Chapter One
Elements of
Financial
Statements
McGraw-Hill/Irwin
©The McGraw-Hill Companies, Inc. 2006
Title Role of Accounting in
Society
Should I
Accounting
provides
information that
is useful in
answering
questions about
resource
allocation.
invest money
in IBM or
General
Motors?
Market-Based Allocations
A market is a
group of people
or entities
organized to
exchange things
of value.
Market-Based Allocations
Consumers
Resource users
Conversion
Agents
Transform resources
into desirable
products
Resource
Owners
Control the
distribution of
resources
Market-Based Allocations
Here are some common terms for the
added value created in the
transformation process:
Profit
Income
Earnings
Financial Resources
Conversion agents need financial resources
(money) to establish and operate their
businesses.
Investors
Creditors
Liquidation
If a business
fails, any
resources
(assets) it still
has are returned
to the resource
providers
(investors and
creditors).
The process of
dividing remaining
assets and returning
them to resource
providers is called
business liquidation.
Physical Resources
In their most primitive
form, physical resources
are called natural
resources.
Owners of physical
resources seek to sell
those resources to
profitable business
because profitable
businesses are more
likely to be able to pay
for them.
Labor Resources
Labor resources include
intellectual as well as
physical labor.
Workers seek
relationships with
businesses (conversion
agents) that have high
earnings potential
because these
businesses are better
able to provide rewards
(pay high wages).
Types of Accounting
Information
Financial
Accounting
Focused on the
needs of external
users
Managerial
Accounting
Focused on the
needs of internal
users
Nonbusiness Resource
Allocation
Not all entities allocate resources based on
profitability. Organizations that are not motivated
by profit are called not-for-profit entities.
Government,
foundations, religious
groups, the Peace
Corps, and various
benevolent
organizations allocate
resources based on
humanitarian concerns.
Nonbusiness Resource
Allocation
Not all entities allocate resources based on
profitability. Organizations that are not motivated
by profit are called not-for-profit entities.
Other organizations
allocate resources to
support art, music,
dance, and theater.
Measurement Rules
Accountants establish measurement and
reporting rules that businesses use to
facilitate communication.
Generally Accepted
Accounting Principles
Reporting Entities
Financial accounting
reports disclose the
financial activities of
particular individuals
or organizations
described as reporting
entities.
Each entity is treated
as a separate reporting
unit.
Business
Owner
Bank
Financial Statements
Income
Statement
Statement
of Changes
in Equity
Balance
Sheet
Statement
of Cash
Flows
Elements of Financial
Statements
1. Assets
2. Liabilities
3. Equity
4. Contributed Capital
5. Revenue
6. Expenses
7. Distributions
8. Net Income
9. Gains
10.Losses
The
elements
represent
broad
categories.
We will discuss
elements 1-8 in this
chapter. We will save
elements 9 and 10 for
a later chapter.
Elements of Financial
Statements
1. Assets—Cash, Equipment, Buildings, Land
2. Liabilities
3. Equity
4. Contributed Capital
5. Revenue
6. Expenses
7. Distributions
8. Net Income
9. Gains
10.Losses
Subclassifications
of the elements
are frequently
called accounts.
Accounts are
reported in the
financial
statements.
Accounting Equation
Claims on the assets are from two sources:
1. Creditors (liabilities)
2. Investors or owners (equity).
Accounting Equation
Assets =
Liab.
$ 500 = $
Assets
-
$ 500
-
Equity
200 + $
Liab.
$
+
=
300
Equity
200 = $
300
Accounting Equation
Common Stock + Retained Earnings
Recording Business Events Under
the Accounting Equation
Businesses obtain assets
from three sources:
1. Owners
2. Creditors
3. Profitable Operations
Now, let’s look at the effects of asset source transactions
on the accounting equation.
Event 1: Rustic Camp Sites (RCS) was formed on
January 1, 2004, when it acquired $120,000 cash
from issuing common stock.
1. RCS increases assets
(cash).
Asset Source
Transaction
2. RCS increases
stockholders’ equity
(common stock).
Assets
Acquired Cash through Stock Issue
Cash
120,000
+
+
Land
n/a
=
Liab.
+
Stockholders' Equity
=
=
N. Pay.
n/a
+
+
C. Stk. +
120,000 +
Double-Entry
Bookkeeping
Ret. Ear.
n/a
Event 2: RCS acquired an additional $400,000 of
cash by borrowing from a creditor.
1. RCS increases assets
(cash).
Asset Source
Transaction
2. RCS increases liabilities
(notes payable).
Assets
Beginning Balance
Acquired Cash by Issuing Note
Ending Balance
Cash
120,000
400,000
520,000
+
+
+
+
=
Land
n/a
n/a
n/a
=
=
=
=
Liab.
+
N. Pay. +
n/a
+
400,000 +
400,000 +
Stockholders' Equity
C. Stk.
120,000
n/a
120,000
+
+
+
+
Ret. Ear.
n/a
n/a
n/a
Event 3: RCS paid $500,000 cash to purchase
land.
1. RCS decreases assets
(cash).
Asset
Exchange
Transaction
2. RCS increases assets
(land).
Assets
Beginning Balance
Paid Cash to Buy Land
Ending Balance
Cash
520,000
(500,000)
20,000
+
+
+
+
Land
n/a
500,000
500,000
=
Liab.
+
Stockholders' Equity
=
=
=
=
N. Pay.
400,000
n/a
400,000
+
+
+
+
C. Stk.
120,000
n/a
120,000
+
+
+
+
Ret. Ear.
n/a
n/a
n/a
Event 4: RCS obtained $85,000 cash by leasing
campsites to customers.
1. RCS increases assets
(cash).
Asset Source
Transaction
2. RCS increases
stockholders’ equity
(retained earnings).
Assets
Beginning Balance
Acquired Cash by Earning Revenue
Ending Balance
Cash
20,000
85,000
105,000
+
+
+
+
Land
500,000
n/a
500,000
=
Liab.
+
Stockholders' Equity
=
=
=
=
N. Pay.
400,000
n/a
400,000
+
+
+
+
C. Stk.
120,000
n/a
120,000
+
+
+
+
Ret. Ear.
n/a
85,000
85,000
Event 5: RCS paid $50,000 cash for operating
expenses such as salaries, rent, and interest.
1. RCS decreases assets
(cash).
Asset Use
Transaction
2. RCS decreases
stockholders’ equity
(retained earnings).
Assets
Beginning Balance
Used Cash to Pay Expenses
Ending Balance
Cash
105,000
(50,000)
55,000
+
+
+
+
=
Land
=
500,000 =
n/a
=
500,000 =
Liab.
+
N. Pay. +
400,000 +
n/a
+
400,000 +
Stockholders' Equity
C. Stk.
120,000
n/a
120,000
+
+
+
+
Ret. Ear.
85,000
(50,000)
35,000
Event 6: RCS paid $4,000 in cash dividends to its
owners.
1. RCS decreases assets
(cash).
Asset Use
Transaction
2. RCS decreases
stockholders’ equity
(retained earnings).
Assets
Beginning Balance
Used Cash to Pay Dividends
Ending Balance
Cash
55,000
(4,000)
51,000
+
+
+
+
=
Land
=
500,000 =
n/a
=
500,000 =
Liab.
+
N. Pay. +
400,000 +
n/a
+
400,000 +
Stockholders' Equity
C. Stk.
120,000
n/a
120,000
+
+
+
+
Ret. Ear.
35,000
(4,000)
31,000
Event 7: The land that RCS paid $500,000 to
purchase had an appraised market value of
$525,000 on December 31, 2004.
Historical Cost
Concept
Reliability
Concept
Requires that most
assets be reported at
the amount paid for
them (their historical
cost) regardless of
increases in market
value.
Information is reliable if
it can be independently
verified.
Appraised values are
opinions and will vary
from appraiser to
appraiser.
Summary of Transactions
Assets
Event
1
2
3
4
5
6
7
Cash
+
Land
$
$
120,000
400,000
(500,000)
500,000
85,000
(50,000)
(4,000)
n/a
n/a
$ 51,000 + $ 500,000
=
Liab.
Notes
=
Payable
$
-
+
Stockholders' Equity
Common
+
Stock
$
120,000
Retained
+ Earnings
$
-
400,000
= $
n/a
400,000
+ $
n/a
120,000
85,000 Revenue
(50,000) Expense
(4,000) Dividend
n/a
+ $ 31,000
Now, let’s prepare the financial
Green = numbers used in the statement of cash flows
statements for RCS using the
Red = numbers used in the balance sheet
dataused
presented
above.
Blue = numbers
in the income statement
Color Code Legend
Other
Account
Titles
Preparing Financial
Statements
RUSTIC CAMP SITES
Income Statement
For the Year Ended December 31, 2004
Revenue (asset increases)
$
85,000
Operating Expenses (asset decreases)
(50,000)
Net Income
$
35,000
Beginning Common Stock
Plus: Common Stock Issued
Matching
Ending Common Stock
Concept
Beginning
Retained Earnings
Plus: Net Income
Less: Dividends
Ending Retained Earnings Net
Total Stockholders' Equity
$
$
Loss
120,000
$
120,000
$
31,000
151,000
35,000
(4,000)
Accounting
Period
Preparing Financial
Statements
RUSTIC CAMP SITES
Income Statement
For the Year Ended December 31, 2004
Revenue (asset increases)
$
85,000
Operating Expenses (asset decreases)
(50,000)
Net Income
$
35,000
Beginning Common Stock
Plus: Common Stock Issued
Ending Common Stock
Beginning Retained Earnings
Plus: Net Income
Less: Dividends
Ending Retained Earnings
Total Stockholders' Equity
$
$
120,000
$
120,000
$
31,000
151,000
35,000
(4,000)
Preparing Financial
Statements
RUSTIC CAMP SITES
Balance Sheet
As of December 31, 2004
Assets
Cash
Liquidity Land
Total Assets
$
51,000
500,000
Liabilities
Notes Payable
Stockholders' Equity
Commn Stock
$
Retained Earnings
Total Stockholders' Equity
Total Liabilities and Stockholders' Equity
$
551,000
$
400,000
$
151,000
551,000
120,000
31,000
Preparing Financial
Statements
RUSTIC CAMP SITES
Statement of Cash Flows
For the Year Ended December 31, 2004
Cash Flows from Operating Activities
Cash Receipts from Revenue
$ 85,000
Cash Payments for Expenses
(50,000)
Net Cash Flow from Operating Activities
$
35,000
Cash Flows for Investing Activities
Cash Payments to Purchase Land
(500,000)
Cash Flows from Financing Activities
Cash Receipts from Borrowing Funds
400,000
Cash Receipts from Issuing Common Stock
120,000
Cash Payments for Dividends
(4,000)
Net Cash Flow from Financing Activities
516,000
Net Increase in Cash
51,000
Plus Beginning Cash Balance
Ending Cash Balance
$
51,000
Operating
Investing
Financing
Statement of Cash Flows
Classifications
Horizontal Financial
Statements Model
Price-Earnings Ratio
Price-Earnings
Ratio
=
Market Price Per Share
Earnings Per Share
Earnings per share (EPS), in its simplest form,
is computed by dividing the company’s net
income by the number of shares of common
stock outstanding.
A higher price-earnings ratio means that
investors are willing to pay a premium
for a company’s stock because of
optimistic future growth prospects.
Measuring Growth Through
Percent Analysis
The following earnings information was taken from the
2002 and 2003 income statements of Cammeron, Inc.
and Diller Enterprises.
Company
Cammeron
Diller
2002
2003
Growth
$ 42.4 $ 46.6 $
4.2
9.9
12.8
2.9
Percentage
9.9%
29.3%
Alternative Year Earnings – Base Year Earnings
Base Year Earnings
Business Entities
Service
Businesses
Merchandising
Businesses
Manufacturing
Businesses
Annual Reports
(1) Financial Statements
(2) Notes
(3) Auditor’s Report –Chapter 2
(4) Management’s Discussion
and Analysis (MD&A)—
Chapter 4
Traditionally, large companies
have distributed expensive
annual reports with many color
photographs.
Increasingly, however,
companies are issuing more
modest annual reports or are
simply distributing their 10-K
reports.
Special Terms in Real-World
Reports
The financial statements of real-world companies include
numerous items relating to advanced topics that are not
covered in introductory accounting textbooks.
However, we encourage you to look for annual reports in
the library, from your employer, or on the Internet.
The best way
to learn
accounting is
to use it.
End of Chapter One