CHAPTER 1
The Financial Statements
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ACCOUNTING - THE BASIS
OF DECISION MAKING
• Accounting is the “language of
business”
• Accounting is the information system
that
– Measures business activities
– Processes that information into reports
– Communicates the results to decision
makers
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THE ACCOUNTING SYSTEM:
THE FLOW OF INFORMATION
1. People make decisions
2. Business transactions occur
3. Businesses prepare reports to show the
results of their operations
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ACCOUNTING VS.
BOOKKEEPING
• Bookkeeping is the procedural element
of accounting that processes the
accounting data
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DECISION MAKERS WHO USE
ACCOUNTING INFORMATION
•
•
•
•
•
•
Individuals
Businesses
Investors and Creditors
Government Regulatory Agencies
Taxing Authorities
Nonprofit Organizations
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FINANCIAL ACCOUNTING AND
MANAGEMENT ACCOUNTING
• Financial accounting provides
information to managers and people
outside the firm
– Financial accounting information must
meet certain standards of relevance and
reliability
• Management accounting generates
confidential information for internal
decision makers, e.g.,
– Top executives
– Department heads
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ETHICAL CONSIDERATIONS
• Ethical standards in accounting are
designed to produce accurate
information for decision making
• The result of ethical behavior by
accountants is information that people
can rely on for decision making
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TYPES OF BUSINESS
ORGANIZATIONS
• Proprietorships
– Have a single owner who is generally the
manager
– Are business entities, but not legal entities
– Have debt for which the proprietor is
personally liable
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TYPES OF BUSINESS
ORGANIZATIONS
• Partnerships
– Join two or more persons together as coowners
– Are business entities, but not legal entities
– Have debt for which each partner is
personally liable
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TYPES OF BUSINESS
ORGANIZATIONS
• Corporations
– Are owned by stockholders or
shareholders
– Are business entities and legal entities
– Are liable for all debts
• Stockholders have no personal obligation for
corporation debts
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ACCOUNTING PRINCIPLES
AND CONCEPTS
• Generally accepted accounting
principles (GAAP) are
– The rules that govern how accountants
operate
– Based upon a conceptual framework
written by the Financial Accounting
Standards Board (FASB)
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ACCOUNTING PRINCIPLES
AND CONCEPTS
• The FASB works with the SEC
(Securities and Exchange Commission)
and the AICPA (American Institute of
Certified Public Accountants)
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KEY ACCOUNTING ORGANIZATIONS
Public Sector
Law creates the SEC to
regulate the stock and
bond market in the U.S.
Private Sector
Accountants apply
GAAP through
the AICPA
GAAP governs
accounting
information
Private Sector
The FASB determines
generally accepted
accounting principles
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ACCOUNTING PRINCIPLES
AND CONCEPTS
• The entity concept
– States that an organization is an
economic entity that keeps its affairs
separate from those of the owner(s)
• The reliability (objective) principle
– States that accounting records and
statements are based on the most reliable
data available and documented by
objective evidence
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ACCOUNTING PRINCIPLES
AND CONCEPTS
• The cost principle
– States that acquired assets and services
should be recorded at their actual
(historical) cost and should maintain that
historical cost for as long as they are
owned
• The going-concern concept
– States that the entity will remain in
operation for the foreseeable future
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ACCOUNTING PRINCIPLES
AND CONCEPTS
• The stable-monetary-unit concept
– States that each dollar has the same
purchasing power as any other dollar at
any other time
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THE ACCOUNTING EQUATION
• The accounting equation presents the
resources of the business and the
claims to those resources
Economic Resources = Claims to Economic Resources
or
Assets = Liabilities + Owners’ Equity
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THE ACCOUNTING EQUATION
• Assets are the economic resources of a
business that are expected to be of
benefit in the future
• Claims to assets come from
– Liabilities
• Economic obligations - debts payable to
outsiders, called creditors
– Owners’ equity (capital)
• Assets held by the owners of the business
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THE ACCOUNTING EQUATION
• For a corporation, stockholders’
(owners’) equity consists of two main
categories
– Paid-in capital
– Retained earnings
Assets = Liabilities + Stockholders’ Equity
or
Assets = Liabilities + Paid-in Capital + Retained Earnings
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THE ACCOUNTING EQUATION
• Paid-in (contributed) capital is
– The amount invested in the corporation by
its owners
– Comprised basically of common stock
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THE ACCOUNTING EQUATION
• Retained earnings
– Is the amount earned by income-producing
activities and kept for use in the business
– Is affected by
• Revenues - increases in retained earnings
from delivering goods or services
• Expenses - decreases in retained earnings that
result from operations
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THE ACCOUNTING EQUATION
• Net income (net earnings)
– Total revenues exceed total expenses
• Net loss
– Total expenses exceed total revenues
• Dividends
– Distributions to stockholders (usually cash)
generated by net income
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COMPONENTS OF RETAINED EARNINGS
Revenues for the
Period
-
Expenses for the
Period
Start of the
Period
End of the
Period
=
Beginning Balance
of Retained
Earnings
+
-
Net Income (Loss)
for the Period
-
Dividends for the
Period
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=
Ending Balance of
Retained
Earnings
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THE ACCOUNTING EQUATION
• The owners’ equity of proprietorships
and partnerships
– Makes no distinction between paid-in
capital and retained earnings
– Accounts for the equity of each owner
under the single heading of Capital
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INFORMATION REPORTED
ON THE FINANCIAL
STATEMENTS
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Question
Answer
Financial Statement
1.
H o w w e ll d id th e
c om p a n y p e rfo rm
d u rin g th e p e rio d ?
R evenues
-E x p e n s e s
N e t in c o m e (lo s s )
In c o m e s ta tem e n t
(S ta te m e n t o f
o p e ra tio n s o r
S ta te m e n t o f
e a rn in g s )
2.
W h y d id th e
c om p a n y’s re ta in e d
e a rn in g s c h a n g e
d u rin g th e p e rio d ?
B e g in n in g R .E .
+ N e t in c o m e (-lo s s )
-D iv id e n d s
E n d in g R .E .
S ta te m e n t o f re ta in e d
e a rn in g s (S ta te m e n t
o f s to ck h o ld e rs ’
e q u ity)
3.
W ha t is th e
c om p a n y’s fin a n c ia l
p o s itio n a t th e e n d o f
th e p e rio d ?
A s s e ts = L ia b ilitie s +
O w n e rs ’
E q u ity
B a la n c e s h e e t
(S ta te m e n t o f
fin a n c ia l p o s itio n )
4.
H o w m u c h c a s h d id
th e c o m p a n y
g e n e ra te a n d s p e n d
d u rin g th e p e rio d ?
O p e ra tin g c a s h flo w s
+ In ve s tin g c a s h flo w
+ F in a n c in g c a s h flo w
In c re a s e (d e c re a s e )
in c a s h d u rin g th e
p e rio d
S ta te m e n t o f c a s h
flo w s
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INCOME STATEMENT
• The income statement (statement of
earnings) reports the company’s
revenues, expenses, and net income or
net loss for the period
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INCOME STATEMENT
A IR & S E A T R A V E L , IN C .
In c o m e S ta te m e n t
M o n th E n d e d A p ril 3 0 , 2 0 0 1
Revenue:
S e rv ic e re v e n u e
Expenses:
S a la ry e x p e n s e
Rent expense
U tilitie s
T o ta l e x p e n s e s
N e t In c o m e
$ 8 ,5 0 0
$ 1 ,2 0 0
1 ,1 0 0
400
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2 ,7 0 0
$ 5 ,8 0 0
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INCOME STATEMENT
• Revenues are
– Increases in retained earnings from
delivering goods or services to customers
or clients
• Expenses are
– Decreases in retained earnings that result
from operations
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INCOME STATEMENT
• Expenses include
– Cost of goods sold (cost of sales)
• The cost of the goods that a company sold to
its customers
– Operating expenses
• The costs of operating the business
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INCOME STATEMENT
• Operating expenses
– Advertising
• The cost to promote the company’s products
– Depreciation
• The expense of using company-owned
buildings, equipment, and furniture
– Other operating expenses
• The costs of salaries, utilities, rent, and supplies
– Interest expense
• The cost of borrowed money
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STATEMENT OF
RETAINED EARNINGS
• The statement of retained earnings
reports that portion of net income the
company has retained, or kept for use in
the business
– Net income increases retained earnings
– Dividends paid to stockholders decrease
retained earnings
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STATEMENT OF
RETAINED EARNINGS
A IR & S E A T R A V E L , IN C .
S ta te m e n t o f R eta in e d E a rn in g s
M o n th E n d e d Ap ril 3 0, 2 0 0 1
R e ta in e d e a rn in g s, A p ril 1, 2 0 01
A d d : N e t in c o m e fo r th e m o n th
L e s s : D ivid e n d s
R e ta in e d E arn in g s, Ap ril 3 0, 2 0 0 1
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$
0
5,8 0 0
$ 5 ,8 0 0
(2,1 0 0 )
$ 3 ,7 0 0
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BALANCE SHEET
• The balance sheet (statement of
financial position) reports the company’s
assets, liabilities, and owners’ equity
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BALANCE SHEET
A IR & S E A T R A V E L , IN C .
B a la n c e S h e e t
A p ril 3 0 , 2 0 0 1
A s s e ts
L ia b ilitie s
C a sh
A cco u n ts re ce iva b le
O ffice su p p lie s
Land
$ 3 3 ,3 0 0
2,0 0 0
500
1 8,0 0 0
T ota l a ssets
$ 5 3 ,8 0 0
A cco u n ts p a ya b le
$
100
S to c k h o ld e rs’ E q u ity
C o m m o n stock
5 0,0 0 0
R e ta in e d e a rn ing s
3,7 0 0
T ota l sto ck h o ld e rs’ eq u ity 5 3 ,7 0 0
T ota l lia b ilitie s a n d
sto ck h o ld e rs’ eq u ity
$ 5 3 ,8 0 0
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ASSETS
• Current assets are
– Those assets which the company expects
to convert to cash, sell, or consume during
the next 12 months or within the business's
normal operating cycle if longer than a year
• Current assets include
– Cash
– Accounts receivable
– Merchandise inventory
– Prepaid expenses
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ASSETS
• Long-term assets are
– Those assets which the company expects
to hold longer then the next 12 months or
the business’s normal operating cycle if
longer than one year
• Long-term assets include
– Property
– Equipment
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ASSETS
• Intangible assets are
– Those with no physical form
• Trademarks
• Patents
• Other assets are
– Those with small values which do not fall
within any other standard asset category
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LIABILITIES
• Current liabilities are
– Debts payable within one year or within the
business’s normal operating cycle if longer
than a year
• Current liabilities include
– Notes payable, short term
– Accounts payable
– Accrued expenses payable
– Income taxes payable
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LIABILITIES
• Long-term liabilities are
– Debts not payable within one year or within
the business’s normal operating cycle if
longer than a year
• Long-term liabilities include
– Notes payable, long term
– Bonds payable
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OWNERS’ EQUITY
• Owners’ equity
– Represents the shareholders’ ownership of
the assets of the business
• Owners’ equity of a corporation consists
of
– Common stock
– Retained earnings
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STATEMENT OF CASH FLOWS
• The statement of cash flows reports the
company’s cash inflows and outflows
from operating, investing, and financing
activities
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A IR & S E A T R A V E L , IN C .
S ta te m e n t o f C a s h F lo w s
M o n th E n d e d Ap ril 3 0, 2 0 0 1
C a s h flow s fro m o p e ra tin g a c tivitie s:
C o lle ctio n s from cu stom ers
$ 6 ,5 0 0
P a ym e n ts to su p p lie rs a n d e m p lo ye e s
(3 ,1 0 0 )
N e t ca sh inflo w from o p era ting a ctiv itie s
3 ,4 0 0
C a s h flow s fro m in ve s tin g a c tivities :
A cq u isitio n of la n d
$ (4 0 ,0 0 0)
S a le of la n d
2 2,0 0 0
N e t ca sh o utflo w from in ve sting a ctivitie s
(1 8 ,0 0 0)
C a s h flow s fro m fin a n c in g a c tivitie s:
Issu a n ce (sa le) of sto ck
$ 5 0,0 0 0
P a ym e n t of d ivid e n d s
(2,1 0 0 )
N e t ca sh inflo w from fin a n cin g a ctivitie s
4 7 ,9 0 0
N e t in cre a se in cash
$ 3 3 ,3 0 0
C a sh b a la n ce , A p ril 1 , 2 0 0 1
0
C a sh b a la n ce , A p ril 3 0 , 2 0 0 1
$ 3 3 ,3 0 0
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STATEMENT OF CASH FLOWS
• Operating activities
– Companies operate by buying goods and
services, which are sold to customers
• Investing Activities
– Companies invest in long-term assets that
are used to run the business
• Financing Activities
– Companies finance themselves by issuing
stock and borrowing money
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RELATIONSHIPS AMONG THE
FINANCIAL STATEMENTS
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A IR & S E A T R A V E L , IN C .
S ta te m e n t o f C as h F lo w s
M o n th E n d e d A p ril 3 0 , 2 0 0 1
C a sh flo w s fro m o p e ra tin g a ctivitie s:
C o lle ctio n s fro m cu sto m e rs
P a y m e n ts to su p plie rs an d e m p lo ye e s
N e t ca sh in flo w fro m o p e ra tin g a ctivitie s
C a sh flo w s fro m in ve stin g a ctivitie s:
A cq u isitio n o f la n d
$ (4 0 ,0 00 )
S a le o f la n d
2 2 ,0 00
N e t ca sh o utflo w fro m in ve sting a ctivitie s
C a sh flo w s fro m fin a n cing a ctivitie s:
Issu a n ce (sa le ) o f sto ck
$ 5 0 ,0 00
P a y m e n t o f d ivide n d s
(2 ,10 0 )
N e t ca sh in flo w fro m fin a n cin g a ctivitie s
N e t in cre a se in ca sh
C a sh b ala n ce , A p ril 1 , 2 00 1
C a s h b a la n c e , A p ril 3 0 , 2 0 01
A IR & S E A T R A V E L , IN C .
S ta te m e n t o f R e ta in e d E a rn in g s
M o n th E n d e d A p ril 3 0 , 2 0 0 1
R e ta in e d e a rn in g s , A p ril 1 , 2 0 0 1
A d d : N e t in c o m e fo r th e m o n th
$
0
5 ,8 0 0
$ 5 ,8 0 0
L e s s : D ivid e n d s
(2 ,1 0 0 )
R e ta in e d E a rn in g s , A p ril 3 0 , 2 0 0 1 $ 3 ,7 0 0
A IR & S E A T R A V E L , IN C .
In c o m e S tate m e n t
M o n th E n d e d Ap ril 3 0, 2 0 0 1
$ 6 ,5 0 0
(3 ,1 00 )
3 ,4 0 0
(1 8 ,0 0 0)
4 7 ,9 0 0
$ 3 3 ,3 00
0
$ 3 3 ,3 00
R e ve n u e :
S e rvice re ve n u e
E xp e n se s:
S a la ry e xp e n se
R e n t e xp e n se
U tilitie s
T ota l e xp e n se s
N e t In c o m e
$ 8 ,5 0 0
$ 1 ,2 0 0
1,1 0 0
400
2,7 0 0
$ 5 ,8 0 0
A IR & S E A T R A V E L , IN C .
B a la n c e S h e e t
A p ril 3 0 , 2 0 0 1
A sse ts
L ia bilitie s
Cash
$ 3 3 ,3 0 0
A cco u n ts re ceivab le
2 ,0 0 0
O ffice su p plie s
500
Land
1 8 ,0 0 0
T o tal a sse ts
_______
$ 5 3 ,8 0 0
A cco u n ts p a ya ble
$
100
S to ckh o lde rs’ E q uity
C o m m o n sto ck
5 0 ,0 0 0
R e ta in e d e a rn in g s
3 ,7 0 0
T o tal sto ckh old ers’ e q uity 5 3 ,7 0 0
T o tal lia bilitie s an d
_______
sto ckh old ers’ e q uity
$ 5 3 ,8 0 0
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END OF CHAPTER 1
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