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Financial Accounting Study Notes
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Saylor URL: http://www.saylor.org/books Saylor.org
Saylor URL: http://www.saylor.org/books Saylor.org
How to Use This Book: From the Authors to the Students If we have done our job properly during the creation of this textbook, it will be like no other educational material that you have ever experienced. We literally set out to rethink the nature, structure, and purpose of college textbooks. Every feature that you find here was designed to enhance student learning. We want this material to be presented in a manner that is both innovative and effective.
The two of us have taught in college for over sixty years. Year in and year out, financial accounting has always seemed to us to be both interesting and relevant to everyday life. We believe it is knowledge well worth acquiring. From the day we started this project, we hoped to share our enthusiasm with you, to develop a book that you will find to be both readable and worth reading.
Historically, textbooks have been presented as dry monologues, a one-way conversation that often seems to talk to the teacher more than to the student. “Boring” and “confusing” should never be synonymous with any aspect of education. Instead, we seek to promote an active dialogue. Authors, teachers, and students should work together to create an environment where education flourishes. We want you, the student, to understand the nature of our endeavor. After all, the only reason that this book exists is to aid you in learning financial accounting. If you do not read the chapters because you find them boring or if you do not understand the material that is included, no one benefits. We will have wasted our time.
We view this textbook as a guide. In constructing these seventeen chapters, we have worked to guide you on a voyage through the world of business and financial reporting. We want to help you attain a usable knowledge of the principles of financial accounting as well as an appreciation for its importance and logic. By learning its theory, presentation, and procedures, individuals become capable of using financial accounting to make prudent business decisions. That is an important goal regardless of the direction of your career. We have relied on our experience as teachers to highlight the aspects of this material that make it interesting, logical, and relevant.
Saylor URL: http://www.saylor.org/books Saylor.org
every answer, every topic need to connect directly to the world we all face. Students should always be curious about the relevance of every aspect of a textbook’s coverage. We believe that it is helpful to consider this material from the perspective of a person already working in the business environment of the twenty-first century.
States moves from following U.S. rules (U.S. GAAP) to international standards (IFRS). The world is getting smaller as companies and their operations become more global. At the same time, technology makes the amount of available information from around the world almost beyond comprehension. Consequently, throughout this textbook, we interview one of the partners of a large international accounting firm about the impact of possibly changing financial accounting in this country so that all reporting abides by international accounting rules rather than solely U.S. standards.
repetitive fashion, we challenge you to select the five most important elements of each chapter. Some coverage is simply more important than others. That is a reasonable expectation. Part of a successful education is gaining the insight to make such evaluations. Then, we provide you with our own top five. The lists do not need to match; in fact, it is unlikely that they will be the same. That is not the purpose. This exercise should encourage you to weigh the significance of the material. What really makes a difference based on your understanding of financial accounting? In what areas should you focus your attention?
Is This Book Unique? We truly believe so. We believe that it has an educationally creative structure that will promote your learning and make the educational process more effective and more interesting: Opening videos for the chapters Socratic method Embedded multiple-choice questions Discussions with both an investment analyst and an international accounting expert Closing videos establishing top-five lists for each chapter
Saylor URL: http://www.saylor.org/books Saylor.org
Every page of this book, every word in fact, has been created to encourage and enhance your understanding. We want you to benefit from our coverage, but just as importantly, we want you to enjoy the process. When presented correctly, learning can be fun and, we believe, should be.
Please feel free to contact us if you have any suggestions for improvement. We would love to hear from you.
Finally, this book is dedicated to our wives and our families. It is also dedicated to the thousands of wonderful teachers across the world who walk into countless college classrooms each day and make learning happen for their students. You make the world better.
Saylor URL: http://www.saylor.org/books Saylor.org
prospects for the future. They seek information. Financial accounting provides data that these individuals need and want.
organization → reports information based on the principles of financial accounting → individual assesses financial health
Question : Every semester , most college students are enrolled in several courses as well as participate in numerous outside activities. All of these compete for the hours in each person’s day. Why should a student invest valuable time to learn the principles of financial accounting? Why should anyone be concerned with the information communicated about an organization? More concisely , what makes financial accounting important?
Answer: Many possible benefits can be gained from acquiring a strong knowledge of financial accounting and the means by which information is communicated about an organization. In this book, justification for the serious study that is required to master the subject matter is simple and straightforward: obtaining a working knowledge of financial accounting and its underlying principles enables a person to understand the information conveyed about an organization so that better decisions can be made.
Around the world, millions of individuals make critical judgments each day about the businesses and other organizations they encounter. Developing the ability to analyze financial information and then using that knowledge to arrive at sound decisions can be critically important. Whether an organization is as gigantic as Wal-Mart or as tiny as a local convenience store, a person could have many, varied reasons for making an assessment. As just a single example, a recent college graduate looking at full-time employment opportunities might want to determine the probability that Company A will have a brighter economic future than Company B. Although such decisions can never be correct 100 percent of the time, knowledge of financial accounting and the information being communicated greatly increases the likelihood of success. As Kofi Annan, former secretary-general of the United Nations, has said, “Knowledge is power. Information is liberating.” [1]
Saylor URL: http://www.saylor.org/books Saylor.org
Thus, the ultimate purpose of this book is to provide students with a rich understanding of the rules and nuances of financial accounting so they can evaluate available information and then make good choices about those organizations. In the world of business, most successful individuals have developed this talent and are able to use it to achieve their investing and career objectives.
Question: Knowledge of financial accounting assists individuals in making informed decisions about businesses and other organizations. What kinds of evaluations are typically made? For example, assume that a former student—one who recently graduated from college—has been assigned the task of analyzing financial data provided by Company C. What real-life decisions could a person be facing where an understanding of financial accounting is beneficial?
Answer: The number of possible judgments that an individual might need to make about a business or other organization is close to unlimited. However, many decisions deal with current financial health and the prospects for future success. In making assessments of available data, a working knowledge of financial accounting is invaluable. The more in-depth the understanding is of those principles, the more likely the person will be able to use the available information to arrive at the best possible choice. Common examples include the following:
The college graduate might be employed by a bank to work in its corporate lending department. Company C is a local business that has applied to the bank for a large loan. The graduate has been asked by bank management to prepare an assessment of Company C to determine if it is likely to be financially healthy in the future so that it will be able to repay the money when due. A correct decision to lend the money eventually earns the bank profit because Company C (the debtor) will be required to pay an extra amount (known as interest ) on the money borrowed. Conversely, an incorrect analysis of the information could lead to a substantial loss if the loan is granted and Company C is unable to fulfill its obligation. Bank officials must weigh the potential for profit against the risk of loss. That is a daily challenge in virtually all businesses. The former student’s career with the bank might depend on the ability to analyze financial accounting data and then make appropriate choices about the actions to be taken. Should a loan be made to this company?
Saylor URL: http://www.saylor.org/books Saylor.org
Should a business buy a building to serve as its new headquarters or rent a facility instead? What price should a data processing company charge customers for its services? Should advertisements to alert the public about a new product be carried on the Internet or on television?
Answer: Organizational decisions such as these are extremely important for success. However, these examples are not made about the reporting organization. Rather, they are made within the organization in connection with some element of its operations.
The general term “accounting” refers to the communication of financial information for decision-making purposes. Accounting is then further subdivided into (a) financial accounting and (b ) managerial accounting. [2]^ Financial accounting is the subject explored in this textbook. It focuses on conveying relevant data (primarily to external parties) so that decisions can be made about an organization (such as Motorola or Starbucks) as a whole. Thus, questions such as the following all fall within the discussion of financial accounting:
Do we loan money to Company C? Do we sell on credit to Company C? Do we recommend that our clients buy the ownership shares of Company C?
They relate to evaluating the financial health and prospects of Company C as a whole.
Managerial accounting is the subject of other books and other courses. This second branch of accounting refers to the communication of information within an organization so that internal decisions (such as whether to buy or rent a building) can be made in an appropriate manner. Individuals studying an organization as a whole have different goals than do internal parties making operational decisions. Thus, many unique characteristics have developed in connection with each of these two branches of accounting. Financial accounting and managerial accounting have evolved independently over the decades to address
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the specific needs of the users being served and the decisions being made. This textbook is designed to explain those attributes that are fundamental to attaining a usable understanding of financial accounting.
It is not that one of these areas of accounting is better, more useful, or more important than the other. Financial accounting and managerial accounting have simply been created to achieve different objectives. They both do their jobs well; they just do not have the same jobs.
Link to multiple-choice question for practice purposes:http://www.quia.com/quiz/2092571.html Question: Financial accounting refers to the conveyance of information about an organization as a whole and is most frequently directed to assisting outside decision makers. Is there any reason for a person who is employed by a company to care about the financial accounting data reported about that organization? Why should an employee in the marketing or personnel department of Company C be interested in the financial information that it distributes?
Answer: As indicated, financial accounting is designed to portray the overall financial condition and prospects of an organization. Every employee should be quite interested in assessing that information to judge future employment prospects. A company that is doing well will possibly award larger pay raises or perhaps significant end-of-year cash bonuses. A financially healthy organization can afford to hire new employees, buy additional equipment, or pursue major new initiatives. Conversely, when a company is struggling and prospects are dim, employees might anticipate layoffs, pay cuts, or reductions in resources.
Thus, although financial accounting information is often directed to outside decision makers, employees should be vitally interested in the financial health of their own organization. No one wants to be clueless as to whether their employer is headed for prosperity or bankruptcy. In reality, employees are often the most avid readers of the financial accounting information distributed by their employers because the results can have such an immediate and direct impact on their jobs and, hence, their lives.
Saylor URL: http://www.saylor.org/books Saylor.org
1.2 Incorporation and the Trading of Capital Shares
At the end of this section, students should be able to meet the following objectives:
Question: Above, in discussing the possible decisions that could be made about an organization, ownership shares were mentioned. Occasionally, on television, in newspapers, or on the Internet, mention is made that the shares of one company or another have gone up or down in price during that day because of trading on one of the stock markets. Why does a person or an organization acquire ownership shares of a business such as Capital One or Intel?
Answer: In the United States, as well as in many other countries, owners of a business or other type of organization can apply to the state government to have it identified as an entity legally separate from its owners. This process is referred to as incorporation. Therefore, a corporation is an organization that has been formally recognized by the government as a legal entity. A business that has not been incorporated is legally either a sole proprietorship (one owner) or a partnership (more than one owner).
As will be discussed in detail in Chapter 16 "In a Set of Financial Statements, What Information Is Conveyed about Shareholders’ Equity?", several advantages can be gained from incorporation. For one, a corporation has the ability to issue (sell) shares to obtain monetary resources and allow investors to become owners (also known as stockholders or shareholders ). The Walt Disney Company and General Electric, as just two examples, are corporations. They exist as legal entities completely distinct from the multitude of individuals and organizations that possess their ownership shares (also known as equity or capital stock ).
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Any investor who acquires one or more capital shares of a corporation is an owner and has rights that are specified by the state government or on the stock certificate. The number of shares and owners can be staggering. At the end of 2008, owners held over 2.3 billion shares of The Coca-Cola Company. Thus, possession of one share of The Coca-Cola Company at that time gave a person approximately a 1/2,300,000,000th part of the ownership. [1]
If traded on a stock exchange, shares of the capital stock of a corporation continually go up and down in value based on myriad factors, including the perceived financial health and prospects of the organization. As an example, during trading on December 4, 2009, the price of an ownership share of Intel rose by $0.59 to $20.46, while a share of Capital One went up by $1.00 to $37.92.
For countless individuals and groups around the world, the most popular method of investment is through the purchase and sell of these shares of corporate ownership. Although a number of other types of investment opportunities are available (such as the acquisition of gold or land), few evoke the level of interest of capital stock. [2]^ On the New York Stock Exchange alone, billions of shares are bought and sold every business day at a wide range of prices. As of December 4, 2009, an ownership share of Ford Motor Company was trading for $8.94, while a single share of Berkshire Hathaway sold for thousands of dollars.
Link to multiple-choice question for practice purposes:http://www.quia.com/quiz/2092597.html
Question: In most cases, the owners of a small corporation should be able to operate the business effectively. For example, one person might hold one hundred shares of capital stock while another owns two hundred. Those two individuals must learn to work together to manage the business on a day-to- day basis. Large corporations offer a significantly different challenge. How could millions of investors possessing billions of capital shares of a single corporation ever serve in any reasonable capacity as the ownership of that organization?
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Question: The acquisition of capital shares is an extremely popular investment strategy across a wide range of the population. A buyer becomes one of the owners of the corporation. Why spend money in this way especially since very few stockholders can ever hope to hold enough shares to participate in managing or influencing the operations? Ownership shares sometimes cost small amounts but can also require hundreds if not thousands of dollars. What is the potential benefit of buying capital stock issued by a business organization?
Answer: Capital shares of thousands of corporations trade each day on markets around the world, such as the New York Stock Exchange or NASDAQ (National Association of Securities Dealers Automated Quotation Service). One party is looking to sell shares whereas another is seeking shares to buy. Stock markets match up these buyers and sellers so that a mutually agreed-upon price can be negotiated. This bargaining process allows the ownership interest of all these companies to change hands with relative ease.
When investors believe a company is financially healthy and its future is bright, they expect prosperity and growth. If that happens, the negotiated price for this company’s capital stock should rise over time. Everyone attempts to anticipate such movements in order to buy the stock at a low price and sell it later at a higher one. Conversely, if predictions are not optimistic, then the share price is likely to drop and owners face the possibility of incurring losses in the value of their investments. Many factors affect the movement of stock prices such as the perceived quality of the management, historical trends in profitability, the viability of the industry in which it operates, and the health of the economy as a whole.
Financial accounting information plays an invaluable role in this market process as millions of investors attempt each day to assess the financial condition and prospects of corporate organizations. Being able to understand and make use of reported financial data helps improve the investor’s knowledge of a company and, thus, the chance of making wise decisions that will generate profits from buying and selling capital shares. Ignorance can lead to poor decisions and much less lucrative outcomes.
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In the United States, such investment gains—if successfully generated—are especially appealing to individuals if the shares are held for over twelve months before being sold. For income tax purposes, the difference between the buy and sale prices for such investments is referred to as a long- term capital gain or loss. Under certain circumstances, significant tax reductions are allowed in connection with long-term capital gains. [4]^ Congress created this tax incentive to encourage investment so that businesses could more easily obtain money for growth purposes.
Link to multiple-choice question for practice purposes:http://www.quia.com/quiz/2092598.html
Question : Investors acquire ownership shares of selected corporations hoping that the stock values will rise over time. This investment strategy is especially tempting because net long-term capital gains are taxed at a relatively low rate. Is the possibility for appreciation of stock prices the only reason that investors choose to acquire capital shares?
Answer: Many corporations—although certainly not all—also pay cash dividends to their stockholders periodically. A dividend is a reward for being an owner of a business that is prospering. It is not a required payment; it is a sharing of profits with the stockholders. As an example, for 2008, Duke Energy reported earning profits (net income) of $1.36 billion. During that same period, the corporation distributed a total cash dividend of approximately $1.14 billion to the owners of its capital stock. [5]
The board of directors determines whether to pay dividends. Some boards prefer to leave money within the business to stimulate future growth and additional profits. For example, Yahoo! Inc. reported profits (net income) for 2008 of over $424 million but paid no dividends to its owners. Not surprisingly, a variety of investing strategies abound. Some investors acquire ownership shares almost exclusively in hopes of benefiting from the potential for significant appreciation of stock prices. Another large segment of the investing public is more interested in the possibility of dividend payments.
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Incorporation allows an organization to be viewed as a separate entity apart from its ownership. As a corporation, shares of capital stock can be issued that give the holder an ownership right. If the organization is financially healthy and prospering, these shares can increase in value—possibly by a significant amount. In addition, a profitable organization may well share its good fortune with the ownership through the distribution of cash dividends. In most large organizations, few owners want to be involved in the operational decision making. Instead, these stockholders elect a board of directors to oversee the company and direct the work of management.
[1] Sole proprietorships and partnerships rarely sell capital shares. Without the legal authority of incorporation, a clear distinction between owner and business often does not exist. For example, debts incurred by the business may ultimately have to be satisfied by the owner personally. Thus, individuals tend to avoid making investments in unincorporated businesses unless they can be involved directly in the management. For that reason, active trading of partnership and proprietorship ownership interests is usually limited or nonexistent. One of the great advantages of incorporation is the ease by which capital stock can usually be exchanged. Investors frequently buy or sell such shares on stock exchanges in a matter of moments. However, partnerships and sole proprietorships still remain popular because they are easy to create and offer possible income tax benefits as will be discussed in a future chapter.
[2] The most prevalent form of capital stock is common stock so that these two terms have come to be used somewhat interchangeably. As will be discussed in a later chapter, the capital stock of some corporations is made up of both common stock and preferred stock. [3] A story produced by National Public Radio on the roles played by a board of directors can be found at http://www.npr.org/templates/story/story.php?storyId=105576374.
[4] This same tax benefit is not available to corporate taxpayers, only individuals.
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[5] The receipt of cash dividends is additionally appealing to stockholders because, in most cases, they are taxed at the same reduced rates as are applied to net long-term capital gains.
1.3 Using Financial Accounting for Wise Decision Making
At the end of this section, students should be able to meet the following objectives:
Question: Investors are interested (sometimes almost obsessively interested) in the financial information that is produced by a company based on the rules and principles of financial accounting. They want to use this information to make wise investing decisions. What do investors actually hope to learn about a company from this financial information?
Answer: The information reported by financial accounting is similar to a giant, complex portrait painted of the organization. There are probably hundreds, if not thousands, of aspects that can be examined, analyzed, and evaluated in assessing the financial health and future prospects of the model. Theories abound as to which pieces of information are best to use when studying a business. One investor might prefer to focus on a particular portion of the data almost exclusively (such as profitability) while another may believe that entirely different information is most significant (such as the sources and uses of cash during the period).
Ultimately, in connection with the buying and selling of capital stock, all investors are trying to arrive at the same two insights. They are attempting to use the provided data to estimate (1) the price of the
