Chapter 1
Accounting and the
Financial Statements
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Learning Objectives
(1 of 2)
By the end of this chapter you should be able to:
1. Explain the nature of accounting.
2. Identify the forms of business organizations and the types of business
activities.
3. Describe the relationships shown by the fundamental accounting equation.
4. Prepare a classified balance sheet and explain the information it
communicates.
5. Prepare an income statement and explain the information it communicates.
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accessible website, in whole or in part.
Learning Objectives
By the end of this chapter you should be able to:
6. Prepare the retained earnings statement and explain the information it
communicates.
7. Identify the information communicated by the statement of cash flows.
8. Describe the relationships among the financial statements.
9. Explain the importance of ethics in providing useful financial information.
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accessible website, in whole or in part.
Why Is Accounting Important?
(Learning Objective 1)
•
Accounting is an information system that identifies, measures, records, and
communicates financial information about a company’s business
activities so decision makers can make informed decisions.
•
Accounting is the “language of business” because it communicates relevant
and reliable information about the economic activities of a company that
helps people make better decisions.
•
Multiple decision-makers, both inside and outside of a company, use the
financial information provided by accountants.
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Financial Accounting Versus
Managerial Accounting
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Business: Forms and Activities
(Learning Objective 2)
•
Forms of Business Organizations
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accessible website, in whole or in part.
Knowledge Check 1
All of the following are advantages of the corporate form of business except:
A. Greater potential to raise money
B. Less legal liability for owners
C. Greater ease of transferability of ownership
D. Greater taxation
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accessible website, in whole or in part.
Business Activities
(Learning Objective 2)
•
Business Activities include Operating, Investing, and Financing Activities
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accessible website, in whole or in part.
Operating Activities
•
When a corporation acquires the assets that it needs, it starts operations.
Regardless of the unique purposes served by different businesses, they all
want to generate revenue.
•
Revenue: the increase in assets that results from the sale of products or
services. While earning revenue, a corporation will incur various costs or
expenses.
•
Expenses: the costs of assets used up in the creation of liabilities during
the operation of a business. The results of a operating activities for a
company can be determined by comparing revenues to expenses.
•
When revenues are greater than expenses, a corporation earns a net
income. When expenses are greater than revenues, a corporation incurs a
net loss.
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accessible website, in whole or in part.
Investing Activities
•
As a corporation obtains funds through its financing activities, it buys assets
like machinery, land and buildings, that enable it to operate.
•
Purchases (and sales) of operational assets (commonly referred to as
property, plant, and equipment) are a corporation’s investing activities.
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accessible website, in whole or in part.
Financing Activities
•
The financing activities of a company include obtaining the funds necessary
to begin and continue to finance the operations of a business.
•
These funds come from either issuing stock or borrowing money.
•
Nearly all companies use both types of financing to obtain funds.
• Individuals or entities that the corporation owes money to are called creditors.
• Obligations to repay creditors are called liabilities.
• Claims of the stockholders are called stockholders’ equity.
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Knowledge Check 2
Which type of activity includes the profit activities of an organization?
A. Financing activities
B. Operating activities
C. Investing activities
D. Creditor activities
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accessible website, in whole or in part.
The Four Financial Statements
(Learning Objective 3)
•
•
Transactions are organized and reported in a set of standardized reports
called financial statements.
Companies prepare four basic financial statements:
• The Balance Sheet – composed of the resources (assets), claims against
resources (liabilities and stockholders’ equity) at a specific point in time.
• The Income Statement – reporting how well a company’s operations has
performed (revenues, expenses, and income) over a period of time.
• The Retained Earnings Statement – reflecting the amount of a company’s
income retained in the business over a period of time.
• The Statement of Cash Flows – expressing the sources and uses of a
company’s cash over a period of time.
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Financial Statement Time Periods
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Knowledge Check 3
Which of the following is false regarding the balance sheet?
A. The accounts shown on a balance sheet represent the basic accounting
equation for a particular business entity.
B. The retained earnings balance shown on the balance sheet must agree with
the ending retained earnings balance shown on the statement of retained
earnings.
C. The balance sheet reports the changes in specific account balances over a
period of time.
D. The balance sheet reports the amount of assets, liabilities, and stockholders’
equity of an accounting entity at a point in time.
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Common Set of Rules and Conventions
•
•
•
To make it easier to use financial statements over time and across
companies, a common set of rules and conventions has been established
(called generally accepted accounting principles or GAAP). These were
developed by different organizations over many years to guide the
preparation of financial statements.
Within the United States, the Securities and Exchange Commission
(SEC) has the power regulate accounting rules for publicly traded
companies. The SEC has entrusted the Financial Accounting Standards
Board (FASB) with the authority to promulgate financial accounting
standards on its behalf.
The FASB has been working closely with the International Accounting
Standards Board (IASB) in its development of international financial
reporting standards (IFRS) globally.
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Fundamental Accounting Equation
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accessible website, in whole or in part.
Using the Fundamental Accounting Equation
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The Classified Balance Sheet
(Learning Objective 4)
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Balance Sheet Classified Categories
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Knowledge Check 4
Which of the following is a liability account?
A. Accounts Receivable
B. Accounts Payable
C. Long-Term Investments
D. Buildings
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Example 1.2: Preparing a Classified Balance Sheet
(1 of 3)
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accessible website, in whole or in part.
Example 1.2: Preparing a Classified Balance Sheet
(2 of 3)
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accessible website, in whole or in part.
Example 1.2: Preparing a Classified Balance Sheet
(3 of 3)
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accessible website, in whole or in part.
Using Balance Sheet Information
•
The relationship between current assets and current liabilities gives
investors and creditors insights into a company’s liquidity—the ability to
pay obligations as they become due.
•
Two useful measures of liquidity: Working capital and Current ratio.
•
$ Working capital = $ Current Assets – $ Current Liabilities
•
Answers: Does a company have adequate funds to pay its current
obligations?
•
Current Ratio = Current Assets ÷ Current Liabilities
•
Answers: Liquidity questions when comparing different companies
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The Income Statement
(Learning Objective 5)
•
The long-term survival of a company depends on its ability to produce Net
Income
•
Net Income = Revenue – Expenses
•
Revenues are the increase in assets that result from the sale of products or
services, which are the principle activity of a business.
•
Expenses are the cost of resources used to earn revenues during a period.
•
Gains are different from revenues because they are increases in net assets
that occur from peripheral or incidental transactions.
•
Losses are different from expenses because they are decreases in net
assets that occur from peripheral or incidental transactions.
•
Income statement formats: single-step or multiple-step income
statements.
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accessible website, in whole or in part.
Preparing a Single-Step Income Statement
(1 of 2)
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accessible website, in whole or in part.
Preparing a Single-Step Income Statement
(2 of 2)
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accessible website, in whole or in part.
Preparing a Multiple-Step Income Statement
(1 of 2)
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accessible website, in whole or in part.
Preparing a Multiple-Step Income Statement
(2 of 2)
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accessible website, in whole or in part.
Revenue and Expense Relationships
•
Gross Margin = Net Sales – Cost of Goods Sold
Gross margin represents the initial profit made from selling a product, but it
is not a measure of total profit because other operating expenses have not
yet been subtracted. However, gross margin is closely watched by
managers and other financial statement users.
•
Income from Operations = Gross Margin – Operating Expenses
Operating expenses are the expenses the business incurs in selling goods
or providing services and managing the company. Operating expenses
typically include research and development expenses, selling expenses,
and general and administrative expenses.
•
Net Profit Margin = Net Income ÷ Sales Revenue
Net profit margin shows the percentage of profit in each dollar of sales.
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Discussion 1: Financial Statement Analysis
Companies
Browne
Enterprise.
Total
Revenues
$92,740
Cooke, Ltd.
Total
Expenses
$77,900
75,340
Marlow & Sons
59,400
Greshen Co.
86,710
Net Income Total
(Loss)
Assets
$141,200
$15,600
$76,500
47,960
97,330
Stockholders’
Equity
$70,000
109,750
21,670
93,220
Total
Liabilities
50,680
70,110
Required: (1) Calculate the two missing amounts for each company.
(2) Analyze which company is in better shape economically and what might change your
answer.
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accessible website, in whole or in part.
Discussion 1 Debrief
Companies
Total
Total Revenues Expenses
Net Income
(Loss)
Total
Total Assets Liabilities
Stockholders’
Equity
Browne
Enterprise.
$92,740
$77,900
$ 14,840
$141,200
$70,000
$71,200
Cooke, Ltd.
100,940
75,340
25,600
109,750
33,250
76,500
Marlow & Sons
59,400
37,730
21,670
98,640
47,960
50,680
Greshen Co.
86,710
93,220
(6,510)
97,330
70,110
27,220
Solution: The table represents simplified income statements and balance sheets. From a cursory look,
it appears that Cooke Ltd. is in the best shape with the highest income and the lowest debt. However,
this answer might change if all four required financial statements are given, along with the detailed
breakdown of information in each statement plus the financial statement footnotes. The analysis might
also change depending on which user perspective you use – best economical shape for investors,
management, creditors, regulators, etc.
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Example 1.5: Preparing a Retained Earnings
Statement (Learning Objective 6)
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accessible website, in whole or in part.
Example 1.5: Preparing a Retained Earnings
Statement (Learning Objective 6)
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accessible website, in whole or in part.
Statement of Cash Flows
•
The last of the major financial statements, the statement of cash flows, describes
the company’s cash receipts (cash inflows) and cash payments (cash outflows) for
a period of time. Cash flows are classified into one of three categories:
• Cash flows from operating activities—any cash flows directly related to earning
income. This category includes cash sales and collections of accounts receivable as well
as cash payments for goods, services, salaries, and interest.
• Cash flows from investing activities—any cash flow related to the acquisition or sale
of investments and long-term assets such as property, plant, and equipment.
• Cash flows from financing activities—any cash flow related to obtaining capital of the
company. This category includes the issuance and repayment of debt, common stock
transactions, and the payment of dividends.
•
A company with healthy cash flow—particularly if it comes from operating
activities—is in a good position to repay debts as they come due, pay dividends,
and is a low-risk borrower.
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Relationships Among the Statements
(Learning Objective 8)
•
There are three key linkages:
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The Way Statements Are Interrelated
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Professional Ethics
•
Accountants serve the greater good of society and have an ethical
responsibility to all the users who make decisions based on the financial
information presented.
•
Confidence that standards of ethical behavior will be maintained—even
when individuals have incentives to violate those standards—is crucial to
the financial reporting process.
•
Although you may be faced with difficult decisions in your career,
accountants are expected to maintain the highest level of ethical behavior.
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