Chapter 1. Financial Statements and Business
Decisions
Understanding the business
● Stockholders: sole owners
● Creditor: lender make money by charging interest
● Dividends: a portion of what the company earned in the form of cash payments
The accounting system
● Accounting: a system that collects and processes (analyzes, measures and records) financial
information about the organization and reports that information to decision makers
● Managers (/internal decision makers) need info abt business activities to manage operating,
investing, and financing activities of the firm
● Stockholders and creditors (/ external decision makers) need info abt the business activities to
assess whether the company will be able to pay back its debts, interests and pay
dividends
● 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 ( plant & equipment for production of beverages)
○ Operating activities: The day-to-day process of purchasing goods from suppliers,
manufacturing, delivering, collecting cash, paying suppliers
● The focus is on the accounting for external decision makers: financial accounting
The four basic financial statements: an overview
● Balance sheet: reports the economic resources it owns and the sources of financing for
these resources
● Income statement: Reports its ability to sell goods for more than their cost
● Statement of Stockholders’ equity: reports additional contributions from or payments to
investors and the amount of income the company reinvested for future grows
● Statement of cash flows: Reports its ability to generate cash and how it was used
● Quarterly reports and annual reports
The balance sheet
● Report the financial position= the economic resources that the company owns and the
sources of financing for those resources
,Structure
● Name of the entity (E.G. Le-Nature’s Inc.)
○ The organization for which financial data are to be collected = accounting entity
○ The business itself: viewed as owning the resources + responsible for its debt
● Title of the statement (Balance sheet)
● Specific date of the statement (At December 31, 2015; a particular time)
● Unit of measure (in millions of dollars)
The basic accounting equation
Assets Liabilities Stockholders’ equity
= +
Economic resources Financing from creditors (e.g. Financing from stockholders
(e.g. cash, inventory, amounts owed to suppliers, (e.g. common stock, retained
buildings, = everything employees, banks, = earnings)
receivable) everything payable)
Elements
● Assets: the economic resources owned by the entity
○ Measured at the total cost incurred to acquire it
● Liabilities & stockholders’ equity: sources of financing for company's economic resources
○ Liabilities: Accounts payable (=purchase goods or services from suppliers on credit without a formal
written contract /note) < >Notes payable to bank (= cash borrowings based on a formal written debt
contract with banks)
○ Stockholders’ equity: Owners are called stockholders / shareholders
○ Common stock (=investments of cash by owners) + retained earnings (= amount of earnings
reinvested in the business)
The income statement
Structure
● The income statement reports the accountant’s primary measure of performance of a
business, revenues - expenses, during the accounting period
● Reports for a specific period of time → accounting period
Revenues Expenses Net income
(cash and promises received
= (resources used to earn
+ (revenues earned -
from delivery of goods and period’s revenues) expenses incurred, same as
services) profit)
Elements
● Company earns revenues from sale of goods / services (whether or not the customer has paid)
● Expenses reported in one accounting period actually may be paid for in another period
○ Includes tax
○ Only products sold are included
, ● Net income / net loss
○ Net income usually does not match net cash (As they can actually receive / pay later)
Statement of Stockholders’ Equity
Structure
● Covers a specified period of time, reports changes in each equity’s accounts
● Net income earned in that period increases balance of retained earnings
○ Relationship of income statement and balance sheet
● Declaring dividend decreases retained earnings
Elements
● Starts with the beginning balance in stockholders' equity accounts, lists the increases
and decreases, and reports the resulting ending balance
○ Beginning-of-the-year retained earnings + net income - dividend = end-of-the-
year retained earnings
Statement of Cash Flows
Structure
● Reports inflows and outflows of cash during the accounting period in the categories of
operating, investing and financing
● Revenues are not equal to cash, expenses are not equal to cash paid out
● The income statement does not provide info concerning cash flows, so this is made
+/- Cash flows from operating
+/- Cash flows
activities (CFO)from investing
+/- Cash flows
activities (CFI) from financing
activities (CFF)
Change in cash
+ Ending
Beginning cash
cash
balance
balance
Elements
● Cash flows from operating activities: directly related to earning income
○ Salaries, bills from suppliers, sales
● Cash flows from investing activities: related to acquisition / sale of company’s plant and
equipment and investments
● Cash flows from financing activities: directly related to financing the enterprise itself
○ Receipt/payment of money to investors and creditors (except suppliers)
, Relationships among the statements
● Net income from the income statement → increase in ending retained earnings on
Ending retained earnings from the statement of stockholders’ equity is 1 of the 2
components of stockholders’ equity on the balance sheet
● Change in cash on cash flow statement added to the beginning-of-the-year balance in
cash = end-of-the-year balance in cash on the balance sheet
Notes and financial statement formats
● Notes provide supplemental information about the financial condition of a company
○ WIthout reading the notes, the financial statements cannot be fully understood
● Assets are listed to cash, liabilities are listed by their maturity (due date)
● Before the first dollar amount in a group of items + for group totals → $
● Add a single underline below the last item in a group before a (sub)total
Generally Accepted Accounting Principles (GAAP)
● =the measurement & disclosure rules used to develop information in financial statements
How are Generally accepted accounting principles determined?
● US: SEC got created and got powers to determine the GAAP rules for stockholders
● Today: Financial Accounting Standard Board (FASB)
Why is GAAP important to managers and external users?
● Companies,managers+owners: directly affected by info 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 + employees
3. Loss of competitive information to other companies
● Changes in GAAP are actively debated
Ensuring the accuracy of financial statements
What if the numbers are wrong
● Ponzi scheme: borrowing more and more money to pay off the earlier creditors
● Numbers are wrong → jail sentence (or ther severe consequences)
Ethical conduct
● Intentional misreporting of financial statements is clearly unethical and illegal
● Many situations, however, are less clear-cut, require weighing 2 moral principles
Decisions
Understanding the business
● Stockholders: sole owners
● Creditor: lender make money by charging interest
● Dividends: a portion of what the company earned in the form of cash payments
The accounting system
● Accounting: a system that collects and processes (analyzes, measures and records) financial
information about the organization and reports that information to decision makers
● Managers (/internal decision makers) need info abt business activities to manage operating,
investing, and financing activities of the firm
● Stockholders and creditors (/ external decision makers) need info abt the business activities to
assess whether the company will be able to pay back its debts, interests and pay
dividends
● 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 ( plant & equipment for production of beverages)
○ Operating activities: The day-to-day process of purchasing goods from suppliers,
manufacturing, delivering, collecting cash, paying suppliers
● The focus is on the accounting for external decision makers: financial accounting
The four basic financial statements: an overview
● Balance sheet: reports the economic resources it owns and the sources of financing for
these resources
● Income statement: Reports its ability to sell goods for more than their cost
● Statement of Stockholders’ equity: reports additional contributions from or payments to
investors and the amount of income the company reinvested for future grows
● Statement of cash flows: Reports its ability to generate cash and how it was used
● Quarterly reports and annual reports
The balance sheet
● Report the financial position= the economic resources that the company owns and the
sources of financing for those resources
,Structure
● Name of the entity (E.G. Le-Nature’s Inc.)
○ The organization for which financial data are to be collected = accounting entity
○ The business itself: viewed as owning the resources + responsible for its debt
● Title of the statement (Balance sheet)
● Specific date of the statement (At December 31, 2015; a particular time)
● Unit of measure (in millions of dollars)
The basic accounting equation
Assets Liabilities Stockholders’ equity
= +
Economic resources Financing from creditors (e.g. Financing from stockholders
(e.g. cash, inventory, amounts owed to suppliers, (e.g. common stock, retained
buildings, = everything employees, banks, = earnings)
receivable) everything payable)
Elements
● Assets: the economic resources owned by the entity
○ Measured at the total cost incurred to acquire it
● Liabilities & stockholders’ equity: sources of financing for company's economic resources
○ Liabilities: Accounts payable (=purchase goods or services from suppliers on credit without a formal
written contract /note) < >Notes payable to bank (= cash borrowings based on a formal written debt
contract with banks)
○ Stockholders’ equity: Owners are called stockholders / shareholders
○ Common stock (=investments of cash by owners) + retained earnings (= amount of earnings
reinvested in the business)
The income statement
Structure
● The income statement reports the accountant’s primary measure of performance of a
business, revenues - expenses, during the accounting period
● Reports for a specific period of time → accounting period
Revenues Expenses Net income
(cash and promises received
= (resources used to earn
+ (revenues earned -
from delivery of goods and period’s revenues) expenses incurred, same as
services) profit)
Elements
● Company earns revenues from sale of goods / services (whether or not the customer has paid)
● Expenses reported in one accounting period actually may be paid for in another period
○ Includes tax
○ Only products sold are included
, ● Net income / net loss
○ Net income usually does not match net cash (As they can actually receive / pay later)
Statement of Stockholders’ Equity
Structure
● Covers a specified period of time, reports changes in each equity’s accounts
● Net income earned in that period increases balance of retained earnings
○ Relationship of income statement and balance sheet
● Declaring dividend decreases retained earnings
Elements
● Starts with the beginning balance in stockholders' equity accounts, lists the increases
and decreases, and reports the resulting ending balance
○ Beginning-of-the-year retained earnings + net income - dividend = end-of-the-
year retained earnings
Statement of Cash Flows
Structure
● Reports inflows and outflows of cash during the accounting period in the categories of
operating, investing and financing
● Revenues are not equal to cash, expenses are not equal to cash paid out
● The income statement does not provide info concerning cash flows, so this is made
+/- Cash flows from operating
+/- Cash flows
activities (CFO)from investing
+/- Cash flows
activities (CFI) from financing
activities (CFF)
Change in cash
+ Ending
Beginning cash
cash
balance
balance
Elements
● Cash flows from operating activities: directly related to earning income
○ Salaries, bills from suppliers, sales
● Cash flows from investing activities: related to acquisition / sale of company’s plant and
equipment and investments
● Cash flows from financing activities: directly related to financing the enterprise itself
○ Receipt/payment of money to investors and creditors (except suppliers)
, Relationships among the statements
● Net income from the income statement → increase in ending retained earnings on
Ending retained earnings from the statement of stockholders’ equity is 1 of the 2
components of stockholders’ equity on the balance sheet
● Change in cash on cash flow statement added to the beginning-of-the-year balance in
cash = end-of-the-year balance in cash on the balance sheet
Notes and financial statement formats
● Notes provide supplemental information about the financial condition of a company
○ WIthout reading the notes, the financial statements cannot be fully understood
● Assets are listed to cash, liabilities are listed by their maturity (due date)
● Before the first dollar amount in a group of items + for group totals → $
● Add a single underline below the last item in a group before a (sub)total
Generally Accepted Accounting Principles (GAAP)
● =the measurement & disclosure rules used to develop information in financial statements
How are Generally accepted accounting principles determined?
● US: SEC got created and got powers to determine the GAAP rules for stockholders
● Today: Financial Accounting Standard Board (FASB)
Why is GAAP important to managers and external users?
● Companies,managers+owners: directly affected by info 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 + employees
3. Loss of competitive information to other companies
● Changes in GAAP are actively debated
Ensuring the accuracy of financial statements
What if the numbers are wrong
● Ponzi scheme: borrowing more and more money to pay off the earlier creditors
● Numbers are wrong → jail sentence (or ther severe consequences)
Ethical conduct
● Intentional misreporting of financial statements is clearly unethical and illegal
● Many situations, however, are less clear-cut, require weighing 2 moral principles
