Chapter 1:Highlights
1.Firms prepare financial statements for various external users: owners, lenders, regulators, and employees. The statements attempt to present in a meaningful way the results of a firm's business activities.
2.Companies establish goals or targets that are the end results toward which the firm directs its energies. The company's strategies are the means for achieving the company's goals.
3.Financing activities involve obtaining funds from two principal sources: owners and creditors. For a corporation, owners receive shares of common stock to provide evidence of ownership. The firm need not repay the owners at a particular future date. Instead the owners receive distributions, called dividends, when the firm decides to pay them. Creditors provide funds and require that the firm repay the funds, usually with interest, at a specific date.
4.Firms invest funds obtained from owners and creditors in various items needed to carry out its business activities. The firm invests the funds in various resources in order to generate earnings.
5.Firms communicate the results of their business activities through the annual report to shareholders. Included in the annual report are a letter from the chairperson of the firm’s board of directors and from its chief executive officer, a management discussion and analysis section in which a firm’s management discusses reasons for changes in profitability and risk during the past year, and the firm’s financial statements and supplementary information.
6.The balance sheet presents a snapshot, at a moment in time, of the investing and financing activities of a firm. The balance sheet presents a listing of a firm's assets, liabilities, and shareholders' equity.
7.Assets are economic resources that have the potential or ability to provide future services or benefits to the firm.
8.Liabilities are creditors' claims on the assets of a firm and show the sources of the funds the firm uses to acquire the assets. Typically, liabilities require that a firm pay a specific amount on a specified date.
9.Shareholders' equity is the owners' claim on the assets of the firm. The owners' claim is called a residual interest because owners have a claim on all assets of the firm in excess of those required to meet creditors' claims.
10.Shareholders' equity includes two parts: contributed capital and retained earnings. The funds invested by shareholders make up contributed capital. Retained earnings represent the earnings realized by a firm since its formation in excess of dividends distributed to shareholders.
11.The relative mix of assets reflects a firm's investment decisions, and the relative mix of liabilities plus shareholders' equity reflects a firm's financing decisions. Therefore, Assets = Liabilities + Shareholders' Equity
or
Investing = Financing
Resources = Sources of Resources
Resources = Claims on Resources
12.The balance sheet portrays a firm’s financial position as of a given date and classifies assets and liabilities as being either current or noncurrent.
13.Current assets include cash and assets that a firm expects to turn into cash, or sell, or consume within approximately one year from the date of the balance sheet. Current liabilities represent obligations that a firm expects to pay within one year.
14.Noncurrent assets include property, plant and equipment and other assets that a firm holds and uses for several years. Noncurrent liabilities and shareholders' equity are a firm's longer-term sources of funds.
15.Assets, liabilities, and shareholders' equity items might have balance sheet values measured on one of two bases: (a) a historical valuation, or (b) a current valuation.
16.A historical valuation reflects the acquisition cost of assets or the amounts of funds originally obtained from creditors or owners. A current valuation reflects the current cost of acquiring assets or the current market value of creditors' and owners' claims on a firm.
17.The income statement presents the results of the operating activities of a firm for a period of time. Net income or earnings is the difference between revenues and expenses.
18.Revenues are a measure of the inflows of assets (or reductions in liabilities) from selling goods and providing services to customers. Expenses are a measure of the outflows of assets (or increases in liabilities) used in generating revenue. Net income results when revenues exceed expenses. When expenses for a period exceed revenues, a firm incurs a net loss.
19.The income statement links the beginning and ending balance sheets through the Retained Earnings account. The amount of net income helps explain the change in retained earnings between the beginning and end of the period.
20.The statement of cash flows reports the net cash flows relating to operating, investing, and financing activities for a period of time. The statement explains the change in cash between the beginning and end of the period and details the major investing and financing activities of the period.
21.For most firms, a primary source of cash is the firm's operating activities. The excess of cash received from customers over the amount of cash paid to suppliers, employees, and others is the amount of cash provided by the firm's operating activities.
22.Investing activities include selling existing noncurrent assets and the acquisition of noncurrent assets.
23.Financing activities include new financing (issuing bonds or common stock) and using cash to pay dividends and to retire old financing.
24.Explanatory notes supplement the principal financial statements. These notes indicate the accounting methods that a firm uses and disclose additional information that elaborates on items presented in the three principal statements. To fully understand a firm's balance sheet, income statement, and statement of cash flows requires a careful reading of the notes.
25.One issue that faces the accounting profession is: Who should have the authority to establish acceptable accounting standards? A governmental body could develop accounting standards and use its legislative power to enforce them. A private sector body would more likely incorporate viewpoints of various preparer and user groups in developing accounting standards but would lack the power to enforce the accounting standards.
26.Another issue faced by the accounting profession is: Should standard-setters require uniformity in accounting methods across firms or should firms be allowed flexibility in selecting accounting methods?
27.A third issue concerns the type of accounting standards that standard-setting bodies should adopt. One approach is to specify general principles for a particular reporting topic and permit firms and their independent auditors to make judgments as to the application of those general principles to the particular circumstances. A second approach is a detailed rules-based approach, which attempts to constrain opportunistic actions by management by closing perceived loopholes in reporting standards.
28.The Securities and Exchange Commission (SEC) has the legal authority to set acceptable accounting methods, or standards, in the United States. The SEC has delegated most of the responsibility for establishing such standards to the Financial Accounting Standards Board (FASB).
29.The FASB issues its major pronouncements in the form of Statements of Financial Accounting Standards. Common terminology refers to these pronouncements as generally accepted accounting principles (GAAP). For some financial reporting topics, the FASB requires the use of a uniform accounting method by all firms. In other cases, firms enjoy some freedom to select from a limited set of alternative methods. The current standard-setting approach lies somewhere between uniformity and flexibility, tilting toward uniformity.
30.The FASB has developed a conceptual framework to use as a guide for setting accounting standards. One of the components of the conceptual framework is a statement of the objectives of financial reporting. The seven objectives are:
a.Provide information useful for making investment and credit decisions.
b.Provide information to help investors and creditors assess the amount, timing, and uncertainty of cash flows.
c.Provide information about economic resources and claims on those resources.
d.Provide information about a firm's operating performance.
e.Provide information about how a firm obtains and uses cash.
f.Provide information for assessing management's stewardship responsibility to owners.
g.Provide explanatory and interpretative information to help users understand the financial information provided.
31.The Public Company Accounting Oversight Board (PCAOB) has responsibility for monitoring the quality of audits and the financial reporting process. The Sarbanes-Oxley Act, which set up the PCAOB, requires the PCAOB to register firms conducting independent audits, establish or adopt acceptable auditing, quality control, and independence standards, and provide for periodic “audits” of the auditors.
32.The globalization of capital markets in recent years has increased the need for comparable and understandable financial statements across countries. The International Accounting Standards Board (IASB) has played an important role in developing acceptable accounting principles worldwide. Standards set by the IASB are International Financial Reporting Standards (IFRS).
33. Currently, over 100 countries require or permit IFRS to be used in financial reporting.
Starting in 2009, the SEC allowed large, multinational US companies to select between US GAAP and IFRS. Another proposal is to require US SEC registrants to report using IFRS beginning in 2014.
34.An audit of a firm’s financial statements involves (a) an assessment of the capability of the firm's accounting system to accumulate, measure, and synthesize transactional data properly, (b) an assessment of the operational effectiveness of the firm's accounting system to "present fairly the financial position...and the results of operations and cash flows... in conformity with generally accepted accounting principles.”
35.A certified public accountant, upon the examination of a firm’s accounting records and procedures, expresses an opinion on the fairness of the firm’s financial statements.
36.Financial statements should serve as reliable signals of value changes of firms so that investors, security analysts, and other users can make wise economic decisions. Minimizing intentional management bias through appropriately applied accounting standards and effective, independent audits enhance the reliability of the financial statements.
37. The basic accounting concepts include recognition and realization. In order for a transaction to be recognized (included in the financial statements), certain criteria must be met. Realization refers to converting a noncash item to cash (e.g. collecting accounts receivable).
38. Cash basis of accounting recognizes revenue when cash is collected from a customer and recognizes expenses when cash is paid for goods and services received.
39. Accrual accounting recognizes revenue when a firm provides goods or services and recognizes expenses in the same period the revenues are reported. Thus accrual accounting matches expenses to revenues. When the usage of future benefits does not match with a particular revenue, the firm recognizes these costs in the period the benefits are used.