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Chapter One FAB

This chapter introduces key concepts in financial accounting including what accounting is, its role in business, and its users. Accounting measures and communicates financial information about a company. It provides information to internal managers and external investors and creditors to help with decision making. The chapter distinguishes between financial accounting, which follows regulations and reports historical data externally, and managerial accounting, which provides more detailed internal reports for managers. It defines the accounting equation that balances a company's assets with its liabilities and owners' equity.

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0% found this document useful (0 votes)
48 views63 pages

Chapter One FAB

This chapter introduces key concepts in financial accounting including what accounting is, its role in business, and its users. Accounting measures and communicates financial information about a company. It provides information to internal managers and external investors and creditors to help with decision making. The chapter distinguishes between financial accounting, which follows regulations and reports historical data externally, and managerial accounting, which provides more detailed internal reports for managers. It defines the accounting equation that balances a company's assets with its liabilities and owners' equity.

Uploaded by

Kirubel Solomon
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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Financial and Managerial

Accounting (MBA 521)

Chapter One
Financial Accounting Basics
Instructor: Habtamu B. Abera [PhD]
Learning Objectives
• After studying this chapter, you should be able to:
– Explain what accounting is and describe its role in making
informed decisions
– Identify the users and uses of accounting
– Identify business goals and activities
– Explain, briefly, the difference between Financial
Accounting and Managerial Accounting
– Define financial position and the accounting equation
– Identify the four basic financial statements
Accounting as an information system

• Accounting is an information system that measures,


processes, and communicates financial information
about an economic entity.

• What is an economic entity?

• Accounting is a link between business activities and


decision makers.
– Accounting measures economic or business activities by
recording data about them for future use
– The data are stored until needed and then processed to
become useful information
– The information is communicated through reports to decision
makers.
The
accounting
process

Accounting “links”
Economic decision makers Accounting
or Business with economic
information
activities activities  and
with the results of
their decisions.

Actions
Reports
(decisions) Decision Results of
makers Actions
(decisions)
Users and Uses of Accounting Information

Internal Users
Researchers
Management
Human Investors
Resources
There are two broad groups
Labor
of users of financial Unions
Finance information: internal users
and external users.
Creditors
Marketing

Customers AABE
External
Users
Users and Uses of Accounting Information

Primary
Users
Uses and Users of Accounting Information
Common Questions Asked User

1. Can we afford to give our


employees a pay raise?
Human Resources

2. Did the company earn a


satisfactory income?
Investors

3. Should any product lines be


eliminated?
Management
4. Is cash sufficient to pay dividends
to stockholders?
Finance

5. What price for our product will


maximize net income?
Marketing

6. Will the company be able to pay


its debts as they become due?
Trade Creditors
LO 2
Exercise
• What does the term ‘accounting’ mean?
a) The act of reporting
b) The act of collecting, organizing, and interpreting
financial data
c) The act of filing receipts from transactions
d) The act of recording financial data to be used later
e) The act of writing checks in a check register
Exercise
• Why is accounting important to business?
a) It lets a business owner know how much money
s/he is making
b) It lets a business owner know how much money
s/he spending.
c) It provides the information that a business needs to
file taxes with ERCA
d) It lets a business owner know what her/his assets
are worth
e) All of the answers are correct
Accounting Information System

Financial information provided


Information Decision
Users Supported
Cost & Revenue Determination
 Job costing  CVP analysis
 Managers  Process costing  Performance
 Investors  ABC evaluation
 Creditors  Sales  Ratio analysis
 Owners Assets, Liabilities & Equity  Incremental analysis
 Customers
 Cash, Receivables, inventory  Budgeting
 Employees
 Plant, Property and equipment  Capital allocation
 Regulatory
agencies  ST Payables, Loans &
 General  Equity
Public Cash Flows
 From operations
 From financing
 From investing
Business Goals and Activities
• A business is an economic entity that aims to sell goods and
services to customers at prices that will provide an adequate
return to its owners.
• E.g. You name three businesses /entities you know! [1 min.]
• Do you think all the businesses /entities you named have similar
goals and activities? Y or N , Why? [1 min]
• Despite their differences, all businesses have similar goals and
engage in similar activities.
• Business Goals:
– Profitability
– Liquidity
• Business Activities:
– Operating
– Investing
– Financing
Exercise
 Which of these transactions would not be an example of the
operating activities?
a) credit purchase of inventory
b) sales of product, for cash
c) cash paid for purchase of equipment
d) salary payments to employees

 Which of these transactions would be part of the financing


activities?
a) Land purchased for cash
b) cash paid as a repayment of bank loan
c) sales of product, on account
d) dividend payments to shareholders, paid in cash
Financial Accounting Vs Managerial Accounting
• Financial Accounting:
– The day-to-day processing of an organisation’s
financial transactions and the summarising of
those transactions to satisfy the information needs
of the primary and other user groups shown
previously.
– It is sometimes referred to as meeting the external
accounting needs of the organisation.
– Subject to many rules and regulations (a
regulatory framework) imposed by company
legislation, stock exchange regulations and
financial reporting standards.
Financial Accounting Vs Managerial Accounting
• Managerial Accounting:
– Sometimes referred to as meeting the internal
accounting needs of the organisation, as it is
designed to help managers with decision-making
and planning.
– Unlike financial accounting, it often involves
estimates and forecasts.
– It is not subject to the same regulatory
framework as financial accounting.
Management and financial accounting compared

Management accounting Financial accounting

Nature of the
reports produced Tend to be specific purpose Tend to be general purpose

Level of detail Often very detailed Usually broad overview

Regulations Subject to accounting


Unregulated
regulation

Reporting As short as required


interval Usually annual or bi-annual
by managers

Uses projected future


Time horizon information as well as past Almost always historical
information

Range and quality Contains financial and non- Focus on financial


of information financial information. Uses information. Emphasis on
information that cannot be objective, verifiable
verified evidence
A means
to an End

Usefulness
Enhanced via
Broader
Explanation than FS
Externally
Reported
Information
Based on
Features
General- Historical
Purpose in Nature
Assumption
Results from
Inexact and
Approximate
Measures
A means
to an End

Measures of
Importance
Efficiency
of
& Effectiveness Timeliness
Features
of MAI

Oriented Identity of
towards the Decision
future maker
Financial Position and the Accounting Equation
• Financial position:
– refers to a company’s economic resources, such as cash,
inventory, and buildings, and the claims against those
resources at a time.
• Claims are also called equities
• Economic Resources = Creditors’ Equities + Owners’ Equities

• In accounting, economic resources are called ASSETS, and


creditors’ equities are called LIABILITIES

• ASSETS = LIABILITIES + OWNERS’ EQUITY


Financial Position and the Accounting Equation

• The accounting equation can also be expressed as:


• ASSETS – LIABILITIES = OWNERSHIP INTEREST

Assets Minus Liabilities Equals Ownership Interest (OI)

• The ownership interest is the residual claim after


liabilities to third parties have been satisfied. The
equation expressed above emphasizes this aspect.
Financial Position and the Accounting Equation
• In a corporate business or entity, the accounting equation
can be read as:
• ASSETS = LIABILITIES + SHAREHOLDERS’ EQUITY
• Or
• ASSETS – LIABILITIES = SHAREHOLDERS’ EQUITY
• The shareholders’ equity has two parts:
– contributed capital and
– retained earnings
• Contributed capital:
– is the amount that shareholders invest in the business which is
represented by shares of capital stock
– Is divided between par value and additional paid in capital
Financial Position and the Accounting Equation
• Example:
– Ato Birru bought 10,000 shares of GENZEB S. Co at Br. 2500 each
where the par value of the share of the Company is Br. 1000 a share.
a. Compute the total investment made by Ato Birru
b. What is the value of the additional paid in capital (PIC)?
• Soln.
a. Investment value Br. 2500/share x 10,000 shares = Br. 25,000,000
b. The value at par = Br. 1000/share x 10,000 shares = Br. 10,000,000.
Then, the additional Paid In Capital is Br. 15,000,000
i.e. Br. 25,000,000 – Br. 10,000,000.

• Retained Earnings:
– Represent shareholders’ equity that has been generated by the
business’s income producing activities and kept for use in the
business.
Exercises
1. The assets of ABC Co. are Br. 240,000, and the liabilities
are Br. 90,000. What is the amount of the stockholders’
equity?

2. The liabilities of PS Co. equal one-fifth of the total assets.


The stockholders’ equity is Br. 40,000. What is the amount
of the liabilities?
Effects of Business Transactions on the accounting
equation
• Assume, Ato Ahmed started his own consulting business
on Meskerem 1, 2012. Some of the transactions of the
same month are indicated below.

• Mes. 3 He transferred Br. 500,000 cash to the business.


• Mes. 5 Purchased office equipment Br. 20,000 cash
• Mes. 15 Received cash from customers Br. 45,000 cash
• Mes. 19 Purchased Office supplies Br. 12,000 on credit
• Mes. 20 Provided Br. 25,000 services to customers on
account.
• Mes. 30 Received Br. 10,000 in partial collection from
customers.
Financial Statements
Financial Statements
a financial statement is simply a
declaration of what is believed to be true
about an enterprise, communicated in
terms of a monetary unit, such as the Birr.

a financial statement includes:


- Balance sheet
- Income statement
- Statement of cash flows
- Statement of changes in equity
Balance Sheet
/Statement of Financial
Position/
Statement of Financial Position
• Statement of financial position or balance
sheet lists all resources, obligations /claims/
and net worth of an economic entity on a
specific date, usually at the last date of the
fiscal period.
• Resources are ASSETS
• Obligations are LIABILITIES or CLAIMS
• Net worth are EQUITIES or OWNERS’
INTEREST
Uses of the statement of financial position
Shows how the business is financed and how funds
are deployed

Can provide a basis for assessing the value of the


business

To assess the relationships between assets and


claims

Performance can be better assessed


Defining Basic Terms of the Balance Sheet

• Assets: an asset is defined as


– a resource controlled by the entity as a result of past
events and from which future economic benefits are
expected to flow to the entity.
Features of an asset
• A probable future benefit must exist
– Evidence of existence or happening
• The business must have the right to control the
resources
• The benefit must arise from some past transaction
or event
• The asset must be capable of measurement in
monetary terms

• Note:
• All four of these conditions must apply. If one of them is
missing, the item will not be treated as an asset for accounting
purposes
Exercise
• Indicate which of the following items could appear as an asset
on the statement of financial position of a business. Explain
your reasoning in each case.
a) Br. 1,000 owed to the business by a customer who is unable
to pay.
b) A patent, bought from an inventor, that gives the business the
right to produce a new product. Production of the new
product is expected to increase profits over the period during
which the patent is held.
c) A new marketing director, whom the business had recently
hired, who is confidently expected to increase profits by over
30 per cent during the next three years.
d) A recently purchased machine that will save the business Br.
10,000 each year. It is already being used by the business but
it has been acquired on credit and is not yet paid for.
Categories of ASSETS
• An entity’s assets can be categorized into two as:

• Current assets and

• Long-term assets

• Current assets bring short-term benefits to an entity which will


be consumed or converted into cash within one accounting
period.

• Long-term assets will give long term benefit and which cannot
be converted into cash easily within a year (i.e. more than one
accounting period).
Examples of Current Assets
• Cash — currency, bank deposits, and investments
with an original maturity of 90 days or less (called
cash equivalents);
• Marketable securities—short-term investments that
can be quickly sold to raise cash;
• Accounts receivable, net—amounts due to the
company from customers arising from the sale of
products and services on credit (―net‖ refers to
uncollectible accounts);
• Inventory — goods purchased or produced for sale to
customers;
• Prepaid expenses — costs paid in advance for rent,
insurance, advertising or other services.
The circulating nature of current assets

Inventories
(stock)

Trade receivables
Cash (trade debtors)
Examples of Long-term Assets
• Property, plant and equipment (PPE), net — land,
factory buildings, warehouses, office buildings,
machinery, motor vehicles, office equipment and
other items used in operating activities (―net‖ refers
to subtraction of accumulated depreciation, the
portion of the assets’ cost that has been transferred
from the balance sheet to the income statement);
• Long-term investments — investments that the
company does not intend to sell in the near future;
• Intangible and other assets — assets without
physical substance, including patents, trademarks,
franchise rights, goodwill and other costs the
company incurred that provide future benefits.
Defining Basic Terms of the Balance Sheet

• Liabilities: a liability is as
– a present obligation of an entity arising from past events,
the settlement of which is expected to result in an outflow
from the entity of resources embodying economic
benefits

– Present obligation: a legal obligation is evidence that a


liability exists because there is another person or entity
having a legal claim to payment. (either by contract or
statute law).
– Past events: … finding some reasonably objective way
of confirming existence of a liability.
– Outflow of economic benefits: when the resource of
cash is the economic benefit transferable in respect of
most obligations.
The classification of Liabilities

Current liabilities

Non-current liabilities
Examples of Current Liabilities
• Accounts payable— amounts owed to suppliers for goods
and services purchased on credit.
• Accrued liabilities—obligations for expenses that have
been incurred but not yet paid; examples are accrued wages
payable (wages earned by employees but not yet paid),
accrued interest payable (interest that is owing but has not
been paid), and accrued income taxes (taxes due).
• Unearned revenues—obligations created when the
company accepts payment in advance for goods or services it
will deliver in the future; also called advances from customers,
customer deposits, or deferred revenues.
• Short-term notes payable —short-term debt payable to
banks or other creditors.
• Current maturities of long-term debt—principal portion
of long-term debt that is due to be paid within one year.
Non-current liabilities

Do not meet the definition of


current liabilities
Examples of Noncurrent Liabilities

• Long-term debt —amounts borrowed from


creditors that are scheduled to be repaid more than
one year in the future; any portion of long-term debt
that is due within one year is reclassified as a
current liability called current maturities of long-
term debt. Long-term debt includes bonds,
mortgages, and other long-term loans.

• Other long-term liabilities —various obligations,


such as pension liabilities and long-term tax
liabilities, that will be settled a year or more into the
future.
Defining Basic Terms of the Balance Sheet
 Owners’ Equity:
– represents the owners’ claims on the assets of the
business. Because liabilities or creditors’ claims have
legal priority over those of the owners, owners’ equity
is a residual amount.
– Owners’ equity does not represent a specific claim to
cash or any other particular asset. Rather, it is the
owners’ overall financial interest in the entire
company
• Owners’ Equity:
– Consists of contributed Capital (cash raised from the issuance
of shares)
– Earned Capital (retained earnings). Which is updated each
period as follows:
Examples of Equity Accounts
• Common stock — par value received from the
original sale of common stock to investors.
• Preferred stock— value received from the original
sale of preferred stock to investors; preferred stock
has fewer ownership rights compared to common
stock.
• Additional paid-in capital — amounts received from
the original sale of stock to investors in addition to
the par value of common stock.
• Treasury stock — amount the company paid to
reacquire its common stock from shareholders.
• Retained earnings — accumulated net income
(profit) that has not been distributed to stockholders
as dividends.
Accounting Equation
Exercise
• Use the following accounts and balances to prepare
a balance sheet with the accounts in proper order
for Global Company at June 30, 2019.

– Accounts Receivable Br. 1,600


– Wages Payable 700
– Retained Earnings 4,700
– Common Stock 24,000
– Building 22,000
– Cash ?
Income Statement
Income Statement
• Reports on an entity’s revenues, expenses and
the net change in revenue over a given period
of time.
• Hence, shows a company’s profit or loss over a
given period of time
Income Statement
When are Revenues and Expenses Recognized?

• Revenue Recognition Principle—recognize


revenues when earned
• Matching Principle—recognize expenses
when incurred.
Profit vs. Cash
• Net Income does not necessarily correspond to a net cash
flow. A firm could have “good income” but “poor cash flow”
or vice versa (i.e., there are two dimensions to consider).
Operating vs. Nonoperating
• Operating expenses are the usual and
customary costs that a company incurs to
support its main business activities.

• Non-operating expenses relate to the


company’s financing and investing activities
Statement of
Shareholders’ Equity
Statement of Stockholders’ Equity

• Statement of Equity is a reconciliation of


the beginning and ending balances of
stockholders’ equity accounts.
• Main equity categories are:
– Contributed capital
– Retained earnings
– Treasury stock
Articulation of Financial Statements

• Financial statements are linked within and


across time – they articulate.
• Balance sheet and income statement are
linked via retained earnings.
Statement of Cash Flows
Statement of Cash Flows
• Statement of cash flows (SCF) reports cash inflows and
outflows
• Cash flows are reported based on the three business
activities of a company:
– Cash flows from operating activities - Cash flows from the
company’s transactions and events that relate to its
operations.
– Cash flows from investing activities - Cash flows from
acquisitions and divestitures of investments and long-term
assets.
– Cash flows from financing activities- Cash flows from
issuances of and payments toward borrowings and equity.
Relationships among Financial Statements
Financial and Managerial
Accounting (MBA 521)

End of Chapter One

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