Financial Accounting

Accounting - a system of maintaining a company’s records and communicating this information

to decision-makers.
Accounting information that is provided to internal users is called managerial accounting.
Accounting information provided to external users is called financial accounting.
Corporation refers to a legal entity separate from its owners. The advantage of being legally
separate is that the stockholders have limited liability. Limited liability prevents stockholders from
being held personally responsible for the financial obligations of the corporation. A potential
disadvantage of a corporation is double taxation:
(1) The company first pays corporate income taxes on income it earns and
(2) Stockholders then pay personal income taxes when the company distributes that income
as dividends to them
Sole proprietorship refers to a business owned by one person.
Partnership refers to a business owned by two or more persons.

A company can engage in the following financial activities:

(1) Financing activities include transactions the company has with investors and creditors,
such as issuing stock and borrowing money.
(2) Investing activities include transactions involving the purchase and sale of the resources
that are expected to benefit the company for several years.
(3) 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.

Assets - the total resources of a company

Liabilities - amounts owed to creditors
Stockholders’ equity - the owners’ claims to resources

The accounting equation

Assets = Liabilities + Stockholders’ Equity
The accounting equation illustrates a fundamental model of business valuation. The value of a
company to its owners equals total resources of the company minus amounts owed to creditors.
Stockholders can claim all resources in excess of the amount owed to creditors.

Communicating through financial statements

Financial statements - periodic reports published by the company for the purpose of providing
information to external users. There are four primary financial statemets:
1. Income statement
2. Statement of stockholders’ equity
3. Balance sheet
4. Statement of cash flows

Income statement - a financial statement that reports the company’s revenues and expenses
over an interval of time. It shows whether the company was able to generate enough revenue to
cover the expenses of running the business. If revenues exceed expenses, then the company
reports net income, otherwise it is a net loss.
Underlines - In a financial statement, a single underline generally represents a subtotal (such
as total revenues or total expenses), while a double underline indicates a final total.

The statement of stockholders’ equity - a financial statement that summarizes the changes in
stockholders’ equity over an interval of time.
Stockholders’ Equity = Common stock + Retained Earnings
Retained earnings - an internal source of stockholders’ equity. Its balance represents all net
income minus all dividends over the life of the company.
Retained earnings = All net income - All dividends
Dividends represent the payment of cash but are not considered an expense in running the
business.

Balance sheet - 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 accounting equation.
The statement of cash flows - a financial statement that measures activities involving cash
receipts and cash payments over an interval of time.
(1) Operating cash flows include cash receipts and cash payments for transactions involving
revenue and expense activities during the period. In other words, operating activities
include the cash effects of the same activities that are reported in the income statement
to calculate net income.
(2) Investing cash flows generally include cash transactions for the purchase and sale of
investments and long-term assets. Long-term assets are resources owned by a
company that are thought to provide benefits for more than a year.
(3) Financing cash flows include cash transactions with lenders, such as borrowing money
and repaying debt, and with stockholders, such as issuing stock and paying dividends. \

Change in cash = Operating cash flows + Investing cash flows + Financing cash flows

The financial statements are a key component of a company’s annual report. Two other
important components of the annual report are
(1) The management discussion and analysis (MD&A) section typically includes
management’s views on significant events, trends, and uncertainties pertaining to the
company’s operations and resources.
(2) Note disclosures offer additional information either to explain the information presented
in the financial statements or to provide information not included in the financial
statements.

Financial Accounting Standards

The rules of financial accounting are called Generally Accepted Accounting Principles, often
abbreviated as GAAP.

The Accounting Cycle (During the period)

The accounting cycle refers to the full set of procedures used to accomplish the two functions of
financial accounting.

Six steps in measuring external transactions:

 (1) Use source documents to identify accounts affected by an external transaction
(2) Analyze the impact of the transaction on the accounting equation
(3) Assess whether the transaction results in a debit or credit to account balances
(4) Record the transaction in a journal using debits and credits
(5) Post the transaction to the general ledger
(6) Prepare a trial balance

Revenue recognition principle states that companies recognize revenue at the time they provide
goods and services to customers. The amount of revenue to recognize equals the amount the
company is entitled to receive from customers.

In accounting terminology, we refer to increases in assets as debits, and we refer to decreases

in assets as credits.

Posting to the General Ledger

Formally, posting is the process of transferring the debit and credit information from the journal
to individual accounts in the general ledger. The general ledger provides, in a single collection,
each account with its individual transactions and resulting account balance.

Trial Balance
A trial balance is a list of all accounts and their balances at a particular date, showing that total
debits equal total credits. The trial balance is used for internal purposes only and provides a
check on the equality of the debits and credits.

The accounting cycle (at the end of the period)

On the last day of the period we need to
(1) Record and post adjusting entries
(2) Prepare financial statements
(3) Record and post closing entries

Accrual-basis accounting
Under the accrual-basis accounting
(1) We record revenues in the period that goods and services are provided to customers.
 (2) We record expenses in the period that costs are used to provide those goods and
services to customers.

Accrual-basis compared with cash-basis accounting

Under cash-basis accounting

(1) We record revenues at the time we receive cash
(2) We record expenses at the time we pay cash

In contrast to cash-basis accounting, under accrual-basis accounting revenues can be recorded

before, during, or after the company receives cash from customers.

Adjusting entries are used to record changes in assets and liabilities (and their related revenues
and expenses) that have occured during the period but that we have not yet recorded. The
timing differences that create the need for adjusting entries can be grouped into two broad
categories - prepayments and accruals.
Prepayments involve cash flows occurring before the revenues and expenses are recognized.
Accruals involve cash flows occurring after the revenues and expenses are recognized.
Depreciation is the process of allocating the cost of an asset, such as equipment, to expense
over the asset’s useful life.
Book value is the original cost of an item less the accumulated depreciation.

Accrued expenses occur when a company has used costs in the current period, but the
company hasn’t yet paid cash for those costs. Common examples include the current cost of
employee salaries, utilities, interest, and taxes that won’t be paid until the following period.
Accrued revenues occur when a company provides products or services but hasn’t yet received
cash. Examples include selling products and services to customers on account or being owed
interest on amounts lent to others.

Transactions in which we receive cash at the same time we record revenue or in which we pay
cash at the same time we record an expense do not require adjusting entries.
All accounts that appear in the balance sheet, including Retained Earnings, are permanent
accounts. This means we carry forward their balances from one period to the next.
However, that’s not the case with temporary accounts - revenues, expenses and dividends.
These start with $0 balance at the beginning of next year. We accomplish the transfer of
balances from temporary accounts to Retained Earnings with closing entries.
Closing entries transfer the balances of all temporary accounts (revenues, expenses, and
dividends) to the balance of the Retained Earnings account.

The post-closing trial balance is a list of all accounts and their balances at a particular date after
we have updated account balances for closing entries.

Chapter 5: Uncollectible accounts

Credit sales transfer goods or services to a customer today while bearing the risk of collecting
payment from that customer in the future. Credit sales typically include an informal credit
agreement supported by an invoice. An invoice is a source document that identifies the date of
sale, the customer, the specific items sold, the dollar amount of the sale, and the payment
terms. Payment terms typically require the customer to pay within 30 to 60 days after the sale.
Note: Even though no cash is received at the time of the credit sale, the seller records revenue
immediately once goods or services are provided to the customer and future collection from the
customer is probable.

Net returns:
After accounting for each of these reductions, a company will calculate its net revenues as total
revenues less any amounts for returns, allowances, and net discounts.

Trade discounts represent a reduction in the listed price of a good or service. Trade discounts
also can be a way to change prices without publishing a new price list or to disguise real prices
from competitors.

A sales return is when a customer returns goods previously purchased.

A sales allowance occurs when the customer does not return goods, but instead the seller
reduces the customer’s balance owed for goods or services provided. The seller reduces the
customer’s balance owed or provides at least a partial refund because of some deficiency in the
company’s good or service.

A sales discount represents a reduction, not in the selling price of a good or service, but in the
amount to be received from a credit customer if collection occurs within a specified period of
time.

Allowance Method (GAAP):

Generally Accepted Accounting Principles (GAAP) require that we account for uncollectible
accounts using what’s called the allowance method. Under the allowance method, a company
reports its accounts receivable for the net amount expected to be collected.

We report the allowance for uncollectible accounts in the asset section of the balance sheet, but
it represents a reduction in the balance of accounts receivable.

Bad Debt Expense - The offsetting debit in the entry to establish the allowance account is bad
debt expense.

Overall, the write-off of the account receivable has no effect on total amounts reported in the
balance sheet or in the income statement. There is no decrease in total assets and no decrease
in net income with the write-off. We have already recorded the negative effects of the bad news.

Notes receivable and interest:

Notes receivable are similar to accounts receivable but are more formal credit arrangements
evidenced by a written debt instrument, or note.
 Chapter 7: Long-term assets

Tangible assets

Property, Plant, and Equipment:

The property, plant, and equipment category consists of land, land improvements, buildings,
equipment, and natural resources. We record a long-term asset at its cost plus all expenditures
necessary to get the asset ready for use.

Land:
The Land account represents land a company is using in its operations. In contrast, land
purchased for investment purposes is recorded in a separate investment account. We capitalize
to Land all expenditures necessary to get the land ready for its intended use, such as attorney
fees, real estate agent commissions, title, title search and recording fees.
Land improvements, such as adding a parking lot, sidewalks, driveways etc. have limited useful
lives. For this reason, we record land improvements separately from the land itself.

Buildings:
Buildings include administrative offices, retail stores, manufacturing facilities, and storage
warehouses. The cost of acquiring a building usually includes realtor commissions and legal
fees in addition to the purchase price.

Equipment:
Equipment is a broad term that includes machinery used in manufacturing, computers and other
office equipment, vehicles, furniture and fixtures. The cost of equipment is the actual purchase
price plus all other costs necessary to prepare the asset for use. These can be any of a variety
of other costs including sales tax, shipping, delivery insurance, assembly, installation, testing,
and even legal fees.

Basket purchases:
Sometimes companies purchase more than one asset at the same time for one purchase price.
In this case, we allocate the total purchase price of each based on the estimated fair values of
each of the individual assets.
Therefore, tangible assets such as land, land improvements, buildings, equipment, and natural
resources are recorded at cost plus all costs necessary to get the asset ready for its intended
use.

Intangible assets:
The other major category of long-term assets, intangible assets, have no physical substance.
Assets in this category include patents, trademarks, copyrights, franchises, and goodwill.
Despite their lack of physical substance, intangible assets can be very valuable indeed. One of
the most valuable intangible assets for many companies is their trademark or brand.

Companies acquire intangible assets in two ways:

1. They purchase intangible assets like patents, copyrights, trademarks, or franchise rights
from other companies.
2. They develop intangible assets internally, for instance by developing a new product or
process and obtaining a protective patent.

The reporting rules for intangible assets vary depending on whether the company purchased the
asset or developed it internally. Reporting purchased intangibles is similar to reporting
purchased property, plant and equipment. We record purchased intangible assets at their
original cost plus all other costs, such as legal fees, necessary to get the asset ready for use.
For intangible assets, on the other hand, we report as expenses in the income statement most
of the costs for internally developed intangible assets in the period we incur those costs.

Patents:
A patent is an exclusive right to manufacture a product or to use a process. The U.S. Patent and
Trademark Office grants this right for a period of 20 years. When a firm purchases a patent, it
records the patent as an intangible asset at its purchase price plus other costs such as legal
and filing fees to secure the patent.
One exception regarding internally produced patents are the legal fees. The firm will record in
the Patent asset account the legal and filing fees to secure a patent, even if it developed the
patented item or process internally.

Copyrights:
A copyright is an exclusive right of protection given by the U.S. Copyright office to the creator of
a published work such as a song, film, painting, photograph, book or computer software.
Copyrights are protected by law and give the creator (and his or her heirs) the exclusive right to
reproduce and sell the artistic or published work for the life of the creator plus 70 years. A
copyright also allows the copyright holder to pursue legal action against anyone who attempts to
infringe the copyright.

Trademarks:
A trademark, like the name Apple, is a word, slogan, or symbol that distinctively identifies a
company, product, or service. The firm can register its trademark with the U.S. Patent and
Trademark Office to protect it from use by others for a period of 10 years. The registration can
be renewed for an indefinite number of 10-year periods, so a trademark is an example of an
intangible asset whose useful life can be indefinite.

A firm can record attorney fees, registration fees, design costs, successful legal defense, and
other costs directly related to securing the trademark as an intangible asset in the Trademark
asset account. This is how Apple Inc. can have a trademark valued at $181.2 billion, but
reported in the balance sheet for much less.
The estimated value of the trademark is not recorded in the Trademark account; instead, only
the legal, registration, and design fees are recorded.

Franchises:
Franchises are local outlets that pay for the exclusive right to use the franchisor company’s
name and to sell its products within a specified geographical area. Many franchisors provide
other benefits to the franchisee, such as participating in the construction of the retail outlet,
training employees, and purchasing national advertising.

Goodwill:
Goodwill often is the largest (and the most unique) intangible asset in the balance sheet. It is
recorded only when one company acquires another company. Goodwill is recorded by the
acquiring company for the amount that the purchase price exceed the fair value of the acquired
company’s identifiable net assets.

Expenditures after acquisition:

- We capitalize an expenditure as an asset if it increases future benefits

- We expense an expenditure if it benefits only the current period.

Different types of expenditures: repair and maintenance, additions, improvements, and litigation
costs.

Repairs and maintenance:

We expense repairs and maintenance expenditures like these in the period incurred because
they maintain a given level of benefits. They also are likely to recur again in the following period.
More extensive repairs that increase the future benefits of the delivery truck would be
capitalized as assets. These include major repairs that are unlikely to recur each period, such
as a new transmission or an engine overhaul.

Additions:
An addition occurs when we add a new major component to an existing asset. We should
capitalize the cost of additions if they increase, rather than maintain, the future benefits from the
expenditure. For example, adding a refrigeration unit to a delivery truck increases the capability
of the truck beyond that originally anticipated, thus increasing its future benefits.

Improvements:
An improvement is the cost of replacing a major component of an asset.

Intangible assets also can require expenditures after their acquisition, the most frequent being
the cost of legally defending the right that gives the asset its value.
If a firm successfully defends an intangible right, ir should capitalize the litigation costs.
However, if the defense of an intangible right is unsuccessful, then the firm should expense the
litigation costs as incurred because they provide no future benefit.

Materiality:
An item is said to be material if it is large enough to influence a decision.

Cost allocation

Depreciation (Accounting definition) - allocation of an asset’s cost to an expense over time

For intangible assets, the cost allocation process is called amortization

Book value refers to the original cost of the asset minus the current balance in Accumulated
Depreciation.

Recording depreciation requires accountants to establish three factors at the time the asset is
put into use:
1. Service life (or useful life) - the estimated use the company expects to receive from the
asset before disposing of it
2. Residual value (or salvage value) - the amount the company expects to receive from
selling the asset at the end of its service life
3. Depreciation method - the pattern in which the asset’s depreciable cost (original cost
minus residual value) is allocated over time.
- The three most common depreciation methods used in practice are straight-line,
declining balance, and activity-based.
1. Straight-line: This method allocated an equal amount of depreciation to
each year. The implication is that the asset is used evenly over its useful
life.
 2. Declining-balance: This method is an accelerated method, meaning that
more depreciation expense is taken in the earlier years than in the later
years of an asset’s life.
The most common declining-balance rate is 200%, which we refer to as
the double-declining balance method since the rate is double the
straight-line rate.

Double-declining depreciation rate = 2/Estimated service life.

We multiply the rate by book value (cost minus accumulated

depreciation), rather than by the depreciable cost (cost minus residual
value).
However, under the declining-balance method, depreciation expense in
the final year is the amount necessary to reduce book value down to
residual value.

3. Activity-based: This method calculates depreciation based on the activity

associated with the asset.
We first compute the average depreciation rate per unit by diving the
depreciable cost (cost minus residual value) by the number of units
expected to be produced.

The residual value is never depreciated.

We record depreciation for land improvements, buildings, and equipment, but we don’t record
depreciation for land.

Straight-line produces a higher net income than accelerated methods in the earlier years of an
asset’s life. Higher net income can improve bonuses paid to management, increase stock
prices, and reduce the likelihood of violating debt agreements with lenders.

Tax depreciation:
An accelerated method serves the objective of reducing taxable income by reducing this income
more in the earlier years of an asset’s life than does straight-line. Thus, companies record
higher net income using straight-line depreciation and lower taxable income using MACRS
depreciation. MACRS combines declining-balance methods in earlier years with straight-line in
later years to allow for a more advantageous tax depreciation deduction.

Amortization of Intangible Assets:

The expected residual value of most intangible assets is zero. Most companies use straight-line
amortization for intangibles. Also, many companies credit amortization to the intangible asset
itself rather than to accumulated amortization.
We don’t depreciate land because it has an unlimited life. Similarly, we do not amortize
intangible assets with indefinite useful lives.
Intangible assets not subject to amortization: goodwill, trademarks with indefinite life

Management must review long-term assets for a potential write-down when events or changes
in circumstances indicate the asset’s “recoverable amount” is less than its “recorded amount” in
the accounting records.

Asset disposition: sale, retirement, or exchange

A sale is the most common method to dispose of an asset. When a long-term asset is no longer
useful but cannot be sold, we have retirement. An exchange occurs when two companies trade
assets.

Sale of long-term assets

The sale of a long-term asset typically involves a transaction in which cash is received for the
asset given up. The difference between the cash received and the book value of the asset given
up is reported as a gain or loss in the income statement.

Asset impairment
Impairment occurs when the expected future cash flows generated for a long-term asset fall
below its book value.

Taking a Big Bath

Some companies time their impairment losses with other one-time losses such as losses on
sales of assets, inventory write-downs, and restructuring charges, to record a big loss in one
year. We refer to this practice as taking a big bath - recording all losses in one year to make a
bad year even worse. Management thus cleans its slate and is able to report higher earnings in
future years.