Chapter 1
Accounting Activities and
Financial Statements
ACCT 100
Objectives of the Chapter
1. Principal activities of business firms.
2. Understanding four financial statements.
3. The users of financial statements.
4. The financial reporting reform.
5. The types of business entity.
6. The authorities prescribing accounting standards
and the need for international accounting
standards.
7. Accounting concepts and principles.
The Financial Statements
2
I. Principal Activities of Business
Firms


Establishing Corporate Goals and
Strategies
Obtaining Financing (from owners and
creditors)

Making Investments (i.e., Investments,
Purchase of Property, Plant and Equipment,
Purchase of Intangibles, etc.)

Carrying Out Operations (i.e., purchase of
materials/inventory, production, marketing and
administration)
Overview of Financial Statements
3
2. Understanding Four Financial
Statements
Q1: What is accounting?
An information system to account for
business transactions and to
communicate the financial information
to users.
Q2: How do accountants communicate
financial information to users?
Overview of Financial Statements
4
Annual Financial Reports


1.
Public firms communicate their financial
information via the annual reports to
shareholders.
The content of an annual report
includes:
A letter to shareholders from the CEO
(i.e., IBM 2008 Annual Report, p1-9).
2.
Management’s Discussion and
Analysis (MD&A) (i.e., IBM 2008 Annual Report,
p18-57).
Overview of Financial Statements
5
Annual Financial Reports (contd.)
3.
Report of Management (i.e., on the
effectiveness of Internal control; required by
Sarbanes-Oxley Act of 2002). (IBM 2008 Annual
Report, p58)
4.
Report of Independent Registered Public
Accounting Firm. (i.e., IBM 2008 Annual
Report, p59)
5.
Audited Consolidated Financial
statements and Notes. (i.e., IBM 2008
Annual Report60-119)
Overview of Financial Statements
6
The Four Financial Statements




1. Consolidated Income Statement
2. Consolidated Statement of Retained
Earnings
3. Consolidated Balance Sheet
4. Consolidated Statement of Cash Flows
Overview of Financial Statements
7
The Content of Four Financial
Statements


The Income Statement (Statement of
Earnings): reports the operating results
of a firm for a period of time.
Accounts reported include revenue,
expenses, gains, losses, the net
income and the earnings per share.
Overview of Financial Statements
8
The Content of Four Financial
Statements (Contd.)


The Statement of Retained Earnings:
reports the earnings not distributed to
shareholders.
Accounts reported include beginning
balance of retained earnings, current
year’s net income, dividends distributed
for the reporting period and the ending
balance of retained earnings.
Overview of Financial Statements
9
The Content of Four Financial
Statements (contd.)


The Balance Sheet Statement
(Statement of Financial Position) :
reports the financial position of a firm
on a particular date.
Accounts reported include assets,
liabilities and stockholders’ equity.
Overview of Financial Statements
10
The Content of Four Financial
Statements (contd.)


The Statement of Cash Flows:
reports cash flows from three business
activities and the net increase (or
decrease) of the cash during the year.
Business activities affect cash flows:
operating, investing and financing.
Overview of Financial Statements
11
Exhibit 1-1 (from Financial Accounting by Harrison and Horngren)
LANDS’ END, INC. & SUBSIDIARIES
Consolidated Statement of Earnings
For the fiscal years ended
(In thousands)
2/2/2006 1/27/2005
1. Net sales
$1,031,548 $992,106
2. Cost of sales
588,017
571,265
3. Gross profit
443,531
420,841
4. Selling, general, and admin. exps.
392,484
357,516
5. Charges from sale of subsidiary
1,882
3,500
6. Income from operations
49,165
59,825
7. Other income (expense):
8. Interest expense
(2,771)
(1,769)
9. Interest income
253
307
10. Other
4,278
1,300
11. Total other income (expense), net
1,760
(162)
12. Income before income taxes
50,925
59,663
13. Income tax provision
20,370
23,567
14. Net income
$ 30,555 $ 36,096
The Financial Statements
12
Exhibit 1-2 (from Financial Accounting by
Harrison and Horngren)
LANDS’ END, INC. & SUBSIDIARIES
Consolidated Statement of Retained Earnings
For the fiscal years ended
2/2/2006 1/27/2005
(In thousands)
Retained Earnings
1. Beginning balance
2. Net income
3. Cash dividends paid
4. Issuance of treasury stock
5. Ending balance
$229,554
30,555
----$260,109
The Financial Statements
$193,460
36,096
--(2)
$229,554
13
Exhibit 1- 3(from Financial Accounting by Harrison and
Horngren)
LANDS’ END, INC. & SUBSIDIARIES
Consolidated Balance Sheet
(In thousands)
2/2/2006
ASSETS
Current assets:
1. Cash
$17,176
2. Receivables
8,046
3. Inventory
164,816
4. Prepaid advertising and other exp.
32,033
5. Total current assets
222,089
Property, plant & equip., at cost:
6. Land and buildings
72,248
7. Fixtures and equipment
83,880
8. Leasehold improvements
2,912
9. Total property, plant & equipment
159,040
10. Less accum. depr. & amortization
60,055
11. Property, plant, & equipment, net
98,985
12. Intangibles, net
2,423
13. Total assets
$323,497
The Financial Statements
1/27/2005
$5,426
4,459
168,652
19,631
198,168
69,798
74,745
1,862
146,405
49,414
96,991
2,453
$297,612
14
Exhibit 1- 3 (contd.)
LIABILITIES AND SHAREHOLDERS’ INVESTMENT
Current liabilities:
14. Interest payable
$ 9,319
15. Accounts payable
62,380
16. Salary payable
4,555
17. Accrued liabilities
23,751
18. Accrued profit sharing
1,483
19. Income taxes payable
13,256
20. Current maturities of long-term debt
--21. Total current liabilities
114,744
22. Deferred income taxes
7,212
23. Long-term liabilities
349
Shareholders’ investment:
24. Com. stock, 40,221 shares issued
26,567
25. Retained earnings
260,109
26. Other
(85,484)
27. Total shareholders’ investment
201,192
28. Total liabilities & shareholders’ inv.
$323,497
The Financial Statements
$7,539
52,762
5,011
25,959
1,679
9,727
40
102,717
5,379
388
26,219
229,554
(66,645)
189,128
$297,612
15
Exhibit 1- 4 (from Financial Accounting by
Harrison and Horngren)
LANDS’ END, INC. & SUBSIDIARIES
Consolidated Statement of Cash Flows
For the fiscal years ended
(In thousands)
2/2/2006 1/27/2005
Cash flows from operating activities:
1.
Cash received from customers
$1,027,943 $991,291
2.
Cash received from interest
253
307
3.
Cash paid to suppliers & employees (967,075) (926,714)
4.
Cash paid for interest
(2,833)
(2,828)
5.
Cash paid for income taxes
(16,896) (27,595)
6. Net cash flows from operating activities
41,392
34,461
Cash flows from investing activities:
7.
Cash paid for capital additions
and businesses acquired
(13,904) (32,102)
8.
Proceeds from divestiture
1,665
--9. Net cash flows used
for investing activities
(12,239) (32,102)
The Financial Statements
16
Exhibit 1-4 (contd.)
Cash flows form financing activities:
10. Proceeds from short-term and
long-term debt
1,780
11. Payment of long-term debt
(40)
12. Purchases of treasury stock
(20,001)
13. Issuance of treasury stock
858
14. Cash dividends paid
--15. Net cash flows used
for financing activities
(17,403)
16. Net increase (decrease) in cash
11,750
17. Beginning cash
5,426
18. Ending cash
$ 17,176
The Financial Statements
$7,539
(40)
(27,979)
1,978
--(18,502)
(16,143)
21,569
$ 5,426
17
Exhibit 1-5 (from Financial Accounting by Harrison and
Horngren)
Income Statement -- Fiscal Year 2006
(Details given in Exhibit 1-8)
Net income ……………………………..
$ 30,555
Statement of Retained Earnings -- Fiscal Year 2006

Beginning retained earnings ………….. $229,554
Net income ………………………………
30,555
Cash dividends ………………………….
--Ending retained earnings ……………… $260,109
The Financial Statements
18
Exhibit 1- 5 (contd.)
Statement of Retained Earnings -- Fiscal Year 2006
Beginning retained earnings ……………...
Net income ………………………………….
Cash dividends ……………………………..
Ending retained earnings ………………….
$229,554
30,555
--$260,109
Balance Sheet Statement - Fiscal Year 2006
ASSETS
Cash ……………………………………...
All other assets ………………………….
Total assets ……………………………...
$ 17,176
306,321
323,497
Total liabilities …………………………...
$122,305
Common stock ………………………….
Retained earnings ……………………...
Other equity ……………………………..
Total liabilities & stockholders’ equity …
26,567
260,109
(85,484)
$323,497
LIABILITIES
STOCKHOLDERS’ EQUITY
The Financial Statements

19
Exhibit 1- 5 (contd.)
Balance Sheet Statement -- Fiscal Year 2006
ASSETS
Cash ……………………………………...
$ 17,176
All other assets ………………………….
306,321
Total assets ……………………………...
323,497
LIABILITIES
Total liabilities …………………………...
$122,305
STOCKHOLDERS’ EQUITY
Common stock ………………………….
26,567
Retained earnings ……………………...
260,109
equity ……………………………..
(85,484)
 Other
Total liabilities & stockholders’ equity …
$323,497
Statement of Cash Flows - Fiscal Year 2006
Net cash flows from operating activities …...
Net cash flows used for investing activities ..
Net cash flows used for financing activities ..
Net increase in cash ………………………….
Beginning cash ………………………………..
Ending cash ……………………………………
The Financial Statements
$41,392
(12,239)
(17,403)
11,750
5,426
$17,176
20
Definitions of Assets, Liabilities and
Equity (all are presented on a balance sheet statement)


Assets: the economic resources of a
business that are expected to be of
benefit to the business entity in the
future.
Examples: cash, office supplies,
inventories, accounts receivable,
buildings, equipment, etc.)
The Financial Statements
21
Definitions of Assets, Liabilities and
Equity (contd.)



Liabilities: claims to assets; legal
obligations required future payments of
assets or services as a result of a
business entity’s past transactions.
Examples: accounts payable, bonds
payable…
Equity: residual claims to a business
entity from stockholders.
The Financial Statements
22
Definitions of Revenues and
Expenses




Revenues: increase or inflow of assets; will
eventually increase stockholders’ equity
(i.e., sales revenue)
Expenses: decrease or outflow of assets;
will eventually decrease stockholders’ equity.
Gains: increase in assets from incidental
transactions not related to the major
operation.
Losses: decrease in assets from incidental
transactions.
The Financial Statements
23
The Accounting Equation and the
Computation of Accounting Net Income

Assets = Liabilities + Stockholders’ Equity
Balance Sheet
Assets
Liabilities
Equity

Net Income = Revenues - Expenses + Gains
- Losses
The Financial Statements
24
3. Users of Accounting Information


Internal users: mangers; managerial
accounting produce internal accounting
reports for mangers to make decisions.
External users: investors, creditors,
IRS, SEC, etc.; financial accounting
produces financial statements for these
users.
The Financial Statements
25
External Users and Usage of Financial Statements
Group
Stockholders
Bankers and
other creditors
Mainly
Interestd In
Reaseon
What They Look for
Net Income
Stockholders enhance their personal wealth
Steadily rising level of net income
through an increase in market price of the
over time means the company's
company's stock, and dividends received. Net
profits look solid
income affects both stock prices and dividends.
Cash Flows
Cash flows report how the company generates
Operating activities should be the
and uses its cash. Wise use of cash produces
main source of cash.
net income and more cash.
Assets and
liabilities
Net income
Cash flows
Liabilities indicate how much the company
owes other creditors. Assets show what the
company can pledge as collateral that a
creditor can take if the company fails to pay its
debts.
Profitable companies can usually pay their
debts
same as for stockholders
The Financial Statements
Assets far in excess of liabilities,
or assets increasing faster than
liabilities over time.
Same as for stockholders.
Same as for stockholders.
26
Why Are Financial Statements Important ?



Assess the risks (i.e., credit risk).
Provide an economic history.
Thus, financial statement can be used for
various purposes:
 Analytical
tool (i.e., to assess liquidity,
efficiency of using financial resources,
profitability and solvency of companies.)
 Management report card
 Early warning signal
 Basis for predictions
27
4. The Financial Reporting Reform


The collapse of Enron and the accounting
scandals of some high-profile firms
severely damaged public confidence in
the accounting profession and the
financial reporting.
At the demand of the public, Sarbanes
and Oxley Act was passed in 2002 to
restore the public confidence in the
credibility of the financial reports.
Overview of Financial Statements
28
Key Provisions of Sarbanes and Oxley Act


Creating the Public Company
Accounting Oversight Board: establish
auditing standards.
Increasing Corporate Executive
Accountability.

Prohibition of Non-Audit Services.

Evaluation of Internal Control.
Overview of Financial Statements
29
5. Types of Business
1. Proprietorships
2. Partnerships
3. Corporations
The Financial Statements
30
Types of Business (contd.)
Owner(s)
Proprietorship
Partnership
Proprietor -- one
owner
partners -- two or
more owners
Corporation
Stockholders -generally many
owners
Limited by owner's Limited by owners'
Life of entity
Indefinite
choice or death
choice or death
personal liability
Stockholders are
Proprietor is
Partners are
of owner(s) for
not personally
personally liable
personally liable
business debts
liable
Accounting entity is Accounting entity is Accounting entity
Accounting
separate from
separate from
is separate from
status
proprietor
partners
stockholders
The Financial Statements
31
Corporations


A business entity formed under a state
law.
A corporation is a legal entity by itself.
It has all the rights of a person (i.e.,
pay taxes, own properties, can sue or
be sued, can sign contract,…) except
the rights of voting and marriage.
The Financial Statements
32
Corporations (contd.)



The ownership of a corporation is divided
by shares.
To be an owner of a corporation, an
individual just need to buy shares from
stock markets.
Owners of a corporation have limited
liability. The most an owner can lose is
what he (she) invested.
The Financial Statements
33
Corporations (contd.)


The stockholders elect “board of
directors” who sets business policies for
the corporation.
The board elects a chairman (usually is
also the chief executive officer (CEO),
and designates a president who is in
charge of daily operations (COO).
The Financial Statements
34
Corporations (contd.)

The board also appoints vice presidents
who are in charge of different areas
(i.e., marketing, accounting, finance...).
The Financial Statements
35
6. The Authorities prescribing the
Accounting Standards


Financial Statements (F/S) are
prepared based on generally accepted
accounting principles (GAAP).
The authorities prescribe the
accounting standards include:
The Financial Statements
36
The Authorities prescribing the
Accounting Standards (contd.)
the
Financial Accounting Standards
Board (FASB, a private agency),
the Securities and Exchange
Commission (SEC, a public agency).

The Financial Statements
37
A Historical Perspective of Authorities
prescribing the Accounting Standards
1934
Congreess
SEC
1938
Official Prouncements
Regulation S-X, ASR , FRR and Staff
Accounting Bulletins
Accounting Profession
1938-1959
1959-1973
AICPA
CAP
APB
1973
FASB
ARBs(51)
APB Opinion (31)
1. Statements of Financial Accounting
Standard
2. Interpretations
3. Concepts of Financial Accounting
4. Technique Bulletins
5. Statement of EITF
The Financial Statements
38
The Need for International Accounting
Standards


Companies doing business in more than
one nation found that it is hard to comply
with more than one set of accounting
standards established by authorities in
different nations.
In response to this problem, International
Accounting Standards Committee (IASC)
was founded in 1973 to develop a single
set of global accounting standards.
Environment and Theoretical Structure of Financial Accounting
39
The History of International Accounting
Standard Setting (cont.)



41 International Accounting Standards
(IAS) were issued by IASC.
IASC created International Accounting
Standards Board (IASB) in April, 2001 to
be in charge of prescribing the standards.
IASB endorsed 41 IAS and named its
pronouncement as International Financial
Reporting Standards (IFRS).
Environment and Theoretical Structure of Financial Accounting
40
Convergence of the U.S. Accounting Standards
and the International Accounting Standards


To increase the international
comparability and the quality of US
accounting standards, the FASB has
been engaged in activities toward the
convergence of the accounting standards.
The FASB is working closely with the
IASB on the convergence of accounting
standards.
Environment and Theoretical Structure of Financial Accounting
41
Short-Term International Convergence (source:
FASB Project Updates)


The FASB started a short term joint
project with the IASB to eliminate narrow
differences between US GAAP and IFRS
in October 2002.
Both IASB and FASB acknowledged that
convergence of IFRS and U.S. GAAP is a
primary objective of both Boards.
Environment and Theoretical Structure of Financial Accounting
42
A Single Global Accounting Language
- International financial reporting standards?
 In 2008, the Securities and Exchange
Commission (SEC) proposed a
roadmap for the US issuers to
prepare financial statements in
accordance with “IFRS” for the
purposes of their filings with the SEC.
 This roadmap, if achieved, could lead
to the required use of IFRS by U.S.
issuers in 2015 or 2016.
43
The SEC’s Roadmap Toward Global Accounting
Standards (Source: Intermediate Accounting by Kieso, Weygandt
and Warfield)
The Financial Statements
44
Current Compliances



Since there is no single set of high-quality
accounting standards, domestic (U.S.)
firms filing reports with the SEC must use
U.S. GAAP.
Foreign issuers filing reports with the
SEC can use U.S. GAAP, the
international standards or the GAAP of its
home country.
If foreign firms chose to use the standards
of its home country, they must file reports
with reconciliation to U.S. GAAP.
Environment and Theoretical Structure of Financial Accounting
45
7. Accounting Concepts and
Principles
1. The entity concept
2. The going-concern concept
3. The stable-monetary unit concept
4. The cost principle
5. The reliability principle
The Financial Statements
46