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Principles of Business Financial Accounting

AuthorHouse

Contents

Preface................................................................ix1 Introduction to Accounting...........................................12 Accounting Information...............................................73 Accounting and Reporting.............................................334 Cost Method of Accounting............................................515 Internal Control, Audits, and Sarbanes-Oxley Act.....................796 Accounts Payable and Suppliers.......................................977 Mergers and Acquisitions.............................................1058 Financial Market.....................................................1179 Appendix A...........................................................14510 Financial Statements Walmart Stores, Inc............................145Glossary...............................................................191Solution...............................................................201References.............................................................205Index..................................................................207

Chapter One

The accounting function has an important role in the successful operations of today's successful business. The American Accounting Association (AAA) defined accounting as "the process of identifying, measuring and communicating economic information to permit informed judgments and decisions by the users of that information." Accounting has oft en been called financial management language, such as in terms of net income, assets, liabilities, and so forth. This function provides relevant information to internal and external decision makers. The internal parties are managers, chief financial officers (CFOs), presidents, chief executive officers (CEOs), and so forth. The external parties include investors, creditors, and federal, state, and city tax agencies (for example, sales, property, and income taxes). Financial accounting's objective is achieved as per Generally Accepted Accounting Principles (GAAP) through the preparation of periodic financial statements ( income statement, balance sheet, change of financial position, and so forth). Financial statements that are distributed outside of a company are to be prepared in accordance with GAAP. Also, financial accounting effectively processes business transactions so informative financial statements can be prepared. It is the process of recording information and maintaining accounting books, activities that are also called bookkeeping. Independent certified public accountants (CPAs) must audit the financial statements of the corporation whose stock is publicly traded. These CPAs certify that the financial statements were prepared in accordance with GAAP.

Financial accounting serves those who use the information it provides in three separate but related ways:

1. Accounting provides an important information base on particular analytical orientation that helps the decision maker assess the potential financial implications and various alternatives that are being considered. Such interested parties include potential investors, government agencies, customers, and so forth.

2. Accounting provides a continuing measurement of the financial effects of a series of decisions already made, the results of which are communicated to the decision makers via periodic financial statements, including income statements, balance statements, and statement of change financial position.

3. Accounting keeps track of a wide range of items to meet the safeguarding responsibilities imposed on all organization by the company. This is called internal control.

The Need of Financial Accounting

The Financial Accounting Standards Board (FASB) is a private sector, independent rule-making agency that is the main source of GAAP. Financial accounting provides decision makers with useful information in making economics decisions. There are many type of economics decision. The terms "financial accounting," "tax accounting," and " inventory accounting" describe the accounting information in the business community.

Financial accounting refers to the information described in financial statements and used for many different purposes. Investors make decisions with it, banks and creditors provide credit limits with it, and internal management makes sound decision for company position, such as profit, earning per share, cash flow, and so forth, with it.

Tax accounting is used in preparation of income tax, property tax, and so forth. All tax returns are based upon the company's financial information. However, the financial information is oft en adjusted for income tax reporting requirements.

Inventory accounting reports the inventory status. Inventory could be the single largest asset on some company's balance sheet. Inventory is very important for manufacturers and retailers, while financial institutions do not carry any or very little inventory. The cost of inventory is reported on the balance sheet as a current asset.

Type of Business Entities

There are three types of business entities:

1. A business owned by one person is called a sole proprietorship. Generally, the owner is also the manager of the business. For example, small retail businesses or service establishments are sole proprietorships.

2. A business owned by at least two partners is called a partnership. The agreements among the owners are set forth in a partnership contract. Each partner is responsible for the debts of the business, which is called "unlimited liabilities." Partners are jointly responsible for all the risks of the business and jointly receive all the profits of the business.

3. A business incorporated under the law of a particular state, whereby the owners are known as shareholders or stockholders, is a corporation. The state issues a charter, which gives the corporation the right to operate legally as an entity, separate and apart from its owners. Ownership is represented by shares of capital stock owned by individual shareholders that can be bought and sold. The owner has limited liabilities, that is, he or she is liable for the debts of the corporation only to the extent of his or her investment. The shareholders elect a board of directors.

Management Accounting and Financial Accounting

Management accounting is more than just bookkeeping and reporting. The organization also uses the basic raw data in a number of other purposes, for example, the process of preparing management accounts that provide accurate and timely key financial and statistical information required by managers to make day-to-day and short-term decisions. Management accounting generates weekly or monthly reports for the firm's internal users, such as department manager, CFO, and CEO. These reports provide current status of the cash flow, revenue, orders on hand, raw material, risk exposures, and other statistics such as trend chart.

According to the Chartered Institute of Management Accountants (CIMA), management accounting is:

[T]he process of identification, measurement, accumulation, analysis, preparation, interpretation and communication of information used by management to plan, evaluate and control within an entity and to assure appropriate use of and accountability for its resources. Management accounting also comprises the preparation of financial reports for non-management group such as shareholders, creditors, regulatory agencies and tax authorities.

The American Institute of Certified Public Accountants ( AICPA) states that management accounting as practice extends to the following three areas:

1. Strategic Management: Advancing the role of the management accountant as a strategic partner in the organization

2. Performance Management: Developing the practice of business decision making and managing the performance of the organization

3. Risk Management: Contributing to framework and practices for identifying, measuring, managing, and reporting risk to the achievement of the objectives of the organization

Financial accounting is the process of summarizing financial data taken from an organization's accounting records and publishing a company's annual performance report (annual report) for the benefit of people outside the organization. Both local and international accounting standards govern financial accounting in a global corporation. Financial accounting also refers to business management.

In brief, financial accounting prepares financial information for external users for decision-making processes, such as stockholders, suppliers, bank, investors, and so forth.

Chapter Two

Basic Concept of Accounting

There are three basic components in finance accounting. The entire chart of accounts is broken down into assets, liabilities, and equity. These three components balance in the following accounting model. These three components represent the financial position of the business at the point of time.

Assets = Liabilities + Owner Equity or Liabilities = Assets - Owner Equity or Owner Equity = Assets - Liabilities

Assets

Fundamentally, assets are resources of business and divided into two categories: tangible and intangible. Tangible assets are cash, land, buildings, and machinery. Intangible assets are rights or legal claims. For example, accounts receivable from customers, goodwill, and patents (protected rights). Assets initially are reported on the balance sheet.

Liabilities

Liabilities are debts that the business owes and are reported on the balance sheet. There are two types of liabilities: current and long term. For example, accounts payable, notes payable, and income tax payable are the current or short-term liabilities. The long-term debts—long-term loans and debentures—are not classified as current liabilities.

Owner's Equity

Owner's equity—also called net worth, capital, or proprietorship—represents the owners' residual claim.

Owner's Equity = Total Assets - Total Liabilities

Investments and revenue increase owner's equity; expenses and withdrawals decrease it.

External Financial Statements

There are three primary financial statements for a profit-making entity for internal and external reporting to owners, investors, creditors, and other decision makers: income statement, balance sheet, and statement of changes in financial position.

Income Statement

The income statement reports the profit performance of a business entity for a specific period of time, such as month, quarter, or year. Net income or profit represents the difference between revenue and expenses for the specified period of time.

Revenue

Revenues are inflows of cash from goods sold or services rendered into the business. Revenue is generally recognized when the shipment process is completed and the title has been transferred from seller to buyer.

Expenses

Expenses are outflows of resources. Expenses are costs associated with selling goods and services. Expenses are recognized in the period in which it is incurred rather than in the period in which the cash is paid. The accounting model for income statement is the following:

Revenue - Expenses = Net Income

The Balance Sheet

The balance sheet—or the statement of financial position—is one of the main financial statements. The balance sheet reports the financial position of a business at a particular point of time. This is in contrast to the income statement, which covers a period of time. Financial position refers to the assets and liabilities of the business on a specific date. This statement is also called the statement of financial position of business.

The assets are listed first on the balance sheet. Assets are valuable resources owned by the business. Assets are two types: short term and long term. These include cash, accounts receivable, land, building, machinery, equipment, inventory, and intangible assets such as goodwill.

The liabilities are listed second. Liabilities are what you owe to others in business. This include notes payable, accounts payable, wages payable, interest payable, income tax payable, and bonds payable.

Stockholders' equity is the difference between the amounts reported for assets and liabilities.

The accounting model for the balance sheet is the following:

Assets = Liabilities + Owner's Equity

Owner's Equity

Exhibit 2-1 shows owner's equity. Owner's equity generates from two sources: contributed capital, the investment of cash or other assets (for example, building, land, machinery, and so forth) in business by the owners, and retained earnings, the accumulated profit of the business minus the losses and withdrawals. When the owners receive cash from the business through withdrawals, the total amount of owner equity is reduced. When business incurs a loss, owner's equity also is reduced.

Contributed Capital

Shareholders invested $33,000 in business and received three thousand shares of capital stock, par value $10 per share, as shown in exhibit 2-1. Also, they invested $1 above par value. Therefore the three thousand shares issued are reported at their par value (3,000 x $10 = $30,000) as capital stock and (3,000 x $1 = $3,000) is reported as contributed capital.

Retained Earnings

The accumulated earnings is less all dividends paid to shareholder, as shown in exhibit 2-1 under owner's equity. The business earned $13,500 during the 1985 year, as shown in the ABC income statement. This amount is reported on the balance sheet as retained earnings.

Owner's Equity

The total owner's equity is the sum of the investment plus the retained earnings ($33,000 + $13,500 = $46,500).

Financial Ratio Tests of Profitability

The profitability ratio test analysis has been classified under four categories:

a. Return on Investment (ROI) on owner's equity: ROI ratio is the true profitability test. To measure the profitability of any investment, the amount of profit must be measured against the resource invested. The following equation computes the ROI ratio: Return on Owner Investment = Net Income/Owner's Equity. (Exhibit 2-2, M & B Company = $27,000 /$341,000 = 7.9 percent)

b. Return on Total Investment: This is another way of measuring the return on total investment. The denominator (liabilities and owner's equity) represents total investment in the company. The following equation computes the return on total investment: Return on Total Investment = Net Income + Interest Expense/ Liabilities + Owner's Equity. (Exhibit 2 -2, M & B Company = $27,000 + $1,000 = $105,000 + $341,000 = 6.07 percent)

c. Earnings per Share: This ratio test of profitability is from the common stock or earning per share on common stock. The following equation computes earnings per share:

Earnings per Share = Net Income/Average Number of Common Stock Outstanding. (Exhibit 2-1, ABC Company = $13,000/3,000 = $4.5 per share)

d. Profit Margin: This profit margin is related to the income statements. The percentage ratio indicates the performance of company. In other words, it is how good the company is performing. The following equation computes the profit margin:

Profit Margin = Net Income/Net Sales. (Exhibit 2-5, M & B Company = $27,000/$242,000 = 11.15 percent)

Financial Market Ratio Tests

Several market tests have been developed to measure current market stock price indicator of the profit for investors. There are two most common tests are:

a. Price/Earnings Ratio: This is the rate at which the stock market apparently is capitalizing the current earnings. The following equation computes the price/earnings ratio:

Price/Earnings Ratio = Current Market Price per Share/Earnings per Share.

(Assuming ABC Company current market price is $20 per share, so the price/earnings ratio = $20/$4.5 = 4.4/1 = 4 to 1.) Thus, this means this stock was selling at four times of the earnings per share. This is also referred to as the capitalization rate. The capitalizing current earnings is the following: $4.5/$20 = 22.5 percent.

b. Yield Ratio: The yield ratio measures the potential return to the investor based upon the dividends per share. This ratio is referred as the yield because the stock price changes frequently. The following equation computes the yield ration:

Yield = Dividends per Share/Market Price per Share. (Assuming ABC Company dividend paid $0. 60 per share, so the yield = $0.60/$20 = 3 percent.) This ratio is referred to simply as the yield or potential return to the investor.

Statement of Changes in Financial Position

The objective of the statement of changes in financial position is to communicate to the user about the inflows and outflows of cash or working capital. The statement of cash flows is a period of time as the income statement stated. Because investors and creditors oft en think in terms of present and potential future cash flows, this statement provides an important information input to the decision-making process. The statement of cash flows must be included in financial statement to be in accordance with GAAP.

In the recent era, the financial activities of operations have become increasingly very complex. The business requires substantial funds for operations, business expansion, and emergency need. These funds come from three sources: owner investment, borrowings, and net earnings (retain earnings). The statement of changes in financial position is derived from an analysis of the balance sheet and the income statement. The accounting model for this statement is:

Resource Inflows - Resource Outflows = Change in Resources.

In the above illustration, Nathan generated all cash from operations and investment. The total cash increased during the period of 1985 was $100,500.

Growth Company Cash Flow from Profit

Growth company means increase in profit and increase in shareholder's equity. Exhibit 2-7 focuses on changes in the company's income statement, balance sheet, and cash flow statement. The XYZ Company is budgeting significant growth in sales revenue and profit for the next fiscal year and wants to know how this growth will impact the company's cash flow from profit next year.

The company's income statement for the year 2007 ended with the profit of $3,048. Budget changes for 2008 profit is $3,392. The changes in sales revenue and expenses in exhibit 2-7 then moves changes in operating assets and liabilities in exhibit 2-7A. The changes caused by the changes in sales revenue and expenses then moves over to the cash flow statement exhibit 2-7B, where the changes in the operating assets and liabilities are entered as adjustment to net income.

(Continues...)

Excerpted from Principles of Business Financial Accountingby Pramod Gupta Copyright © 2012 by Pramod Gupta. Excerpted by permission of AuthorHouse. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
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