chapter 1 Financial Statements

and Business Decisions

Financial Accounting
10e
9e
Libby • Libby • Hodge

1-1
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What are we going to learn?

1. Some basic concepts

2. Four basic financial statements

3. GAAP and IFRS

Tips: this is an overview chapter; most content will be

elaborated in the near future
Who are the principal players?
• Managers (may or may not be owners).

• Owners (stockholders) are investors. They may also be

managers. Owners invest money and/or other property in
a company for:
• Dividends
• Higher future stock prices

• Lenders (creditors). The lenders' potential return:

• To earn interest on the loan

• Suppliers and Customers.

• Whether the supplier has sufficient resources to meet future
demand.
Business activities
• Operating activities
• Purchase parts from supplier, pay salaries to employee, sell
products to customers
• e.g., Starbucks sold a grande Latte to you.

• Financing activities
• Borrow/pay back money from/to a bank
• pay dividends to owners
• e.g., Starbucks borrowed $100 million from Bank of America (BOA)

• Investing activities
• Purchase or sell land, equipment
• e.g., Starbucks purchased equipment and factories to in Malaysia to
roast coffee beans.
The Accounting System

Accounting
The means by which
we measure and
describe the
economic activities of
a business AND
communicate these
results to interested
users.

Accounting is the
“language of business”.
Why Study Financial Accounting?
Decision makers rely on financial information:

• Investors

• Creditors

• Customers

• Any other players?

Financial Statements

The four basic financial statements

 Balance sheet
 Income statement
 Statement of cash flows
 Statement of stockholder’s equity
Tips:
• Focus on:
• Content: the categories, or elements, reported on each
of the four statements.
• 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

• No need to memorize all the concepts for now.

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 (for example, Balance Sheet).
• Specific date of the statement (for example, At December 31, 2020).
• Unit of measure (in millions of dollars).
Balance Sheet
 Report the financial position of an accounting entity at a
particular point in time (snapshot).

 Assets: economic resources from past transactions

 Expect to provide future benefits.
 Initially measured at the total cost incurred to acquire it (historical
cost).

 Liabilities: debts or obligations from past transactions

 Represent future economic detriment.
 Financing provided by creditors.

 Stockholders’ equity
 Contributed Capital: amounts invested by the owners.
 Retained Earnings : accumulations of undistributed earnings.
The Basic Accounting Equation

• The basic accounting equation refers to a company’s

financial position: the economic resources that the
company owns and the sources of financing for those
resources.
Interpreting the Balance Sheet
• Creditors and shareholders analyze assets to determine if the
company has sufficient resources available to operate. Assets
can be sold for cash if the company goes out of business.
• Creditors and shareholders are concerned about whether the
company has sufficient sources of cash to pay its liabilities
(debts). If a company does not pay its creditors, the creditors
can force the sale of assets.
• Stockholders’ Equity is considered a protective “cushion” to
creditors because the creditors’ claims legally come before
those of the owners. If the company goes out of business and its
assets are sold, the creditors are paid back before the
shareholders receive any money.
Example: Netflix
Example: Netflix
Example: Netflix
Content Accounting
• [Link]
Income Statement
• The primary measure of performance of a business
for a period of time (fiscal period).

• Alias:
• Statement of Operations; profit and loss (P&L) statement

• Performance report for your study – midterm exam

Performance report for a company – income statement
The Income Statement Equation

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

Income Statement
Example: Netflix
Interpreting the Income Statement
• Investors and creditors 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 rely on future earnings to provide the
resources to repay loans. The income statement helps
investors and creditors estimate the company’s future
earnings.
Statement of Stockholders’ Equity
Elements of the Statement of
Stockholders’ Equity

Common Stock Retained Earnings

Beginning Common Stock Beginning Retained Earnings

+Stock Issuance +Net Income
Ending Common Stock −Dividends
Ending Retained Earnings
Exhibit 1.4: Statement of Stockholders’ Equity
Example: Netflix
Interpreting Retained Earnings

• Reinvestment of earnings, or retained earnings, is an

important source of financing for companies.
• Creditors closely monitor a firm’s statement of
stockholders’ equity because the company’s policy on
dividend payments affects its ability to repay its debts.
• Every dollar the company pays to stockholders as a
dividend is not available for use in paying back its debt.
• Investors examine retained earnings to determine
whether the company is reinvesting a sufficient portion
of earnings to support future growth.

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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

Note that each of the three cash flow

/ sources can be positive (net cash
inflow) or negative (net cash outflow)
Statement of Cash Flows
• This statement shows cash inflows (receipts) and cash
outflows (payments).

• Recall the three business activities we talked about:

• Cash flow from operating activities (CFO) - directly related
to normal business activities.
• Cash flow from investing activities (CFI) - acquisitions and
sales of plant and equipment, intangibles, and other
investment assets.
• Cash flow from financing activities (CFF) - involves dealings
with the company owners and lenders.
Relationships Between Financial Statements.
Statement of Cash Flow

Cash from operations

Beginning Balance Sheet Cash from investing Ending Balance Sheet

Cash from financing Assets

Assets
Cash Net change in cash Cash
Other Assets Other Assets
Statement of retained earnings
Liabilities Liabilities
B.B. of retained earnings
Stockholder’s equity + Net income Stockholder’s equity
Contributed Capital - Dividend Contributed Capital
Retained Ending balance of retained earnings Retained
earnings earnings
Income Statement

Revenues
- Expenses
Net income

Last period Current period

Dates of Financial Statements are Important!

• Balance sheet is “AS OF…” or “AT” a particular date,

sometimes called a “snapshot” in time.

• Income statement
• Statement of stockholders’ equity
• Statement of cash flows

These last three cover a period of time, and thus are

“FOR THE PERIOD ENDING”
Generally Accepted Accounting Principles

• The rules that determine the content and

measurement rules of the statements are called
generally accepted accounting principles, or GAAP.

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How are GAAP Principles Determined?

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International Perspective
• Financial accounting standards and disclosure requirements are adopted by national
regulatory agencies.
• Since 2002, 144 jurisdictions have adopted International Financial Reporting
Standards (IFRS) issued by the International Accounting Standards Board (IASB).

• Examples of jurisdictions requiring the use of IFRS:

• European Union (Germany, France, the Netherlands, Belgium, Poland, etc.) and United
Kingdom.
• Australia and New Zealand.
• Hong Kong (S.A.R. of China), Malaysia, and Republic of Korea.
• Israel and Turkey.
• Brazil and Chile.
• Canada and Mexico.

• In the U.S., the SEC now allows foreign companies whose stock is traded in the United
States to use IFRS.
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Ethical Conduct
• Intentional misreporting of financial statements is unethical and
illegal. However, many situations are less clear-cut and required
individuals to weigh one moral principal (for example, honesty)
against another (for example, loyalty to a friend).

• Three-Step Process for Making Ethical Decisions

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.

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Consequences of Unethical Behavior
• After it was determined that the financial statements for Le-Nature’s Inc. • What if the
numbers
were misleading, the consequences for the defendants were severe. are wrong?

• The Prison Tally

Defendant Sentence
Gregory Podlucky, CFO 20 years in federal prison
Robert Lynn. President 15 years in federal prison
Andrew Murin, Consultant 10 years in federal prison
Jonathan Podlucky. COO 5 years in federal prison
Karla Podlucky (CEO's wife) 4¼ years in federal prison
G. Jesse Podlucky (CEO's son) 9 years in federal prison
Donald Pollinger, Businessman 5 years in federal prison
Tammy Jo Andreycak, Bookkeeper 5 years in federal prison

• Crime clearly did not pay for Podlucky and his co-conspirators.
• The auditors who missed the fraud agreed to pay $50 million to the creditors.
• Wachovia Capital Markets, which marketed the loans, agreed to pay $80 million.
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Take-away of chapter 1

• What is the goal of business and who are the key

players?

• What is an accounting system?

• What are the four financial statements?