chapter 1 Financial Statements

and Business Decisions

Financial Accounting
10e
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.

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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 (external)
➢ Creditors (external)
➢ Managers within the firm such as:
▪ Marketing managers (internal)
▪ Credit managers (internal)
▪ Supply chain managers (internal)
▪ Human resource managers (internal)

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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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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 – reports the financial position (amount of assets,

liabilities, and stockholders’ equity) of an accounting entity at a point in
time.

INCOME STATEMENT – 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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 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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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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 Exercise 1-4 (E1-4)

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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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 Exercise 1-6 (E1-6)

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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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Statement of Stockholders’ Equity

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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Statement of Cash Flows
Cash Flows from Operating Activities
Elements of the
Cash collected from customers less cash paid for Statement of
operating expenses such as cash paid to Cash Flows
suppliers and employees.

Cash Flows from Investing Activities

Cash flows related to acquisition or sale of the
company’s plant and equipment and
investments.

Cash Flows from Financing Activities

Cash flows from the receipt or payment of
money to investors and creditors (except
suppliers)

The Statement of Cash Flows reports inflows and

outflows of cash during the accounting period.
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Statement of Cash Flows

+/- Cash Flows from Operating Activities (CFO)

+/- Cash Flows from Investing Activities (CFI)
+/- Cash Flows from Financing Activities (CFF)
Change in Cash
+ Beginning Cash Balance
Ending Cash Balance

Note that each of the three cash flow

/- sources can be positive (net cash inflow)
or negative (net cash outflow)

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Exhibit 1.5
Statement of Cash Flows

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

Cash flows from operating activities $ 87.5 Cash flows directly related to earning income
Cash flows from investing activities (125.5) Cash flows from purchase/sale of plant, equipment, & investments
Cash flows from financing activities 47.0 Cash flows from investors and creditors
Net increase (decrease) in cash 9.0 Change in cash during the period
Cash balance December 31, 2014 1.6 Last period’s cash on the balance sheet
Cash balance December 31, 2015 $ 10.6 Ending cash on the balance sheet

The notes are an integral part of these financial statements.

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Interpreting the Cash Flow Statement
FINANCIAL ANALYSIS

$$$
Analyze cash flow from operations in order
to check the following:

✓Ability to repay creditors

✓Opportunity for expansion
✓Ability to distribute cash dividends

The Operating Activities section indicates the company’s ability

to generate cash from sales to meet the company’s current cash needs.

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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

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
period in the categories of purchase equipment, cash
operating, investing, and borrowed from banks
financing.
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Rules that Determine Content of Financial Statements

Generally
Accepted
Accounting
Principles
(GAAP)

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Generally Accepted Accounting Principles

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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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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Supplement B: Employment in the
Accounting Profession Today PROFESSIONAL DESIGNATIONS

Career Opportunities CPA

CMA
Public Accounting CIA
➢Audit or Assurance Services
➢Management Consulting or Advisory Services
➢Tax Services

Employment by Organizations
➢Internal Accounting
➢External Reporting
➢Tax Planning
➢Various Other Functions

Employment in the Public and Not-for-Profit Sector

➢ Not-for-Profit hospitals and universities
➢ Government agencies such as the SEC, GAO, and
FCC

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