Accounting Principles: Business Transactions

• Describes the forms of business entities
• Introduces financial reports.
• Reviews the sequence of accounting procedures completed during each accounting period
• Explains the efficient market hypothesis, ethics, harmonization of international accounting standards, consolidated statements, and accounting for business combinations.

Forms of Business Entities

• Sole proprietorship: A business owned by one person and is not a separate legal entity from its owner
• The accountant treats the business as a separate accounting entity
• The profit or loss goes on the owner's income tax return, and the owner is responsible for debts
• Partnership: A business owned by two or more individuals
• Each individual (partner) is personally responsible for the debts of the partnership
• The accountant treats the partners and the business as separate accounting entities
• The profit or loss goes on the individual income tax return of the partners
• Corporation: A legal entity incorporated in a particular state, with ownership evidenced by shares of stock
• A corporation is separate and distinct from the stockholders
• Stockholders risk only their investment and are not responsible for the debts of the corporation
• The profits or losses are treated as a separate entity on an income tax return
• The owners are not taxed until profits are distributed to the owners (dividends)

Financial Statements

• Balance sheet
• Income statement
• Statement of cash flows
• Notes which accompany these financial statements

Balance Sheet (Statement of Financial Position)

• Shows the financial condition of an accounting entity as of a particular date
• Consists of three major sections: assets, liabilities, and stockholders' equity
• Assets: Resources of the firm
• Liabilities: Debts of the firm
• Stockholders' equity: The owners' interest in the firm
• The total assets amount must equal the total amount of the contributions of the creditors and owners
• Accounting equation: Assets = Liabilities + Stockholders' Equity
• Stockholders' Equity = Common stock + Retained earnings

Statement of Stockholders' Equity (Reconciliation of Stockholders' Equity Accounts)

• Firms reconcile the beginning and ending balances of their stockholders' equity accounts
• This is accomplished with a statement of stockholders' equity
• Retained earnings links the balance sheet to the income statement
• Retained earnings increases by net income and decreases by net losses and dividends paid to stockholders

Income Statement (Statement of Earnings)

• Summarizes revenues and expenses and gains and losses, ending with net income
• Summarizes the results of operations for a particular period of time
• Net income is included in retained earnings in the stockholders' equity section

Statement of Cash Flows (Statement of Inflows and Outflows of Cash)

• Details the inflows and outflows of cash during a specified period of time
• The same period that is used for the income statement
• Consists of cash flows from operating activities, investing activities, and financing activities

Notes

• Used to present additional information about items included in the financial statements
• They present other additional information
• Notes are essential to understanding the financial statements
• Accounting policies are disclosed as the first note or in a separate summary
• Accounting policies include the method of inventory valuation and depreciation policies
• Note disclosure is the existence of contingent liabilities and some subsequent events
• Contingent liabilities depend upon the occurrence or nonoccurrence of one or more future events
• Examples: Settlement of litigation or the ruling of a tax court
• Signing as guarantor on a loan also creates contingent liability

Accounting Cycle

• Accounting cycle: The sequence of accounting procedures completed during each accounting period
• Recording Transactions
• Recording Adjusting Entries
• Preparing The Financial Statements

Recording Transactions

• Transaction: An event that causes a change in a company's assets, liabilities, or stockholders' equity, changing the company's financial position
• Transactions may be external or internal to the company
• External transactions involve outside parties, while internal transactions are confined within the company
• Transactions must be recorded in a journal (book of original entry)
• All transactions could be recorded in the general journal
• Companies also use a number of special journals to record most transactions
• A transaction recorded in a journal is referred to as a journal entry
• All transactions are recorded in a journal (journal entry) and are later posted from the journals to a general ledger
• General ledger: Group of accounts for a company
• The general ledger accounts contain the same information as the journals, but the information has been summarized by account
• Asset, liability, and stockholders' equity accounts are permanent accounts
• Balances in these accounts carry forward to the next accounting period
• Balances in revenue, expense, gain, loss, and dividend accounts are temporary accounts
• They are closed to retained earnings and not carried into the next period

Recording Adjusting Entries

• Accrual basis requires that revenue be recognized when realized (realization concept) and expenses recognized when incurred (matching concept)
• Point of cash receipt for revenue and cash disbursement for expenses is not important under the accrual basis when determining income
• A company must use the accrual basis to achieve a reasonable result for the balance sheet and the income statement
• The accrual basis needs numerous adjustments to account balances at the end of the accounting period

Preparing the Financial Statements

• The accountant prepares the financial statements after adjustments have been made
• These statements represent the output of the accounting system
• Two principal financial statements: The income statement and the balance sheet
• They can be prepared directly from the adjusted accounts
• Preparation of the statement of cash flows requires further analysis of the accounts

Auditor's Opinion

• An auditor (certified public accountant) conducts an independent examination of the accounting information presented by the business
• The auditor issues a report
• An auditor's report is the formal statement of the auditor's opinion of the financial statements after conducting an audit
• Unqualified opinion: The financial statements present fairly, in all material respects, the financial position, results of operations, and cash flows of the entity, in conformity with generally accepted accounting principles
• Qualified opinion: States that, except for the effects of the matter(s) to which the qualification relates, the financial statements present fairly, in all material respects, the financial position, results of operations, and cash flows of the entity, in conformity with generally accepted accounting principles
• Adverse opinion: The financial statements do not present fairly the financial position, results of operations, and cash flows of the entity, in conformity with generally accepted accounting principle
• Disclaimer of opinion: The auditor does not express an opinion on the financial statements, and is rendered when the auditor has not performed an audit sufficient in scope to form an opinion

Internal Control over Financial Reporting

• Under Sarbanes-Oxley, management of public companies must present a Report of Management on Internal Control over Financial Reporting

Responsibility for Financial Statements

• Responsibility for the preparation and for the integrity of financial statements rests with management
• The auditor conducts an independent examination of the statements and expressing an opinion on the financial statements
• Some companies have presented management statements to shareholders as part of the annual report

Proxy

• The proxy is sent to stockholders for the election of directors and for the approval of other corporation actions
• The proxy represents the shareholder authorization regarding the casting of that shareholder's vote
• The proxy contains notice of the annual meeting, beneficial ownership, board of directors, standing committees, compensation of directors, compensation of executive officers, employee benefit plans, certain transactions with officers and directors, relationship with independent accountants, and other business

Summary Annual Report

• Available to public companies
• It is a condensed report, omits much of the financial information typically included in an annual report
• Contains a set of fully audited statements and other required financial disclosures

Ethics

• Ethics and morals are synonymous
• Ethics is derived from Greek, morals is derived from Latin
• Interchangeable terms: ideals of character and conduct
• Ideals, in the form of codes of conduct, furnish criteria for distinguishing between right and wrong
• Ten essential values: Caring, Honesty, Accountability, Promise keeping, Pursuit of excellence, Loyalty, Fairness, Integrity, Respect for others, Responsible citizenship

Harmonization of International Accounting Standards

• Changes in accounting practice have come from the needs of the business community and governments
• The business community and governments have an increased interest in international accounting standards
• Problems caused by the lack of harmonization of international accounting standards:
  • Need for employment of key personnel in multinational companies to bridge the "gap” in accounting requirements between countries
  • Difficulties in reconciling local standards for access to other capital markets
  • Difficulties in accessing capital markets for companies from less-developed countries
  • Negative effect on the international trade of accounting practice and services

Topics agreed upon by the FASB and IASB

• Business combinations
• Consolidations
• Fair value measurement guidance
• Liabilities and equity distinctions
• Performance reporting
• Postretirement benefits
• Revenue recognition
• Derecognition
• Financial instruments
• Intangible assets
• Leases

Consolidated Statements

• Financial statements of legally separate entities may be that show financial position, income, and cash flow as if the companies were consolidated as a single entity
• Reflect an economic, rather than a legal, concept of the entity
• All intercompany transactions must be eliminated

Accounting Business Combinations

• The combination of business entities by merger or acquisition is frequent
• Reasons for the combination: Achieving economies of scale and savings of time in entering a new market
• Combination is accounted for using the purchase method
• The firm doing the acquiring records the identifiable assets and liabilities at fair value at the date of acquisition
• The difference between the fair value of the identifiable assets and liabilities and the amount paid is recorded as goodwill (an asset)
• With a purchase, the acquiring firm picks up the income of the acquired firm from the date of acquisition
• Retained earnings of the acquired firm do not

Explore business structures, liabilities, and accounting cycles. Understand external vs internal transactions and special journals. Learn about permanent accounts and adjusting entries under accrual accounting.