Financial Accounting Basics: The income statement Gapenski Chapter 3

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Financial Accounting BasicsThe income
statement(Gapenski Chapter 3)

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Accounting and social development

• Ancient record keeping
• Double entry BK emerges with Luca Paciolos
  Summa 14th C. Italy initially a trade secret.
• What had to be in place for modern accounting to
  emerge (A. C. Littleton)
• Private Property Capital Money
• Commerce Credit Writing
• Arithmetic

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Accounting changes little.

• Many of Paciolos concepts persist to today
  memorandum, journal, ledger with debits and
  credits.
• Key components of financial statements income
  statement balance sheet, statement of cash flows
• Information system for many interests.

Reliable accounts are critical to modern
businessask anyone who used to work for Enron
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Who uses financial statements?

• Public vs. closely-held corporations
• Shareholders (investors) vs. stakeholders
  (creditors, venture partners, directors, etc.)
• Potential investors or their reps
• Government reporting and tax filing
• Transparent business many non-profits report
• Financial reports vs. tax books
• Donors and potential donors/ funders

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A common language is needed

• Generally Accepted Accounting Principles (GAAP)
  common definitions, reporting conventions, and
  principles.
• The SEC has statutory authority re financial
  statements but farms out responsibility to the
  Financial Accounting Standards Board (FASB) to
  set rules for private business reporting.
• FASB tends to move at glacial speed.

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FASB guidance framework

• Statements of financial accounting concepts (7
  since 1978, last in 2000)
• Statements of financial accounting standards
  (more detailed -- 154 to date)
• Interpretations and technical bulletins many
  more

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FASB sets general rules

• Issues broad statements or opinions
• Many issues are industry-specific, e.g. oil and
  gas accounting, and health care.
• The American Institute of Certified Public
  Accountants (AICPA) industry committees provide
  detailed guidance on preparing/ auditing
  financial statements.
• Other groups (e.g., Healthcare Financial
  Management Assoc.) have less heft.

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Public Accountancya profession

• Many people get accounting degrees but never
  become licensed as a CPA.
• Internal vs. public accounting
• Each state establishes licensure rules exams
  required experience and what public services
  require a license.
• Continuing ed requirements
• Ethical standards
• Functions accounting, audit, attest

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Accounting entity/ accounting period

• Separates the business from its investors
  establishes what is in/out of statements
• When are accounts consolidated?

• The going concern assumption financial
  statements not unduly influenced by short-term
  perturbations
• Most firms use months/ quarters/ years
• Fiscal years may start any month (e.g. federal
  government).

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Some key accounting concepts

• Objectivity documentation of events
• Reliability correct representation users can
  depend on it reproducible
• Full disclosure no hiding of assets or events
• Materiality avoid obfuscation what is
  material to Dr. Jones practice is likely not
  material to Methodist Hospital

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The Three Cs

• Conservatism if alternative accounting
  interpretations yield different results pick the
  one that is less likely to overstate the entitys
  financial status
• Consistency apply the same guidelines over
  time disclose any change, e.g. a change in
  inventory basis
• Comparability apply approaches common to the
  sector, e.g., hospitals use terminology and
  definitions

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Cash vs. accrual accounting

• Cash accounting revenues and expenses apply to
  the period in which the cash comes in/ goes out.
• Small, non-reporting entities often use cash
  accounting.
• Accrual accounting, required for reporting
  entities, revenue is recognized on purchaser
  payment obligation an expense is recognized when
  the business incurs a payment obligation better
  matching.
• Matching principle report revenues with their
  accompanying expenses even if expenses must be
  estimated (as in capitation.)

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Depreciation

• Fixed assets decay in value over time (i.e. they
  depreciate). Some faster than others computers
  vs. buildings.
• Depreciation expense represents the financial
  assessment of that loss.
• The matching principle requires that depreciation
  be recognized as a cost.
• Depreciation is a non-cash item on the income
  statement.

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Debits and credits

• Accounting data is compiled in accounts through
  double entry into a journal
• Debit and credit are conventions meaning
  left and right in the T-accounts that
  represent the transaction.
• For every debit there must be an equal credit
  to keep the books balanced.
• Income statement accounts are revenues and
  expenses balance sheet accounts are assets,
  liabilities, and equities.

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Handy crib sheet
Source www.ivey.uwo.ca
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What constitutes revenue?

• Revenues are generated by delivering goods/
  services that create a purchaser obligation to
  pay.
• Revenues are not generated
• When initial investors contribute assets
• When stockholder shares are newly placed in the
  market
• When stockholder shares gain value in the market
• When receivables are collected
• When held assets gain market value

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Income statement defined

• The income statement answers the basic question
  how much profit was made in a given time period?
• Profit or net income is
• Net income revenue expenses
• Even non-profits have profits in this sense!
• Economists call this type of measure a flow
  and the Balance Sheet, measured at a moment in
  time, a stock.

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Net income vs. cash flow

• Net income is nice, but cash is king.
• Approximate cash flow
• cash flow net income non-cash expense
• What is usually the largest non-cash expense?

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Assignment for next class

• Read Gapenski Ch. 3 Financial Acct. Basics and
  the Income Statement
• Do problems 3.2, 3.3, 3.4, 3.5, 3.6
• Anthony Text and workbook
• Part 1, 2, and 3