Chapter 1

Uses of
Accounting
Information and
the Financial
Statements

Multimedia Slides by: Gail A. Mestas, MAcc, New Mexico State University
 Learning Objectives

1. Define accounting, identify business goals

and activities, and describe the role of
accounting in making informed decisions.
2. Identify the many users of accounting
information in society.
3. Explain the importance of business
transactions, money measure, and separate
entity to accounting measurement.
4. Identify the three basic forms of business
organization.

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 Learning Objectives (cont’d)

5. Define financial position, state the

accounting equation, and show how they are
affected by simple transactions.
6. Identify the four financial statements.
7. State the relationship of generally accepted
accounting principles (GAAP) to financial
statements and the independent CPA’s
report, and identify the organizations that
influence GAAP.

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Accounting as an Information System

• Objective 1
– Define accounting, identify business goals
and activities, and describe the role of
accounting in making informed decisions

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 Accounting

… is an information system that

measures
processes
communicates
financial information
about an identifiable, economic entity

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 Accounting

…supplies the information

decision makers need to make
reasoned choices
among alternative uses of
scarce resources
in the conduct of business and
economic activities

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 Accounting …

• Is a link between business activities and

decision makers
– Decision makers use accounting
information to make informed decisions
about available alternatives
• Measures business activities by
recording data about them for future use
• Is communicated to decision makers
through reports

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Accounting as an Information System
Input Output

Accounting System

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 Business Goals, Activities, and
Performance Measures

• Business
– An economic unit that aims to sell goods
and services to customers at prices that
will provide an adequate return to its
owners

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 Business Goals

• Profitability
– The ability to earn enough income to
attract and hold investment capital
• Liquidity
– Having enough cash available to pay debts
when they are due

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 Business Activities

• Financing Activities
• Investing Activities
• Operating Activities

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 Financing Activities

• Activities associated with obtaining

adequate funds, or capital, to begin and
continue operations
– Owner investments
– Paying a return to owners
– Obtaining loans from creditors
– Repaying amounts to creditors, plus
interest

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 Investing Activities

• Activities associated with spending

funds to begin and continue operations
– Buying resources such as land, buildings,
and equipment needed in the operation
of the business
– Selling these resources when no longer
needed

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 Operating Activities

• Activities associated with the course of

running a business
– Selling goods and services
– Employing managers and workers
– Buying goods and services
– Paying taxes

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 Performance Measures

• Indicators
– Used to determine whether
1. Managers are achieving their business goals
2. Business activities are well managed
• Include
– Earned income
– Cash flow
– Ratio of expenses to revenue
– Ratio of money owed to total resources
controlled

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Financial and Management Accounting

• Accounting’s role is divided into two

categories
1. Management accounting
2. Financial accounting
• The functions of both categories
overlap
• Primary difference between the two is
the principal users of the information

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 Management Accounting

• Focuses on internal decision makers

– Managers and employees
• Reporting format is flexible and based
on the type of information needed, such
as budgets and sales forecasts
• Used to report past performance and
expected future performance

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 Financial Accounting

• Focuses on external decision makers

– Stockholders
– Banks and other creditors
– Government regulators
• Financial information of company is
reported in the financial statements
– Used to report directly on goals of
profitability and liquidity

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 Discussion

Q. What is the difference between

profitability and liquidity?
A. Profitability
• Earning enough income (revenues minus
expenses) to attract and hold investors
Liquidity
• Having enough funds available (cash) to pay
debts when they are due

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 Decision Makers:
The Users of Accounting Information

• Objective 2
– Identify the many users of accounting
information in society

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 Decision Makers

… fall into three categories

1. Those who manage a business

– Finance
– Investment
– Operations and Production
– Marketing
– Human Resources
– Information Systems
– Accounting

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 Decision Makers (cont’d)

2. Those with a Direct Financial Interest

– Investors
– Creditors
3. Those with an Indirect Financial Interest
– Tax Authorities
– Regulatory Agencies
– Labor Unions
– Financial Advisors
– Customers
– Economic Planners

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 Management

• Managers are internal users of accounting

information
– Make key decisions using accounting information
– Basic management functions require accounting
information for decision making
• Financing the business
• Investing resources
• Producing goods and services
• Marketing goods and services
• Managing employees
• Providing information to decision makers

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 Users With a Direct Financial Interest

… are external users of accounting

information
• Investors
– Put money into a business in order to
make money (by purchasing and selling
stocks and receiving dividends)
– Use financial statements to judge the
prospects for profitable investments

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 Users With a Direct
Financial Interest (cont’d)

• Creditors
– Loan money to a business in order to make
money (by charging interest)
– Use financial statements to judge whether
a company will have enough cash to
• Pay interest charges
• Repay debt at appropriate time

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 Users With an Indirect
Financial Interest
… are external users of accounting
information
• Tax authorities
– Use accounting information to determine amount
of tax due
– Procedures for tax reporting mandated by law
• Government regulatory agencies
– Federal, state, and local levels
– Securities and Exchange Commission (SEC)
• Regulates the issuing, buying, and selling of stocks in the
U.S.
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 Users With an Indirect
Financial Interest (cont’d)

• Other groups
– Labor unions
– Those advising investors and creditors
• Financial analysts and advisors
• Brokers
• Underwriters
• Lawyers
• Financial press
– Consumer groups
– Customers
– General public
– Economic planners

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 Government and Not-for-Profit
Organizations
• Include
– Hospitals
– Universities
– Professional organizations
– Charities

• Have the same categories of decision makers as

profit-oriented organizations
– Managers
– Those with a direct financial interest
– Those with an indirect financial interest

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 Discussion

[Link] do management accounting and

financial accounting differ?
A. Management Accounting
–Focus on internal users
–All types of information
–Communicated in format most suitable to purpose

Financial Accounting
–Focus on external users as well as internal users
–Specific information
–Communicated in financial statements
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 Accounting Measurement

• Objective 3
– Explain the importance of business
transactions, money measure, and
separate entity to accounting measurement

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 Accounting Measurement

Four Basic Questions

1. What is measured?
• Business transactions affecting the
financial position of the business entity
2. When should the measurement be
made?
• Discussed in Chapter 2, The
Recognition Issue

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 Accounting Measurement (cont’d)

3. What value should be placed on

what is measured?
• Discussed in Chapter 2, The Valuation
Issue
4. How should what is measured be
classified?
• Discussed in Chapter 2, The
Classification Issue

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 Business Transactions

… are economic events that affect the

financial position of a business entity

– Involve an exchange of value

• Purchase
• Sale
• Payment
• Collection
– Events that have the same effect as an exchange
of value
• Loss from fire, flood, theft
• Physical wear and tear on equipment
• Accumulation of interest

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 Money Measure

• Recording of all business transactions

in terms of money
• Money is the only factor common to all
business transactions
• Basic unit of money determined by the
country in which business resides
• Exchange rates are used to translate
transactions from one currency to
another

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 Money Measure (cont’d)

• Exchange Rate
– The value of one currency in terms of another
– Changes daily

• Example:
– Assume the price of one British pound is 1.61 U.S.
dollars. How many British pounds would one U.S.
dollar buy?
1 British pound ÷ 1.61 U.S. dollars
= 0.62 British pounds per U.S. dollar

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 Separate Entity

• A business is distinct from its

– Owner(s)
– Creditors
– Customers
• Its financial records and reports should
refer only to its own financial affairs

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 Discussion

Q. Identify each of the following as most

closely related to a
a) business (b) 1. Partnership
transaction,
(c) 2. U.S. dollar
b) separate (a) 3. Payment of an expense
entity, or
(b) 4. Corporation
c) money (a) 5. Sale of an asset
measure

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 Forms of Business Organization

• Objective 4
– Identify the three basic forms of business
organization

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 Forms of Business Enterprises

• Three basic forms of business

enterprises
– Sole proprietorship
– Partnership
– Corporation

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 Separate Entities

• All three forms of businesses are

economically separate entities from
their owners
– Financial records and reports refer to the
financial affairs of the business only
• Only the corporation is a legally
separate entity from its owners

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 Sole Proprietorships

• Business owned by one person

– The owner
• Receives all profits or losses
• Is liable for all obligations of the business

• Not incorporated
• Life of business ends when the owner
– Decides to stop operating business
– Dies
– Is incapacitated

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 Partnerships

• Business owned by more than one person

– The partners share all profits or losses according
to an agreed upon formula
– At least one partner is liable for all obligations of
the business
• Not incorporated
• Life of business ends when
– Ownership changes
• A partner leaves the business or dies
• A new partner is admitted

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 The Corporation as a
Separate Entity

• Legally and economically separate from its

owners
– Business unit chartered by the state and legally
separate from owners (incorporated)
– Owners (stockholders) do not directly control
operations
– Elected board of directors run the corporation
– Owners’ risk of loss limited to amount paid for
shares of stock – owners are not liable for the
obligations of the business

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Sole Proprietorships and Partnerships
versus Corporations
Sole Proprietorships
and Partnerships Corporations
• Separate economic entity • Separate economic entity

• Not separate legal entity • Separate legal entity

• Owner(s) directly control • Owner do not directly control

operations operations – elected board
of directors runs corporation
• No economic separation
between owner(s) and the • Owner’s risk of loss (liability)
business – owners liable for limited to amount paid for
obligations of the business shares of stock

• Ownership cannot be • Ownership can be

transferred transferred

• Life of business is limited • Life of business is unlimited

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 Discussion
Q. How do a sole proprietorship, partnership, and
corporation differ?

A. Sole proprietorship
B. One owner
– OOwner legally obligated to pay company liabilities

Partnership
– MMultiple owners (partners)
– PPartners legally obligated to pay company liabilities

Corporation
– OOwned by stockholders
– SStockholders not legally obligated to pay company
liabilities

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 Financial Position and the
Accounting Equation

• Objective 5
– Define financial position, state the
accounting equation, and show how they
are affected by simple transactions

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 Financial Position

The economic resources that belong

to a company
and the claims against those resources
at a point in time

Economic Resources = Equities

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 Developing the Accounting Equation

Economic Resources = Equities

Two types of equities
Creditor’s equities and owner's equities,
therefore,

Economic Resources
Assets = Creditor’s
LiabilitiesEquities
+ Owner’s Equities
In accounting terminology
Economic resources are called assets
Creditor’s equities are called liabilities

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 Accounting Equation

Assets = Liabilities + Owner’s Equity

Two sides of equation are always in balance
• Assets
– Economic resources owned by a company that are expected
to benefit future operations
• Liabilities
– Obligations of a business to pay cash, transfer assets, or
provide services to other entities in the future
– Represent claims of creditors to the assets of the business
• Owner’s Equity
– Represents the claims by owners to the assets of the
business

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 Owner’s Equity

• Equals the residual interest in a company’s

assets after deducting all liabilities
• Also called residual equity or net assets
• Defined by rearranging the accounting
equation

Assets = Liabilities + Owner’s Equity

Owner’s Equity = Assets – Liabilities

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 Transactions That Affect Owner’s Equity

• Owner’s investments
– Assets the owner puts into the business
• Owner’s withdrawals
– Assets the owner takes out of the business
• Revenues
– Increases in owner’s equity that result from
operating a business
• Expenses
– Decreases in owner’s equity that result from
operating a business

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Illustrative Transactions for Shannon Realty

Effects of Transactions
on the Accounting Equation

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 Owner’s Investments
1. Deposited $50,000 in a bank account in the name of
Shannon Realty
Assets = Liab. + Owner’s Equity
John Shannon,
Cash Capital
1.+$50,000 +$50,000

A = $50,000 L + OE = $50,000

Notice that the accounting equation

Assets = Liabilities + Owner's Equity, or
A = L + OE,
is always in balance

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 Purchase of Assets with Cash
2. Purchased a lot for $10,000 and a small building on a lot
for $25,000
Assets = Liab. + Owner’s Equity
John Shannon,
Cash Land Building Capital
1. $50,000 $50,000
2. -35,000 + $10,000 +$25,000
bal. $15,000 $10,000 $25,000 $50,000

A = $50,000 L + OE = $50,000

This transaction only affects one side of the

accounting equation – Assets
Whenever a transaction affects only one side
of the accounting equation, the total on each
side of the equal sign remains unchanged

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 Purchase of Assets
by Incurring a Liability
3. Purchased office supplies for $500 on credit

Assets = Liab. + Owner’s Equity

John Shannon,
Cash Supplies Land Building A/P Capital
1. $50,000 $50,000
2. -35,000 $10,000 $25,000
3. +$500 +$500
bal. $15,000 $500 $10,000 $25,000 $500 $50,000

A = $50,500 L + OE = $50,500

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 Payment of a Liability
4. Paid $200 of the $500 owed for supplies

Assets = Liab. + Owner’s Equity

John Shannon,
Cash Supplies Land Building A/P Capital
1. $50,000 $50,000
2. -35,000 $10,000 $25,000
3. $500 $500
4. -200 -200
bal. $14,800 $500 $10,000 $25,000 $300 $50,000

A = $50,300 L + OE = $50,300

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 Revenues
5. Earned and received a commission of $1,500 in cash

Assets = Liab. + Owner’s Equity

John Shannon,
Cash Supplies Land Building A/P Capital
1. $50,000 $50,000
2. -35,000 $10,000 $25,000
3. $500 $500
4. -200 -200
5. +1,500 +1,500
bal. $16,300 $500 $10,000 $25,000 $300 $51,500

A = $51,800 L + OE = $51,800

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 Revenues
6. Earned a commission of $2,000 to be received at a later
date
Assets = Liab. + Owner’s Equity
John Shannon,
Cash A/R Supplies Land Building A/P Capital
1. $50,000 $50,000
2. -35,000 $10,000 $25,000
3. $500 $500
4. -200 -200
5. 1,500 1,500
6. +$2,000 +2,000
bal. $16,300 $2,000 $500 $10,000 $25,000 $300 $53,500

A = $53,800 L + OE = $53,800

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 Collection of Accounts Receivable
7. Received $1,000 from client for commission earned earlier
in the month
Assets = Liab. + Owner’s Equity
John Shannon,
Cash A/R Supplies Land Building A/P Capital
1. $50,000 $50,000
2. -35,000 $10,000 $25,000
3. $500 $500
4. -200 -200
5. 1,500 1,500
6. $2,000 2,000
7. +1,000 -1,000
bal. $17,300 $1,000 $500 $10,000 $25,000 $300 $53,500

A = $53,800 L + OE = $53,800

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 Expenses
8. Paid $1,000 to rent equipment for office

Assets = Liab. + Owner’s Equity

John Shannon,
Cash A/R Supplies Land Building A/P Capital
1. $50,000 $50,000
2. -35,000 $10,000 $25,000
3. $500 $500
4. -200 -200
5. 1,500 1,500
6. $2,000 2,000
7. 1,000 -1,000
8. -1,000 -1,000
bal. $16,300 $1,000 $500 $10,000 $25,000 $300 $52,500

A = $52,800 L + OE = $52,800

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 Expenses
9. Paid $400 in wages to part-time helper

Assets = Liab. + Owner’s Equity

John Shannon,
Cash A/R Supplies Land Building A/P Capital
1. $50,000 $50,000
2. -35,000 $10,000 $25,000
3. $500 $500
4. -200 -200
5. 1,500 1,500
6. $2,000 2,000
7. 1,000 -1,000
8. -1,000 -1,000
9. -400 -400
bal. $15,900 $1,000 $500 $10,000 $25,000 $300 $52,100

A = $52,400 L + OE = $52,400

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 Expenses
10. Recorded utilities expense of $500 incurred in December
but not yet paid
Assets = Liab. + Owner’s Equity
John Shannon,
Cash A/R Supplies Land Building A/P Capital
1. $50,000 $50,000
2. -35,000 $10,000 $25,000
3. $500 $500
4. -200 -200
5. 1,500 1,500
6. $2,000 2,000
7. 1,000 -1,000
8. -1,000 -1,000
9. -400 -400
10. +300 -300
bal. $15,900 $1,000 $500 $10,000 $25,000 $600 $51,800

A = $52,400 L + OE = $52,400

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 Owner’s Withdrawals
11. Withdrew $600 in cash from Shannon Realty and
deposited it in a personal account
Assets = Liab. + Owner’s Equity
John Shannon,
Cash A/R Supplies Land Building A/P Capital
1. $50,000 $50,000
2. -35,000 $10,000 $25,000
3. $500 $500
4. -200 -200
5. 1,500 1,500
6. $2,000 2,000
7. 1,000 -1,000
8. -1,000 -1,000
9. -400 -400
10. 300 -300
11. -600 -600
bal. $15,300 $1,000 $500 $10,000 $25,000 $600 $51,200

A = $51,800 L + OE = $51,800
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 Discussion

Q. What does the accounting equation

represent?

A. The economic resources owned by a company

and the claims against those resources
at a point in time

Assets = Liabilities + Owner’s Equity

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 Communications Through
Financial Statements

• Objective 6
– Identify the four financial statements

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 Communications Through Financial
Statements

• Four Major Financial Statements

– Income Statement
– Statement of Owner’s Equity
– Balance Sheet
– Statement of Cash Flows

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 Income Statement

• Summarizes revenues earned and

expenses incurred over a period of time
• Dated “For the Month Ended …”
• Purpose to measure a company’s
performance over a period of time
• Shows whether or not a company
achieved its profitability goal

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 Income Statement (cont’d)

• Considered by many to be most important

financial statement
• Also called the capital statement
• First financial statement to be prepared in a
sequence
• Net income figure used to prepare statement
of owner’s equity

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Income Statement Date reflects
revenues and
expenses incurred
over a period of time
Shannon Realty
Income Statement
For the Month Ended December 31, 20xx

Revenues
Commissions earned $3,500
Expenses
Equipment rental expense $1,000
Wages expense 400
Utilities expense 300
Total expenses 1,700
Net income $1,800

Net income figure used to prepare

statement of owner’s equity
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 Statement of Owner’s Equity

• Shows changes in owner’s equity over

a period of time
• Dated “For the Month Ended …”
• Uses net income figure from income
statement
• End of period balance in Capital
account used to prepare balance sheet

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Statement of Owner’s Equity

Date reflects changes in John Shannon,

Capital, over a period of time
Shannon Realty
Statement of Owner’s Equity
For the Month Ended December 31, 20xx

John Shannon, Capital, December 1, 20xx $ 0

Add: Investments by John Shannon $50,000
Net income for the month 1,800 51,800
Subtotal 51,800
Less: Withdrawals by John Shannon 600
John Shannon, Capital, December 31, 20xx $51,200

Ending balance of John

Shannon, Capital, used to Net income figure from
prepare the balance sheet income statement

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 Balance Sheet

• Shows the financial position of a company on

a certain date
• Dated as of a certain date
• Also called the statement of financial position
• Presents view of business as holder of assets
that are equal to the claims against those
assets
• Claims consist of liabilities and owner’s equity

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Balance Sheet Date reflects account
balances as of a
certain date

Shannon Realty
Balance Sheet
December 31, 20xx

Assets Liabilities

Cash $15,300 Accounts payable $ 600

Accounts receivable 1,000
Supplies 500 Owner’s Equity
Land 10,000
Building 25,000 John Shannon, Capital 51,200

Total liabilities
Total assets $51,800 and owner’s equity $51,800

Balance in Cash
account used in John Shannon, Capital, from
statement of cash statement of owner’s equity
flows
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 Statement of Cash Flows

• Shows cash flows into and out of a

business over a period of time
• Dated “For the Month Ended …”
• Focuses on whether the business met
its liquidity goal
• Explains how the Cash account
changed during the period

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Statement of Cash Flows Date reflects
Shannon Realty cash flows
Statement of Cash Flows over a period
For the Month Ended December 31, 20xx of time
Cash flows from operating activities
Net income $ 1,800
Adjustments to reconcile net income to net cash
flows from operating activities
Increase in accounts receivable ($1,000)
Begins
Increase in supplies (500) with net
Increase in accounts payable 600 (900) income
Net cash flows from operating activities $ 900
from
Cash flows from investing activities
Purchase of land ($10,000) income
Purchase of building (25,000) statement
Net cash flows from investing activities (35,000)
Cash flows from financing activities
Investments by John Shannon $50,000
Withdrawals by John Shannon (600)
Net cash flows from financing activities 49,400
Net increase (decrease) in cash $15,300
Cash at beginning of month 0
Cash at end of month
Cash at end of month $15,300
same as Cash account
balance on balance sheet
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 Discussion

Q. The balance sheet is often referred to as

the statement of financial position. What
does financial position mean?
A. Financial position is the resources, or assets,
owned by a business as of a certain date
These resources are offset by claims against
them and stockholders’ equity, as shown on the
balance sheet

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 Generally Accepted Accounting
Principles

• Objective 7
– State the relationship of generally accepted
accounting principles (GAAP) to financial
statements and the independent CPA’s
report, and identify the organizations that
influence GAAP

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 Generally Accepted Accounting
Principles (GAAP)

• The conventions, rules, and procedures

necessary to define accounting practice
at a particular time
• Developed to provide guidelines for
financial accounting
• Are altered as better methods evolve or
circumstances change

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 Financial Statements, GAAP, and the
Independent CPA’s Report (Audit)
Financial Statements Audit
• Summary of financial affairs of a • Examination of a company's
business financial statements

• Prepared by management of • Prepared by independent

company certified public accountant
(CPA)
• Management has an interest in • CPA should have no
company performance; not compromising ties with
independent company
• Should be prepared in • Ascertains that financial
accordance with GAAP statements prepared in
accordance with GAAP

• Implies that investors and

creditors can rely on financial
statements
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 Organizations That Influence
Current Practice
• Financial Accounting Standards Board (FASB)
– Most important body for developing and issuing rules on
accounting practice
– Issues Statements of Financial Accounting Standards
(SFAS)
• American Institute of Certified Public Accountants
(AICPA)
– Professional association of certified public accountants
– Influences accounting practice through activities of senior
technical committees

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 Organizations That Influence Current
Practice (cont’d)

• Securities and Exchange Commission (SEC)

– Federal agency set up to protect the public by regulating the
issuing, buying, and selling of stocks and bonds
– Has legal power to set and enforce accounting policies for
companies whose securities are offered for sale to the
general public

• Government Accounting Standards Board (GASB)

– Established under same governing body as Financial
Accounting Standards Board (FASB)
– Responsible for issuing accounting standards for state and
local governments

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 Organizations That Influence Current
Practice (cont’d)
• International Accounting Standards Board (IASB)
– An independent board, cooperating with national accounting
standard setters, to develop high quality, understandable,
and enforceable global accounting standards
– Has published over 30 standards in a series of
pronouncements called International Financial Reporting
Standards (IFRS)
• Internal Revenue Service (IRS)
– Branch of the Department of Treasury
– Administers the Internal Revenue Code enacted by
Congress
– Interprets and enforces U.S. tax laws governing the
assessment and collection of revenues from income taxes

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 Discussion

Q. What are GAAP?

A. Generally accepted accounting principles
The conventions, rules, and procedures
necessary to define accounting practice
at a particular time
Q. What organization has the greatest
influence on GAAP?
A. Financial Accounting Standards Board
(FASB)

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 Time for Review

1. Define accounting, identify business goals

and activities, and describe the role of
accounting in making informed decisions
2. Identify the many users of accounting
information in society
3. Explain the importance of business
transactions, money measure, and separate
entity to accounting measurement
4. Identify the three basic forms of business
organization

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 and Finally …

5. Define financial position, state the

accounting equation, and show how they are
affected by simple transactions
6. Identify the four financial statements
7. State the relationship of generally accepted
accounting principles (GAAP) to financial
statements and the independent CPA’s
report, and identify the organizations that
influence GAAP

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