1. Financial Statements and Business Decisions
Chapter 1
Financial Statements
and Business Decisions
Chapter 1: Financial Statements and Business Decisions
McGraw-Hill/Irwin
Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Understanding the Business
Businesses are started by owners or stockholders of a company. Bank and other lenders become creditors who help finance the business. Creditors make money on loans by charging interest. Additional individuals may became part owners or stockholders. They hope to receive a portion of what the company earns in the form of cash payments called dividends and to eventually sell their share of the company at a higher price than they paid. The willingness of creditors to lend and for additional stockholders to invest depends on the expected future performance of the company. Both groups often judge future performance based on information in the company’s financial statements.
Stockholders
Creditors
Potential Return for Stockholders:
Dividends
Higher future stock prices
Potential Return for Creditors:
Interest $ $

3. The Accounting System
The accounting system collects and processes financial information about an organization and reports that information to decision makers. The accounting system provides financial accounting reports which include periodic financial statements and related disclosures to external decision makers. These decision-makers include investors, creditors, suppliers, customers, union representatives, and all other interested parties. The accounting system also provides managerial accounting reports including detailed plans and continuous performance reports. These reports are used by internal decision makers throughout the organization to make decisions about pricing, production, quality, and numerous other day-to-day activities.

4. Business Activities Financing Activities Ex: Borrow money from bank
Investing Activities
Ex: Purchase equipment
Operating Activities
Ex: Sell merchandise to customers
Business activities include:
• Financing Activities: borrowing or paying back money to lenders and receiving additional funds from stockholders or paying them dividends.
• Investing Activities: buying or selling items such as plant and equipment.
• Operating Activities: the day-to-day operations of the business, purchasing materials from suppliers, delivering products and services to customers, collecting cash from customers, and paying suppliers.

5. The Four Basic Financial Statements
BALANCE SHEET – reports the amount of assets, liabilities, and stockholders’ equity of an accounting entity at a point in time.
INCOME STATEMENT – reports the revenues less the expenses of the accounting period.
STATEMENT OF STOCKHOLDERS’ EQUITY – reports the changes in each of the company’s stockholders’ equity accounts, including the change in the retained earnings balance caused by net income and dividends during the reporting period.
STATEMENT OF CASH FLOWS – reports inflows and outflows of cash during the accounting period in the categories of operating, investing, and financing.
Companies usually publish four basic financial statements, as follows:
BALANCE SHEET – reports the amount of assets, liabilities, and stockholders’ equity of an accounting entity at a point in time.
INCOME STATEMENT – reports the revenues less the expenses of the accounting period.
STATEMENT OF STOCKHOLDERS’ EQUITY – reports the changes in each of the company’s stockholders’ equity accounts, including the change in the retained earnings balance caused by net income and dividends during the reporting period.
STATEMENT OF CASH FLOWS – reports inflows and outflows of cash during the accounting period in the categories of operating, investing, and financing.

6. Elements of the Balance Sheet
Assets Cash Short-Term Investment Accounts Receivable Notes Receivable Inventory (to be sold) Supplies Prepaid Expenses Long-Term Investments Equipment Buildings Land Intangibles
Liabilities Accounts Payable Accrued Expenses Notes Payable Taxes Payable Unearned Revenue Bonds Payable
The purpose of the balance sheet is to report the financial position (assets, liabilities and stockholders’ equity) of an entity at a particular point in time. Here is a sample list of balance sheet accounts grouped into categories. These categories, also known as elements, are assets, liabilities, and stockholders’ equity.
Assets are economic resources owned by the company. The exact list of assets depends on the individual company, but this is a representative list. All assets are expected to provide future benefits to the company.
Liabilities are the company’s debts or obligations.
Stockholders’ equity generally consists of two parts. First, Common Stock indicates the amount of financing provided by owners of the business. Next, Retained Earnings is the amount of income that has been earned by the company that has been reinvested in the business rather than being distributed as dividends to shareholders.
In this course we will discuss all of these accounts in detail.
Stockholders’ Equity Common Stock Retained Earnings

7. The Accounting Equation
A = L + SE
Assets
Liabilities
Stockholders’ Equity
The basic accounting equation shows a company’s financial position: the economic resources (assets) that the company owns and the sources of financing for those assets (liabilities and stockholders’ equity) are always equal. Assets are economic resources of the company that have some future economic benefit. Liabilities are the company’s debts or obligations. Stockholders’ equity indicates the amount of financing provided by owners of the business and earnings of the company since inception that were not distributed as dividends to the shareholders.
Economic Resources
Sources of Financing for Economic Resources
Liabilities: From Creditors Stockholders’ Equity: From Stockholders

8. Balance Sheet
Here is a sample balance sheet. Notice the four-line heading for our balance sheet. The heading includes the name of the company (Le-Nature’s Inc.), the title of the financial statement (Balance Sheet), the specific date of the statement (at December 31, 2012), and a unit of measure (in millions of dollars).
When preparing the balance sheet, the basic accounting equation of assets equal liabilities plus shareholders’ equity holds true. On this balance sheet, total assets are equal to total liabilities and stockholders’ equity, at an amount of $527.4 (million).

9. Elements of the Income Statement
Revenues Sales Revenue Fee Revenue Interest Revenue Rent Revenue
Expenses Cost of Goods Sold Wages Expense Rent Expense Interest Expense Depreciation Expense Advertising Expense Insurance Expense Repair Expense Income Tax Expense
The income statement reports the revenues less the expenses of the accounting period. Here is a list of the typical account titles on the income statement, grouped into the elements of revenues and expenses.
The first element, or category, is revenues. Companies earn revenues from the sale of goods and services to customers. A few examples of revenues include Sales Revenue, Interest Revenue and Rent Revenue.
Expenses represent the dollar amount of resources used to earn revenues during the period. Examples are Wages Expense, Rent Expense, and Advertising Expense.
When revenues exceed expenses for the period, the company has generated net income. If expenses are greater than revenues in the period, the company has incurred a net loss.
As with the balance sheet accounts, we will discuss each of these revenue and expense accounts as we move through the course.

10. Income Statement
Here is an example of an income statement. Notice our standard four-line heading. The first line contains the name of the company. The second line is the name of the financial statement which, in this case, is the “Income Statement.” The third line is the accounting period covered by the income statement, for example, “for the year ended December 31, 2012.” While the balance sheet has a date for a point in time, the income statement covers of period of time. The fourth line indicates the unit of measure, in this case, millions of dollars.
On the income statement, we subtract expenses from revenues to arrive at net income.

11. Statement of Stockholders’ equity
Elements of the Statement of Stockholders’ Equity
Common Stock
Retained Earnings
Beginning Retained Earnings
+Net Income
-Dividends
Ending Retained Earnings
The statement of stockholders’ equity reports the changes in each of the company’s stockholders’ equity accounts, including the change in the retained earnings balance caused by net income and dividends during the reporting period. Beginning Retained Earnings plus Net Income minus Dividends equals Ending Retained Earnings.

12. Statement of Stockholders’ equity
Here is an example of a statement of stockholders’ equity for Le-Nature’s Inc. for the year ended December 31, 2012.
Notice that when a formal statement of stockholder’s equity is prepared, the format of the title is similar to the other financial statements. The first line contains the name of the company. The second line is the name of the financial statement, in this case the words “statement of stockholders’ equity.” The third line is the accounting period covered, for example “for the year ended December 31, 2012.” Like the income statement, the statement of stockholders’ equity covers of period of time. Some companies show dollar amounts in thousands or millions.
Le-Natures’ had no changes in common stock during the period. Had it issued or repurchased common stock during the year, the transactions would be reported on separate lines.
The retained earnings column reports the impact of net income and the distribution of dividends on the balance in retained earnings. Net income earned during the year increases the balance of retained earnings, showing the relationship of the income statement to the balance sheet. (Net losses decrease the retained earnings balance.) Declaring dividends to the stockholders decreases retained earnings.

13. Statement of cash flows
Elements of the Statement of Cash Flows
Cash Flows from Operating Activities
Cash Flows from Investing Activities
Cash Flows from Financing Activities
The statement of cash flows reports inflows and outflows of cash for a stated period of time classified into three categories: operating, investing, and financing activities.
Cash flows from operating activities are cash flows that are directly related to earning
income.
Cash flows from investing activities include those related to the acquisition or sale of the company’s plant and equipment and investments.
Cash flows from financing activities are directly related to the financing of the enterprise itself.
Note that each of the three cash flow sources can be positive (net cash inflow) or negative (net cash outflow). + / -

14. Statement of Cash Flows
The statement of cash flows reports inflows and outflows of cash during the accounting period using three categories: operating, investing, and financing activities.
On the statement of cash flows, operating activities involve the cash provided and used in the normal business operations of the company. This includes cash flows directly related to earning income.
Investing activities involve the purchase or sale of long-term plant, equipment, and investments. When we purchase a long-term productive asset, it is a cash outflow; when we sell a productive asset, it is a cash inflow.
Financing activities involve cash flows from investors and creditors. It includes borrowing and repaying amounts from financial institutions and the sale or repurchase of the company’s stock. In addition, the payment of a cash dividend is classified as a financing activity. When we borrow money from a financial institution, it’s a cash inflow; repaying the principal amount is a cash outflow.
Notice that our three-line heading contains the name of the company, the name of the financial statement and the time period covered by the statement. In addition, the statement shows dollar amounts in millions. Similar to the income statement and the statement of stockholders’ equity, the statement of cash flows cover a period of time.

15. Relationships Among the Statements
Several relationships exist among the individual financial statements. First, net income reported on the income statement flows to the statement of retained earnings and increases the retained earnings account balance. In this example, the $22.9 net income reported on the income statement increases retained earnings on the statement of stockholders’ equity.
A second relationship that exists among the financial statements is that ending retained earnings from the statement of stockholders’ equity is one of the two components of stockholders’ equity on the balance sheet. In this example, the $64 balance in ending retained earnings from the statement of stockholders’ equity also appears on the balance sheet.
A third relationship exists between the statement of cash flows and the cash account that appears on the balance sheet. On the statement of cash flows, the total increase or decrease in cash from the three categories of activities is added to the beginning of the year cash balance to arrive at the end of the year cash balance. This amount also appears on the balance sheet. In this example, the $10.6 balance for cash at end of period from the statement of cash flows also appears on the balance sheet.
1-15

16. Did you notice a sentence at the bottom of each financial statement?
Notes
Did you notice a sentence at the bottom of each financial statement?
All financial statements should be accompanied by notes which provide the reader with supplemental information about the financial condition and results of operations of the company.
All financial statements should be accompanied by notes which provide the reader with supplemental information about the financial condition and results of operations of the company, without which the financial statements cannot be fully understood.
There are three basic types of notes. The first type provides descriptions of the accounting rules applied in the company’s financial statements. The second presents additional detail about a line on the financial statement. For example, it is common to find a note that describes the details of a long-term debt agreement. The last type of note provides additional financial disclosures about items not listed in the financial statements. For example, a company may disclose that it leased, rather than purchased, major pieces of machinery and equipment.

17. Financial Statement SUMMARY
We have learned a great deal about the content of the four basic financial statements. This slide provides a summary by listing each financial statement, its purpose, structure, and examples of content.

18. Responsibilities for the Accounting Communication Process
Generally Accepted Accounting Principles (GAAP)
The Rules
Decision makers need to understand the measurement rules applied in computing the numbers on the financial statements. These rules are called Generally Accepted Accounting Principles, or GAAP.

19. How are Generally Accepted Accounting Principles Determined?
Our accounting system has a long and distinguished history. An Italian monk and mathematician, Luca Pacioli, published the first elements of double-entry bookkeeping in 1494.
Prior to 1933, the management teams of most companies were largely free to choose their own financial reporting practices.
Luca Pacioli, an Italian monk and mathematician, first published the elements of our double-entry bookkeeping system in Until the stock market crash of 1929, most companies determined their own accounting practices. There was little uniformity or comparability of accounting information. Congress stepped in to regulate accounting measurement in 1933.

20. Generally Accepted Accounting Principles
Securities Act of 1933
Securities and Exchange Act of 1934
The Securities and Exchange Commission (SEC)
has been given broad powers to determine
measurement rules for
financial statements.
In the United States, Congress created the Securities and Exchange Commission (SEC) and gave it broad powers to determine the measurement rules for financial statements that companies issuing stock to the public (publicly traded companies) must provide to stockholders.

21. Generally Accepted Accounting Principles
The SEC has worked closely with the
accounting profession to
work out the detailed rules that have
become known as GAAP.
Currently, the Financial Accounting Standards Board
(FASB) is recognized as the body to formulate GAAP.
The Securities and Exchange Commission has worked with organizations of professional accountants to establish groups that are given the primary responsibilities to work out the detailed rules that become generally accepted accounting principles (GAAP). Currently, the Financial Accounting Standards Board (FASB) has the responsibility to formulate generally accepted accounting principles. The official pronouncements of the FASB are called Financial Accounting Standards.

22. Generally Accepted Accounting Principles
Companies incur the cost of preparing the financial statements and bear the following economic consequences of their publication . . .
Effects on the selling price of stock.
Effects on the amount of bonuses received by managers and other employees.
Loss of competitive information to other companies.
Generally accepted accounting principles (GAAP) are of great interest to the companies that must prepare financial statements, their auditors, and the readers of the statements. Companies and their managers and owners are most directly affected by the information presented in financial statements. Companies incur the cost of preparing the statements and bear the major economic consequences of their publication, which include, among others,
1. Effects on the selling price of a company’s stock.
2. Effects on the amount of bonuses received by management and employees.
3. Loss of competitive information to other companies.

23. International perspective
The International Accounting Standards Board and
Global Convergence of Accounting Standards
Since 2002, there has been substantial movement toward the adoption of International Financial Reporting Standards (IFRS) issued by the International Accounting Standards Board (IASB).
Examples of jurisdictions requiring the use of IFRS either currently or by 2012:
• European Union • Israel and Turkey
• Australia and New Zealand • Brazil and Chile
• Canada and Mexico • Hong Kong, India, Malaysia, & South Korea
In the United States, the Securities and Exchange Commission now allows foreign companies whose stock is traded in the U.S. to use IFRS and is considering requiring the use of IFRS for U.S. domestic companies by 2015.
Since 2002, there has been substantial movement toward the adoption of International Financial Reporting Standards (IFRS) issued by the International Accounting Standards Board (IASB). The use of IFRS is increasing, with many countries or jurisdictions either currently requiring IFRS or committed to require IFRS by In the United States, the Securities and Exchange Commission now allows foreign companies whose stock is traded in the U.S. to use IFRS and is considering requiring the use of IFRS for U.S. domestic companies by To prepare you for this eventuality, we will point out key differences between IFRS and U.S. GAAP starting in Chapter 5. The basic principles and practices we discuss in Chapters 1 through 4 apply equally to both sets of standards.

24. Ethical conduct Three Step Process for Making Ethical Decisions
Identify the benefits of a decision (often to the manager or employee involved) and who will be harmed (other employees, owners, creditors, the environment).
Identify alternative courses of action.
Choose the one you would like your family and friends to see reported on your local news.
Ethics are standards of conduct for judging right from wrong, honest from dishonest, and fair from unfair. Many situations are not clear cut and require that individuals weigh one moral principle (e.g., honesty) against another (e.g., loyalty to a friend).
When money is involved, people can easily fool themselves into believing that bad acts are justified. To avoid falling prey to this tendency, when faced with an ethical dilemma, it is often recommended that you follow a three step process:
1. Identify the benefits of a decision (often to the manager or employee involved) and who will be harmed (other employees, owners, creditors, the environment).
2. Identify alternative courses of action.
3. Choose the one you would like your family and friends to see reported on your local news. That is usually the ethical choice.

25. Ensuring the Accuracy of Financial Statements
To ensure the accuracy of the company’s financial information, management:
Maintains a system of controls.
Hires external independent auditors.
Forms a committee of the board of directors
to review these other two safeguards.
Primary responsibility for the information in the financial statements lies with management, represented by the highest officer of the company and the highest financial officer. Companies take three important steps to assure investors that the company’s records are accurate: (1) they maintain a system of controls over both the records and the assets of the company, (2) they hire external independent auditors to audit the fairness of the financial statements, and (3) they form a committee of the board of directors to oversee the integrity of these other two safeguards.

26. External Auditors
Overall, I believe
these financial
statements are
fairly stated.
An audit is an examination of the financial reports to ensure that they represent what they claim and conform with GAAP.
Management prepares the financial statements for a company and an external, independent auditor is hired to express an opinion as to the fairness of the financial statement presentation. An audit is an examination of the financial reports to ensure that they represent what they claim and conform with GAAP.

27. What if the numbers are wrong?
After it was determined that the financial statements for Le-Nature’s were misleading, the consequences for the defendants were severe.
Shortly after the issuance of the statements presented in this chapter, Le-Nature’s worked with the Wachovia Capital Markets group from Wells Fargo Bank to borrow an additional $285 million from various lenders. Le-Nature’s financial statements played a major role in the lenders’ decisions to back the loan. The statements presented a picture of a growth company with amazing future prospects. Clearly, Le-Nature’s looked like a good bet. But if the numbers are wrong, all bets are off. The financial statements were misleading. The company was never a real success—it was all fake. The consequences for many were severe.

28. Supplement A: Types of Business Entities
Sole Proprietorship: owned by a single individual.
Partnership: owned by two or more individuals.
Corporation: ownership represented by shares of stock.
Advantages of a Corporation:
Limited liability
Continuity of life
Ease of transfer of ownership
Opportunity to raise large amounts of money
Disadvantage of a Corporation:
Double taxation
Supplement A: Types of Business Entities
This textbook emphasizes accounting for profit-making business entities. Supplement A discusses three types of business entities: sole proprietorship, partnership, and corporation. A sole proprietorship is owned by one person; it usually is small in size and is common in the service, retailing, and farming industries. A sole proprietorship is not legally separate from its owner and the owner bears unlimited liability. A partnership is owned by two or more persons known as partners. Similar to a sole proprietorship, a partnership is not legally separate from its owners and each general partner has unlimited liability. In a corporation ownership is represented by shares of stock. The owners are called stockholders or shareholders.
In terms of economic importance, the corporation is the dominant form of business organization in the United States. This dominance is caused by the many advantages of the corporate form: (1) limited liability for the stockholders, (2) continuity of life, (3) ease in transferring ownership (stock), and (4) opportunities to raise large amounts of money by selling shares to a large number of people. The primary disadvantage of a corporation is that its income may be subject to double taxation (income is taxed when it is earned and again when it is distributed to stockholders as dividends).

29. Supplement B: Employment in the Accounting Profession Today
Career Opportunities
Public Accounting
Audit and Assurance Services
Management Consulting Services
Tax Services
Employment by Organizations
Internal accounting
External reporting
Tax planning
Various other functions
Employment in the Public and Not-for-Profit Sector
Professional Designations
CPA
CMA
Supplement B: Employment in the Accounting Profession Today
Supplement B discusses employment opportunities in the accounting profession. An accountant may be licensed as a certified public accountant, or CPA. An accountant may also be licensed as a certified management accountant, or CMA, or a certified internal auditor, or CIA.
Career opportunities include careers in public accounting firms. Accounting firms usually render three types of services: audit or assurance services, management consulting services, and tax services.
Another option for employment for accountants is working with individual profit-making organizations. A primary function of the accountants in organizations is to provide data that are useful for internal managerial decision making and for controlling operations. The functions of external reporting, tax planning, control of assets, and a host of related responsibilities normally are also performed by accountants in industry.
There are also career opportunities for accountants in governmental units, from the local to the international level. The same holds true for other not-for-profit organizations such as hospitals and universities.
CIA

30. End of Chapter 1
End of chapter 1.