Chapter 1

Accounting – process of recording, summarizing, and analyzing financial transactions

Two categories:

  1. Financial accounting – used primarily by decision makers outside of the company
  2. Managerial accounting – used primarily by decision makers within the company

Users of financial accounting information:

  1. Shareholders and potential shareholders - to evaluate management performance and assess the company’s financial condition
  2. Creditors and suppliers - to monitor and adjust their contracts and commitments with a company
  3. Managers and directors - FS act as financial report card for management
  4. Directors – review the results of operations, evaluate future strategy, and assess management performance
  5. Financial analysts - Identify and assess risk, forecast performance, establish prices for new issues of stock, and make buy or sell recommendations
  6. Prospective employees
  7. Labor unions
  8. Customers
  9. Tax agencies/government agencies

Disclosure – the act of providing financial information to external users; has associated benefits and costs

Business Activities
Planning Activities
Produces a company’s goals and strategies
Investing Activities
Acquiring and disposing of resources needed to produce and sell a company’s products and services
Assets – provide future benefit
Financing Activities
Methods used to fund investments
Equity financing – funds contributed to the company by its owners along with any income retained by the company; no obligation for repayment
Creditor or debt financing – funds contributed by non-owners which create liabilities; with legal obligation to repay
Accounting equation: assets = liabilities + equity
Investing = creditor financing + owner financing
Operating activities
Production, promotion, and selling of a company’s products and services
Involves input markets (suppliers) and output markets (customers)
Revenue – increase in equity resulting from the sale of goods and services to customers
Expense – cost incurred to generate revenue
Income – net increase in equity from the company’s operating activities

Financial Statements
Companies can report their financials using either a calendar year or fiscal year.
Balance sheet
Reports a company’s financial position at a point in time; a snapshot of a company’s financial condition at a particular time
Income statement
Reports the results of a company’s operating activities over a period of time.
Statement of stockholders’ equity
Reports the changes in equity accounts over a period of time
Three categories
Contributed capital – includes common stock, and APIC
Retained earnings – cumulative net income or loss minus dividends
Other stockholders’ equity
Statement of cash flows
Reports net cash flows from operating, investing, and financing activities over a period of time

Financial statement linkages
Statement of cash flows links the beginning and ending cash in the balance sheet.
Income statement links the beginning and ending retained earnings in the statement of stockholders’ equity.
Statement of stockholders’ equity links the beginning and ending equity in the balance sheet.

GAAP – generally accepted accounting principles

Sarbanes-Oxley Act

Auditor – provides an opinion as to whether the FS present fairly and in all material respects a company’s financial condition and the results of operations.

Financial Statement Analysis
Profitability Measure
Return on Equity (ROE)=(Net Income)/(Average Stockholders' Equity)

Risk Measure
The riskier the investment, the greater the return demanded by investors
Solvency – the ability of a company to remain in business and avoid bankruptcy
Risk of bankruptcy increases as the amount of debt increases.
Debt-to-Equity Ratio = (Total Liabilities)/(Total Stockholders' Equity)

Answers to Exercises
M1-21. Recall the accounting equation: assets = liabilities + equity
a. 81,981 - 43,837 = 38,144
b. 18,207 - 5,772 = 12, 435
c. 13,043 + 16,920 = 29,963
Percentage of owner financing:
recall that liabilities represent non-owner financing while equity represents owner financing; liabilities + equity represent the total financing
HP: 38,144 / 81,981 = 47%
General Mills: 5,772 / 18,207 = 32%
Coca-cola: 16,920 / 29,963 = 56%
Coca-cola is more owner-financed while General Mills is more non-owner financed.
An alternative solution is to compute for and compare the debt-to-equity ratios for the three companies.
HP: 43,837 / 38,144 = 1.15
General Mills: 13,135 / 5,772 = 2.28
Coca-cola: 13,043 / 16,920 = 0.77
Coca-cola which has the lowest D-E ratio is the most owner-financed; General Mills which has the highest D-E ratio is the most non-owner-financed.

E1-27 apply same concepts as M1-21
a. 38,593 - 17,142 = 21,451
b. 27,019 + 28,555 = 55,574
c. 44,570 - 27,010 = 17,560
Percentage of owner-financing
Motorola: 17,142 / 38,593 = 44%
Kraft: 28,555 / 55,574 = 51%
Merck: 17,560 / 44,570 = 39%
Kraft is more owner-financed while Merck is more creditor-financed

Chapter 2

Asset - resource that is expected to provide a company with future economic benefits
- measured either at historical cost or fair market value
Two characteristics of an asset:

  1. must be owned or controlled by the company
  2. must possess expected future benefits that can be measured

Liquidity - ease of converting noncash assets into cash
Assets in a balance sheet are presented in order of liquidity

Current Assets - assets expected to be converted into cash or used in operations within the next year
ex. cash, marketable securities, accounts receivable, inventory, prepaid expenses

Non-current Assets - ex. long-term and equity investments, PPE, intangible and other assets

Liability - future economic sacrifice resulting from a current or past event
Three conditions:

  1. future sacrifice is probable
  2. amount of the obligation is known or can be reasonably estimated
  3. transaction that caused the obligation has occured

executory contract - conditions 1 and 2 are met but the transaction has not occured
Liabilities are listed in order of maturity. Obligations with earlier maturity are listed first

Current Liabilities - obligations that are due within one year
ex. accounts payable, accrued liabilities, short-term borrowings, deferred (unearned) revenues, current maturities of long-term debt

Non-current liabilities - obligations to be paid after one year
ex. long-term debt, other long-term liabilities

Stockholders' Equity - capital provided by the owners of the company
Earned capital - cumulative net income and losses retained by the company
- includes retained earnings, accumulated other comprehensive income or loss
Contributed capital - net funding a company has received from issuing and reacquiring its equity shares
- includes common stock, additional paid-in capital, treasury stock

Financial Statement Effects Template
Double entry accounting system - each transaction must affect at least two accounts

Revenues - increases in net assets that result from business activities
Expenses - outflow to generate revenues
Net income/loss - difference between revenues and expenses
Operating expenses - costs that a company incurs to support its main business activities
Nonoperating revenues and expenses - relate to the company's financing and investing activities
Recurring versus Non-recurring income

Accrual accounting - recognition of revenue when earned (even if no cash has been received) and matching of expenses when incurred (even if not paid in cash)

Equity Transactions - no revenue or income is recorded from a stock issuance; no expense is recorded from a dividend

T-account - left side: debit; right side: credit
assets - normal debit balance; increased by a debit
liabilities and equity - normal credit balance; increased by a credit
Journal entry - recording of transaction by summarizing debits and credits

Assessing Liquidity
net working capital = current assets - current liabilities
current ratio = current assets / current liabilities

  • if greater than or equal to one, company's current assets are enough to cover its current liabilities
  • if less than one, the current assets are not enough to meet the current liabilities

quick ratio = cash and cash equivalents / current liabilities

Answers to Exercises
b. increase assets (accounts receivable)
increase equity (service revenue)
c. decrease assets (cash)
decrease equity (rent expense)
d. increase assets (cash)
increase equity (service revenue)
e. increase assets (cash)
decrease assets (accounts receivable)
f. increase assets (office equipment)
increase liabilities (accounts payable)
g. decrease assets (cash)
decrease equity (salary expense)
h. decrease assets (cash)
decrease liabilities (accounts payable)
i. decrease assets (cash)
decrease equity (retained earnings)

a. +1,000 in cash asset; +1,000 in contributed capital (common stock) (note: balance sheet effect only)
b. -500 in cash asset; +500 in noncash asset (inventory) (note: balance sheet effect only)
c. +2,000 in noncash assets (accounts receivable); +2,000 in earned capital (retained earnings); +2,000 in revenues (sales revenue); +2,000 in net income (note: balance sheet and income statement effect)
d. -500 in noncash assets (inventory); -500 in earned capital (retained earnings); +500 in expenses (COGS); -500 in net income (note: balance sheet and income statement effect)
e. +2,000 in cash asset; -2,000 in noncash asset (accounts receivable) (note: balance sheet effect only)

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