Accounting 978 Chapter 1
Financial Statements and Business Decisions
Luo Jianchuan
jluo@luiss.it
Spring 2023
This set of slides is based on Libby 10e/11e and contains adaptations from the text and
publisher’s material. Its main purpose is to guide the lectures. It does not replace the lectures
or the text. Compilation time stamp: February 3, 2023 8:45pm +01:00
Outline
Financial statements and decision makers (LO 1-1)
Generally accepted accounting principles (GAAP) (LO 1-2)
Types of Business Entities
Sole proprietorship owned by a single individual
Partnership owned by two or more individuals
Corporation ownership represented by shares of stock that can be bought
and sold and operates separately from its owners
Advantages of a corporation
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Limited liability
Continuity of life
Ease in ownership transfer
Access to capital
Disadvantage of a corporation
▶ Double taxation
Corporate investors and their goals
Stockholders
▶ Dividends
▶ Higher future stock prices
Creditors
▶ Interest
The accounting system and decision makers
Accounting is an
information system
that collects and
processes
(analyzes,
measures, and
records) financial
information about
an organization
and reports that
information to
decision makers.
Business activities
Financing activities Borrowing or paying back money to lenders and receiving
additional funds from stockholders or paying them dividends.
Operating activities Buying or selling items such as plant and equipment.
Investing activities Day-to-day operations of the business, such as purchasing
materials from suppliers, delivering products and services to customers,
collecting cash from customers, and paying suppliers.
Why study financial accounting?
Decision makers who rely on financial information:
▶ Investors
▶ Creditors
▶ Managers within the firm such as:
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Marketing managers
Credit managers
Supply chain managers
Human resource managers
The four basic financial statements
Balance sheet reports the financial position (amount of assets, liabilities, and
stockholders’ equity) of an accounting entity at a point in time.
Income statement reports the revenues less the expenses during the
accounting period.
Statement of stockholders’ equity reports the changes in each of the
company’s stockholders’ equity accounts, including the change in the
retained earnings balance caused by net income and dividends, during the
reporting period.
Statement of cash flows reports inflows and outflows of cash during the
accounting period in the categories of operating, investing, and financing.
Notes are an integral part of these financial statements.
Financial statement time period & structure
The four basic financial statements can be prepared at any point in time such
as:
▶ End of the year (for the year ended, annual reports)
▶ Quarterly (for the quarter ended, quarterly reports)
▶ Monthly (for the month ended, monthly reports)
The financial statement heading includes:
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Name of the entity (Company name)
Title of the statement (e.g., Balance Sheet)
Specific date of the statement (e.g., at December 31, 20XX)
Unit of measure (e.g., in millions of dollars)
Balance sheet
Assets
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Cash
Short-term investments
Accounts receivable
Notes receivable
Inventory
Supplies
Prepaid expenses
Long-term investments
Equipment
Buildings
Land
Intangibles
Liabilities
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Unearned revenue
Accounts payable
Accrued expenses
Notes payable
Taxes payable
Bonds payable
Stockholders’ Equity
▶ Common stock
▶ Retained earnings
The accounting equation
Assets = Liabilities + Stockholders’ Equity
Assets Economic resources
Liabilities Financing for resource from creditors
Stockholders’ equity Financing for resource from stockholders
LE-NATURE’S INC.
Balance Sheet
At December 31, 2005
(in millions of dollars)
Assets:
Cash
Accounts receivable
Inventories
Property, plant, and equipment
$ 10.6
6.6
51.2
459.0
Total assets
$527.4
Liabilities and stockholders’ equity:
Liabilities
Accounts payable
Notes payable to banks
Income before income taxes
Income tax expense
$ 26.0
381.7
Total liabilities
Stockholders’ equity
Common stock
Retained earnings
407.7
Total stockholders’ equity
119.7
Total liabilities
and stockholders’ equity
LE-NATURE’S INC.
Income Statement
For the Year Ended Dec. 31, 2005
(in millions of dollars)
Revenues
Sales revenue
$275.1
Expenses
Cost of goods sold
140.8
Selling, general,
and administrative expenses
77.1
Interest expense
17.2
55.7
64.0
$527.4
Net income
40.0
17.1
$ 22.9
Income statement
Revenues
Expenses
Cash and promises received
from delivery of goods and
services. Examples:
▶ Sales revenue
▶ Fee revenue
▶ Interest revenue
▶ Rent revenue
Resources used to earn period’s
revenues. Examples:
▶ Cost of goods sold
▶ Wages expense
▶ Rent expense
▶ Depreciation expense
▶ Insurance expense
▶ Repair expense
▶ Income tax expense
The income statement equation
Revenues = Expenses + Net Income
Revenues Cash and promises received from delivery of goods and services.
Expenses Resources used to earn period’s revenues.
Net income Revenues earned minus expenses incurred. Also called “profit”,
“net earnings”, or “the bottom line.” If total expenses exceed total revenues,
a net loss is reported.
Statement of stockholders’ equity
Common stock
Retained earnings
Amounts invested in the business
by stockholders.
Past earnings not distributed to
stockholders.
+
Beginning common stock
(Net) Stock Issuance
Ending common stock
+
–
Beginning retained earnings
Net income
Dividends declared
Ending retained earnings
LE-NATURE’S INC.
Statement of Stockholders’ Equity
For the Year Ended December 31, 2005
(in millions of dollars)
Cmn.
Retained
Stock
Earnings
Balance Dec. 31, 2004
$ 55.7
Net income for 2005
Dividends for 2005
Balance Dec. 31, 2005
$ 43.1
22.9
(2.0)
$ 55.7
$ 64.0
LE-NATURE’S INC.
Statement of Cash Flows (Summary)
For the Year Ended December 31, 2005
(in millions of dollars)
Cash flows from operating activities
$ 87.5
Cash flows from investing activities
(125.5)
Cash flows from financing activities
47.0
Net increase (decrease) in cash
Cash balance December 31, 2004
9.0
1.6
Cash balance December 31, 2005
$ 10.6
The notes are an integral part of these financial
statements.
The Le-Nature’s statements presented are a
simplified version of its audited 2005 statements.
Statement of cash flows
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Cash flows from operating activities (CFO)
Cash flows from investing activities (CFI)
Cash flows from financing activities (CFF)
Change in Cash
Beginning cash balance
Ending cash balance
Statement of cash flows (cont.)
The operating activities section indicates the company’s ability to generate
cash from sales to meet the company’s current cash needs. Analyze cash flow
from operations in order to check the following:
▶ Ability to repay creditors
▶ Opportunity for expansion
▶ Ability to distribute cash dividends
Relationships among financial statements
Statement
Purpose
Contents
Balance sheet
(Statement of
financial
position)
Reports the financial position
(economic resources and
sources of financing) of an
accounting entity at a point in
time.
Reports the accountant’s primary
measure of economic
performance during the
accounting period.
Cash, accounts receivable, plant
and equipment, long-term debt,
common stock
Reports changes in the
company’s common stock and
retained earnings during the
accounting period.
Reports inflows (receipts) and
outflows (payments) of cash
during the accounting period in
the categories of operating,
investing, and financing.
Beginning and ending
stockholders’ equity balances,
stock issuances, net income,
dividends
Cash collected from customers,
cash paid to suppliers, cash
paid to purchase equipment,
cash borrowed from banks
Income statement
(Statement of
income/
earnings/
operations)
Statement of
stockholders’
equity
Statement of cash
flows (Cash
flow statement)
Sales revenue, cost of goods
sold, selling expense, interest
expense
History of financial reporting
The accounting system in use today has a long history.
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Fr. Luca Pacioli’s Summa de Arithmetica (1494)
Practice prior to 1933
Securities and Exchange Commission (SEC) (1934)
Financial Accounting Foundation (FAF) (1972)
Financial Accounting Standards Board (FASB) (1973)
Sangster 2018
FASB
The Financial Accounting Standards Board (FASB) is the body to formulate
GAAP. The official pronouncements of the FASB are called the FASB
FASB ASC
Accounting Standards Codification.
Generally Accepted Accounting Principles (GAAP)
Companies incur the cost of preparing the financial statements and bear the
following economic consequences of their publication:
▶ Effects on the selling price of stock
▶ Effects on the amount of bonuses received by management and other
employees
▶ Loss of competitive information to other companies
International Financial Reporting Standards
▶ International Accounting Standards Committee (IASC) (1973–2001)
▶ International Financial Reporting Standards Foundation (IFRSC) (2001)
IASB
▶ International Accounting Standards Board (IASB) (2001)
International perspective
Since 2002, there has been substantial movement toward the adoption of
International Financial Reporting Standards (IFRS) issued by the International
Accounting Standards Board (IASB). Examples of jurisdictions requiring the
IFRS Standards
use of IFRS:
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European Union
Australia and New Zealand
Hong Kong, Malaysia, and Republic of Korea
Israel and Turkey
Brazil and Chile
Canada and Mexico
In the U.S., the SEC now allows foreign companies whose stock is traded in
the United States to use IFRS.
Ethical conduct
Intentional misreporting of financial statements is unethical and illegal.
However many situations are less clear-cut and required individuals to weigh
one moral principal (e.g., honesty) against another (e.g., loyalty).
Three-step process for making ethical decisions
1
2
3
Identify the benefits of a decision (often to the manager or
employee involved) and who will be harmed (other employees,
owners, creditors, the environment).
Identify alternative courses of action.
Choose the one you would like your family and friends to see
reported on your local news.
Responsibility and controls
A company ensures the accuracy of its financial information by:
▶ maintaining a system of controls over the records and assets.
▶ hiring external independent auditors.
▶ forming a committee of the board of directors to review these other two
safeguards.
Legal consequences of unethical behavior
After it was determined that the financial statements for Le-Nature’s Inc. were
misleading, the consequences for the defendants were severe.
Le Nature’s Prison Tally
Defendant
Gregory Podlucky, CEO
Robert Lynn, President
Andrew Murin, Consultant
Jonathan Podlucky, COO
Karla Podlucky (CEO’s wife)
G. Jesse Podlucky (CEO’s son)
Donald Pollinger, Businessman
Tammy Jo Andreycak, Bookkeeper
Extra
Sentence
20 years in federal prison
15 years in federal prison
10 years in federal prison
5 years in federal prison
1
4 /4 years in federal prison
9 years in federal prison
5 years in federal prison
5 years in federal prison
Career opportunities
Public accounting
▶ Audit or assurance services
▶ Management consulting or advisory services
▶ Tax services
Employment by organizations
▶ Internal accounting
▶ External reporting
▶ Tax planning
▶ Various other functions
Employment in the public and not-for-profit sector
▶ Not-for-profit hospitals and universities
▶ Government agencies such as the SEC, GAO, and FCC