Accounting Lec 1 PDF

Chapter 1 – Lecture Notes Fall 2024 Dr. Mohamed Shehata Chapter 1 Overview of the Accounting Discipline 1  Chapter 1 – Lecture Notes Fall 2024...

Chapter 1 – Lecture Notes Fall 2024 Dr. Mohamed Shehata Chapter 1 Overview of the Accounting Discipline 1  Chapter 1 – Lecture Notes Fall 2024 Dr. Mohamed Shehata Overview of the Accounting Discipline (continued) Business Entity Concept (or Separate-Entity Assumption) The business entity concept holds that once a company is incorporated or registered, the business law grants the newly borne entity a legal personality that is separate and distinct from the personality of its owners. In addition, the law empowers the company with all the rights & obligations to carry out all the business activities on behalf of its owners. This concept has two important implications: 1. All the business activities (such as buying, selling, hiring, firing, renting, suing others or being sued, etc.) are carried out in the name of the company. 2. The accounting system should track, record, and report the results of the performance of the business activities, and should not be mixed with the personal affairs of its owners. Figure 2 Concepts Related to Measuring Financial Performance of a Business Entity Going Concern (Continuity) Assumption The going concern (continuity) assumption holds that the entity is financially stable enough to stay in business for the foreseeable future. This means that the entity will continue to operate long enough to use existing assets for their intended purposes. Accounting Period (Periodicity) Assumption The accounting period assumption states that the lifespan of a company can be divided into equal artificial time periods of equal intervals, each is called an “Accounting Period”. These intervals could be one month, three months or one year. In the absence of information about the length of the accounting period, we assume that it is “one-year period” starting on January 1st and ends on December 31st of each year. Stable-Monetary-Unit Assumption To measure the financial performance of a company, accounting uses the currency (e.g. US$ or CD$) as the primary unit of measurement to quantify the business transactions. The monetary unit assumption implies that the purchasing power of currency is stable over time. This unrealistic assumption enables the users of financial statements to compare the financial performance of different reporting periods. 2 Chapter 1 – Lecture Notes Fall 2024 Dr. Mohamed Shehata 3  Chapter 1 – Lecture Notes Fall 2024 Dr. Mohamed Shehata Figure 4 Financial Accounting Information System 1. Revenues - Liabilities 2. Expenses (Less) 3. Assets Net Income = Revenue - Expenses - Owner’s Equity = Net Income NI = R - E Assets = Liabilities + Owner’s Equity Assets = Liability + Capital + Retained Earnings (kept profit) A = L + C + RE 1. Revenues 2. Expenses 3. Assets 4. Liabilities 5. Owner’s Equity Needed to complete financial statements What is a Business Transaction? note: DIVIDENDS are NOT expenses, they are income distribution A business transaction is a legally binding agreement between the company and a third-party who agree to exchange certain resource (e.g., goods, services, cash, assets, etc.). To complete a transaction, the company must surrender certain resources, and in return receives back some other resources of equal monetary value. Consequently, each transaction generates two opposite sides that have the same value; where one side captures the resources surrendered and the other side captures the resources received. To qualify as a business transaction, the business activity (event) must satisfy all the following four conditions: 1. The agreement has been executed by at least one of the two parties, 2. The monetary value of the exchanged objects (items) can be reliably measured in financial terms, 3. The total monetary value of the objects (items) received by the company must equals the total monetary value for the objects (items) given-up by the company. 4. The transaction is supported by objective evidence (e.g., invoice, receipt, credit card approval, etc.). 4 Chapter 1 – Lecture Notes Fall 2024 Dr. Mohamed Shehata Conceptual Framework for Financial Statements The Conceptual Framework is the theoretical foundation for the development of GAAP/, which govern the preparation of the financial statements. GAAP consist of a coherent set of interrelated concepts, principles, methods, assumptions, and guidelines. Types of Business Activities: 1. Operating Activities Operating activities are the day-to-day normal business activities performed for the purpose of generating profit (net income). To achieve this goal, the company must earn Revenues by selling goods or performing services to its customers. To generate revenues, the company must incur Expenses (e.g., pay salary, pay rent, etc.). Difference between revenues and expenses is the PROFIT (net income) 2. Investing Activities (Acquisition of Assets) To perform operating activities, the company needs to acquire Assets to be used in the company’s operating activities to generate revenues. Assets are economic resources that have future benefits owned or controlled by the company. Following are examples of transactions qualified as assets: Buy merchandise inventory for the purpose of selling them to customers. Inventory is not an expense, it is an asset because it has future benefits (can sell it later on) Buy a truck to deliver the goods sold to customers. Truck is not an expense because it can generate revenue for delivering goods 3. Financing Activities Financing activities are related to where to get the money needed to fund the investing and operating activities. They are obtained from two different sources: 1. Borrowing money (Labilities) e.g. a bank 2. Obtaining money directly from the owners (Owners’ Equity). 5 Chapter 1 – Lecture Notes Fall 2024 Dr. Mohamed Shehata Any statements must have the following: Name of company Type of statement Date (specific point of time) Cash Accounts Payable (AP) Inventory Short-term Loans Accounts Receivable Mortgage Bonds Equipment Cars Furniture Capital Stock Retained Earnings (RE) Assets are divided into two depending on how fast they become cash 6 Chapter 1 – Lecture Notes Fall 2024 Dr. Mohamed Shehata Qualitative Characteristics of Accounting Information Qualitative characteristics are the attributes that make the accounting information presented in the financial statements to more useful for external users to make better (well informed) investment and credit decisions. To be useful, the accounting information must posses two fundamental (primary)characteristics: (1) relevance, and (2) representational faithfulness. To enhance the usefulness of the fundamental characteristics, it is desirable that the financial information possess four additional (secondary) characteristics: (1) comparability, (2) verifiability, (3) understandability, and (4) timeliness. Fundamental (Primary) Qualitative Characteristics 1. Relevance Relevance refers to the ability of the information to influence the decision-making process and help the decision maker to make better informed decisions. To be relevant, the information should posses the following properties: a. Predictive Value Accounting information has predictive value if it enables the decision maker to predict the entity’s future events, performance, and outcomes. b. Feedback/Confirmatory Value Information has confirmatory value if it confirms or disconfirm the decision makers’ prior expectations about the entity’s performance. c. Materiality For the information to be relevant it must be significant enough in nature or magnitude to make a difference in the decision-making process. Therefore, excluding or misstating such information could affect the decisions of the recipients. 2. Representational Faithfulness (also called Reliability) Financial statements are faithfully represented if they accurately reflect the economic reality of business events and transactions. Representational faithfulness increases the trust of the decision makers and their reliability on the accounting information. For financial statements to be considered as faithfully represented, it should possess the following properties: 7 Chapter 1 – Lecture Notes Fall 2024 Dr. Mohamed Shehata a. Complete Completeness means that the financial statements must include all the information necessary for a user to understand the economic reality of the firm. Therefore, the financial statements should not exclude any transaction. b. Neutral (Free from Bias) Neutrality refers to the degree to which information is free from bias in the selection or presentation of financial information. Therefore, the information should not be selected to favor one set of users over another. c. Accurate (Free from Material Error) Accuracy refers to the degree to which information is free from material error which would make a difference to the economic decision. Enhancing (Secondary) Qualitative Characteristics: To enhance the usefulness of the financial statements, it would be desirable (preferable) to have the following four enhancing qualitative characteristics: 1. Comparability Comparability states that the information should be measured and reported in the same way across companies and consistently from year to year. Financial statements, therefore, enable users to identify the real similarities and differences across companies at the same time and over time. 2. Verifiability Verifiability requires that the reported information should be supported by objective evidence to check for its accuracy. Verifiability enhances faithful representation characteristic. 3. Timeliness Timeliness states that accounting information should be available to its users on time and before it losses its ability to influence their decisions. Timeliness enhances the relevance characteristic. 4. Understandability Understandability is the degree to which information is easily understood. Users should have reasonable business knowledge and financial accounting to understand the information in the financial statements. 8