Financial Accounting, Appunti di Analisi Di Bilancio E Principi Contabili

Scarica Financial Accounting e più Appunti in PDF di Analisi Di Bilancio E Principi Contabili solo su Docsity! Financial Accounting | UCSC 1 FINANCIAL ACCOUNTING 2nd semester Listed company: it is a company that sells its shares on the market. Listed companies usually have very long annual reports, which is something that does not apply to small and medium enterprises. The financial statements that are part of the annual report are 4 Learning objectives 1. Understand the role of accounting in communicating financial information 2. Understand the underlying accounting concepts in the IFRS (International Financial Reporting Standards) Conceptual Framework 3. Obtain insights into business operations through financial statements 4. Identify financial statements and their inter-relationships 5. Understand the role of ethics in accounting Financial statement: it is a business document that reports how a company has been doing during a specific financial year. Financial statements are there to help with the decision-making process. Accounting is the language of business but is also an information system. How does it work? 1. Accounting starts with collecting data to measure business activities; we collect data because if we do not measure the activities of our company, we do not know how the company is performing. Once we have collected the data, we need to order them, and to do that there are 2 tools: the Double Entry Bookkeeping and the T-Account 2. The next step is processing the collected data into reports, in order for outside users of financial information to be able to reed them. This step is especially important for large multinational companies which have lots of transactions every day, and therefore must summarize them into reports 3. The third step is presenting the reports made to the decision makers, who make decisions that will have an impact on business activities. Accounting helps companies, their shareholders, and management to make the following decisions: • assessing the company’s performance • sources of funding and capital • costing and pricing • analysing the performance of various business groups within the company Accounting is the language of communication in all businesses. The better our understanding of this language is, the better we can understand our finances, our businesses, or our investments. It is used by: • individuals • investors and creditors • regulatory bodies There is a distinction between financial accounting and managerial accounting. There are financial data both when it comes to financial and managerial accounting, the difference is between the users. • Financial accounting: it is for decision makers outside the entity (investors, creditors, government agencies, the public). When we talk about financial accounting, we talk about financial information that will be communicated to external users; financial accounting is Financial Accounting | UCSC 2 prepared to satisfy the informational needs of external users. Financial accounting must be prepared according to regulations and accounting standards, so accountants are not free to report financial data the way they want • Managerial accounting: it is for managers inside the entity (for budgets, forecasts, projections). When we talk about people inside the company, we talk about managerial accounting. In managerial accounting the financial data is not presented according to regulations and standards, but according to the best and most useful way for a specific company Who is supposed to present financial data to the public? A business generally takes one of the following forms: • proprietorships: they are pieces owned and run by a single owner, called proprietor. They tend to be small retail stores or individual providers of professional services (physicians, attorneys, software programmers, or accountants). Legally, there is no distinction between the owner and the business, so the owner is personally liable for all business’s debts (unlimited liability), but for accounting purposes a proprietorship is a distinct entity, separate from its proprietor. Thus, the business records should not include the proprietor’s personal finances • partnerships: they have two or more parties who act as co-owners, and each owner is a partner. Many partnerships are small or medium-sized, but some are very large. General partnerships have unlimited liability, meaning that each partner may conduct business in the name of the entity and can make agreements that legally bind all partners without limit for the partnership’s debts. Therefore, partnerships can be quite risky • corporations: they are the opposite of proprietorships and partnerships. They are businesses owned by the shareholders, who own shares representing ownership in the corporation. In this case, there is a legal distinction between business and owners, so the shareholders have no personal obligation towards the corporation’s debts (limited liability) Accounting standards Accounting rules tend to vary in different jurisdictions. • International Financial Reporting Standards (IFRS): it is a set of accounting standards that are issued by an independent body (not related to any specific country or government) which is the International Accounting Standards Board (IASB) • Generally Accepted Accounting Principles (GAAP): they are formulated by the Financial Accounting Standards Board, which is different for each country. In Italy this task is performed by Organismo Italiano di Contabilità (OIC) To enhance cross-country financial investments, the European Union has decided that: • listed companies should prepare annual reports using IFRS • non listed companies should prepare annual reports using GAAP The IASB also issues the so-called Conceptual Framework. It is a document that precedes standards and sets some important characteristics that financial information should have. The Conceptual Framework precedes accounting standards because it is more general. It helps answering the following questions: • why is financial reporting important? • who are the users of financial reports? • what makes financial information useful? • what constraints do we face in providing useful information? • what are our assumptions in financial reporting? Financial Accounting | UCSC 5 RECAP Accounting is an information system which objective is to collect and communicate financial information. In order to be understandable, and therefore useful, financial information must be prepared according to some rules: each jurisdiction has its own general accepted accounting principles, but in our course we are going to talk about the International Financial Reporting Standards (IFRS), which are issued by the IASB, an independent accounting body. The Conceptual Framework provides accountants with a guideline in order to prepare annual reports in the correct way. The objective is to provide useful information for the decision-making process. The IASB has established that the primary users of financial information are investors, lenders, and creditors. When these categories are satisfied with the financial information, then it will probably be the same for all the other categories. The main categories of financial items to be reported on financial statements are: • assets, resources controlled by the business from which we expect future economic benefit • liabilities, present obligations of the business from which we expect an outflow of future economic benefit • shareholders’ equity (assets – liabilities), it represents the claim of the shareholders to the business. It can be divided into share capital and retained earnings Assets, liabilities, and shareholders’ equity can be found, and are reported, on the face of the balance sheet (in what is called “statement of financial position”). Then there are two more categories of financial items: • income, the outflow of economic production resources of a company when the company sells products or delivers services. There are 2 types of income: - revenues: when it is generated from the ordinary activities of the firm - gain: it has the same nature, but it is not generated from the ordinary course of the firm, it is generated by activities carried out by the firm but that are not part of its core business • expenses, the inflow of production economic resources when a company purchases goods or services. There are 2 types of expenses: - expenses: they are generated by the core business of the firm - loss: it is not generated by the core business of the firm Revenues (and gains) – Expenses (and losses) = Net Income/Net Loss (2nd accounting equation) When total revenues exceed total expenses, the result is called net income/net profit; when expenses exceed revenues, the result is called net loss. We find revenues, expenses, gains, and losses in a specific financial statement that is called the “income statement”. Retained earnings are a percentage of net income and are retained by the company for reinvestments or debt payment. A successful business usually pays dividends to shareholders in the form of cash. Dividends are recorded as direct reductions of retained earnings, but are not an expense and will never affect net income. This is the basic accounting equation: Assets – Liabilities = Shareholders’ Equity. Financial Accounting | UCSC 6 The whole double entry bookkeeping system is based on this equation, which can also be written in another way: Assets = Liabilities + Shareholders’ Equity. This is the underlying premise of the double entry bookkeeping, because we will always have a right side and a left side: • the left side is called “debit side”, where there are assets • the right side is called “credit side”, where there are liabilities and shareholders’ equity Total debits will always equal total credits. Shareholders’ Equity = Share Capital + Retained Earnings. The share capital, which is the initial amount of money the company starts with, can be increased or decreased depending on the performances of the company, therefore shareholders’ equity may increase or decrease too: • revenues increase shareholders’ equity • expenses decrease shareholders’ equity Net income increases retained earnings if I do not pay dividends to the owners, and therefore it increases shareholders’ equity. Net loss decreases shareholders’ equity. The higher the revenues and the lower the expenses, the higher net income (and vice versa). And what about if I decide to pay dividends to the shareholders? Dividends are the retained earnings that the company decides not to retain. If I pay dividends to the owners, the shareholders’ equity decreases. The basic accounting equation is Assets = Liabilities + Shareholders’ Equity. And this equation changes: you have to keep in mind that the shareholders’ equity can be increased by revenues and issue shares, and it can be decreased by expenses and dividends. Where to find financial information: Financial Accounting | UCSC 7 There are 4 different financial statements that are all part of the annual report. The annual report must be complete, and in order to be complete, it must show an income statement, a statement of changes in equity, a balance sheet, and a statement of cash flows. Then there is one more document, called “notes to the accounts”: it is a written document which follows the first statements and has an explanatory function, which means that it clarifies numbers on the face of financial statements, and it also provides more detailed info about the financial operations. Then there is also a report that is prepared by the company’s directors, but that is not part of the annual report. Proper headings for financial statements include: • the name of the company • the type of financial statement • the financial year date • the currency THE INCOME STATEMENT The income statement reports revenues and expenses for the period. The bottom line of the income statement represents the net income (or net loss) for the period. Net Income/Net Loss = Total Revenues and Gains – Total Expenses and Losses Alibaba’s income statement March 31st is the financial year end-date for Alibaba. This company closes books on March 31st and restarts its reporting period on April 1st. Starting from row 3 there are the financial items. Revenues: • cost of revenue/cost of goods sold: they are all the expenses incurred in order to manufacture the goods that have been sold during the reporting period Income from operations: it represents all the expenses of the company, which are named like that because they are all expenses related to the core business of the activity. It is a sort of an intermediate profit generated by the core business of the activity only • interest expense: it is the cost of borrowing money • income tax expenses: they are related to the need of paying taxes N.B The net income that we see on the face of the income statement does not always coincide with the taxable income, it depends on the jurisdiction and the law Financial Accounting | UCSC 10 SHAREHOLDERS’ EQUITY It represents the shareholders’ ownership of the business’s assets. We have: • share capital • retained earnings • other equity items: they depend on the type of business activity Alibaba’s consolidated balance sheet Based on the basic accounting equation (Assets = Liabilities + Shareholders’ equity): Total assets = Total liabilities + Equity It should always be like this, otherwise there is something that doesn’t work in the balance sheet. Revenues (and gains) – Expenses (and losses) = Net Income/Net Profit Financial Accounting | UCSC 11 THE STATEMENT OF CASH FLOWS The statement of cash flows represents a flow in monetary amounts, as the income statement does. The difference between the two is that the income statement represents an inflow and outflow of economic/production resources (all the production resources I purchased, and all the production resources that, after manufacturing, I was able to sell), whereas the statement of cash flows represents a flow of all the money that has entered and outflowed the company during the reporting period. Example: ® We sell finished goods for $300. As we sell a finished good and collect cash, we also experience an outflow of economic resources. So, there are two sides: on one side we have an inflow of cash, and on the other side we have an outflow of economic resources, and this outflow is called revenue ® In order to manufacture those finished goods, we bought raw materials for $100. We again have two sides: on one side we have an outflow of cash, and on the other side we have an inflow of production resources, and this inflow is called expense The statement of cash flows shows a company’s cash receipts and payments. The cash flow statement represents inflows and outflows of cash, but ASA7, which is an accounting standard that provides guidance to prepare the cash flow statement, requires accountants to report inflows and outflows of cash related to 3 different categories of activities: • operating activities: cash inflows from selling goods and services to customers, and outflows from buying raw materials to manufacture the goods and producing the services. Operating activities are activities that relate to the core business of the company • investing activities: cash flows from purchasing and selling long-term assets. Investing activities relate to both investments in the production capacity, that are related to the core business, and also to investments in the so-called collateral activities, which are not related to the core business • financing activities: cash flows from borrowing or repaying funds or equity transactions Financial Accounting | UCSC 12 The 4 financial statements are linked together, and they should be used together in order to have a complete picture of the company. When I look at the income statement, I can understand whether the company has performed in a good way for what concerns effectiveness and efficiency; but I also need to know whether it has increased or decreased cash during the reporting period, to understand its financial performance; then I need to look at the balance sheet to understand the amount of resources and liabilities at the end of the reporting period, which is the value of the company. Finally, there is also a link between the balance sheet and the statement of cash flows because we have the beginning and the ending amount of cash among the assets on the balance sheet, and we can find them also at the end of the statement of cash flows. When we look at financial statements, we have the story of the company for what concerns its money, its production resources, the resources and the obligations at the end of the reporting period, what the shareholders actually own (shareholders’ equity). We have a link between financial statements because we are looking at different sides of the same phenomena, that are business activities and their performance during 1 year. Financial Accounting | UCSC 15 - Revenues (and gains): retained earnings are increased by revenues, and when I have an increase in retained earnings (shareholders’ equity), I record it on the right side. Therefore, the normal balance side of revenues falls on the right side (credit side) - Expenses (and losses): retained earnings are decreased by expenses, and when I have a decrease in retained earnings (shareholder’s equity), I record it on the left side. The more expenses I have, the less shareholders’ equity I have. Therefore, the normal balance side of expenses falls on the left side (debit side) CLARIFICATION ® Revenues are the result obtained from delivering goods and services They increase shareholders’ equity and an asset When selling finished goods, those resources are delivered to customers (outflow called revenue). In return, the company will collect money (inflow of cash, so an asset) ® Expenses are the cost of operating the business They decrease shareholders’ equity and an asset When paying for utilities, those resources are consumed by the company (inflow called expense). At the same time, the company pays cash (outflow of cash, so an asset) Therefore, revenues and expenses are not money, they represent inflows and outflows of production resources. When we have all the T-Accounts of a company grouped together in one place, it is called ledger. When we post to the ledger, it means that we set up T-Accounts all together after having journalized transactions. Therefore, the ledger is a document in which we can find all the T-Accounts of a company. At the end of the reporting period, accountants can look at the ledger and say: - we have an ending balance of cash equal to $33.000 - we still have liabilities (obligations) for $1.800 to pay off next year - next year we still have to collect cash (accounts receivable) for $2.000 Journal entries: • it is a double-entry system • it records dual effects of each transaction (at least two accounts in each transaction) • it reports the monetary effects of transactions in a chronological way • there are 3 steps: 1. specify each account affected by the transaction and classify it by type 2. determine if each account has increased or decreased during the transaction (debit or credit) 3. record the effects of the transaction in the journal During the reporting period we: 1. journalize transactions 2. post the effects of those transactions in the T-Accounts 3. group all the T-Accounts into the ledger 4. at the end of the reporting period, we prepare a trial balance (trial balance: a document that lists, usually at the end of the reporting period, all the accounts that the company has posted Financial Accounting | UCSC 16 to the ledgers during the reporting period with their ending balances. It allows us to check whether total debit equals total credit) 5. then we make the year-end adjustments 6. then we are ready to prepare the annual report Both T-Accounts and journal entries are tools for recording transactions which are based on the Double Entry Bookkeeping (Total debit = Total credit). The main difference between these two tools is that when you look at a T-Account, you see just one financial item, and you can compute its ending balance, which is very important because the ending balance is the starting point to prepare financial statements. On the other hand, when you look at journal entries you are not able to compute the ending balances of each single financial item. We can compute the ending balances of each single financial item only using T-Accounts, while journal entries allow us to see the counter item of each single financial item that was recorded during the reporting period, and therefore allow us to understand the reason behind the transactions. Thanks to the ledger, we can clearly see the ending balances of assets, liabilities, and shareholders’ equity, which are the starting point to prepare the annual report. Looking at income (revenues) and expenses, we are able to compute the net income, and therefore to assess whether the company performed well or not. We need ending balances because financial statements report ending balances of our accounts. We start from the ledger to prepare the so-called trial balance, which is one step closer to financial statements. Trial balance: • lists all the T-Accounts recorded by the company during the reporting period (ledger), starting from assets, then liabilities and shareholders’ equity (share capital, dividends, revenues, and expenses) • accountants prepare the trial balance to have an idea of all the accounts that must be shown in the financial statement, but also because they want to check whether the debit side equals the credit side • it is usually prepared at the end of the reporting period • it facilitates the preparation of the financial statements Financial Accounting | UCSC 17 YEAR-END ADJUSTMENTS Starting from the trial balance, to prepare financial statements we need to do some more journal entries, called year-end adjustments. Basically, starting from the ending balances shown on the trial balance, we need to adjust some of them (and this is why it is called “trial” balance). After the adjustments, we obtain the adjusted trial balance, and then the financial statements are ready to be presented (“closing the books”). The chart of accounts is a list of all the possible accounts that accountants of the company may have to record. Cash-basis accounting vs Accrual accounting We need to adjust the accounts because, during the reporting period, when we make journal entries related to transactions, we usually do not apply the accrual accounting principle. Since we do not apply this principle, we need to revise our ending balances in order to make them consistent with accrual accounting. From a hypothetical point of view, we could record transactions and prepare financial statements using two different principles/basis: the cash-basis accounting and the accrual accounting. However, it is just a theoretical distinction because accountants are actually not allowed to apply the cash-basis accounting, because it fails to represent the economic reality. Cash-basis accounting: Revenues can be conceived as outflows of production resources, and expenses as inflows of production resources. Better, we could think about expenses as production resources that inflow to the company, but which only become expenses when the company consumes them and uses them up. So, if you buy raw materials, initially they are assets for the company, and become expenses when the company consumes them to manufacture finished products. Using the cash-basis accounting fails to correctly represent this reality: as a matter of fact, we only record those transactions that imply an immediate outflow or inflow of cash. This means that if during the reporting period I sold finished goods and I immediately collected cash, under the cash-basis accounting I must record that transaction, because it is a cash transaction. But if I sell a finished good and did not immediately collected cash, that is not a cash transaction and therefore I do not have to record the sale under the cash- basis accounting. By doing so, we do not represent the underlying economic phenomenon, because if we want to report what has happened during a specific reporting period, the cash-basis accounting is not accurate. Recording transactions using the cash-basis accounting means recording them only when an immediate inflow or outflow of cash occurs. Only cash transactions must be recorded, that is, transactions implying - cash receipts, but not increases in receivables - cash payments, but not increases in payables. Therefore, the cash-basis accounting fails to capture the underlying economic phenomenon, as it does not provide any information related to production resources inflows and outflows occurred during the reporting period. This results in incomplete financial statements. Accrual accounting: Instead, accrual accounting records transactions when they occur, without distinguishing whether they are or not cash transactions. Therefore, accrual accounting requires to record: - cash transactions, such as: collecting cash from customers, receiving cash from interest earned, paying salaries, rent, and other expenses, borrowing money, paying off loans, issuing shares but also - revenues when earned: for example, delivery of finished goods and services Financial Accounting | UCSC 20 • temporary accounts are revenues and expenses (and dividends) they are called temporary accounts because we already consumed them during this reporting period, and next reporting period there will be new ones. They are all the accounts related to a limited period of time, therefore all the production resources already consumed or sold during the reporting period We just have to close the temporary accounts, because the permanent ones will still be there next reporting period. Steps to close the books: 1. debit each income (revenue) for the amount of its credit balance. Credit retained earnings for the sum of all revenues 2. credit each expense account for the amount of its debit balance. Debit retained earnings for the sum of all expenses 3. credit the dividends account for the amount of its debit balance. Debit retained earnings for the same amount Retained earnings are presented as an item of the balance sheet (shareholders’ equity). After having closed the books, we just need to list assets, liabilities, expenses, and revenues according to IAS1, which is the accounting standard that disciplines the presentation of financial statements, that is, the presentation of annual reports. To present the financial statements means that we are going to publish them, and that external users will be able to read them. Financial Accounting | UCSC 21 PREPARING THE ANNUAL REPORT Annual reports are characterized by substance over style. They must be prepared at least once a year, and listed companies are also required to prepare interim reports every 6 months or ¼ a year. Annual reports of companies can now be found on the internet, on the so-called “corporate websites”. Corporate websites are aimed at providing financial information to shareholders and external users of financial information. This is true especially for big companies, because small companies do not usually include as much information on their corporate websites. An annual report usually has the following structure: • corporate information, which may include information like: - history of the company - members of the board of directors and key management personnel - organizational structure - key markets and products - operating statistics - financial highlights - awards and accolades received - any other general information about the company that may be useful to a reader’s understanding of the company • analysis and commentaries, which usually consist in a “letter from the chairman of the board of executive directors” (or president of the company) that discusses achievements in the financial year, returns to shareholders, and the key goals for the future. The next set of commentaries is from the company’s management. The objective of such commentaries is to provide users with an understanding of the company via an analysis of the company’s businesses as seen through the eyes of the directors and management • other statements and disclosures, they vary from one jurisdiction to another, but they all include Corporate Governance, that: - is a set of principles adopted or practised by organizations in order to ensure a clear corporate direction, responsibility, and accountability of those managing the organization - prescribes matters such as the composition, duties, and responsibilities of the board of directors, oversights of management, and its dealing with shareholders • financial statements, this section includes in order: - an acknowledgement by directors and management that they are responsible for the financial statements - an auditor’s report (independent auditors), because the biggest companies are required to submit their financial statements to an external independent auditor by the law - the full set of financial statements, which comprehends the balance sheet (financial position at the end of the period), the income statement (comprehensive income for the period), the statement of changes in equity for the period, the cash flow statement for the period, and the notes to the account, that are required by the law, and which comprise a summary of significant accounting policies and other information not provided by financial statements. Big companies, even if they are not listed, are also required to present non-financial information, so their social and environmental performance, on their corporate websites The auditor’s report: • provides an independent professional opinion to shareholders that the company’s financial statements were prepared in accordance with stipulated standards and represent a true and fair reflection of the company’s performance • contains four sections: 1. audited financial statements 2. outline of the organization’s and auditor’s respective responsibilities Financial Accounting | UCSC 22 3. description of how the audit was performed in accordance with the generally accepted auditing standards of the jurisdiction 4. auditor’s opinion about the company (can be different in different jurisdictions) Auditors must make sure that financial statements are prepared according to the law and provide accurate information. They must grant to external users that financial statements preparers have prepared financial statements according to law requirements and financial accounting requirements. Auditors can give an: • unqualified opinion: it is the best result ever, because it means that the auditor agrees with the way accountants have prepared financial statements. It is issued when financial statements fairly represent the company’s financial position. It is the highest statement of assurance that an independent auditing firm can express • qualified opinion: it means that something is not so good, because the auditor may have found a specific or a few financial items not being presented according to the law or the accounting standards. It is issued if the financial statements are fairly presented, except for disagreement on how to treat a particular transaction • adverse opinion: it is the worst result ever, because it means that the auditor does not agree with the way accountants have prepared financial statements. It is the opposite of an unqualified opinion, so it means that the financial statements do not fairly represent the company’s financial position General presentation requirements for financial statements A complete set of financial statements comprises: 1. a statement of financial position at the end of the period (balance sheet) 2. a statement of comprehensive income for the period (income statement) 3. a statement of changes in equity for the period 4. a statement of cash flows for the period In addition, the financial statements must be properly labelled. IAS1 requires an entity to clearly identify: • the name of the reporting company • if it is a consolidated or an individual entity’s account (consolidated account means that financial statements report not only the financial items of a company, but of a business group; individual account means that financial statements report only the financial items of the company) • the date of the end of the reporting period or the period covered by the financial statements • the presentation currency used • the level of rounding used in presenting the amounts in the financial statements Fair presentation and compliance with IFRS: • a company cannot rectify inappropriate accounting policies neither by disclosure of the accounting policies used nor by notes or explanatory material • a company cannot selectively apply the standards it likes and proclaim compliance with IFRS Going concern: • it refers to a company’s intention to, and its ability to, operate into the foreseeable future Accrual basis of accounting: • it reflects the changes in net assets of a company, rather than how much cash has gone in and out of the company Materiality and aggregation: • real companies use thousands, millions, and even billions of accounts • a company may keep a detailed record of all its expenses, each account perhaps further sub- categorized by location and line of business Financial Accounting | UCSC 25 INTERNAL CONTROL, CASH, AND RECEIVABLES Cash and cash equivalents They are the most liquid items of financial statements. When we talk about cash equivalents, we are talking about investments that can be liquidated in a short period of time and with very low risks for the seller that they lose value. All highly liquid investments with maturities of three months or less at the date of purchase are classified as cash equivalents. Receivables They are the third most liquid asset (after cash and short-term investments), and they can be defined as monetary claims against third parties. Receivables can be acquired by: • selling goods and services (accounts receivables) • lending money (notes receivables) Usually, accounts receivables do not carry any interest, while notes receivables do. Accounts receivables are current assets, which sometimes are called trade receivables if related to sales or service revenues. The allowance method records potential losses form failure to collect receivables, and it is based on the company’s past collection experiences. This method records Uncollectible Account expense, and therefore requires a contra-account. There is a difference between: • allowance for Uncollectible Account, which shows the amount the business expects not to collect (so the loss is not sure) • “writing off”, which is when the loss has already occurred and the entity knows that cash won’t be collected (so the loss is certain) Allowance: • for doubtful accounts (- doubtful account expense) • for bad debt (- bad debt expense) • for uncollectible accounts (- uncollectible account expense) Financial Accounting | UCSC 26 INVENTORY Inventories are assets, and they work as supplies: the company buys them, stocks them, and then sells them. When we sell inventories, we have an increase in the cost of goods sold, which is an expense called “inventory expense”. When we sell inventories, we will have to journalize two transactions: the decrease in inventory, and the increase in sales revenue. Inventory-related transactions are those involving the sale or the consumption of inventory and require recording changes occurred in the following accounts: • inventories (assets): raw materials, work in progress (WIP), finished goods • cost of goods sold (expense) • sales revenue (revenue) The cost of inventory sold shifts from asset to expense when the seller delivers goods to the buyer. We have to distinguish between two different types of goods: • inexpensive goods, we need to keep track of them with two methods: - the period method, which simply computes the amounts on the ledger - the perpetual method, which implies that accounts and data related to inventory are always up to date at any point in time (for ex. in supermarkets) • expensive goods The items that companies should include in inventory are: • inventory purchased and stocked • minus inventory held on consignment • plus inventory out on consignment What about the inventory in transit? This depends on the condition of the purchase, which are called “shipping terms (FOB)”. We can distinguish between shipping point (freight in), which means that once the finished goods leave the company of the seller, they belong to the purchaser, and therefore transportation costs are paid by the buyer; the opposite is destination (fright out), which means that the buyer will become owner of the goods only when delivered, and therefore the transportation costs are paid by the seller. The way according to which we estimate the value of inventory depends on their nature. We can have two different types of inventories, and according to the type we can use the Specific Identification methods or other three methods, which are First-in, First-out (FIFO) cost, Last-in, First-out (LIFO) cost, and Average cost. Financial Accounting | UCSC 27 VOCABULARY CHAPTER 1 Accrual basis: business transactions and other events are recognized when they occur and not when cash is received or paid Balance sheet: list of an entity’s assets, liabilities, and owners’ equity at a specific date. Also called the Statement of Financial Position Double-entry system: a system of recording business transactions where every financial transaction has equal amounts of debits and credits recorded in at least two accounts Ethics: standards of right and wrong that transcend economic and legal boundaries. Ethical standards deal with the way we treat others and restrain our own actions because of the desires, expectations, or rights of others, or with our obligations to them Going concern: an assumption that an entity will remain in operation for the foreseeable future Gross profit: revenue from a particular activity minus the direct costs associated with earning that revenue Income statement: a financial statement listing an entity’s revenues, expenses, and net income or net loss for a specific period. Part of the Statement of Comprehensive Income Inventory: the merchandise that a company holds for sale to customers Materiality: the importance or significance of information that may change the user’s final assessment of a situation Retained earnings: the amount of shareholders’ equity that the corporation has earned through profitable operations that has been retained in the business (not distributed back to shareholders) Statement of cash flows: reports cash receipts and cash payments classified according to the entity’s major activities: operating, investing, and financing Statement of changes in equity: provides a reconciliation of the movement of equity items during a financial period. Affected share issuance, share cancellation, net income (or net loss), and dividends paid CHAPTER 2 Account: the record of the changes that have occurred in a particular asset, liability, or shareholders’ equity during a period. The basic summary device of accounting Accrued liability: a liability for an expense that has not yet been paid by the company Journal: the chronological accounting record of an entity’s transactions Posting: copying amounts from the journal to the respective ledger account Prepaid expenses: paying expenses in advance before actual consumption. Also called prepayments PPE: assets that are expected to be used for more than one period for the purpose of production or supply of goods or services or for administrative purposes Transaction: any event that has a financial impact on the business and can be measured reliably Trial balance: a list of all the ledger accounts with their balances CHAPTER 3 Accrual: an expense or a revenue that occurs before the business pays or receives cash. An accrual is the opposite of a deferral Accrued expense: an expense incurred but not yet paid in cash Accrued revenue: a revenue that has been earned but not yet received in cash Accumulated depreciation: the cumulative sum of all depreciation expense from the date of acquiring a PPE Deferral: an adjustment for which the business paid or received cash in advance Prepaid expense: a category of miscellaneous assets that typically expire or get used up in the near future Unearned revenue: a liability created when a business collects cash from customers in advance of earning the revenue. The obligation is to provide a product or a service in the future