Accounting Principles: An Overview

• Accounting Principles
• Identifies, records, and communicates the economic events of an organization to interested users.
• The accounting process includes the bookkeeping function.
• Transactions should be recorded if the financial position (assets, liabilities, or owner's equity) of the company changed
• Financial Accounting is for external users and is regulated
• Management Accounting is for internal users and is unregulated

Building Blocks of Accounting

• Recent scandals include Enron, WorldCom, HealthSouth, and AIG
• Congress passed the Sarbanes-Oxley Act (SOX), because regulators and lawmakers were concerned that the economy would suffer if investors lost confidence in corporate accounting
• Effective financial reporting depends on sound ethical behaviour.
• Generally Accepted Accounting Principles (GAAP) are standards developed by the accounting profession that are generally accepted and universally practiced
• Financial Statements include the balance sheet, income statement, statement of owner's equity, statement of cash flows and note disclosure
• Standard-setting bodies are the Financial Accounting Standards Board (FASB), the Securities and Exchange Commission (SEC), and the International Accounting Standards Board (IASB)

Measurement Principles

• The Historical Cost Principle dictates that companies record assets at their cost.
• The Fair Value Principle states that assets and liabilities should be reported at fair value, which is the price received to sell an asset or settle a liability. Relevance and faithful representation are two qualities that make accounting information useful for decision-making.

Assumptions

• The Monetary Unit Assumption requires that companies include in the accounting records only transaction data that can be expressed in terms of money.

• The Economic Entity Assumption requires that the activities of the entity be kept separate and distinct from the activities of its owner and all other economic entities.

• Forms of business ownership:

  • Proprietorship: owned by one person, the owner is the manager/operator, they receive any profits and suffer any losses, and are personally liable for all debts.

  • Partnership: owned by two or more people, often retail and service-type businesses, and generally unlimited personal liability

  • Corporation: ownership is divided into shares of stock, it is a separate legal entity organized under state corporation law, with limited liability

The Accounting Equation

• The accounting equation is: Assets = Liabilities + Owner's Equity

Assets

• Resources a business owns
• Provide future services or benefits
• Cash, Supplies, Equipment, vehicle, Land, etc

Liabilities

• Something that the business currently owes to another party
• Claims against assets (debts and obligations)
• A creditor is the party to whom money is owed
• Accounts Payable, Notes Payable, Salaries and Wages Payable, etc.

Owner's Equity

• Represents the value of the assets of the business that the owners can claim
• Increases in Owner's Equity are investments by the owner, and revenues which result from business activities entered into for the purpose of earning income.
• Common sources of revenue are sales, fees, services, commissions, interest, dividends, royalties, and rent.
• Decreases in Owner's Equity are drawings: An owner may withdraw cash or other assets for personal use and expenses.
• Common expenses are salaries expense, rent expense, utilities expense, tax expense, etc.
• Owner's Equity = Owner's Capital + investment - Owner's drawings + Revenues - Expenses.

Transactions

• These are the business's economic events recorded by accountants.
• May be external or internal.
• Not all activities represent transactions.
• Each transaction has a dual effect on the accounting equation. Two rules to analyze transactions:
  • Each transaction has at least two entries
  • The accounting equation must always remain in balance -Assets = Liabilities + Equity Transactions Analysis includes these steps:
  • Identify
  • Classify
  • Determine
  • Calculate
• Summary of Transactions:
  • Each transaction is analyzed in terms of its effect on the three components of the basic accounting equation (assets, liabilities, owner's equity).
  • The two sides of the equation must always be equal.

Financial Statements

• Companies prepare four financial statements: the balance sheet, the owner's equity statement, the income statement, and the statement of cash flows.
• The balance sheet reports the assets, liabilities, and owner's equity at a specific date, lists assets at the top, followed by liabilities and owner's equity, total assets must equal total liabilities and owner's equity and is a snapshot of the company's financial condition at a specific moment in time (usually the month-end or year-end).
• The owner's equity statement reports the changes in owner's equity for a specific period of time, which is the same as that of the income statement.
• The income statement reports the revenues and expenses for a specific period of time, lists revenues first, followed by expenses, and shows net income (or net loss).

Alternative Terminology

• The income statement is sometimes referred to as the statement of operations, earnings statement, or profit and loss statement.
• The statement of cash flows provides information on the cash receipts and payments for a specific period of time, answering: Where did cash come from? What was cash used for? What was the change in the cash balance?

IFRS (International Financial Reporting Standards)

• Both international and U.S. accounting standards emphasize transparency in financial reporting, and both are primarily driven by meeting the needs of investors and creditors.
• These are international standards, developed by the International Accounting Standards Board.
• Accounting standards in the United States are referred to as generally accepted accounting principles (GAAP) are developed by the Financial Accounting Standards Board.
• These tend to be simpler and more "principles-based," where GAAP is more detailed and "rules-based.”
• The internal control standards applicable to Sarbanes-Oxley (SOX) apply only to large public companies listed on U.S. exchanges
• The IASB and the FASB are working towards eliminating major differences in how certain transactions are accounted for and reported.
• Career opportunities vary from public accounting, private or corporate accounting, governmental accounting and forensic accounting
• Steps in the accounting cycle: analyze transactions, journalize transactions, post transactions from journal to ledger, prepare a trial balance, prepare the financial statements