when communicating with investors and creditors.
Management
4 steps for ethical dilemmas
- Understand the ethical decision you face
- Specify the options for alternative courses of action
- Identify the impact of each option on the stakeholders
- Make a decision
(For accountants, ethical decisions most often involve understanding how their actions affect amounts reported in the financial statements.)
What is the FASB’s conceptual framework?
- Think of it as the “theory” of accounting.
- Like our Constitution, it prescribes the correctness of financial accounting rule (the written benchmark for consistent financial reporting rules).
- It provides an underlying foundation for the development of accounting standards and interpretation of accounting information.
comparability vs. consistency
Comparability of financial information is the overriding goal, while consistency of accounting procedures is a means of achieving that goal.
4 assumptions that underlie GAAP
- economic entity assumption
- monetary unit assumption
- periodicity assumption
- going concern assumption
The 6 step process for measuring external transactions is the foundation of financial accounting. What are the 6 steps?
- Use source documents (ex: sales invoices, bills from suppliers, signed contracts, etc.) to identify ACCOUNTS affected by an external transaction.
- Analyze the impact of the transaction on the ACCOUNTING EQUATION.
- Assess whether the transaction results in a DEBIT or CREDIT to account balances.
- Record the transaction in a JOURNAL using debits and credits.
- Post the transaction to the GENERAL LEDGER.
- Prepare a TRIAL balance.
What type of activities are recorded in a company’s accounting records?
Only ones that affect the financial position of the company (activities that affect the basic accounting equation).
Ex: When Walmart borrows cash from a bank, its financial position is affected because assets (cash) increase and liabilities (the loan payable to the bank) increase. So, Walmart records that event in its accounting records. Conversely, hiring a new employee does not change the company’s assets, liabilities, or stockholders’ equity. Walmart’s financial position is unaffected the day someone is hired, and until he/she begins work.
Explain debits and credits in the accounting equation
Increases in assets (left side accounts) are debits and decreases in assets (left side accounts) are credits.
Increases in liabilities and stockholders’ equity (right side accounts) are credits and decreases in liabilities and stockholders’ equity (right side accounts) are debits.
DEALOR acronym
The three accounts on the left (or debit) side of DEALOR – Dividends, Expenses, and Assets – increase with a debit and decrease with a credit.
The three accounts on the right (or credit) side of DEALOR – Liabilities, Owners’ (Stockholders’) Equity, and Revenues – increase with a credit and decrease with a debit.
