2. Financial Accounting, Fifth Edition
Introduction to
Financial Statements
Financial Accounting, Fifth Edition

3. Study Objectives Describe the primary forms of business organization.
Identify the users and uses of accounting information.
Explain the three principal types of business activity.
Describe the content and purpose of each of the financial statements.
Explain the meaning of assets, liabilities, and stockholders’ equity, and state the basic accounting equation.
Describe the components that supplement the financial statements in an annual report.
1. On the topic, “Challenges Facing Financial Accounting,” what did the AICPA Special Committee on Financial Reporting suggest should be included in future financial statements?
Non-financial Measurements (customer satisfaction indexes, backlog information, and reject rates on goods purchases).
Forward-looking Information
Soft Assets (a company’s know-how, market dominance, marketing setup, well-trained employees, and brand image).
Timeliness (no real time financial information)

4. Introduction to Financial Statements
Forms of Business Organization
Users and Uses of Financial Information
Business Activities
Communicating with Users
A Quick Look at Tootsie Roll’s Financial Statements
Sole proprietorship
Partnership
Corporation
Internal users
External users
Ethics in financial reporting
Financing
Investing
Operating
Income statement
Retained earnings statement
Balance sheet
Statement of cash flows
Interrelation-ships of statements
Income statement
Retained earnings statement
Balance sheet
Statement of cash flows
Other elements of an annual report
Service Cost - Actuaries compute service cost as the present value of the new benefits earned by employees during the year. Future salary levels considered in calculation.
Interest on Liability - Interest accrues each year on the PBO just as it does on any discounted debt.
Actual Return on Plan Assets - Increase in pension funds from interest, dividends, and realized and unrealized changes in the fair market value of the plan assets.
Amortization of Unrecognized Prior Service Cost - The cost of providing retroactive benefits is allocated to pension expense in the future, specifically to the remaining service-years of the affected employees.
Gain or Loss - Volatility in pension expense can be caused by sudden and large changes in the market value of plan assets and by changes in the projected benefit obligation. Two items comprise the gain or loss:
difference between the actual return and the expected return on plan assets and,
amortization of the unrecognized net gain or loss from previous periods

5. Forms of Business Organization
Proprietorship
Partnership
Corporation
Generally owned by one person.
Often small service-type businesses
Personally liable for debts of the business
Tax advantages
Owned by two or more persons.
Often retail and service-type businesses
Personally liable for debts of the business
Tax advantages
Ownership in shares of stock
Separate legal entity organized under state corporation law
No personal liability
Easier to raise funds
Service Cost - Actuaries compute service cost as the present value of the new benefits earned by employees during the year. Future salary levels considered in calculation.
Interest on Liability - Interest accrues each year on the PBO just as it does on any discounted debt.
Actual Return on Plan Assets - Increase in pension funds from interest, dividends, and realized and unrealized changes in the fair market value of the plan assets.
Amortization of Unrecognized Prior Service Cost - The cost of providing retroactive benefits is allocated to pension expense in the future, specifically to the remaining service-years of the affected employees.
Gain or Loss - Volatility in pension expense can be caused by sudden and large changes in the market value of plan assets and by changes in the projected benefit obligation. Two items comprise the gain or loss:
difference between the actual return and the expected return on plan assets and,
amortization of the unrecognized net gain or loss from previous periods
SO 1 Describe the primary forms of business organization.

6. Users and Uses of Financial Information
Internal Users
IRS
Management
Investors
Human Resources
Labor Unions
Common Questions
Finance
Creditors
Marketing
SEC
Customers
External Users
SO 2 Identify the users and uses of accounting information.

7. Users and Uses of Financial Information
Common Questions Asked?
User
1. Can we afford to give our employees a pay raise?
Human Resources
2. Did the company earn a satisfactory income?
Investors
3. Which product line is most profitable?
Management
4. Is cash sufficient to pay dividends to the stockholders?
Finance
5. What price for our product will maximize net income?
Marketing
6. Will the company be able to pay its short-term debts?
Creditors
SO 2 Identify the users and uses of accounting information.

10. Users and Uses of Financial Information
Ethics In Financial Reporting
Standards of conduct by which one’s actions are judged as right or wrong, honest or dishonest, fair or not fair, are Ethics.
Recent financial scandals include: Enron, WorldCom, HealthSouth, AIG, and others.
Congress passed Sarbanes-Oxley Act of 2002.
Effective financial reporting depends on sound ethical behavior.
SO 2 Identify the users and uses of accounting information.

11. Users and Uses of Financial Information
Illustration 1-4
Steps in analyzing ethics cases
SO 2 Identify the users and uses of accounting information.

13. Users and Uses of Financial Information
Review Question
Ethics are the standards of conduct by which one's actions are judged as:
right or wrong.
honest or dishonest.
fair or not fair.
all of these options.
SO 2 Identify the users and uses of accounting information.

14. Business Activities
All businesses are involved in three types of activity —
financing,
investing,
and operating.
The accounting information system keeps track of the results of each of these business activities.
SO 3 Explain the three principal types of business activity.

15. Business Activities Financing Activities
Two primary sources of outside funds are:
Borrowing money
Amounts owed are called liabilities.
Party to whom amount is owed are creditors.
Notes payable and bonds payable are different type of liabilities.
Issuing shares of stock for cash.
Payments to stockholders are called dividends.
SO 3 Explain the three principal types of business activity.

16. Business Activities Investing Activities
Purchase of resources a company needs to operate.
Computers, delivery trucks, furniture, buildings, etc.
Resources owned by a business are called assets.
SO 3 Explain the three principal types of business activity.

17. Business Activities Operating Activities
Once a business has the assets it needs, it can begin its operations.
Revenues - Amounts earned from the sale of products (sales revenue, service revenue, and interest revenue).
Inventory - Goods available for sale to customers.
Accounts receivable - Right to receive money from a customer,in the future, as the result of a sale.
SO 3 Explain the three principal types of business activity.

18. Business Activities Operating Activities
Once a business has the assets it needs, it can begin its operations.
Expenses - cost of assets consumed or services used. (cost of goods sold, selling, marketing, administrative, interest, and income taxes expense).
Liabilities arising from expenses include accounts payable, interest payable, wages payable, sales taxes payable, and income taxes payable.
Net income – revenues exceed expenses.
Net loss – expenses exceed revenues.
SO 3 Explain the three principal types of business activity.

19. Communicating with Users
Companies prepare four financial statements from the summarized accounting data:
Income Statement
Balance Sheet
Retained Earnings Statement
Statement of Cash Flows
SO 4 Describe the content and purpose of each of the financial statements.

20. Communicating with Users
Review Question
Net income will result during a time period when:
assets exceed liabilities.
assets exceed revenues.
expenses exceed revenues.
revenues exceed expenses.
SO 4 Describe the content and purpose of each of the financial statements.

21. Communicating with Users
Income Statement
Illustration 1-5
Reports revenues and expenses for a specific period of time.
Net income – revenues exceed expenses.
Net loss – expenses exceed revenues.
SO 4 Describe the content and purpose of each of the financial statements.

22. Communicating with Users
Retained Earnings Statement
Income Statement
Illustration 1-5
Illustration 1-6
Net income is needed to determine the ending balance in stockholder’s equity.
SO 4 Describe the content and purpose of each of the financial statements.

23. Communicating with Users
Retained Earnings Statement
Illustration 1-6
Statement indicates the reasons why retained earnings has increased or decreased during the period.
SO 4 Describe the content and purpose of each of the financial statements.

24. Communicating with Users
Retained Earnings Statement
Balance Sheet
Illustration 1-8
Illustration 1-6
The ending balance in retained earnings is needed in preparing the balance sheet
SO 4 Describe the content and purpose of each of the financial statements.

25. Communicating with Users
Balance Sheet
Reports the assets, liabilities, and stockholder’s equity at a specific date.
Assets listed at the top, followed by liabilities and stockholder’s equity.
Total assets must equal total liabilities and stockholder’s equity.
Illustration 1-8
SO 5 Explain the meaning of assets, liabilities, and stockholders’ equity, and state the basic accounting equation.

27. Communicating with Users
Statement of Cash Flows
Illustration 1-9
Answers:
Where did cash come from during the period?
How was cash used during the period?
What was the change in the cash balance during the period?
SO 5 Explain the meaning of assets, liabilities, and stockholders’ equity, and state the basic accounting equation.

28. Communicating with Users
Review Question
Which of the following financial statements is prepared as of a specific date?
Balance sheet.
Income statement.
Owner's equity statement.
Statement of cash flows.
SO 5 Explain the meaning of assets, liabilities, and stockholders’ equity, and state the basic accounting equation.

29. Other Elements of an Annual Report
U.S. companies that are publicly traded must provide shareholders with an annual report.
The annual report always includes:
Financial statements.
Management discussion and analysis.
Notes to the financial statements.
Independent auditor's report.
SO 6 Describe the components that supplement the financial statements in an annual report.

30. Other Elements of an Annual Report
Management’s Report
The SEC mandates inclusion of Management’s Discussion and Analysis (MD&A).
Management highlights favorable or unfavorable trends related to liquidity, capital resources, and results of operations.
SO 6 Describe the components that supplement the financial statements in an annual report.

31. Other Elements of an Annual Report
Management’s Report
Illustration 1-15
SO 6 Describe the components that supplement the financial statements in an annual report.

32. Other Elements of an Annual Report
Notes are the means of amplifying or explaining the items presented in the main body of the statements.
Accounting Policies
Companies should present a statement identifying the accounting policies adopted (Summary of Significant Accounting Policies).
SO 6 Describe the components that supplement the financial statements in an annual report.

33. Other Elements of an Annual Report
Notes are the means of amplifying or explaining the items presented in the main body of the statements.
Illustration 1-16
SO 6 Describe the components that supplement the financial statements in an annual report.

34. Other Elements of an Annual Report
Auditor’s Report
Standard unqualified opinion – auditor expresses the opinion that the financial statements are presented fairly, in all material respects, in conformity with GAAP.
Illustration 1-17
SO 6 Describe the components that supplement the financial statements in an annual report.

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