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Economics 4 - Financial Accounting - Flashcards

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Class:ECON 4 - Financial Accountng
Subject:Economics
University:University of California - San Diego
Term:Spring 2011
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Accounting Accounting is a formal way of keeping track of cash and other things that business firms need and use and how to measure the profits that businesses make or not.
GAAP GAAP (Generally Accepted Accounting Principles) is the collection of principles-based rules that give business managers formal guidance about:
  • How to measure commercial things of value (called assets), claims to (and obligations for) cash, and an owner or shareholder's interest (called equity). 
  • When to report the results of commercial activities; and 
  • How to report, i.e. "what labels" to put on business transactions. 
An Information System Financial Accounting is a highly stylized information system. Information systems generally consist of four fundamental processes: 
  1. A Collection process; 
  2. Measurement standards; 
  3. A Taxonomy which establishes Classification; and 
  4. A Presentation format. (i.e. balance sheet)
Target Financial Accounting starts with a target  - a common group of things, activities, or phenomena. In financial accounting, this target is business transactions - any exchange of resources or claims (to resources) or obligations (to provide resources) between separate and independent entities. 
Accountants, and their dedicated team-members, collect information about commercial activities, look for transactions, measure, and record them. By recording transactions, accountants classify them. Once classified, the information is compiled, usually by a software system, and periodically aggregated and reported as on financial statements. 
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Fiscal Year The accounting period is twelve months. This is called the company's fiscal year "FY". 
A fiscal year consists of between fifty-one and fifty-three weeks, depending on how fridays fall at the end of a particular quarter or fiscal year. 
A fiscal year is subdivided into four interim periods, i.e. "quarters." Large businesses report quarterly and then consolidate quarters into fiscal year reporting. Most small businesses prepare monthly reports. 
Information In order to appreciate an information system, it is important to understand that information is not knowledge, per se. Information is just well-organized data. Data is limited by the way it is collected and how it is measured and, in some cases, who measures it. 
Classification puts form on the substance - the facts - behind the data. Reported accounting numbers are not facts, rather they are interpretations of facts. Accountants are expected to keep the interpretation process consistent, objective, and relevant so that the results can be useful across companies and over time. 
Transactions and Costs Accountants first start with transactions and measure the costs, or evaluate the inflows, arising from transactions. 
Cost is perhaps the most important, most intriguing, and most debated concept in accounting. The treatment of costs is a serious process in accounting. Costs need to be classified, i.e. it is given a name to describe the nature of the amount exchanged. We pay costs to acquire things of value.
Elements of Accounting There are five core elements of accounting plus to adjunct elements. Classification literally means to label the cost as an element of accounting:
  1. Assets
  2. Liabilities
  3. Equity
  4. Revenue
  5. Expense
  6. Gain
  7. Loss
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Asset Resources that represent probable future benefits
Liabilities Highly-likely future sacrifice of resources
Equity The owner's net interest = Assets - Liabilities
Revenue Inflows from PRIMARY activities
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Expense Outflows from PRIMARY activities
Gain Inflows from ADJUNCT activities
Loss Outflows from ADJUNCT activities
Cost Cost is NEVER a liability. 

Costs represent either expenses or assets and sometimes you get to decide which. This is one of the joys of accounting.
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Stock Elements The stock elements are ASSETS, LIABILITIES, and EQUITY and their "book" value (not to be confused with market value) are reported "at" a point in time - at the end of each accounting period. Book value is a transaction value, minus any accounting charges, is sometimes called CARRYING VALUE because these values are carried "on the books." 
Flow Elements The flow elements are REVENUE, EXPENSES, GAINS, and LOSSES. 

Flows are reported "over" an accounting period - the fiscal year and interim quarters. 

The flow elements - revenues, expenses, gains, and losses - measure the inflows of cash or rights to cash and the outflows of cash or obligations for cash arising from commercial activities of a specific period of time. 
Stock Element Equation ASSETS = LIABILITIES + EQUITY

This equation constrains the accounting process. It reflects the notion that nothing is free. Everything that an entity owns - its assets - must have a source. And this is represented by the BALANCE SHEET. 

Assets are what a business owns. 

Liabilities and Equity are the sources of funds that made such ownership possible. 
Cost: An Asset or an Expense Because "cost" is not an element of accounting, costs must be classified as one of the elements of accounting. This classification process is where the interpretive nature of accounting begins. And, it is where opportunities for misunderstandings, if not outright deception, begin. A business will incur a cost only if it believes that this cost will help sales, otherwise, why waste money? 
Thus, costs must represent either: 
  1. EXPENSES - outflows from current revenue-generating activities, or 
  2. Assets - things that will be useful over many accounting periods.
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Costs (expenses) Ultimately, any and all costs must be associated with an accounting period as EXPENSES. 

Revenues must be "charged" with expenses when, whether or not successfully, those expenses can be matched with revenue-making activities. 
For example, if I take my client to lunch - incur a cost - in hopes of obtaining a consulting engagement, then my accountant would use the MATCHING PRINCIPLE (which guides expense recognition) to classify the cost of this lunch as an M&E expense.
M&E M&E stands or Meals & Entertainment expense. 
Fixed Assets Fixed Assets are buildings, equipment, furniture, fixtures, computers, cars, & trucks. We expect value from these things over more than one fiscal year, but not forever. 
Costs (assets) Costs for fixed assets help companies do business over more than one accounting period. So the costs of fixed assets are CAPITALIZED - recorded on the balance sheet as an asset - and a portion of these costs is reported as DEPRECIATION EXPENSE on the income statement. 
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Depreciation Depreciation is the transfer of a portion of the asset's costs from the balance sheet to the income statement where it is subtracted from revenues, just as if the company were renting those fixed assets. 
Depreciation Process THis process is based upon two accounting principles: (1) Cost principle requiring that the cost of an asset be reported on the balance sheet as its historical (original) cost; and the (2) Matching principle that requires that some of the asset's cost be allocated to amortization/depreciation expense over the useful commercial life of the asset. This means that a portion of the asset's cost is matched revenues earned by using the asset. For example, if the asset has an expected, useful life of five years, then an accountant would divide the cost by 5 so that 20 percent of the cost would be "expensed" in each of the next five years. This satisfies the matching principle. In addition, it illustrates the cost-recovery process, where managers expect sales' revenue to recover the costs of the assets purchased to make sales. 
Current Assets Current Asset Accounts
  • Cash
  • Receivables
  • Allowance for Bad Debt (Element = Contra-Asset)
  • Inventory
  • Pre-paid Expense
Fixed/Intangible Assets Fixed Asset Accounts
  • Plant, Property, & Equity
  • Accumulated Depreciation PP&E (Element = Contra-Asset)

Intangible Asset Accounts
  • Goodwill
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Current Liabilities Current Liability Accounts
  • Unearned Revenue/Advances 
  • Payables: Account & Trade
  • Accrued Expenses
  • Other Current Liabilities 
  • Notes Payables
  • Current Portion of LT Debt
Long-term Liabilities Long-term Liability Accounts
  • Loans ("IBD")
  • Mortgages
  • Bonds (sold)
  • Deferred Taxes
Equity Equity (Element) -- Piad-in-Capital (Type) -- Common Stock (Account)

Equity (Element) -- Repurchased (Type) -- Treasury Stocks (Account)

Equity (Element) -- Earned (Type) -- Retained Earnings (Account)
Recurring Revenue Recurring Revenue Accounts
  • Sales Revenue
  • Service Revenue
  • Interest Income 
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Direct Expenses Direct Expenses Account
  • Cost of Goods ("COGS")
  • Commissions 
SG&A Indirect Expenses SG&A Indirect Expense Accounts
  • Advertising 
  • Store Wages
  • Parking, Travel
  • Supplies & Cleaning
  • R & D
  • Postage, Telephone, Xerox
SG&A Periodic Expenses SG&A Periodic Expense Accounts
  • Store Rent
  • Depreciation
  • Office Rent
  • Office Salaries 
Cash The first account for all businesses is Cash. Cash is a unique asset and it plays several roles in commerce.
  1. Cash can be a COMMODITY. Retail companies need cash to make change.
  2. Cash is LIQUIDITY. Companies do things with it "right now." It is the primary, if not the only, means of making payments. 
  3. Cash is MONEY CAPITAL. It can be used to invest or to expand, to fund research & development, to exploit opportunities, or to embarrass rivals. 
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Only Cash is Cash! Only cash is cash! Accounting decisions can influence reported profits, but accounting decisions cannot produce cash. No amount of talk can replace the ability of cash to do a job ("Money walks while bullshit talks." It means that money takes action while other things talk of action.) 
However, cash alone is not necessarily a sign of business success. Thus, it is important to study cash flow - the sources and and uses of cash - and to contrast cash flow with reported profits. 
(Properly measured, accrual, reported profits are the best measure of business success, or lack of it.)
Cash Flow The sources and uses of cash.
Cash flow - especially cash flow from a company's daily operations - is a reality check on reported profits. 
Unfortunately, the highly stylized nature of the Statement of Cash Flows (the "SCF") is not as transparent as one might wish. (If something is transparent to the extent that its meaning and implications are obvious to the untrained mind, then why would someone pay another to explain it?)
Assets Assets are the things a business owns that offer probable future economic benefit. Only purchased assets are recorded on the balance sheet. This is because all accounting values originate from a transaction. Transactions give accounting values independence, objective values. 
Current Accounts The current accounts, except for cash, represent things that ought to become cash (current assets) or require cash (current liabilities) within the current accounting period, 90 days or less. 
In finance, we call current assets & liabilities the "working accounts." 
These accounts experience a multitude of transactions and represent the means by which day-to-day activities are recorded. 
All liabilities are claims on assets reflected (recorded) in terms on a piece of paper. 
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Long-lived Assets Long-lived assets include fixed, tangible things like buildings and equipment and intangible things like patents, trademarks, and copyrights. 
Intangible Assets GOODWILL is an intangible asset that reflects the value of a good location or a good reputation. 
Only purchased goodwill appears on the balance sheet. 
Long-term Liabilities Long-term liabilities are obligations that stretch-out beyond one year. 
This includes all forms of LONG-TERM DEBT (LTD) - LOANS, BONDS (sold to raise money), or MORTGAGES to finance PLANT, PROPERTY, & EQUIPMENT. 
Other long-term liabilities include PENSION OBLIGATIONS and DEFERRED TAXES. 
Equity Equity is the difference between ASSETS and LIABILITIES. This is just a rearrangement of the fundamental accounting equation. 
Assets - Liabilities = EQUITY

Assets are what the business OWNS and liabilities are what the business OWES to creditors. 
Thus, the difference is the investor's claim on assets. We say that the "NET WORTH" of a business is the difference between assets and liabilities. 
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Net Worth NET WORTH = NET BOOK VALUE = ASSETS - LIABILITIES = EQUITY

Two Types of Equity There are two primary types of equity:
  1. Paid-in-Capital; and 
  2. Retained Earnings.
Paid-in-Capital Paid-in-Capital ("PinK") consists of the proceeds from the sale of common stock plus any excess contributed by owners. 

Paid-in-Capital is synonymous with owner's money from the sale of stock. It represents a claim on the entity by its owners or benefactors. 
Retained Earnings Retained Earnings are the sum of all the profits earned by the business not distributed to investors as dividends. Profits NOT DISTRIBUTED to the owners "are retained" in the business. 
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Example of Intangible Asset IN-PROCESS R&D. 
IPR&D is an accumulation of specialized knowledge intended to result in a patent, copyright, trademark, or in the case of a student - a degree! 
For a student, IPR&D is his/her education, progress towards his/her Degree. Although no one knows, initially, how valuable the education will be, we have some well-founded guesses and that is why there is so much interest in getting an education. Educational IPR&D is also called HUMAN CAPITAL. It requires the payment of direct costs, involves some opportunity costs, and personal effort. 
Four Possible Sources of Money Four possible sources of Money:
  1. TRADE CREDIT
  2. INTEREST-BEARING DEBT
  3. PAID-IN-CAPITAL BY INVESTORS
  4. EARNINGS
Ex. For the typical student, most of his/her tangible assets are likely financed by his/her personal earnings. But the IPR&D (education) may be financed by a combination of interest-bearing debt (school loans) and family contributions. Debt is debt capital but family support is what we might call "investor's contributions" and record it as equity, maybe paid-in-capital ("PinK"). 
Assets, Liabilities, and Equity Assets                                                                        Liabilities and Equity
Cash                                                                               Unearned Revenue
Receivables                                                                                     Payables
Inventory                                                                          Accrued Expenses
Pre-paid Expenses                                                CURRENT LIABILITIES
CURRENT ASSETS
Tangible long-lived assets                                                                  Loans
(Accrued depreciation)                                                                        Bonds
Intangible assets                                                          Pension Obligations
TOTAL ASSETS                                                            TOTAL LIABILITIES 
                                                                                         Contributed Capital
                                                                                           Retained Earnings
                                                                TOTAL LIABILITIES AND EQUITY
Assumptions (4)
  1. The ENTITY Assumption
  2. The GOING CONCERN Assumption
  3. The MONETARY UNIT Assumption
  4. The PERIOD Assumption
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Entity Assumption A business is separate from its owners or other businesses. 

(A business is its own entity)
Going Concern Assumption The business will be in operation indefinitely. 

(A business may not always be in operation)
Monetary Unit Assumption Transactions will be quantified in nominal dollars, or other stable currency, unadjusted for inflation. 

(Transactions conducted in a respective currency)
Period Assumption Business activities will be reported over specific periods: one-year called the fiscal year and four INTERIM periods, or quarters of a year. A company's fiscal year ("FY") can start on the 1st day of any month and end on the 31st day the twelfth month later. 
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Principles (and Constraints) (8)
  1. The COST Principle
  2. The REALIZATION Principle
  3. The MATCHING Principle
  4. The DISCLOSURE Principle
  5. The OBJECTIVITY Principle
  6. The MATERIALITY Principle
  7. The CONSISTENCY Principle
  8. The Principle of CONSERVATISM
Cost Principle The business will report amounts based on acquisition costs, rather than at faire market value ("FMV"), with only selective exceptions. 

The cost principle ensures objectivity - eliminating potentially subjective values. However, this comes at a cost (no pun intended) because acquisition costs, as indicators of potential value, are not very relevant. In some cases, companies are allowed (or required) to use (in some cases) market values and/or (in other cases) fair market values.
Realization Principle (Sometimes called the Revenue Principle)

The business will report revenue only when realized, i.e. when activities related to selling goods or services are complete and cash collection is reasonably likely, not simply when cash is received. 


Matching Principle Expense should be "matched" with revenues. This provides a timely connection between sacrifices and rewards in order to facilitate an evaluation of profitability. 
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Disclosure Principle This principle recognizes that not all information relevant to financial decision-making is quantitative. Some important information is narrative. It also acknowledges that information is costly and therefore burdensome on businesses. 

Some transactions rely on contingencies, i.e. face uncertainties that might impact the company's financial performance or position. Disclosure policies complement quantitative reporting. A lawsuit filed, but pending, against a company is one example of a contingent liability that requires "disclosure." 
Objectivity Principle Reported information should be based on objective evidence. The results of actual transactions with other entities are the preferred basis for objectivity because it lends independence to the reporting process. 
Materiality Principle The significance of a reportable item determines how it will be reported. Thus, small transactions are usually aggregated and reported together. "Don't sweat the small stuff." 
Consistency Principle Business should apply the same accounting choices and methods year after year. 

(Methods for decision-making should be consistent)

Changes in accounting choices or methods require firms to restate past reports so that investors & creditors can more easily assess financial trends consistently. 
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Principle of Conservatism When making accounting choices or deciding on reporting methods, businesses should make these decisions based on understating the value of assets and income. 

This often conflicts with what business managers want to do.
The Conceptual World of Accounting Progressively selective process:

All Imaginable Accounting Practices

                     Generally Accepted Accounting Principles

                                             Reported Based on Accounting Choices
Departures Exceptions, exceptions, exceptions!

Adaption and change are necessary. Therefore, firms may depart from GAAP if following GAAP would be misleading. Departures must be "disclosed" and thorough explanations given. Departures should be rare. They usually follow new legislation or new ways of diong business. Departures may be justified by an unusual degree of materiality or conflicting industry practices. 
Financial Statements (4)
  1. BALANCE SHEET
  2. INCOME STATEMENT
  3. STATEMENT OF CASH FLOWS
  4. STATEMENT OF SHAREHOLDER'S EQUITY

These statements summarize the quantitative story of a company's profit-making activities, the sources, and uses of its cash, its resulting financial position, and how the owner's interest is divided. 
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Income Statement The income statement reports on the business' financial performance over a period of time. It illustrates the difference between inflows and outflows over a period of time, for example: 
INFLOWS: Revenues and Gains
minus
OUTFLOWS: Expenses and Losses
= NET INCOME, which we call "Profits"
Revenues are "inflows" from primary activities and gains are "inflows" from adjunct activities. 
The income statement begins anew with each reporting period, unlike the balance sheet which carries cumulative values forward from period to period. 
Some companies, banks for example, earn money from creating loans - a primary activity for a bank - and from renting office sapce - an adjunct activity for a bank. Expenses are "outflows" from primary activities, while losses are "outflows" from adjunct activities. 
Non-Operating and Non-Recurring Activities The commercial environment can be hostile. There are a number of unexpected things that might happen on the way to making a profit (or not). Most business events are recurring, but some are not. Non-recurring events are infrequent, unusual, or both. 
What qualifies as infrequent or unusual? What qualifies as both infrequent and unusual? These are questions discussed between a company's managers and its auditors. Gains or losses that are EITHER infrequent or unusual are reported below operating income but above income from continuing operations. Gains or losses that are BOTH infrequent and unusual are considered "extraordinary" and will be reported below income from continuing operations but above net income. 
Levels of Profit Sales minus direct expenses, i.e. "COGS" or "COS" = GROSS PROFIT
  1. GROSS PROFIT
  2. EBITDAR
  3. EBITDA
  4. EBIT
  5. EBT (Pre-Tax Earnings)
  6. INCOME FROM CONTINUING OPERATIONS
  7. NET INCOME
Gross Profit Sales Revenue - less "SG&A" or "G&A" expenses excluding depreciation expense.
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EBITDAR Earnings before Interest, Taxes, Depreciation, Amortization, and RENT
(Motivated to get the biggest number possible at some level of income, clever managers have created additional measures in income such as EBITDAR. The R stands for Rent)
EBITDA Earnings before Interest, Taxes, Depreciation, and Amortization.
EBIT Earnings before Interest and Taxes. It is EBITDA minus Depreciation and Amortization.

A common name for EBIT is operating income. Notice that EBIT is earnings "before" interest expense. This means that EBIT measures the net results of the earnings process before subtracting costs related to financing the company's interest-bearing-debt (IBD). 
EBT (Pre-tax Earnings) Earnings before Taxes. It is EBIT minus Interest - also known as Pre-tax earnings.
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Income from Continuing Operations This is net income before any Extraordinary items. 
Net Income The bottom line. 
Expenses Expesnses are aggregated into a single line, including Costs-of-Goods Sold (COGS), Sales General & Administrative expenses (SG&A), Depreciation expense, and Interest expense. 
Types of Expenses
  1. DIRECT
  2. PERIODIC
  3. INDIRECT
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Direct Expenses Those costs that are directly associated with revenue, such as: Cost-of-Goods Sold, Sales Commissions, Shipping.
Periodic Expenses Costs that are billed by time period, regardless of the level of revenue, for example: Rent, Salaries, Insurance premiums, and Interest expense.
Indirect Expenses Those costs required to carry-out the sales process but that are neither directly related to sales nor periodic, for example: the costs of utilities, telephone, travel, advertising, training, supplies. 
Operating Expenses Operating expenses are related to selling things. 
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Financing Expenses Financing expenses are related to how the company is capitalized - its use of debt versus equity - and interest expense is a financing expense. 
The Accounting Process The accounting process starts with the assembly of documentation of a business' transactions with outsiders. Much of this documentation will be:
  • invoices (or cash register tapes) with customers
  • Requisitions for supplies
  • Payroll records for employees, etc.
T-Accounts We start with accounts, often referred to as T-Accounts. The T-Account is a recording device for calculating the net change in an item from the Chart of Accounts. There are permanent and temporary accounts. Permanent accounts are associated with the Balance Sheet and carry-over balances from period-to-period. Temporary accounts exist only during the accounting period and ending balances are transferred to a permanent account at the end of the accounting period. Thus, temporary T-accounts start anew each accounting period. 
The Accounts Permanent Accounts (all stock-type elements)
ASSETS: Cash, Inventory, PP&E, etc.
LIABILITIES: Payables, Accruals, etc.
EQUITY: Paid-in-Capital, Retained Earnings, etc.
Temporary Accounts (all flow-type elements)
REVENUE: Sales
EXPENSES: COGS, Advertising, Rent, Utilities, Wages, Interest, etc.
GAINS: Proceeds from the dispositions of assets.
LOSSES: Costs of the disposition of assets or costs of unusual events - unrelated to the primary business purpose.
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Debits and Credits
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 AccountingAccounting is a formal way of keeping track of cash and other things that business firms need and use and how to measure the profits that businesses make or not.
 GAAPGAAP (Generally Accepted Accounting Principles) is the collection of principles-based rules that give business managers formal guidance about:
  • How to measure commercial things of value (called assets), claims to (and obligations for) cash, and an owner or shareholder's interest (called equity). 
  • When to report the results of commercial activities; and 
  • How to report, i.e. "what labels" to put on business transactions. 
 An Information SystemFinancial Accounting is a highly stylized information system. Information systems generally consist of four fundamental processes: 
  1. A Collection process; 
  2. Measurement standards; 
  3. A Taxonomy which establishes Classification; and 
  4. A Presentation format. (i.e. balance sheet)
 TargetFinancial Accounting starts with a target  - a common group of things, activities, or phenomena. In financial accounting, this target is business transactions - any exchange of resources or claims (to resources) or obligations (to provide resources) between separate and independent entities. 
Accountants, and their dedicated team-members, collect information about commercial activities, look for transactions, measure, and record them. By recording transactions, accountants classify them. Once classified, the information is compiled, usually by a software system, and periodically aggregated and reported as on financial statements. 
 Fiscal YearThe accounting period is twelve months. This is called the company's fiscal year "FY". 
A fiscal year consists of between fifty-one and fifty-three weeks, depending on how fridays fall at the end of a particular quarter or fiscal year. 
A fiscal year is subdivided into four interim periods, i.e. "quarters." Large businesses report quarterly and then consolidate quarters into fiscal year reporting. Most small businesses prepare monthly reports. 
 InformationIn order to appreciate an information system, it is important to understand that information is not knowledge, per se. Information is just well-organized data. Data is limited by the way it is collected and how it is measured and, in some cases, who measures it. 
Classification puts form on the substance - the facts - behind the data. Reported accounting numbers are not facts, rather they are interpretations of facts. Accountants are expected to keep the interpretation process consistent, objective, and relevant so that the results can be useful across companies and over time. 
 Transactions and CostsAccountants first start with transactions and measure the costs, or evaluate the inflows, arising from transactions. 
Cost is perhaps the most important, most intriguing, and most debated concept in accounting. The treatment of costs is a serious process in accounting. Costs need to be classified, i.e. it is given a name to describe the nature of the amount exchanged. We pay costs to acquire things of value.
 Elements of AccountingThere are five core elements of accounting plus to adjunct elements. Classification literally means to label the cost as an element of accounting:
  1. Assets
  2. Liabilities
  3. Equity
  4. Revenue
  5. Expense
  6. Gain
  7. Loss
 AssetResources that represent probable future benefits
 LiabilitiesHighly-likely future sacrifice of resources
 EquityThe owner's net interest = Assets - Liabilities
 RevenueInflows from PRIMARY activities
 ExpenseOutflows from PRIMARY activities
 GainInflows from ADJUNCT activities
 LossOutflows from ADJUNCT activities
 CostCost is NEVER a liability. 

Costs represent either expenses or assets and sometimes you get to decide which. This is one of the joys of accounting.
 Stock ElementsThe stock elements are ASSETS, LIABILITIES, and EQUITY and their "book" value (not to be confused with market value) are reported "at" a point in time - at the end of each accounting period. Book value is a transaction value, minus any accounting charges, is sometimes called CARRYING VALUE because these values are carried "on the books." 
 Flow ElementsThe flow elements are REVENUE, EXPENSES, GAINS, and LOSSES. 

Flows are reported "over" an accounting period - the fiscal year and interim quarters. 

The flow elements - revenues, expenses, gains, and losses - measure the inflows of cash or rights to cash and the outflows of cash or obligations for cash arising from commercial activities of a specific period of time. 
 Stock Element EquationASSETS = LIABILITIES + EQUITY

This equation constrains the accounting process. It reflects the notion that nothing is free. Everything that an entity owns - its assets - must have a source. And this is represented by the BALANCE SHEET. 

Assets are what a business owns. 

Liabilities and Equity are the sources of funds that made such ownership possible. 
 Cost: An Asset or an ExpenseBecause "cost" is not an element of accounting, costs must be classified as one of the elements of accounting. This classification process is where the interpretive nature of accounting begins. And, it is where opportunities for misunderstandings, if not outright deception, begin. A business will incur a cost only if it believes that this cost will help sales, otherwise, why waste money? 
Thus, costs must represent either: 
  1. EXPENSES - outflows from current revenue-generating activities, or 
  2. Assets - things that will be useful over many accounting periods.
 Costs (expenses)Ultimately, any and all costs must be associated with an accounting period as EXPENSES. 

Revenues must be "charged" with expenses when, whether or not successfully, those expenses can be matched with revenue-making activities. 
For example, if I take my client to lunch - incur a cost - in hopes of obtaining a consulting engagement, then my accountant would use the MATCHING PRINCIPLE (which guides expense recognition) to classify the cost of this lunch as an M&E expense.
 M&EM&E stands or Meals & Entertainment expense. 
 Fixed AssetsFixed Assets are buildings, equipment, furniture, fixtures, computers, cars, & trucks. We expect value from these things over more than one fiscal year, but not forever. 
 Costs (assets)Costs for fixed assets help companies do business over more than one accounting period. So the costs of fixed assets are CAPITALIZED - recorded on the balance sheet as an asset - and a portion of these costs is reported as DEPRECIATION EXPENSE on the income statement. 
 DepreciationDepreciation is the transfer of a portion of the asset's costs from the balance sheet to the income statement where it is subtracted from revenues, just as if the company were renting those fixed assets. 
 Depreciation ProcessTHis process is based upon two accounting principles: (1) Cost principle requiring that the cost of an asset be reported on the balance sheet as its historical (original) cost; and the (2) Matching principle that requires that some of the asset's cost be allocated to amortization/depreciation expense over the useful commercial life of the asset. This means that a portion of the asset's cost is matched revenues earned by using the asset. For example, if the asset has an expected, useful life of five years, then an accountant would divide the cost by 5 so that 20 percent of the cost would be "expensed" in each of the next five years. This satisfies the matching principle. In addition, it illustrates the cost-recovery process, where managers expect sales' revenue to recover the costs of the assets purchased to make sales. 
 Current AssetsCurrent Asset Accounts
  • Cash
  • Receivables
  • Allowance for Bad Debt (Element = Contra-Asset)
  • Inventory
  • Pre-paid Expense
 Fixed/Intangible AssetsFixed Asset Accounts
  • Plant, Property, & Equity
  • Accumulated Depreciation PP&E (Element = Contra-Asset)

Intangible Asset Accounts
  • Goodwill
 Current Liabilities Current Liability Accounts
  • Unearned Revenue/Advances 
  • Payables: Account & Trade
  • Accrued Expenses
  • Other Current Liabilities 
  • Notes Payables
  • Current Portion of LT Debt
 Long-term LiabilitiesLong-term Liability Accounts
  • Loans ("IBD")
  • Mortgages
  • Bonds (sold)
  • Deferred Taxes
 Equity Equity (Element) -- Piad-in-Capital (Type) -- Common Stock (Account)

Equity (Element) -- Repurchased (Type) -- Treasury Stocks (Account)

Equity (Element) -- Earned (Type) -- Retained Earnings (Account)
 Recurring RevenueRecurring Revenue Accounts
  • Sales Revenue
  • Service Revenue
  • Interest Income 
 Direct ExpensesDirect Expenses Account
  • Cost of Goods ("COGS")
  • Commissions 
 SG&A Indirect ExpensesSG&A Indirect Expense Accounts
  • Advertising 
  • Store Wages
  • Parking, Travel
  • Supplies & Cleaning
  • R & D
  • Postage, Telephone, Xerox
 SG&A Periodic ExpensesSG&A Periodic Expense Accounts
  • Store Rent
  • Depreciation
  • Office Rent
  • Office Salaries 
 CashThe first account for all businesses is Cash. Cash is a unique asset and it plays several roles in commerce.
  1. Cash can be a COMMODITY. Retail companies need cash to make change.
  2. Cash is LIQUIDITY. Companies do things with it "right now." It is the primary, if not the only, means of making payments. 
  3. Cash is MONEY CAPITAL. It can be used to invest or to expand, to fund research & development, to exploit opportunities, or to embarrass rivals. 
 Only Cash is Cash!Only cash is cash! Accounting decisions can influence reported profits, but accounting decisions cannot produce cash. No amount of talk can replace the ability of cash to do a job ("Money walks while bullshit talks." It means that money takes action while other things talk of action.) 
However, cash alone is not necessarily a sign of business success. Thus, it is important to study cash flow - the sources and and uses of cash - and to contrast cash flow with reported profits. 
(Properly measured, accrual, reported profits are the best measure of business success, or lack of it.)
 Cash FlowThe sources and uses of cash.
Cash flow - especially cash flow from a company's daily operations - is a reality check on reported profits. 
Unfortunately, the highly stylized nature of the Statement of Cash Flows (the "SCF") is not as transparent as one might wish. (If something is transparent to the extent that its meaning and implications are obvious to the untrained mind, then why would someone pay another to explain it?)
 AssetsAssets are the things a business owns that offer probable future economic benefit. Only purchased assets are recorded on the balance sheet. This is because all accounting values originate from a transaction. Transactions give accounting values independence, objective values. 
 Current AccountsThe current accounts, except for cash, represent things that ought to become cash (current assets) or require cash (current liabilities) within the current accounting period, 90 days or less. 
In finance, we call current assets & liabilities the "working accounts." 
These accounts experience a multitude of transactions and represent the means by which day-to-day activities are recorded. 
All liabilities are claims on assets reflected (recorded) in terms on a piece of paper. 
 Long-lived AssetsLong-lived assets include fixed, tangible things like buildings and equipment and intangible things like patents, trademarks, and copyrights. 
 Intangible AssetsGOODWILL is an intangible asset that reflects the value of a good location or a good reputation. 
Only purchased goodwill appears on the balance sheet. 
 Long-term LiabilitiesLong-term liabilities are obligations that stretch-out beyond one year. 
This includes all forms of LONG-TERM DEBT (LTD) - LOANS, BONDS (sold to raise money), or MORTGAGES to finance PLANT, PROPERTY, & EQUIPMENT. 
Other long-term liabilities include PENSION OBLIGATIONS and DEFERRED TAXES. 
 EquityEquity is the difference between ASSETS and LIABILITIES. This is just a rearrangement of the fundamental accounting equation. 
Assets - Liabilities = EQUITY

Assets are what the business OWNS and liabilities are what the business OWES to creditors. 
Thus, the difference is the investor's claim on assets. We say that the "NET WORTH" of a business is the difference between assets and liabilities. 
 Net WorthNET WORTH = NET BOOK VALUE = ASSETS - LIABILITIES = EQUITY

 Two Types of EquityThere are two primary types of equity:
  1. Paid-in-Capital; and 
  2. Retained Earnings.
 Paid-in-CapitalPaid-in-Capital ("PinK") consists of the proceeds from the sale of common stock plus any excess contributed by owners. 

Paid-in-Capital is synonymous with owner's money from the sale of stock. It represents a claim on the entity by its owners or benefactors. 
 Retained EarningsRetained Earnings are the sum of all the profits earned by the business not distributed to investors as dividends. Profits NOT DISTRIBUTED to the owners "are retained" in the business. 
 Example of Intangible AssetIN-PROCESS R&D. 
IPR&D is an accumulation of specialized knowledge intended to result in a patent, copyright, trademark, or in the case of a student - a degree! 
For a student, IPR&D is his/her education, progress towards his/her Degree. Although no one knows, initially, how valuable the education will be, we have some well-founded guesses and that is why there is so much interest in getting an education. Educational IPR&D is also called HUMAN CAPITAL. It requires the payment of direct costs, involves some opportunity costs, and personal effort. 
 Four Possible Sources of MoneyFour possible sources of Money:
  1. TRADE CREDIT
  2. INTEREST-BEARING DEBT
  3. PAID-IN-CAPITAL BY INVESTORS
  4. EARNINGS
Ex. For the typical student, most of his/her tangible assets are likely financed by his/her personal earnings. But the IPR&D (education) may be financed by a combination of interest-bearing debt (school loans) and family contributions. Debt is debt capital but family support is what we might call "investor's contributions" and record it as equity, maybe paid-in-capital ("PinK"). 
 Assets, Liabilities, and EquityAssets                                                                        Liabilities and Equity
Cash                                                                               Unearned Revenue
Receivables                                                                                     Payables
Inventory                                                                          Accrued Expenses
Pre-paid Expenses                                                CURRENT LIABILITIES
CURRENT ASSETS
Tangible long-lived assets                                                                  Loans
(Accrued depreciation)                                                                        Bonds
Intangible assets                                                          Pension Obligations
TOTAL ASSETS                                                            TOTAL LIABILITIES 
                                                                                         Contributed Capital
                                                                                           Retained Earnings
                                                                TOTAL LIABILITIES AND EQUITY
 Assumptions (4)
  1. The ENTITY Assumption
  2. The GOING CONCERN Assumption
  3. The MONETARY UNIT Assumption
  4. The PERIOD Assumption
 Entity AssumptionA business is separate from its owners or other businesses. 

(A business is its own entity)
 Going Concern AssumptionThe business will be in operation indefinitely. 

(A business may not always be in operation)
 Monetary Unit AssumptionTransactions will be quantified in nominal dollars, or other stable currency, unadjusted for inflation. 

(Transactions conducted in a respective currency)
 Period AssumptionBusiness activities will be reported over specific periods: one-year called the fiscal year and four INTERIM periods, or quarters of a year. A company's fiscal year ("FY") can start on the 1st day of any month and end on the 31st day the twelfth month later. 
 Principles (and Constraints) (8)
  1. The COST Principle
  2. The REALIZATION Principle
  3. The MATCHING Principle
  4. The DISCLOSURE Principle
  5. The OBJECTIVITY Principle
  6. The MATERIALITY Principle
  7. The CONSISTENCY Principle
  8. The Principle of CONSERVATISM
 Cost PrincipleThe business will report amounts based on acquisition costs, rather than at faire market value ("FMV"), with only selective exceptions. 

The cost principle ensures objectivity - eliminating potentially subjective values. However, this comes at a cost (no pun intended) because acquisition costs, as indicators of potential value, are not very relevant. In some cases, companies are allowed (or required) to use (in some cases) market values and/or (in other cases) fair market values.
 Realization Principle(Sometimes called the Revenue Principle)

The business will report revenue only when realized, i.e. when activities related to selling goods or services are complete and cash collection is reasonably likely, not simply when cash is received. 


 Matching PrincipleExpense should be "matched" with revenues. This provides a timely connection between sacrifices and rewards in order to facilitate an evaluation of profitability. 
 Disclosure PrincipleThis principle recognizes that not all information relevant to financial decision-making is quantitative. Some important information is narrative. It also acknowledges that information is costly and therefore burdensome on businesses. 

Some transactions rely on contingencies, i.e. face uncertainties that might impact the company's financial performance or position. Disclosure policies complement quantitative reporting. A lawsuit filed, but pending, against a company is one example of a contingent liability that requires "disclosure." 
 Objectivity PrincipleReported information should be based on objective evidence. The results of actual transactions with other entities are the preferred basis for objectivity because it lends independence to the reporting process. 
 Materiality PrincipleThe significance of a reportable item determines how it will be reported. Thus, small transactions are usually aggregated and reported together. "Don't sweat the small stuff." 
 Consistency PrincipleBusiness should apply the same accounting choices and methods year after year. 

(Methods for decision-making should be consistent)

Changes in accounting choices or methods require firms to restate past reports so that investors & creditors can more easily assess financial trends consistently. 
 Principle of ConservatismWhen making accounting choices or deciding on reporting methods, businesses should make these decisions based on understating the value of assets and income. 

This often conflicts with what business managers want to do.
 The Conceptual World of AccountingProgressively selective process:

All Imaginable Accounting Practices

                     Generally Accepted Accounting Principles

                                             Reported Based on Accounting Choices
 DeparturesExceptions, exceptions, exceptions!

Adaption and change are necessary. Therefore, firms may depart from GAAP if following GAAP would be misleading. Departures must be "disclosed" and thorough explanations given. Departures should be rare. They usually follow new legislation or new ways of diong business. Departures may be justified by an unusual degree of materiality or conflicting industry practices. 
 Financial Statements (4)
  1. BALANCE SHEET
  2. INCOME STATEMENT
  3. STATEMENT OF CASH FLOWS
  4. STATEMENT OF SHAREHOLDER'S EQUITY

These statements summarize the quantitative story of a company's profit-making activities, the sources, and uses of its cash, its resulting financial position, and how the owner's interest is divided. 
 Income StatementThe income statement reports on the business' financial performance over a period of time. It illustrates the difference between inflows and outflows over a period of time, for example: 
INFLOWS: Revenues and Gains
minus
OUTFLOWS: Expenses and Losses
= NET INCOME, which we call "Profits"
Revenues are "inflows" from primary activities and gains are "inflows" from adjunct activities. 
The income statement begins anew with each reporting period, unlike the balance sheet which carries cumulative values forward from period to period. 
Some companies, banks for example, earn money from creating loans - a primary activity for a bank - and from renting office sapce - an adjunct activity for a bank. Expenses are "outflows" from primary activities, while losses are "outflows" from adjunct activities. 
 Non-Operating and Non-Recurring ActivitiesThe commercial environment can be hostile. There are a number of unexpected things that might happen on the way to making a profit (or not). Most business events are recurring, but some are not. Non-recurring events are infrequent, unusual, or both. 
What qualifies as infrequent or unusual? What qualifies as both infrequent and unusual? These are questions discussed between a company's managers and its auditors. Gains or losses that are EITHER infrequent or unusual are reported below operating income but above income from continuing operations. Gains or losses that are BOTH infrequent and unusual are considered "extraordinary" and will be reported below income from continuing operations but above net income. 
 Levels of ProfitSales minus direct expenses, i.e. "COGS" or "COS" = GROSS PROFIT
  1. GROSS PROFIT
  2. EBITDAR
  3. EBITDA
  4. EBIT
  5. EBT (Pre-Tax Earnings)
  6. INCOME FROM CONTINUING OPERATIONS
  7. NET INCOME
 Gross ProfitSales Revenue - less "SG&A" or "G&A" expenses excluding depreciation expense.
 EBITDAREarnings before Interest, Taxes, Depreciation, Amortization, and RENT
(Motivated to get the biggest number possible at some level of income, clever managers have created additional measures in income such as EBITDAR. The R stands for Rent)
 EBITDAEarnings before Interest, Taxes, Depreciation, and Amortization.
 EBITEarnings before Interest and Taxes. It is EBITDA minus Depreciation and Amortization.

A common name for EBIT is operating income. Notice that EBIT is earnings "before" interest expense. This means that EBIT measures the net results of the earnings process before subtracting costs related to financing the company's interest-bearing-debt (IBD). 
 EBT (Pre-tax Earnings)Earnings before Taxes. It is EBIT minus Interest - also known as Pre-tax earnings.
 Income from Continuing OperationsThis is net income before any Extraordinary items. 
 Net IncomeThe bottom line. 
 ExpensesExpesnses are aggregated into a single line, including Costs-of-Goods Sold (COGS), Sales General & Administrative expenses (SG&A), Depreciation expense, and Interest expense. 
 Types of Expenses
  1. DIRECT
  2. PERIODIC
  3. INDIRECT
 Direct ExpensesThose costs that are directly associated with revenue, such as: Cost-of-Goods Sold, Sales Commissions, Shipping.
 Periodic ExpensesCosts that are billed by time period, regardless of the level of revenue, for example: Rent, Salaries, Insurance premiums, and Interest expense.
 Indirect ExpensesThose costs required to carry-out the sales process but that are neither directly related to sales nor periodic, for example: the costs of utilities, telephone, travel, advertising, training, supplies. 
 Operating ExpensesOperating expenses are related to selling things. 
 Financing ExpensesFinancing expenses are related to how the company is capitalized - its use of debt versus equity - and interest expense is a financing expense. 
 The Accounting ProcessThe accounting process starts with the assembly of documentation of a business' transactions with outsiders. Much of this documentation will be:
  • invoices (or cash register tapes) with customers
  • Requisitions for supplies
  • Payroll records for employees, etc.
 T-AccountsWe start with accounts, often referred to as T-Accounts. The T-Account is a recording device for calculating the net change in an item from the Chart of Accounts. There are permanent and temporary accounts. Permanent accounts are associated with the Balance Sheet and carry-over balances from period-to-period. Temporary accounts exist only during the accounting period and ending balances are transferred to a permanent account at the end of the accounting period. Thus, temporary T-accounts start anew each accounting period. 
 The AccountsPermanent Accounts (all stock-type elements)
ASSETS: Cash, Inventory, PP&E, etc.
LIABILITIES: Payables, Accruals, etc.
EQUITY: Paid-in-Capital, Retained Earnings, etc.
Temporary Accounts (all flow-type elements)
REVENUE: Sales
EXPENSES: COGS, Advertising, Rent, Utilities, Wages, Interest, etc.
GAINS: Proceeds from the dispositions of assets.
LOSSES: Costs of the disposition of assets or costs of unusual events - unrelated to the primary business purpose.
 Debits and Credits 
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