Chapter One

The Financial
Statements
Why Accounting?
• Financial Accounting
• Tax Accounting and Tax Planning
• Regulatory Accounting
• Management Accounting
• Information Systems
• Auditing
• Governmental and Not-for-Profit
Accounting
Accounting: The Language of
Business
• Accounting is an information system:
• Economic events become accounting
events
• Measures business activity
• Processes data into reports
• Communicates results to people via the
financial statements
• Users of the accounting process make
decisions
Users of Accounting Information
• Financial Accounting primarily provides
information for external users
• Individuals
• Investors and Creditors
• Taxing Authorities
• Government and Regulatory Authorities
• Management Accounting primarily
provides information for internal users
• Managers within a firm
Business Organizational Forms
• Sole Proprietorships
• One owner
• Owner is personally liable for debts
• Partnerships
• Two or more owners (partners)
• All partners are personally liable for debts (general
partners only)
• Corporations
• Many owners (stockholders)
• Stockholders are not liable for debts
Business Organizational Forms

How many are there?

20,000,000
Sole
15,000,000 Proprietorship
Partnership
10,000,000

5,000,000 Corporation

How much business do they do?

$16,000,000,000,000
$14,000,000,000,000
$12,000,000,000,000 Sole Proprietorship
$10,000,000,000,000
$8,000,000,000,000 Partnership
$6,000,000,000,000 Corporation
$4,000,000,000,000
$2,000,000,000,000
$0

Source for organizational form percentages and business transacted: US Treasury Department, Internal
Revenue Service, Statistics of Income Bulletin, Spring 1997, pp. 200-203.
Generally Accepted Accounting
Principles
• Generally Accepted Accounting
Principles (GAAP)
• Represents professional guidelines that
govern how accountants measure, process,
and communicate financial information – i.e.,
rules that govern accounting.
• Primary objective of financial reporting is to
provide information that is useful for
investment and lending decisions.
Accounting Principles and
Concepts
• Entity Concept – an accounting entity stands
apart as a separate economic unit.
• Reliability Principle – information is free of
bias: verifiable, representationally faithful, neutral.
• (Historical) Cost Principle – assets and
services are recorded at historical cost.
• Going-Concern Concept – assumes that the
business will continue into the future.
• Stable-Monetary Unit Concept – ignores the
effect of inflation.
Note: Additional accounting principles and concepts exist.
 The Accounting Equation

Assets = All of a firm’s assets

Liabilities + Assets: are subject to
Economic claims either by its
Owner’s Equity creditor(s) or its
Resources owner(s).

Liabilities:
Creditors’
Owners’ Equity:
Claims Owners’
Claims
Adapted from Smith et al. (2001)
Assets
• Assets are economic resources expected
to produce a future benefit.
• Cash, both cash and cash equivalents.
• Accounts Receivable (A/R), a promise of future
collection of cash.
• Inventory, goods purchased by a company for resale.
• Supplies, short-term assets used or consumed by a
company.
• Prepaid Expenses, expenses paid for in advance (such
as Prepaid Rent).
• Property, plant, and equipment, land, buildings,
and equipment (long-term).
Refer to pages 18-19 and 51 for examples of assets.
Liabilities
• Liabilities are claims (debts) payable to
creditors. This represents the portion of the
assets owed to creditors.
• Accounts Payable (A/P): liability backed by the
reputation of the seller (generally short-term).
• Notes Payable: written promise to pay a debt at a future
date (generally long-term).
• Accrued Liabilities: liability for an expense not yet paid.
• Unearned Revenue: collection of cash from customers
prior to earning the revenue.
Refer to pages 19 and 51-52 for examples of liabilities.
Owners’ Equity
• Owners’ Equity represents the
portion of the assets owned by the
owners.
• Alternative names include:
• Shareholders’ Equity
• Stockholders’ Equity
• Capital
• “Net Assets” (Assets – Liabilities =
Owners’ Equity)
Owners’ Equity
• A corporation’s owners’ equity has
two primary sub-parts:
• Paid-in-Capital – the amount invested in
the corporation by the stockholders.
Includes Common and Preferred Stock.
• Retained Earnings – the amount earned
by the organization and kept for use in
the business. Is affected by Revenues,
Expenses, and Dividends.

Refer to pages 20 and 52 for examples of owners’ equity.

In-Class Exercise
• Classify each of the following as an
Asset, Liability, or Owners’ Equity.

Accounts Receivable Accounts Payable

Long-term Debt Common Stock
Merchandise Inventory Supplies
Notes Payable Retained Earnings
Salaries Payable Land
Equipment Prepaid Expenses
Revenues
• Revenues represent increases in
Retained Earnings due to the
delivery of goods or performance of
services to customers.
• Cash sale of goods or services to a customer.
• Informal customer promise at the time of
sale to pay for goods or services (Accounts
Receivable, or A/R).
• Terms include: Sales Revenue, Service
Revenue, Interest Revenue, Fees, etc.
Refer to pages 16 and 52 for a brief description of revenues.
Expenses
• Expenses represent decreases in Retained
Earnings due to operations, such as the cost
of selling products or providing services.
• Cash paid for merchandise sold to customers or for
related costs.
• Informal company promise to pay for the various costs of
doing business (Accounts Payable, or A/P).
• Terms include: Cost of Goods Sold, Salary Expense, Rent
Expense, Interest Expense, etc.
Refer to pages 16-17 and 52 for a brief description of expenses.
Distributions to Owners
• Distributions to owners in the form of
cash or other property are not expenses
and do not affect net income.
• For a corporation, distributions to
stockholders of cash (or other assets)
generated by net income are dividends.
• These distributions, including dividends,
decrease retained earnings.

Dividends NEVER affect net income!

Financial Statements
• Income Statement (Statement of
Operations)
• Statement of Retained Earnings (Statement
of Stockholders’ Equity or the Statement of
Owners’ Equity)
• Balance Sheet (Statement of Financial
Position)
• Statement of Cash Flows

Refer to Exhibit 1-16 on page 15 for a chart summarizing the

information reported in each financial statement.
Income Statement
• Time Frame: Reports a period of time.
• Content: Revenue - Expense = Net Income
• Use/Objective: Used as a tool to measure/evaluate
performance of management.

Revenues and Gains

– Expenses and Losses
Net Income

• Statement form can vary:

• May have comparative data/periods.
• May have a single step vs. multi-step approach to income
determination.
Statement of Retained Earnings
• Time Frame: Reports a period of time.
• Content: Retained Earnings, Income earned and
Dividends paid. (Does not show capital contributed by
owners).
• Use/Objective: To track the ongoing balance of
earnings not yet paid out to stockholders, and to
determine why the company’s retained earnings
balance changed during the year.

Beginning retained earnings

+Net income (-Net loss)
-Dividends
Ending retained earnings
Balance Sheet
• Time Frame: Reports a point in time (i.e., a
snapshot in time).
• Content: Lists the book value (remember the cost
principle) of all the variables in the accounting
equation: Assets, Liabilities, and Owner’s Equity.
• Use/Objective: Depicts the overall financial position
of the company at the end of a period. Puts the
relationship of claims on the firm’s resources
(liabilities and owner’s equity) to the firm’s
resources (assets) in perspective.

Assets = Liabilities + Owner’s Equity

Statement of Cash Flows
• Time Frame: Reports a period of time.
• Content: Sources of Cash and Uses of Cash.
• Use/Objective: Illustrates the uses and sources of cash over a period
of time to show where the firm is generating and spending its cash.

Operating cash flows

+ Investing cash flows
+ Financing cash flows
Increase (decrease) in cash
 Relationships among the Financial
Statements

Balance Sheet
Income Statement
Cash
Net Income (Loss)
Retained Earnings

Stmt of Retained Earnings Statement of

Net Income (Loss) Cash Flows
Ending Retained Earnings Ending Cash

Refer to pages 22-23 for more information on these relationships.

Chart is adapted from Evans (2006)
Questions?
• Any questions or concerns?