Financial Accounting Basics: The income statement Gapenski Chapter 3

1. Financial Accounting Basics:The income statement(Gapenski Chapter 3) Preview

2. Accounting and social development Ancient record keeping “Double entry” BK emerges with Luca Paciolo’s 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

3. Accounting changes little…. Many of Paciolo’s 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.

4. 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

5. 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.

6. 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

7. 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.

8. Public Accountancy…a 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

9. Accounting entity/ accounting period Separates the business from its investors; establishes what is “in/out” of statements When are accounts “consolidated?”

10. 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

11. Conservatism: if alternative accounting interpretations yield different results pick the one that is less likely to overstate the entity’s 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

12. 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.)

13. 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.

14. 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.

15. Handy crib sheet…

16. 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

17. 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.”

18. 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?

19. 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