Financial Accounting
Eleventh Edition
Global Edition
Chapter 1
Conceptual Framework
and Financial
Statements
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Learning Objectives
1.1 Understand the role of accounting in communicating
financial information.
1.2 Understand the underlying accounting concepts in the
IFRS Conceptual Framework.
1.3 Obtain insights into business operations through
financial statements.
1.4 Identify financial statements and their inter-relationships.
1.5 Understand the role of ethics in accounting.
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Learning Objective 1.1
Understand the role of accounting in communicating financial information.
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Understand the Role of Accounting in
Communicating Financial Information
• Accounting is an information system that:
– Measures business activities
– Processes data into reports
– Communicates results to decision makers
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Exhibit 1-1 The Flow of Accounting
Information
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Accounting Is the Language of
Business
Accounting is the language of communication in all
businesses. The better our understanding of this
language, the better we can understand our finances,
our businesses, or our investments.
It is used by:
• Individuals
• Investors and creditors
• Regulatory and tax authorities
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Two Kinds of Accounting (1 of 2)
Financial Accounting
• For decision makers outside the entity
– Investors
– Creditors
– Government agencies
– Tax authorities
– Banks
– The public
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Two Kinds of Accounting (2 of 2)
Managerial Accounting
• For managers inside the entity
– Forecasts and Budgets
– Costing
– Pricing
– Analyzing the performance of different
departments and activities within the company
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Exhibit 1-2 The Various Forms of
Business Organizations
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Organizing a Business (1 of 7)
• Proprietorship
– Has a single owner, called the proprietor
– Tend to be small retail stores or solo providers of
professional services
– For accounting purposes, the proprietorship is a
distinct entity, separate from its proprietor.
– The business records shouldn’t include the
proprietor’s personal finances
– Legally, the proprietor is personally liable for all
business’s debts
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Organizing a Business (2 of 7)
• Partnership
– Has two or more parties as co-owners and each
owner is a partner
– Individuals, partnerships or corporations can be
partners
– Many are small or medium-sized companies
– Many retail companies, professional service firms (law,
accounting, etc.), real estate, and oil and gas
exploration companies operate as partnerships.
– The “Big 4” accounting firms operate as
partnerships.
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Organizing a Business (3 of 7)
• Partnership
– Income and losses of the partnership “flow through” to
partners and they recognize it based on their agreedupon percentage interest in the business
– The partnership is not a taxpaying entity. Instead, each
partner takes a proportionate share of the entity’s
taxable income and pays tax according to that partner’s
individual or corporate rate.
– Partnerships are governed by agreement, usually
spelled out in writing in the form of a contract between
the partners.
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Organizing a Business (4 of 7)
•
Partnership
• General partnerships have mutual agency and
unlimited personal 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.
• Partnerships are therefore quite risky, because an
irresponsible partner can create large debts for the
other general partners without their knowledge or
authorization. This feature of general partnerships has
spawned the creation of limited-liability partnerships
(LLPs).
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Organizing a Business (5 of 7)
•
Partnership
• A limited-liability partnership is one in which a
wayward partner cannot create a large liability for
the other partners.
• In LLPs, each partner is liable for partnership
debts only up to the extent of his or her investment
in the partnership, plus his or her proportionate
share of the liabilities.
• Each LLP, however, must have one general
partner with unlimited liability for all partnership
debts.
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Organizing a Business (6 of 7)
Corporation
• Owned by shareholders (stockholders), who own
shares representing ownership in the corporation
• One of the major advantage is the ability to raise large
sums of capital from issuing shares to the public
• Proprietorships and partnerships are more numerous
• Corporations are larger in terms of assets, and
number of employees.
• Like an artificial person (has rights and obligations)
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Organizing a Business (7 of 7)
Corporation
• Unlike proprietorships and partnerships, corporations
are legally distinct from its owners – an artificial
person
• Shareholders have no personal obligation for the
corporation’s debts, limited liability
• Ultimate control rests with the stockholders, who
generally get one vote for each share they own.
• Shareholders elect board of directors, which
– Sets policy
– Appoints management officers (CEO, CFO, and
COO)
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Role of Accounting Standards
In accounting, we assign monetary amounts to
represent elements of financial statements in
accordance to some accounting standards.
• International Financial Reporting Standards (IFRS)
– Formulated by the International Accounting
Standards Board (IASB)
• Generally Accepted Accounting Principles (GAAP)
– Formulated by the Financial Accounting Standards
Board (FASB)
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Accounting standards
• IFRS: formed with the objective of developing a
single set of high-quality, understandable, and
enforceable accounting standards to help
participants in the world’s capital markets and
other users make economic decisions.
• GAAP: the most common frameworks used in the
United States with the overall objective to provide
financial information about the reporting entity that
is useful to existing and potential investors,
lenders, and other creditors in making decisions
about providing resources to the entity.
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International Financial standards
• Historically, different countries use their own
accounting standards.
▫ Difficult for investors to compare companies that
operate in different countries
• The IASB has developed international standards
(IFRS)
▫ In the past, U.S. considered its GAAP to be the
strongest set of standards
• In November 2008, the SEC announced it will require
all U.S. public companies to adopt IFRS
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Learning Objective 1.2
Understand the underlying accounting concepts in
the IFRS Conceptual Framework.
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The Conceptual Framework
• Generally the “Why, Who, What, How” of financial
reporting, it:
– lays the foundation for resolving the big issues in
accounting
– prescribes the nature, function, and boundaries within
which financial accounting and reporting operate
– is a joint publication by the IASB and the FASB, used
as a foundation for reviewing existing and developing
new accounting standards
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Exhibit 1-3 Conceptual Framework of
Financial Reporting
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Overview
The Conceptual Framework helps us answer the following
questions:
1. Why Is Financial Reporting Important?
2. Who Are the Users of Financial Reports?
3. What Makes Financial Information Useful?
4. What Constraints Do We Face in Providing Useful
Information?
5. What Are Our Assumptions in Financial Reporting?
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Exhibit 1-4 The Accounting Equation
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Apply the Accounting Equation to
Business Organizations (1 of 5)
The financial statements are based on the
accounting equation.
• Assets:
Are economic resources controlled by the entity
which are expected to produce future economic
benefits to the entity.
Examples of assets include cash, inventory, account
receivables (money owed to the entity by its
debtors), Property, plant, and equipment.
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Apply the Accounting Equation to Business
Organizations (2 of 5)
• Liabilities: Outsider claims – debts payable to
outsiders
Are present obligations of the entity which are
expected to result in an outflow of economic
benefits from the entity.
Examples of liabilities include bank loans, account
payables (money owed by the entity to its creditors),
tax payable and other obligations.
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Apply the Accounting Equation to
Business Organizations (3 of 5)
Owner’s Equity
• Insider claims, shareholders’ interest in the assets
• The residual interest in the entity’s assets after
deducting the entity’s liabilities and represents
shareholder’s residual claim to the entity’s assets.
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Apply the Accounting Equation to
Business Organizations (4 of 5)
Owner’s Equity
• The accounting equation can be rewritten as:
– Assets – Liabilities = Owners’ Equity
• Corporation’s equity is called shareholders’ equity and
it has two parts:
– Share capital
– Retained earning
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Apply the Accounting Equation to
Business Organizations (5 of 5)
Owner’s Equity
▪ Share capital
Is the amount shareholders have invested in the
entity (usually in the form of shares)
▪ Retained Earnings
Is the amount earned by income-producing activities
and kept for use in the business.
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Exhibit 1-6 The Components of
Retained Earnings
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Components of Retained Earnings
• Revenues
– Inflow of resources from delivering goods or
services
– Increase retained earnings
• Expenses
– Outflow of resources due to the cost of operations
– Decrease retained earnings
• Dividends
– Distribution of assets to shareholders
– Decrease retained earnings
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Accounting Equation Elements
Assets
• Economic resources
• Produce future benefits
Liabilities
• Present obligations
• Expected to result in an outflow of economic benefits
Equity
• Represents shareholders’ residual claim to the entity’s
assets
Revenue
• Increases in economic benefits during an accounting
period
Expenses
• Decreases in economic benefits during an accounting
period
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Learning Objective 1.3
Obtain insights into business operations through
financial statements.
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Flow of the Financial Statements
• Income statement
• Statement of changes in owner’s equity
• Balance sheet
• Statement of cash flows
Information about financial position (assets,
liabilities and equity) is primarily provided in a
Balance Sheet, whereas information about financial
performance (income and expenses) is primarily
provided in an Income Statement.
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The Financial Statements
Income
Statement
Statement of
Changes in
Equity
Statement of
Cash Flows
Balance Sheet
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The Accounting Equation and Financial Statement
Preparation (Demonstration)
• At December 31, 2019, DR Painting had the following information:
Cash
270,300
Accounts receivable
19,400
Supplies
19,800
Truck
200,000
Accounts payable
10,000
Share capital
400,000
Retained earnings (Jan.1)
50,000
Retained earnings (Dec. 31)
99,500
Dividends
10,500
Service revenue
70,000
Salary expense
6,000
Rent expense
4,000
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DR Painting, Incorporation
Income Statement
Financial Year Ended December 31
Revenues
Service revenue
$ 70,000
Expenses
Salary expense
Rent expense
$ 6,000
$ 4,000
Total Expenses
$ 10,000
Net Income
$ 60,000
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The Income Statement Shows a
Company’s Financial Performance
• How well did the company perform during the year?
• The income statement reports two main categories;
revenues and expenses for the period.
• The bottom line net income (loss) for the period
Net income = Total Revenues and Gains − Total
Expenses and Losses
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The Statement of Changes in Equity
• Why did the company’s equity change during the
year?
• The Statement of Changes in Equity shows a
company’s transactions with its owners.
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The Statement of Changes in
Equity
• Equity
– owner’s residual interest in the entity after
deducting liabilities
– Net income increases total equity
– Net losses and dividends decrease total equity
– Net income (net loss) flows from the income
statement to the statement of changes in equity
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DR Painting, Incorporation
Statement of Changes in Equity
For the year ending December 31, 2019
Beginning total equity, Jan 1, 2019
Add: Issuance of share Capital
Add: Net income
$ 450,000
$0
$ 60,000
Less: Dividends
$ (10,500)
= Shareholder equity as of December 31, 2010
$ 499,500
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The Balance Sheet
Balance Sheet
• What is the company’s financial position at financial
year end?
• Also called the statement of financial position
• Reports three items:
– Assets
– Liabilities
– Shareholders’ equity
• Reflects the company’s position at a specific moment in
time
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The Balance Sheet – Assets (1 of 3)
There are two main categories of assets: Current
and non-current (long-term) assets.
• Current assets – are assets that are expected to be
converted to cash, sold or consumed within the next 12
months (one business cycle)
– Cash (most liquid asset) and cash equivalents
(financial instruments easily convertible to cash)
– Short-term investments (deposits, financial
instruments)
– Accounts receivable (debtors)
– Inventory
– Prepaid expenses
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The Balance Sheet – Assets (2 of 3)
• Non-current assets (Long-term assets) – expected
to benefit the company beyond just the next fiscal year
(will be held for longer than one year)
– Property, plant, and equipment (PPE) fixed assets,
includes land, equipment, computers
– Long-term investments (investments in its affiliates
and associates – financial assets)
– Intangible: are assets with no physical form, such
as patents, trademarks, goodwill on acquisitions of
subsidiaries
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The Balance Sheet – Liabilities (3 of 3)
Liabilities
• Current liabilities – obligations or debts payable
within one year
– Examples: accounts payable, taxes payable
salaries/wages payable, short-term notes payable
• Non-current or long-term liabilities – obligations or
debts payable after one financial year
– Examples: long-term bank borrowings, long-term
notes payable, long-term bonds payable
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The Shareholders’ Equity in the Balance
Sheet
• Represents shareholders ownership of the
business’s assets
• Consists of:
– Paid-in capital (sometimes labeled Share
Capital or simply, Capital)
– Retained earnings
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DR Painting, Incorporation
Balance Sheet
December 31, 2019
Assets
Liabilities and Shareholders' Equity
Current assets:
Liabilities:
Cash
270,300 Current liabilities:
Accounts receivable
19,400 Accounts payable
10,000
Inventories
Taxes payable
Supplies
19,800 Total current liabilities
Prepaid expenses
Long-term debt
Total current assets
309,500 Total liabilities
10,000
Non-current assets:
Shareholders'equity:
Property and Equipment, net 200,000 Share capital
400,000
Long- term financial investments
Retained earnings
99,500
Intagible assets
Total non-current assets
200,000 Total shareholders' equity
499,500
Total assets
509,500 Total liabilities & shareholders' equity 509,500
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The Statement of Cash Flows
• How much cash did the company generate and
spend during the year?
• Measures cash receipts and cash payments
• Fourth required financial statement
• Categorizes into three types of activities:
– Operating
– Investing
– Financing
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The Statement of Cash Flows
• Three types of activities:
– Operating activities: cash flows from selling and
purchasing goods and services
– Investing activities: cash flows from purchasing
and selling long-term assets
– Financing activities: cash flows from borrowing
or repaying funds or equity transactions
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DR Painting, Incorporation
Statement of Cash Flows
For the year ending December 31, 2019
Net cash provided by operating activities
Net cash used by investing activities
Net cash used/provided by financing activities
= Net Cash Flows for the Period
$$,$$$
$$,$$$
$$,$$$
$$,$$$
Cash at the beginning of the year
$$,$$$
Cash at the end of the year
$$,$$$
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Learning Objective 1.4
Identify financial statements and their interrelationships.
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Relationships between Financial Statements
Income Statement
For the year ended December 31, 2010
Revenues
$$$,$$$
Expenses
($$,$$$)
Net income
$$,$$$
Statement of Changes in Equity
For the year ended December 31, 2010
Beginning equity
$$$,$$$
Net income
$$,$$$
Cash dividends
($$,$$$)
Ending equity
$$,$$$
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53
Statement of Changes in Equity
For the year ended December 31, 2010
Beginning equity
$$$,$$$
Net income
$$,$$$
Cash dividends
($$,$$$)
Ending equity
$$,$$$
Balance Sheet
December 31, 2010
Assets
$$$,$$$
Liabilities
$$$,$$$
Shareholders’ equity:
Share capital
$$$,$$$
Retained earnings
$$$,$$$
Total shareholders’ equity
Total liabilities and equity
$$$,$$$
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$$$,$$$
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Assumptions
Accrual Accounting
• Transactions and other events are
recognized when they occur and not
when the cash is paid or received
Going- concern assumption
• Entity will continue to operate long
enough to use existing assets for its
intended purposes.
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Learning Objective 1.5
Understand the role of ethics in accounting.
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Evaluate Business Decisions
Ethically
Three factors influence business and accounting decisions
• Economics
– Decision should maximize the economic benefits
• Legal
– Free societies are governed by laws written to provide
clarity and prevent abuse of others’ rights
• Ethical
– Recognizes that even when economically profitable
and legal, some actions still may not be right
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Code of Ethics for Professional
Accountants
• The International Ethics Standards Board for
Accountants (IESBA) provides the industry a Code
of Ethics for Professional Accountants with these
principles:
– Integrity
– Objectivity
– Professional Competence and Due Care
– Confidentiality
– Professional Behavior
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