Introduction to Business Activities and Overview of Financial Statements and the Reporting Process 1

Learning Objectives In this chapter, you will: 1.Understand four key activities of business entities: (a) establish goals and strategies, (b) obtain financing, (c) make investments, and (d) conduct operations 2.Understand the purpose and content of the financial statements: (a) balance sheet, (b) income statement, (c) statement of cash flows, and (d) statement of shareholders’ equity 2

Learning Objectives 3.Understand the roles of participants in the financial reporting process, including managers and governing boards, accounting standard setters and regulators, independent external auditors, and financial statement users 4.Gain an awareness of financial reporting as part of a global system for providing information for resource allocation decisions, including two financial reporting systems (U.S. GAAP and International Financial Reporting Standards) 3

Learning Objectives 5. Understand the difference between the cash basis and the accrual basis of accounting, and why the latter provides a better measure of performance 4

What is Financial Accounting? In making resource allocation decisions, investors and creditors depend on: – Reliable and relevant information about financial position, profitability, and risk Financial reports are a key source of this information The process of preparing financial reports is financial accounting – Broadly known as financial reporting 5

Overview of Business Activities Establishing goals and strategies Three types of business activities 1.Obtaining financing 2.Making investments 3.Conducting operations 6

Obtain Financing Financing comes from two sources: – Owners For a corporation, ownership interests are shares of common stock and the owners are shareholders – Creditors Creditors provide funds that the firm must repay in specific amounts at specific dates – Long-term creditors – Short-term creditors 7

Investments Made by a firm to obtain the productive capacity to carry out its business activities Investing activities – Land, buildings, equipment – Patents, licenses, and other contractual rights – Common shares or bonds of other firms – Inventories – Accounts receivable from customers 8

Operations Using the productive capacity to generate earnings Operating activities – Purchasing – Production – Marketing – Administration – Research and development 9

Principal Financial Statements Annual report: Used to communicate the results of their business activities 1.Balance sheet 2.Income statement 3.Statement of cash flows 4.Statement of shareholders’ equity – Notes to the financial statements Management’s Discussion and Analysis: Required by publicly traded firms in the U.S. 10

Financial Reporting Conventions Length of reporting (accounting) period – The most common accounting period for external reporting is one year, the fiscal year Number of reporting periods – Both U.S. GAAP and IFRS require firms to include results for multiple reporting periods in each report: Two for IFRS and Three for US-GAAP 11

Financial Reporting Conventions Monetary amounts – Measuring units - Thousands, millions, or billions – Currency - Dollars ($), Euros (€), or Swedish Kronor (SEK) Terminology and level of detail – U.S. GAAP and IFRS contain broad guidance on what the financial statements must contain Neither completely specifies the level of detail or the names of accounts 12

Characteristics of a Balance Sheet Statement of financial position Provides information at a point in time – Stock measure Report a firm’s: – Assets – Liabilities – Shareholders’ equity 13

Balance Sheet Components Assets: Economic resources with the potential to provide future economic benefits to a firm – Cash, Accounts Receivable, Inventories, Buildings Liabilities: Creditors’ claims – Accounts Payable, Unearned Income, Notes Payable Shareholders’ equity: Owners’ funds provided either by buying shares or by reinvesting (retaining) the net assets generated by earnings – Common Stock, Contributed Capital, Retained Earnings 14

Net assets = Total assets − Total liabilities Retained Earnings Net assets a firm derives from its earnings that exceed the dividends it has distributed to shareholders Amount of assets equal to retained earnings does not appear on any single line on the balance sheet ‘ 왜 기업은 이익을 많이 유보시켜 놓고 투자는 안 하는가 ?’ 라는 정치권 논리의 타당성은 ? 15

Equality of Assets and Liabilities Plus Shareholders’ Equity 16 The Basic Accounting Equation Assets=Liabilities+Shareholders’ Equity This is the same idea as Investing=Financing Resources=Sources of Resources Resources=Claims on Resources

Balance Sheet Classification U.S. GAAP and IFRS require classification of current items and noncurrent items – Current assets - Assets that a firm expects to turn into cash, or sell, or consume within one year – Current liabilities - Obligations a firm expects to pay within one year – Noncurrent assets - Assets that will be used for more than one year – Noncurrent liabilities - Sources of funds whose suppliers do not expect to receive payment within the next year 17

Balance Sheet Measurement U.S. GAAP and IFRS use two bases to measure the monetary amounts – Historical amount Acquisition cost of assets or the amount of funds originally obtained from creditors or owners – Current amount Fair value as of the balance sheet date 18

Income Statement Called the statement of profit and loss by firms applying IFRS Provides information on profitability Reports amounts for a period of time – Typically one year Net income = Revenues – Expenses 19

Revenues and Expenses Revenues (sales or sales revenue): Measure the inflows of assets from selling goods and providing services to customers Expenses: Measure the outflow of assets incurred in generating revenues 20

Relationship between the Income Statement and the Balance Sheet Income statement links the beginning balance sheet with the balance sheet at the end of the period Retained Earnings is increased by net income and decreased by dividends 21

Statement of Cash Flows Reports information about cash generated from or used by: 1.Operating activities 2.Investing activities 3.Financing activities Shows where the firm: – Generates cash – Spends or uses cash 22

Three Sections of the Statement of Cash Flows Operating activities – Cash collected from customers less cash paid in carrying out the firm’s operating activities Investing activities – Cash paid to acquire noncurrent assets less amounts from any sale of noncurrent assets Financing activities – Cash from issues of long-term debt or new capital less dividends 23

The Relationship of the Statement of Cash Flows to the Balance Sheet and Income Statement Explains the change in cash between the beginning and the end of the period Shows the relationship between net income and cash flow from operations 24

Financial Reporting Process Four principal types of participants: – Managers and governing boards of reporting entities – Accounting standard setters and regulatory bodies – Independent external auditors – Users of financial statements Agency problem – Principal: investors (main users) – Agent: managers 25

Managers and Governing Boards of Reporting Entities Managers: Agents of the shareholders who have responsibility for safeguarding and properly using the firm’s resources Governing board: Responsible for: – Selecting, compensating, and overseeing managers – Establishing dividend policy – Making decisions on major issues 26

Generally Accepted Accounting Principles FASB (Financial Accounting Standards Board) sets accounting rules, procedures, and practices known as U.S. GAAP (Generally Accepted Accounting Principles). 27

The Conceptual Framework Guides FASB in standard-setting decisions Addresses: – Objectives of financial reporting: Usefulness – Qualitative characteristics of accounting information Relevance, representational faithfulness, comparability, verifiability, timeliness and understandability – Elements of the financial statements – Recognition and measurement principles 28

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International Financial Reporting Standards (IFRS) International Accounting Standards Board (IASB): An independent accounting standard- setting entity with voting members from several countries International Financial Reporting Standards (IFRS): Standards set by the IASB FASB and IASB are working toward converging their standards to: – Eliminate differences between U.S. GAAP and IFRS 30

Independent Auditors Publicly-traded firms are required to be audited by an independent external auditor 1.Assesses the effectiveness of the firm’s internal control system for measuring and reporting business transactions. 2.Assesses whether the financial statements present fairly a firm’s financial position, results of operations, and cash flows in accordance with accounting standards. 31

Basic Accounting Conventions and Concepts Recognition: Items depicted in words and numbers on the face of the financial statements, with amounts included in the totals Realization: Converting a noncash item to cash 32 Example: The firm recognizes revenue when it ships the goods but realizes revenue when it collects the cash

Basic Accounting Conventions and Concepts Materiality: Captures the notion that financial reports need not include items that are so small as to be meaningless to users Accounting period: Length of financial reporting periods – Interim reports prepared for periods shorter than a year – Interim reports do not eliminate the need to prepare an annual report 33

Accounting Methods for Measuring Performance Two approaches to measure operating performance of a firm – Cash basis – Accrual basis 34

Cash versus Accrual Accounting Cash basis A firm measures performance from selling goods and providing services as it receives cash from customers and makes cash expenditures to providers of goods and services Accrual basis A firm recognizes revenue when it sells goods or renders services and recognizes expenses in the period when the firm recognizes the revenues that the costs helped produce 35