Elements of Financial Statements

Elements of Financial Statements
Chapter One Elements of Financial Statements Why should you study accounting? You should study accounting because it can help you succeed in business. Imagine playing football or monopoly without knowing how to keep score. In business, accounting is how you keep score. If you do not know the rules of the game, you will be severely disadvantaged. In this chapter, we will provide an introduction to the elements of financial statements.

Learning Objective 1 Explain the role of accounting in society.
Learning Objective One: Explain the role of accounting in society.

Title Role of Accounting in Society
Should I invest money in IBM or General Motors? Accounting provides information that is useful in answering questions about resource allocation. Accounting provides information that is useful in answering questions about resource allocation. Do not underestimate the importance of reliable information used to answer these questions. The users of accounting information include a variety of people and organizations. These users are commonly referred to as stakeholders because they have either direct or indirect interests in the entities that issue accounting reports.

Market-Based Allocations
A market is a group of people or entities organized to exchange things of value. Suppose you want to start a business. You will likely need such resources as money, equipment, land, materials, employees, and so on. In the United States, you would compete for these resources in open markets. A market is a group of people or entities organized to exchange things of value.

Resource users Consumers Conversion Agents Transform resources into desirable products Part One The market for business resources involves three distinct participants: consumers, conversion agents, and resource owners. Part Two Consumers are resource owners. Resources, however, are frequently not in a form that consumers want. Part Three Conversion agents (businesses) transform resources such as trees into desirable products such as furniture. Part Four Resource owners control the distribution of resources to conversion agents. Control the distribution of resources Resource Owners

Here are some common terms for the added value created in the transformation process: Profit Income Earnings Here are some common terms for the added value created in the transformation process: Profit, Income, and Earnings. Accountants measure the added value as the difference between the cost of the product or service and the selling price of that product or service.

Market Trilogy for the Allocation of Resources
Exhibit one dash one illustrates the market trilogy involved in resource allocation. Take a minute and review this exhibit and be sure that you understand the relationships illustrated.

Financial Resources Investors Creditors
Conversion agents need financial resources (money) to start and operate their businesses. Investors Creditors Part One Conversion agents need financial resources (money) to start and operate their businesses. Part Two Investors provide financial resources in exchange for ownership interests in a business. Owners expect a business to return to them a share of the income earned. Part Three Creditors lend financial resources to businesses. Creditors expect businesses to repay borrowed resources at a future date.

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. Part One If a business fails, any resources (assets) it still has are returned to the resource providers (investors and creditors). Part Two 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 businesses because profitable businesses are more likely to be able to pay for them. In their most primitive form, physical resources are called natural resources. The process of transforming natural resources can include several stages and numerous independent businesses. In this process, one conversion agent’s output becomes another’s input. Owners of physical resources seek to sell those resources to profitable businesses 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). 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 Part One Accounting information focused on the needs of external users is called financial accounting. For example, investors are interested in whether a business produces more overall income relative to risk. Part Two Accounting information focused on the needs of internal users is called managerial accounting. For example, a regional manager in the business is interested in the store-by-store earnings under her control. Managerial Accounting Focused on the needs of internal users

Nonbusiness Resource Usage
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 prioritize resource usage based on humanitarian concerns. Part One Not all entities allocate resources based on profitability. Organizations that are not motivated by profit are called not-for-profit entities. Part Two Government, foundations, religious groups, the Peace Corps, and various benevolent organizations allocate resources based on humanitarian concerns. Some examples include the John D. and Catherine T. MacArthur Foundation, the American Red Cross, and The Salvation Army.

Nonbusiness Resource Usage
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. Other organizations allocate resources to support art, music, dance, and theater. Some examples include the National Endowment for the Arts and the National Science Foundation.

Accounting as Information Provider
Exhibit one dash two shows three distinct areas of accounting, however, these areas frequently overlap. For example, managers of all types of organizations use managerial accounting information.

Generally Accepted Accounting Principles
Measurement Rules Accountants establish measurement and reporting rules that businesses use to facilitate communication. Generally Accepted Accounting Principles Accountants establish measurement and reporting rules that businesses use to facilitate communication. The measurement rules used in the United States for financial accounting are called Generally Accepted Accounting Principles or GAAP for short. Financial reports issued to the public must follow GAAP. This textbook introduces these principles so you will be able to understand business activity presented in accounting reports issued in the USA.

Learning Objective 2 Distinguish among the different accounting entities involved in business events. Learning Objective Two: Distinguish among the different accounting entities involved in business events.

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 Part One 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. Part Two For example, a business, the person who owns the business, and a bank that loans money to the business are treated as three separate reporting entities. Accountants would prepare three separate sets of financial reports to describe the economic activities of each of the three entities.

Learning Objective 3 Name and define the major elements of financial statements. Learning Objective Three: Name and define the major elements of financial statements.

Statement of Changes in Equity Statement of Cash Flows
Financial Statements Income Statement Statement of Changes in Equity FASB Part One Business entities communicate economic information about their activities to the public through four financial statements: an income statement, a statement of changes in equity, a balance sheet, and a statement of cash flows. Part Two The Financial Accounting Standards Board (also called the FASB) is a privately funded organization with the primary authority for establishing accounting standards (or GAAP) in the United States. Balance Sheet Statement of Cash Flows

Assets Liabilities Equity Contributed Capital Revenue Expenses Distributions Net Income Gains Losses The elements represent broad categories. The information reported in financial statements is organized into categories known as elements. Eight of the ten financial elements the Financial Accounting Standards Board has defined are discussed in this chapter: assets, liabilities, equity, contributed capital, revenue, expenses, distributions and net income. The other two elements (gains and losses) are discussed in a later chapter. We will discuss elements 1-8 in this chapter. We will save elements 9 and 10 for a later chapter.

Assets—Cash, Equipment, Buildings, Land Liabilities Equity Contributed Capital Revenue Expenses Distributions Net Income Gains Losses Subclassifications of the elements are frequently called accounts. Accounts are reported in the financial statements. The elements represent broad categories. Accountants do not identify financial statement items like cash, equipment, buildings, and land as elements, but rather as subclassifications of the element known as assets. The subclassifications of the elements are frequently called accounts. Accounts are reported in the financial statements.

Learning Objective 4 Describe the relationships expressed in the accounting equation. Learning Objective Four: Describe the relationships expressed in the accounting equation.

Accounting Equation Assets = Claims Assets = Liabilities + Equity
Claims on the assets are from two sources: Creditors (liabilities) Investors or owners (equity). Assets are resources that a business uses to produce earnings. Assets of a business belong to the resource providers (creditors and investors). Part One The assets of a business belong to the resource providers. These resource providers have claims on the assets. Part Two The resource providers who have claims on the assets are the creditors and investors. Creditors’ claims are called liabilities (future obligations of the enterprise). Investors’ claims are called equity. Since the creditors have first claim on the assets, claims of the investors (or owners) are described as residual interests. Part Three This is known as the accounting equation. It recognizes the relationship among the assets, the creditors’ claims (called liabilities), and the investors’ claims (called equity). Assets = Liabilities + Equity

Assets = Liabilities + Equity
Accounting Equation Assets = Liabilities + Equity Part One To illustrate, assume a company has assets of five hundred dollars, liabilities of two hundred dollars, and equity of three hundred dollars. Part Two Algebraically, the amount of total assets minus total liabilities equals the equity (which is also called net assets).

Common Stock + Retained Earnings
Accounting Equation Assets = Liabilities + Equity Common Stock + Retained Earnings Part One Equity can also be viewed as two distinct parts. First, common stock represents assets received from investors (owners). The owners of such businesses are often called stockholders, and the ownership interest in the business is called stockholders’ equity. Second, retained earnings represents assets obtained through the earnings activities. Assets a business has earned can either be distributed to the owners or kept in the business. Retained earnings is therefore a component of stockholders’ equity that represents the owners’ claims on the assets. Part Two When a business has common stock and retained earnings, the accounting equation is slightly modified to specifically refer to stockholders’ equity. Assets = Liabilities + Stockholders' Equity

Learning Objective 5 Record business events in general ledger accounts organized under an accounting equation. Learning Objective Five: Record business events in general ledger accounts organized under an accounting equation.

Recording Business Events Under the Accounting Equation
Businesses obtain assets from three sources: Owners Creditors Profitable Operations Businesses obtain assets from three sources: Owners, Creditors, and Profitable Operations. Now, let’s look at the effects of asset source transactions on the accounting equation. 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. RCS increases assets (cash). RCS increases stockholders’ equity (common stock). Asset Source Transaction Part One Event One: Rustic Camp Sites was formed on January 1st, 2004, when it acquired one hundred twenty thousand dollars cash from issuing common stock. Part Two To record this transaction, Rustic Camp Sites increases assets (cash) and increases stockholders’ equity (common stock). This is an asset source transaction. Part Three Here is the impact of this transaction on the accounting equation. Notice that the elements have been divided into accounts. For example, the element of assets is divided into a Cash account and a Land account. Part Four Every transaction affects the accounting equation in at least two places. It is from this practice that the double-entry bookkeeping system derives its name. Double-Entry Bookkeeping

Asset Source Transaction
Event 2: RCS acquired an additional $400,000 of cash by borrowing from a creditor. RCS increases assets (cash). RCS increases liabilities (notes payable). Asset Source Transaction Part One Event Two: Rustic Camp Sites acquired an additional four hundred thousand dollars of cash by borrowing from a creditor. Part Two To record this transaction, Rustic Camp Sites increases assets (cash) and increases liabilities (notes payable). This is an asset source transaction. Part Three Here is the impact of this transaction on the accounting equation. The beginning balances above came from the ending balances produced by the prior transaction.

Asset Exchange Transaction
Event 3: RCS paid $500,000 cash to purchase land. RCS decreases assets (cash). RCS increases assets (land). Asset Exchange Transaction Part One Event Three: Rustic Camp Sites paid five hundred thousand dollars cash to purchase land. Part Two To record this transaction, Rustic Camp Sites decreases assets (cash) and increases assets (land). This is an asset exchange transaction. Part Three Here is the impact of this transaction on the accounting equation.

Asset Source Transaction
Event 4: RCS obtained $85,000 cash by leasing campsites to customers. RCS increases assets (cash). RCS increases stockholders’ equity (retained earnings). Asset Source Transaction Part One Event Four: Rustic Camp Sites obtained eighty-five thousand dollars cash by leasing campsites to customers. Part Two To record this transaction, Rustic Camp Sites increases assets (cash) and increases stockholders’ equity (retained earnings). This is an asset source transaction. Revenue represents an economic benefit a company obtains by providing customers with goods and services. Part Three Here is the impact of this transaction on the accounting equation.

Event 5: RCS paid $50,000 cash for operating expenses such as salaries, rent, and interest.
RCS decreases assets (cash). RCS decreases stockholders’ equity (retained earnings). Asset Use Transaction Part One Event Five: Rustic Camp Sites paid fifty thousand dollars cash for operating expenses such as salaries, rent, and interest. Part Two To record this transaction, Rustic Camp Sites decreases assets (cash) and decreases stockholders’ equity (retained earnings). This is an asset use transaction. In the normal course of generating revenue, a business consumes various assets and services. The assets and services consumed to generate revenue are called expenses. Part Three Here is the impact of this transaction on the accounting equation.

Event 6: RCS paid $4,000 in cash dividends to its owners.
RCS decreases assets (cash). RCS decreases stockholders’ equity (retained earnings). Asset Use Transaction Part One Event Six: Rustic Camp Sites paid paid four thousand dollars in cash dividends to its owners. Part Two To record this transaction, Rustic Camp Sites decreases assets (cash) and decreases stockholders’ equity (retained earnings). This is an asset use transaction. If a business transfers some or all of its earned assets to owners, the transfer is frequently called a dividend. Since assets distributed to stockholders are not used for the purpose of generating revenue, dividends are wealth transfers, not expenses. Part Three Here is the impact of this transaction on the accounting equation.

Learning Objective 6 Explain how the historical cost and reliability concepts affect amounts reported in financial statements. Learning Objective Six: Explain how the historical cost and reliability concepts affect amounts reported in financial statements.

Historical Cost Concept
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 Requires that most assets be reported at the amount paid for them (their historical cost) regardless of increases in market value. Reliability Concept Information is reliable if it can be independently verified. Appraised values are opinions and will vary from appraiser to appraiser. Part One Event Seven: The land that Rustic Camp Sites paid five hundred thousand dollars to purchase had an appraised market value of five hundred twenty-five thousand dollars on December 31st, 2004. Part Two The historical cost concept requires that most assets be reported at the amount paid for them (their historical cost) regardless of increases in market value. Part Three Accountants also rely heavily on the reliability concept. Information is reliable if it can be independently verified. Appraised values are opinions and will vary from appraiser to appraiser. As a result of following the historical cost concept and the reliability concept, event seven does not result in a change in Rustic Camp Sites’ accounting records.

Summary of Transactions
Part One Here is a summary of the impact on the accounting equation of the transactions we just completed. The data in the summary are coded as follows. The numbers in green are used in the statement of cash flows. The numbers in red are used to prepare the balance sheet. Finally, the numbers in blue are used to prepare the income statement. The numbers reported on the statement of changes in stockholders’ equity have not been color coded because they appear in more than one statement. Part Two Now, let’s prepare the financial statements for Rustic Camp Sites using the data presented above. Color Code Legend Green = numbers used in the statement of cash flows Red = numbers used in the balance sheet Blue = numbers used in the income statement Now, let’s prepare the financial statements for RCS using the data presented above.

Learning Objective 7 Classify business events as asset source, use, or exchange transactions. Learning Objective Seven: Classify business events as asset source, use, or exchange transactions.

Classify business events
Classify events into one of three categories: Asset source transactions increase the total amount of assets and increase the total amount of claims Asset exchange transactions decrease one asset and increase another asset Asset use transactions decrease the total amount of assets and the total amount of claims. Classify events into one of three categories: Part One Asset source transactions increase the total amount of assets and increase the total amount of claims Part Two Asset exchange transactions decrease one asset and increase another asset Part Three Asset use transactions decrease the total amount of assets and the total amount of claims

Learning Objective 8 Use general ledger account information to prepare four financial statements. Learning Objective Eight: Use general ledger account information to prepare four financial statements.

Preparing Financial Statements
Matching Concept Part One Here is the income statement. The information used to prepare this statement (and the others that will follow) was drawn from the ledger accounts. Part Two Businesses consume assets and services in order to generate revenues, thereby creating greater quantities of other assets. The income statement follows the Matching Concept. The Matching Concept states that the income statement matches asset increases from operating a business (revenues) with asset decreases from operating the business (expenses). Part Three Rustic Camp Sites has net income because its revenues are greater than its expenses. However, if expenses are greater than revenues, the difference is a net loss. Part Four Income is measured for a span of time called an accounting period. While accounting periods of one year are normal for external financial reporting, income can be measured weekly, monthly, quarterly, semi-annually, or over any appropriate time period. Net Loss Accounting Period

Here is the statement of stockholders’ equity. This statement explains the effects of transactions on stockholders’ equity during the accounting period. It starts with the beginning balance in the common stock account and adds or subtracts any changes that occurred during the accounting period. The statement also describes the changes in retained earnings for the accounting period. NOTE: The income statement is also given so you can trace how net income affects retained earnings.

Liquidity Part One Here is the balance sheet. Notice that total assets equals total liabilities plus equity—just like we discussed earlier with the accounting equation. The balance sheet lists the assets and liabilities of the business and the owners’ claims. Part Two Assets are listed in the order of liquidity. This means that assets are listed in order of how rapidly they will be converted to cash.

Operating Investing Financing Part One Here is the statement of cash flows. It has three major sections: Operating, Investing, and Financing. Part Two Operating activities involve receiving cash from revenue and paying cash for expenses. Part Three Investing activities involve paying cash for productive assets or receiving cash from selling productive assets. Part Four Financing activities include obtaining cash from owners or from creditors and paying cash to owners (dividends) or creditors.

Statement of Cash Flows Classifications
This exhibit summarizes the primary cash inflows and outflows related to the types of business activity introduced in this chapter.

Learning Objective 9 Record business events using a horizontal financial statements model. Learning Objective Nine: Record business events using a horizontal financial statements model.

Horizontal Financial Statements Model
This is called the horizontal statements model. We will use it throughout this text. This model helps you visualize several financial statements simultaneously to help you understand how business events affect financial statements. This is a learning aid—not a financial statement. The model frequently uses abbreviations such as OA for Operating Activities, IA for Investing Activities, FA for Financing Activities, na for not affected, and NC for net change in cash.

Careers in Accounting An Accounting Career can take you to the top of the business world. An Accounting Career can take you to the top of the business world.

What do accountants do? Accountants identify, record, analyze and communicate information about the economic events that affect organizations. What do accountants do? Accountants identify, record, analyze and communicate information about the economic events that affect organizations.

What do accountants do? Public Accountants provide services to various clients. CPA stands for certified public accountant. Services provided: Audit services Tax services Consulting services Private Accountants are employed by a specific company or nonprofit organization. Services provided include a wide variety of functions: Classify/record transactions Prepare financial statements Develop budgets Assess performance Measure costs Part One Public accountants provide service to various clients. The term, CPA, stands for certified public accountant. Services provided by public accountants include: audit services, tax services and consulting services. Part Two Private accountants are employed by a specific company or nonprofit organization. Private accountants provide a wide variety of services to the organizations for which they work. Services provided include: classifying/recording transactions, preparing financial statements, developing budgets, assessing performance, and measuring costs.

Learning Objective 10 Explain the importance of ethics to the accounting profession. Learning Objective Ten: Explain the importance of ethics to the accounting profession.

Importance of Ethics Ethics is the lifeblood of the accounting profession All major professional accounting organizations require their members to follow formal codes of ethical conduct Ethics is the lifeblood of the accounting profession. All major professional accounting organizations require their members to follow formal codes of ethical conduct. However, failure to follow these codes of ethical conduct prompted Congress to pass the Sarbanes-Oxley Act. This Act tightened the rules governing auditors and required chief executive officers (CEO) and chief financial officers (CFO) to certify in writing that they have reviewed the financial statements being issued and that the reports present fairly the company’s financial status.

Common Features of Ethical Misconduct
Existence of a nonsharable problem A problem that must be kept secret Person inclined to secrecy more likely to accept unethical/illegal solution Presence of an opportunity Internal controls designed to decrease opportunity for fraud Capacity for rationalization Justify misconduct Common Features of Ethical Misconduct Part One Existence of a nonsharable problem. This is a problem which must be kept secret. A person inclined to secrecy is more likely to accept unethical or illegal solutions to the problem. Part Two Presence of an opportunity. Accountants design internal controls to decrease opportunity for fraud. Part Three Capacity for rationalization. Individual justifies his/her misconduct. Accountants must develop a strong sense of personal responsibility to avoid involvement in ethical misconduct.

Learning Objective 11 Identify three types of business organizations and some of the technical terms they use in their real-world financial reports. Learning Objective Eleven: Identify three types of business organizations and some of the technical terms they use in their real-world financial reports.

Merchandising Businesses Manufacturing Businesses
Business Entities Service Businesses Merchandising Businesses Manufacturing Businesses Part One Organizations exist in many different forms. Service businesses, which include doctors, attorneys, accountants, dry cleaners, and maids, provide services to their customers. Part Two Merchandising businesses, sometimes called retail or wholesale companies, sell goods to customers that other entities make. Part Three Manufacturing businesses make the goods that they sell to their customers.

Annual Reports Financial Statements Notes Auditor’s Report –Chapter 2
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. Part One Annual reports consist of financial statements, notes to the financial statements, the auditor’s report, and management’s discussion and analysis. Part Two 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 ten 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. 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 In this chapter we introduced the elements of financial statements and provided information on specific accounts and how transactions impact the accounting equation.

Elements of Financial Statements

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