ACCT1101

Dr. Jasmine Kwong

chapter 1 Financial Statements
and Business Decisions

Financial Accounting
11e
9e
Libby • Libby • Hodge

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Learning Objectives
After studying this chapter, you should be able to:
1-1 Recognize the information conveyed in each of the four basic
financial statements and the way that it is used by different
decision makers (investors, creditors, and managers).

1-2 Identify the role of generally accepted accounting principles

(GAAP) in determining financial statement content and how
companies ensure the accuracy of their financial statements.

Chapter Supplement A: Types of Business Entities

(page 22-23 in textbook)

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Learning Objective 1-1
1-1 Recognize the information conveyed in each of the four basic
financial statements and the way that it is used by different
decision makers (investors, creditors, and managers).

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Understanding the Business

Sources of Financial Resources

Stockholders Creditors

Potential Return for Potential Return for

Stockholders: Creditors:
Dividends Interest
Higher future stock prices

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Exhibit 1.1
The Accounting System and Decision Makers

Accounting System

Financial Accounting Reports Managerial Accounting Reports

Periodic financial statements Detailed plans and continuous
and related disclosures performance reports

provided to

External Decision Makers Internal Decision Makers

Evaluate the company Run the company

Creditors Investors Managers

Creditors: ©Anton Violin/Shutterstock; Investors: ©Pressmaster/Shutterstock; Managers: ©kzenon/123RF

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Why Study Financial Accounting?

Decision makers rely on financial information:

➢ Investors
➢ Creditors
➢ Managers within the firm such as:
▪ Marketing managers
▪ Credit managers
▪ Supply chain managers
▪ Human resource managers

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C2
Users of Accounting
Information
Financial accounting Managerial accounting
provides external users provides information needs
with financial statements for internal decision-makers.

External Users Internal Users

•Lenders •Consumer Groups •Managers •Sales Staff
•Shareholders •External Auditors •Officers/Directors •Budget Officers
•Governments •Customers •Internal Auditors •Controllers

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Your Goals for Chapter 1

Focus your attention on learning the:

▪ Content: the categories, or elements, reported on
each statement
▪ Structure: the equation that shows how the
elements within each statement are organized and
related
▪ Use: how the information is used by stockholders
and creditors to make decisions

Note: Rather than trying to memorize the definitions of

every term used in this chapter, try to focus your
attention on learning the general content, structure,
and use of the statements.

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The Four Basic Financial Statements

BALANCE SHEET (or Statement of Financial Position) – reports the

financial position (amount of assets, liabilities, and stockholders’
equity) of an accounting entity at a point in time.

INCOME STATEMENT (or Statement of Comprehensive Income) –

reports the revenues less the expenses during 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.

The notes are an integral part of these financial statements.

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Financial Statement Time Period & Structure
The four basic financial statements can be prepared at
any point in time such as:
▪ End of the year (for the year ended, annual reports)
▪ Quarterly (for the quarter ended, quarterly reports)
▪ Monthly (for the month ended, monthly reports)

The financial statement heading includes:

▪ Name of the entity (Company name)
▪ Title of the statement (e.g., Balance Sheet)
▪ Specific date of the statement (e.g., at December
31, 2018)
▪ Unit of measure (in millions of dollars)

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The Accounting Equation

A = L + SE Stockholders’
Assets Liabilities
Equity

Economic Sources of Financing for Resources

Resources Liabilities: Stockholders’
from Equity:
Creditors from
Stockholders

The balance sheet reports a company's assets, liabilities, and

stockholders' equity at a specific point in time.
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Exhibit 1.2
Balance Sheet
EXPLANATION
LE-NATURE’S INC. Name of the entity
Balance Sheet Title of the statement
At December 31, 2015 Specific date of the statement
(in millions of dollars) Unit of measure

Assets: Resources controlled by the company

Cash $ 10.6 Amount of cash in the company’s bank accounts
Accounts receivable 6.6 Amounts owed by customers from prior sales
Inventories 51.2 Ingredients and beverages ready for sale
Property, plant, and equipment 459.0 Factories, production equipment, and land
Total assets $527.4 Total amount of company’s resources
Liabilities and stockholders’ equity: Sources of financing for company’s resources
Liabilities Financing supplied by creditors
Accounts payable $ 26.0 Amounts owed to suppliers for prior purchases
Notes payable to banks 381.7 Amounts owed to banks on written debt contracts
Total liabilities 407.7
Stockholders’ equity Financing provided by stockholders
Common stock 55.7 Amounts invested in the business by stockholders
Retained earnings 64.0 Past earnings not distributed to stockholders
Total stockholders’ equity 119.7
Total liabilities and stockholders’ equity $527.4 Total sources of financing for company’s resources

The notes are an integral part of these financial statements.

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 Balance Sheet

Assets Elements of the

Cash Balance Sheet
Short-Term Investments
Accounts Receivable
Notes Receivable
Inventory (to be sold) Liabilities
Supplies Accounts Payable
Prepaid Expenses Accrued Expenses
Long-Term Investments Notes Payable
Equipment Taxes Payable
Buildings Unearned Revenue
Land Bonds Payable
Intangibles

Stockholders’ Equity
The Balance Sheet is a Common Stock
financial snapshot at a Retained Earnings
specific point in time.
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 Further explaining some financial
statement items
• Supplies vs Inventory (Current assets)
– Supplies are small materials that a co. uses up from time to
time.
– Inventory is merchandise that a co. carries for sale.
• Accrued Expenses (Current liability)
– Expenses incurred but not yet paid.
• Accrued Revenues
• Tax Payable (Current liability)
– Taxes charged but not yet paid.

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 Further explaining some financial
statement items
• S-T vs L-T Investment (Current vs. Non-current asset)
– S-T investment are those that a co. can sell within a short
period of time while L-T investment are those that the co.
will keep in the long run.
• Tangible assets vs Intangible assets (Non-current assets)
– Tangibles are those that have physical existence.
– Intangibles are those without physical existence but are
valuable to the co., eg, copyright, trademarks.

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 Further explaining some financial
statement items
• Prepaid expenses (Current asset) Eg. Prepaid insurance,
prepaid rent
– Expenses paid in advance for services/goods which have
not yet been consumed.
• Unearned Revenue (Current liability) Eg. Unearned ticket
revenue, unearned subscriptions
– Revenue received in advance for goods/services not yet
rendered.
• Common Stock (Equity)
– Total stockholders’ investments in the co.
• Retained Earnings (Equity)
– Total profits/losses since the co.’s inception.
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 Accounts receivable
vs
Notes Receivable
Accounts Receivable (A/R) Notes Receivable (N/R)
Definition The right to collect $ from The right to collect $ from
Customers Debtors
Source Sales invoice A note (loan agreement)
Document
Maturity Shorter than N/R Longer than A/R
Date
Interests Non Interest-bearing Interest-bearing
(unless overdue)

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 Accounts Payble
vs
Notes Payable
Accounts Payable (A/P) Notes Payable (N/P)
Definition Obligation to pay $$ to Obligation to pay $$ to Creditors
Suppliers to settle the to settle the amount owing to
amount owing to suppliers creditors
Source Purchase invoice A note (loan agreement)
Document
Maturity Shorter than N/P Longer than A/P
Date
Interests Non Interest-bearing Interest-bearing
(unless overdue)

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Financial Analysis - Interpreting Assets, Liabilities, and
Stockholders’ Equity on the Balance Sheet

Assessment of Le-Nature’s assets is important to its creditors, Wells Fargo

Bank and others, and its stockholders because assets provide a basis for
judging whether the company has sufficient resources available to operate.
Assets are also important because they could be sold for cash in the event that
Le-Nature’s goes out of business.

Le-Nature’s debts are important because creditors and stockholders are

concerned about whether the company has sufficient sources of cash to pay
its debts. Le-Nature’s debts are also relevant to Wells Fargo Bank’s decision
to lend money to the company because existing creditors share its claim
against Le-Nature’s assets. If a business does not pay its creditors, the
creditors may force the sale of assets sufficient to meet their claims. The sale
of assets often fails to cover all of a company’s debts, and some creditors
may take a loss.

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Financial Analysis - Interpreting Assets, Liabilities, and
Stockholders’ Equity on the Balance Sheet

Le-Nature’s stockholders’ equity is important to Wells Fargo Bank

because creditors’ claims legally come before those of owners. If Le-Nature’s
goes out of business and its assets are sold, the proceeds of that sale must be
used to pay back creditors before the stockholders receive any money. Thus,
creditors consider stockholders’ equity a protective “cushion.”

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 Self-study Quiz 1
1. Le-Nature’s assets are listed in one section and liabilities and
stockholders’ equity in another. Notice that the two sections
balance in conformity with the basic accounting equation. In
the following chapters, you will learn that the basic
accounting equation is the basic building block for the entire
accounting process. Your task here is to verify that total
assets ($527.4 million) is correct using the numbers for
liabilities and stockholders’ equity presented in Exhibit 1.2.

(slide 12)

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 Self-study Quiz 1
2. Learning which items belong in each of the balance sheet
categories is an important first step in understanding their
meaning. Without referring to Exhibit 1.2, mark each balance sheet item in
the following list as an asset (A), a liability (L), or a stockholders’ equity (SE)
item.
_____ Accounts payable
_____ Accounts receivable
_____ Cash
_____ Common stock
_____ Property, plant, and equipment
_____ Inventories
_____ Notes payable
_____ Retained earnings

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 Solutions to self-study quiz 1

1. Assets ($527.4) = Liabilities ($407.7) +

Stockholders’ Equity ($119.7) (in millions).

2. L, A, A, SE, A, A, L, SE (reading down the

columns).

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The Income Statement Equation

R - E = NI
Revenues Expenses Net Income

Cash and promises Resources Revenues earned

received from used to earn minus expenses
delivery of goods period’s incurred. Also called
and services. revenues “profit”, “net
earnings”, or “the
bottom line.”

If total expenses exceed total revenues, a net loss is reported.

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Income Statement

Elements of the
Revenues
Income
Cash and promises received
Statement
from delivery of goods and
services.

Examples:
Sales Revenue Expenses
Fee Revenue Resources used to earn
Interest Revenue period’s revenues.
Rent Revenue
Examples:
Cost of Goods Sold
Wages Expense
The Income Statement is a Rent Expense
measure of performance of Depreciation Expense
the business. Insurance Expense
Repair Expense
Income Tax Expense

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 Accrual vs. Cash Basis of Accounting

• Accrual basis is preferred because companies

are assumed to be going concern.
• Accrual basis = recognize revenues and
expenses based on their occurrence, not
based receipt and payment of cash.
• Cash basis is only allowed for companies that
are not going concern.
• Cash basis = recognize revenues and expenses
based on receipt and payment of cash.
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Different kinds of revenues & expenses

• Operating vs. Non-operating revenues

• COGS vs. Expenses
– Cost of goods sold is the direct cost of selling
merchandise.
– Expenses are the general costs incur to earn
revenue.
• Operating vs. Non-operating expenses

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Exhibit 1.3
Income Statement

EXPLANATION
LE-NATURE’S INC. Name of the entity
Income Statement Title of the statement
For the Year Ended December 31, 2015 Accounting period
(in millions of dollars) Unit of measure

Revenues
Sales revenue $275.1 Cash and promises received from sale of beverages
Expenses
Cost of goods sold 140.8 Cost to produce beverages sold
Selling, general, and administrative Other operating expenses (utilities, delivery costs, etc.)
expenses 77.1
Interest expense 17.2 Cost of using borrowed funds
Income before income taxes 40.0
Income tax expense 17.1 Income taxes on period’s income before income taxes
Net income $ 22.9 Revenues earned minus expenses incurred

The notes are an integral part of these financial statements.

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 Selling, general & administrative
expenses
• Selling, general and administrative expense (SG&A) is
reported on the income statement as the sum of all direct and
indirect selling expenses and all general and administrative
expenses (G&A) of a company.
• SG&A is not assigned to a specific product, and therefore not
included in the cost of goods sold (COGS).
• They are incurred as part of the day-to-day business
operations.
• Managers target SG&A when a cost-reduction strategy is
implemented because they do not affect the manufacturing
or production of goods directly.

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 Analyzing the Income Statement:
Beyond the Bottom Line
Investors and creditors such as Wells Fargo Bank closely monitor a firm’s
net income because it indicates the firm’s ability to sell goods and services
for more than they cost to produce and deliver. Investors buy stock when they
believe that future earnings will improve and lead to dividends and the ability
to sell their stock for more than they paid. Lenders also rely on future
earnings to provide the resources to repay loans. The details of the statement
also are important. For example, Le-Nature’s had to sell more than $275
million worth of beverages to make just under $23 million. If a competitor
were to lower prices just 10 percent, forcing Le-Nature’s to do the same, its
net income could easily turn into a net loss. These factors and others help
investors and creditors estimate the company’s future earnings.

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 Self-study Quiz 2
1. Learning which items belong in each of the income statement
categories is an important first step in understanding their
meaning. Without referring to Exhibit 1.3 (slide 28), mark each
income statement item in the following list as a revenue (R) or an
expense (E).
_____ Cost of goods sold
_____ Income tax
_____ Sales revenue
_____ Selling, general, and administrative

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 Self-Study Quiz 2
2. Assume that during the period 2015, Le-Nature’s delivered
beverages for which customers paid or promised to pay
amounts totaling $275.1 million. During the same period, it
collected $250.0 million in cash from its customers.
Without referring to Exhibit 1.3, indicate which of these two
amounts will be shown on Le-Nature’s income statement as
sales revenue for 2015. Why did you select your answer?

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 Self-study Quiz 2
3. Assume that during the period 2015, Le-Nature’s produced
beverages with a total cost of production of $142.1 million.
During the same period, it delivered to customers beverages
that cost a total of $140.8 million to produce. Without
referring to Exhibit 1.3, indicate which of the two numbers
will be shown on Le-Nature’s income statement as cost of
goods sold expense for 2015. Why did you select your
answer?

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 Solutions to self-study quiz 2
1. E, E, R, E (reading down the columns).

2. Sales revenue in the amount of $275.1 million is recognized.

Sales revenue is normally reported on the income statement
when goods or services have been delivered to customers who
have either paid or promised to pay for them in the future.

3. Cost of goods sold expense is $140.8. Expenses are the dollar

amount of resources used up to earn revenues during the
period. Only those beverages that have been delivered to
customers have been used up.

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Statement of Stockholders’ Equity (1 of 2)

Elements of the
Common Stock
Statement of
Amounts invested in the
Stockholders’
business by stockholders.
Equity
Beginning Common Stock
+ Stock Issuance
Ending Common Stock
The Statement of
Retained Earnings Stockholders’ Equity reports
Past earnings not distributed the change in each
to stockholders. stockholders’ equity account
during the period.
Beginning Retained Earnings
+ Net Income
− Dividends declared
Ending Retained Earnings

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Exhibit 1.4
Statement of Stockholders’ Equity

EXPLANATION
LE-NATURE’S INC. Name of the entity
Statement of Stockholders’ Equity Title of the statement
For the Year Ended December 31, 2015 Accounting period
(in millions of dollars) Unit of measure

Common Retained
Stock Earnings
Balance December 31, 2014 $55.7 $43.1 Last period’s ending balances
Net income for 2015 22.9 Net income reported on the income statement
Dividends for 2015 (2.0) Dividends declared during the period
Balance December 31, 2015 $55.7 $64.0 Ending balances on the balance sheet

The notes are an integral part of these financial statements.

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 Interpreting Retained Earnings
Reinvestment of earnings, or retained earnings, is an important
source of financing for Le-Nature’s, representing more than 12
percent of its financing. Creditors such as Wells Fargo Bank
closely monitor a firm’s statement of stockholders’ equity
because the firm’s policy on dividend payments to the
stockholders affects its ability to repay its debts. Every dollar
Le-Nature’s pays to stockholders as a dividend is not available for
use in paying back its debt to Wells Fargo. Investors examine
retained earnings to determine whether the company is
reinvesting a sufficient portion of earnings to support future
growth.

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 Self-study Quiz 3
1. Assume that a company’s financial statements reported the
following amounts: beginning retained earnings, $5,510;
total assets, $20,450; dividends, $900; cost of goods sold
expense, $19,475; and net income, $1,780. Without
referring to Exhibit 1.4 (slide 36), compute ending retained
earnings.

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 Solutions to self-study quiz 3

1. Beginning Retained Earnings ($5,510) + Net

Income ($1,780) – Dividends ($900) = Ending
Retained Earnings ($6,390).

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Exhibit 1.6
Relationships Among Le-Nature’s Statements

Statement of Stockholders’ Equity

Income Statement Common Retained
Revenues $ 275.1 Stock Earnings
− Expenses 252.2 1 Beginning $55.7 $43.1
Net Income $ 22.9 + Net Income 22.9
− Dividends (2.0)
Ending $55.7 $64.0
Will cover in Ch 12
Statement of Cash Flows
+/− Cash Flows from Operating
Activities $ 87.5 Balance Sheet
Cash $ 10.6 2
+/− Cash Flows from Investing
Other Assets 516.8
Activities (125.5) 3 Total Assets $527.4
+/− Cash Flows from Financing
Activities 47.0 Liabilities $407.7
Change in Cash 9.0 Common Stock 55.7
+ Cash at Beginning of Period 1.6 Retained Earnings 64.0
Cash at End of Period $ 10.6 Total Liabilities &
Stockholders’ Equity $527.4

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Notes

Did you notice this sentence at the bottom of each financial

statement?

All financial statements should be accompanied by notes that provide

the reader with supplemental information to help the reader better
understand the financial statements.

The notes are also called footnotes.

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Financial Statement Formats
Assets are listed on the balance
sheet by ease of conversion to cash.

Liabilities are listed by the

maturity (due date).

Place a single underline below

the last item in a group before a
total or subtotal, and a double
underline below the group
Include the monetary unit totals.
sign ($) beside the first
dollar amount in a group of
items and by group total

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Exhibit 1.7
Summary of the Four Basic Financial Statements
Financial Statement Purpose Structure Examples of Content

Balance Sheet Reports the financial position Cash, accounts receivable,

(Statement of (economic resources and plant and equipment, long-
Financial Position) sources of financing) of an term debt, common stock
accounting entity at a point
in time.

Income Statement Reports the accountant’s Sales revenue, cost of goods

(Statement of Income, primary measure of sold, selling expense, interest
Statement of Earnings, economic performance expense
Statement of Operations) during the accounting period.

Statement of Reports changes in the Beginning and ending

Stockholders’ Equity company’s common stock stockholders’ equity
and retained earnings during balances, stock issuances,
the accounting period. net income, dividends

Statement of Cash Flows Reports inflows (receipts) Cash collected from

(Cash Flow Statement) and outflows (payments) of customers, cash paid to
cash during the accounting suppliers, cash paid to
Will cover in Ch12 period in the categories of purchase equipment, cash
operating, investing, and borrowed from banks
financing.
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Learning Objective 1-2
1-2 Identify the role of generally accepted accounting principles
(GAAP) in determining financial statement content and how
companies ensure the accuracy of their financial statements.

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Rules that Determine Content of Financial Statements

Generally
Accepted
Accounting
Principles
(GAAP)

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Generally Accepted Accounting Principles (1 of 2)

Congress created the Securities and Exchange Commission (SEC)

and gave it broad powers to determine measurement
rules for financial statements for publicly traded companies.

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 official pronouncements of the FASB are called the
FASB Accounting Standards Codification.

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Generally Accepted Accounting Principles (2 of 2)

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
management and other employees
➢ Loss of competitive information to other companies

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Responsibility and the Need for Controls

To ensure the accuracy of a company’s financial information,

management:
➢ Maintains a system of controls over the records and assets.
➢ Hires external independent auditors.
➢ Forms a committee of the board of directors to review these
other two safeguards.

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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 that
can be bought and sold and operates separately from its owners

Advantages of a Corporation:
➢Stockholders have limited liability
➢Continuity of life
➢Ease in transferring ownership (stock)
➢Opportunity to raise large amounts of money by selling
shares of stock to a large number of people
Disadvantage of a Corporation:
➢Double taxation (income is taxed when earned and
again when distributed to stockholders as dividends)

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