LECTURE 1

Accounting and the Financial Statements

Dr Rui Ding
 LEARNING OBJECTIVES
By the end of this chapter you should be able to:
1.1 Explain the nature of accounting.
1.2 Identify the forms of business organizations and the types of business activities.
1.3 Describe the relationships shown by the fundamental accounting equation.
1.4 Prepare a classified balance sheet and explain the information it communicates.
1.5 Prepare an income statement and explain the information it communicates.
1.6 Prepare the retained earnings statement and explain the information it communicates.
1.7 Identify the information communicated by the statement of cash flows.
1.8 Describe the relationships among the financial statements.
 USERS OF ACCOUNTING INFORMATION

 The demand for accounting information comes from both inside and outside a business. Its users are wide-ranging
with varied needs and different objectives:
 A company’s managers and employees
 Investors
 Government and regulatory agencies
 Vendors and customers
 Lenders and creditors
 Credit rating organizations and financial analysts
 Labor unions (who negotiate for employees)
 WHY IS ACCOUNTING IMPORTANT?
(LEARNING OBJECTIVE 1.1)

 Accounting: The process of identifying, measuring, recording, and communicating financial information about a
company’s activities so decision-makers can make informed decisions.
 The “language of business”—It communicates relevant and reliable information about the economic activities of a company
that helps people make better decisions.
 Multiple decision-makers, both inside and outside of a company, use the financial information provided by accountants.
EXHIBIT 1.1—THE DEMAND FOR
ACCOUNTING INFORMATION

 Financial accounting: Accounting and reporting to satisfy the outside demand (primarily investors and creditors)
for accounting information.
 Managerial accounting: Accounting that is designed to meet the needs of internal users.
FINANCIAL REPORTING

 Financial reporting (or disclosure): The process of communicating financial accounting information to external
decision-makers.
 Allows investors to make informed decisions
 Increases the transparency of a company’s operations
 Reduces the risk of manipulation and fraud
 Adds stability to the capital markets
 Objective: To provide external decision-makers with information that assists in assessing amounts, timing, and
uncertainties of a company’s future cash flows.
 There are four basic financial statements: the balance sheet, the income statement, the retained earnings statement,
and the statement of cash flows.
DATA ANALYTICS

 Data analytics: The process of analyzing data so that businesses can make decisions more efficiently.

Type Description Example

Descriptive Describes what has happened or Did we meet our sales quota for the month?
summarizes outcomes
Diagnostic Explains why things happened by trying Is there a relation between the volume of product sold
to understand how variables are related and its appearance in a video with a popular YouTuber?

Predictive Attempts to predict what will happen in What is the probability of the video going viral, and is
the future this likely to lead to increased product demand?
Prescriptive Recommends a possible course of action If the video has a 70% probability of going viral, we
should increase production.
 BUSINESSES: FORMS AND ACTIVITIES
(LEARNING OBJECTIVE 1.2)

 Sole proprietorship: A business owned by one person.

 Partnership: A business owned jointly by two or more individuals.
 Corporation: A company chartered by the state to conduct business as an “artificial person” and owned by one or
more stockholders.
EXHIBIT 1.3—BUSINESS ACTIVITIES
FINANCING ACTIVITIES

 A corporation’s financing activities include obtaining the funds necessary to begin and operate a business.
 These funds come from either borrowing money or issuing stock.
 Creditor: The person to whom money is owed.
 Liability: Probable future sacrifices of economic benefits; liabilities usually require the payment of cash, the transfer of assets other than
cash, or the performance of services.
 Assets: Economic resources representing expected future economic benefits controlled by the business (e.g., cash, accounts receivable,
inventory, land, buildings, equipment, and intangible assets).
 Stockholders’ equity: The owners’ claims against the assets of a corporation after all liabilities have been deducted.
INVESTING ACTIVITIES

 Once a corporation has obtained funds through its financing activities, it buys assets (land, buildings, machinery,
equipment) that enable it to operate.
 The purchase and sale of the assets that are used in operations (commonly referred to as operating assets) are a
corporation’s investing activities.
 Regardless of its form, assets are economic benefits that a corporation controls.
 The assets purchased by a corporation vary depending on the type of business that the corporation engages in, and the
composition of these assets is likely to vary across different companies and different industries.
 OPERATING ACTIVITIES

 Once a corporation has acquired the assets it needs, it can begin to operate. While different businesses have
different purposes, they all want to generate revenue.
 Revenue: The increase in assets that results from the sale of products or services.
 Expenses: The cost of assets used, or the liabilities created, in the operation of the business.
 Net income: The excess of a company’s revenues over its expenses during a period of time.
 Net loss: The excess of a company’s expenses over its revenue during a period of time.
COMMUNICATION OF ACCOUNTING INFORMATION
(LEARNING OBJECTIVE 1.3)

 Financial statements: A set of standardized reports in which the detailed

transactions of a company’s activities are reported and summarized so they can be
communicated to decision-makers.
 THE FOUR BASIC FINANCIAL STATEMENTS

 Balance sheet: A financial statement that reports the resources (assets) owned by a company and the claims
against those resources (liabilities and stockholders’ equity) at a specific point in time.
 Income statement: A financial statement that reports the profitability of a business over a specific period of time.
 Retained earnings statement: A financial statement that reports how much of the company’s income was
retained in the business and how much was distributed to owners for a period of time.
 Statement of cash flows: A financial statement that provides relevant information about a company’s cash
receipts (inflows of cash) and cash payments (outflows of cash) during an accounting period.
EXHIBIT 1.5—
FINANCIAL STATEMENT TIME PERIODS
RULES AND CONVENTIONS

 Generally accepted accounting principles (G A A P): The rules and conventions used to prepare financial
statements. By following these rules and conventions financial statements users are able to compare performance
over time and across companies.
 Securities and Exchange Commission (S E C): The federal agency established by Congress to regulate securities
markets and ensure effective public disclosure of accounting information. The S E C has the power to set accounting rules for
publicly traded companies.
 Financial Accounting Standards Board (F A S B): The primary accounting standard-setter in the United States which has been granted
this power to set standards by the Securities and Exchange Commission.

 The F A S B has been working closely with the International Accounting Standards Board (I A S B) in its
development of international financial reporting standards (I F R S) globally.
 THE FUNDAMENTAL ACCOUNTING EQUATION

 The fundamental accounting equation states that a company’s resources (its assets) must always be equal to
the claims on those resources (its liabilities and stockholders’ equity).
 The left side shows the assets, or economic resources, of a company.
 The right side of the accounting equation indicates who has a claim on the company’s assets.
EXAMPLE 1.1—USING THE FUNDAMENTAL ACCOUNTING
EQUATION

Why: A company’s resources (its assets) must always equal Assets = Liabilities + Stockholders’ Equity
the claims on those resources (its liabilities and $125,000 = $75,000 + Stockholders’ Equity
stockholders’ equity).
Stockholders’ Equity = $125,000 – $75,000 = $50,000
Information: On January 1, Gundrum Company reported
assets of $125,000 and liabilities of $75,000. During the year, 2. At December 31, liabilities are $104,000. This amount is
assets increased by $44,000 and stockholders’ equity computed by adding the change to the appropriate
increased by $15,000. balance sheet elements and then rearranging the
Required: fundamental accounting equation as follows:
1. What is the amount reported for stockholders’ equity Assets = Liabilities + Stockholders’ Equity
on January 1? ($125,000 + $44,000) =
2. What is the amount reported for liabilities on Liabilities + ($50,000 + $15,000)
December 31?
Liabilities = ($125,000 + $44,000)
Solution: – ($50,000 + $15,000)
1. Stockholders’ equity on January 1 is $50,000. This = $169,000 – $65,000 = $104,000
amount is calculated by rearranging the fundamental
accounting equation as follows:
KNOWLEDGE CHECK

Which of the four basic financial statements reports the profitability of a business over a specific period of time?
a) Balance sheet
b) Income statement
c) Retained earnings statement
d) Statement of cash flows
 KNOWLEDGE CHECK DEBRIEF

Which of the four basic financial statements reports the profitability of a business over a specific period of time?
a) Balance sheet
b) Income statement
The income statement reports the profitability of a business over a specific period of time.
c) Retained earnings statement
d) Statement of cash flows
THE CLASSIFIED BALANCE SHEET
(LEARNING OBJECTIVE 1.4)

 The purpose of the balance sheet is to report the financial position of a company (its assets, liabilities, and
stockholders’ equity) at a specific point in time.
 The balance sheet gets its name because the economic resources of a company (assets) must always equal, or be
in balance with, the claims against those resources (liabilities and stockholders’ equity).
 The balance sheet is organized, or classified, to help users identify the fundamental economic similarities and
differences between the various items within the balance sheet.
EXHIBIT 1.6—
COMMON BALANCE SHEET CLASSIFICATIONS
 CURRENT ASSETS
 Current assets: Cash and other assets that are reasonably expected to be converted into cash within one year or
one operating cycle, whichever is longer.
 Operating cycle: The average time that it takes a company to purchase goods, resell them, and collect the cash from
customers.
 Common types of current assets are:
 Cash
 Marketable securities—Short-term investments in the debt and stock of other companies as well as government securities
 Accounts receivable—The right to collect an amount due from customers
 Inventories—Goods or products held for resale to customers
 Other current assets—A “catch-all” category that includes items such as prepaid expenses (advance payments for rent, insurance, and other
services) and supplies
NONCURRENT ASSETS

 Assets that are not classified as current are classified as long-term or noncurrent assets.
 Long-term investments: Investments that the company expects to hold for longer than one year. This includes land or
buildings that a company is not currently using in operations, as well as debt and equity securities.
 Property, plant, and equipment: The tangible, long-lived, productive assets used by a company in its operations to produce
revenue. This includes land, buildings, machinery, manufacturing equipment, office equipment, and furniture.
 Intangible assets: Intangible assets are similar to property, plant, and equipment in that they provide a benefit to a company
over a number of years; however, these assets lack physical substance.
 Other noncurrent assets: A catch-all category that includes items such as deferred charges (long-term prepaid expenses) and
other long-term miscellaneous items.
 CURRENT LIABILITIES

 Current liabilities: Obligations that require a firm to pay cash or another current asset, create a new current
liability, or provide goods or services within one year or one operating cycle, whichever is longer.
 Typically listed in the order in which they will be paid and include:
 Accounts payable—An obligation to repay a vendor or supplier for merchandise supplied to the company
 Salaries payable—An obligation to pay an employee for services performed
 Unearned revenue—An obligation to deliver goods or perform a service for which a company has already been paid
 Interest payable—An obligation to pay interest on money that a company has borrowed
 Income taxes payable—An obligation to pay taxes on a company’s income
 LONG-TERM LIABILITIES
AND STOCKHOLDERS’ EQUITY

 Long-term liabilities: The obligations of the company that will require payment beyond one year or the operating
cycle, whichever is longer.
 Stockholders’ equity: The owners’ claims against the assets of a corporation after all liabilities have been
deducted.
 Contributed capital: The owners’ contributions of cash and other assets to the company (includes the common stock of a
company).
 Retained earnings: The accumulated earnings (or losses) over the entire life of the corporation that have not been paid out
in dividends.
 Together, a company’s liabilities and equity make up the capital of a business.
PREPARING A CLASSIFIED BALANCE SHEET

Step 1: Prepare a heading that includes the name of the company, the title of the financial statement, and the
time period covered.
Step 2: List the assets of the company in order of their liquidity or nearness to cash. Use appropriate
classifications. Add the assets and double underline the total.
Step 3: List the liabilities of the company in order of their time to maturity. Use appropriate classifications.
Step 4: List the stockholders’ equity balances with appropriate classifications.
Step 5: Add the liabilities and stockholders’ equity and double underline the total.
 USING BALANCE SHEET INFORMATION

 The balance sheet conveys important information about the structure of assets, liabilities, and stockholders’ equity,
which is used to judge a company’s financial health, such as its liquidity.
 Liquidity: A company’s ability to pay obligations as they become due.

 Working capital: A measure of liquidity computed as:

Working Capital = Current Assets – Current Liabilities

 Current ratio: A measure of liquidity that is computed as:

Current Ratio = Current Assets ÷ Current Liabilities
KNOWLEDGE CHECK

What does a balance sheet “balance”?

a) A company’s retained earnings against its contributed capital
b) A company’s current assets against its intangible assets
c) A company’s assets against its liabilities and stockholders’ equity
d) A company’s long-term investments against its long-term liabilities
 KNOWLEDGE CHECK DEBRIEF

What does a balance sheet “balance”?

a) A company’s retained earnings against its contributed capital
b) A company’s current assets against its intangible assets
c) A company’s assets against its liabilities and stockholders’ equity
The balance sheet gets its name because the economic resources of a company (assets) must always
equal, or be in balance with, the claims against those resources (liabilities and stockholders’ equity).
d) A company’s long-term investments against its long-term liabilities

Asset = Liabilities + Equity

THE INCOME STATEMENT
(LEARNING OBJECTIVE 1.5)

 The income statement reports the results of a company’s operations—the sale of goods and services and the
associated cost of operating the company—for a given period.
 The income statement consists of two major items:
 Revenues and gains
 Revenue: The increase in assets that results from the sale of products or services.
 Gains: Increases in net assets that occur from peripheral or incidental transactions.
 Expenses and losses
 Expenses: The cost of assets used, or the liabilities created, in the operation of the business.
 Losses: Decreases in net assets that occur from peripheral or incidental transactions.
PREPARING A SINGLE-STEP INCOME STATEMENT

Step 1: Prepare a heading that includes the name of the company, the title of the financial statement, and the
time period covered.
Step 2: List the revenues of the company, starting with sales revenue (or service revenue) and then listing other
revenue items. Add the revenues to get total revenue.
Step 3: List the expenses of the company, usually starting with cost of goods sold. Add the expenses to get total
expenses.
Step 4: Subtract the expenses from the revenues to get net income (or net loss if expenses exceed revenues).
Double-underline net income.
 MULTIPLE-STEP INCOME STATEMENT

 The multiple-step income statement organizes revenues and expenses into multiple categories.
 The resulting subtotals highlight important relationships between revenues and expenses that financial statement users find
useful.
 A multiple-step income statement contains three important subtotals:
 Gross margin (gross profit): A key performance measure that is computed as sales revenue less cost of goods sold.
 Income from operations (operating income): Gross margin less operating expenses. This represents the results of the core operations
of the business.
 Nonoperating activities: Revenues and expenses from activities other than the company’s principal operations.
EXHIBIT 1.10—TYPICAL NONOPERATING ITEMS
PREPARING A MULTIPLE-STEP INCOME STATEMENT

Step 1: Prepare a heading that includes the name of the company, the title of the financial statement, and the
time period covered.
Step 2: Compute gross profit as the difference between net sales and cost of goods sold.
Step 3: Compute income from operations by subtracting operating expenses from gross profit.
Step 4: Compute income before income taxes by subtracting nonoperating activities from income from
operations.
Step 5: Compute net income (or net loss) by subtracting income taxes expense from income before income
taxes. Double-underline net income.
USING INCOME STATEMENT INFORMATION

 A company’s ability to generate current income is useful in predicting its ability to generate future income.
 Investors’ and creditors’ estimates of the future profitability and growth of a company are aided by a careful examination of
how a company has earned its revenue and managed its expenses.
 Net profit margin*: A measure of the proportion of each sales dollar that is profit, determined by dividing net
income by net sales.

Net Income
Net Profit Margin=
Sales (or Service) Revenue
KNOWLEDGE CHECK

What is a useful measure of a company’s ability to generate profit?

a) Gross margin
b) Net profit margin
c) Net income
d) Income from operations
 KNOWLEDGE CHECK DEBRIEF

What is a useful measure of a company’s ability to generate profit?

a) Gross margin
b) Net profit margin
Net profit margin shows the percentage of profit in each dollar of sales revenue (or service revenue).
Gross margin represents the initial profit made from selling a product, but it is not a measure of total
profit because other operating expenses have not yet been subtracted.
c) Net income
d) Income from operations
 RETAINED EARNINGS STATEMENT
(LEARNING OBJECTIVE 1.6)

 The owners of a company contribute capital in one of two ways:

 Directly—Though purchases of common stock from the company
 Indirectly—By the company retaining some or all of the net income earned each year rather than paying it out in dividends

 The retained earnings statement summarizes and explains the changes in retained earnings during the accounting
period.
 The beginning balance in retained earnings is increased by net income earned during the year and decreased by any dividends
that were declared.
PREPARING A RETAINED EARNINGS STATEMENT

Step 1: Prepare a heading that includes the name of the company, the title of the financial statement, and the
time period covered.
Step 2: List the retained earnings balance at the beginning of the period obtained from the balance sheet.
Step 3: Add net income obtained from the income statement.
Step 4: Subtract any dividends declared during the period. Double-underline the total, which should equal
retained earnings at the end of the period as reported on the balance sheet.
USE OF THE RETAINED EARNINGS STATEMENT

 The retained earnings statement is used to monitor and evaluate a company’s dividend payouts to its
shareholders.
 Some older investors seek out companies with high dividend payouts so that they will receive cash during the year.
 Other investors are more interested in companies that are reinvesting a sufficient amount of earnings that will enable them
to pursue profitable growth opportunities.
 Creditors are interested in a company’s dividend payouts.
 If a company pays out too much in dividends, the company may not have enough cash on hand to repay its debt when it becomes due.
STATEMENT OF CASH FLOWS
(LEARNING OBJECTIVE 1.7)

 The statement of cash flows describes the company’s cash receipts (cash inflows) and cash payments (cash outflows)
for a period of time.
 Cash flows from operating activities: Any cash flows directly related to earning income, including cash sales and
collections of accounts receivable as well as cash payments for goods, services, salaries, and interest.
 Cash flows from investing activities: The cash inflows and outflows that relate to acquiring and disposing of operating
assets, acquiring and selling investments (current and long-term), and lending money and collecting loans.
 Cash flows from financing activities: Any cash flow related to obtaining capital resources from creditors or owners, which
includes the issuance and repayment of debt, common and preferred stock transactions, and the payment of dividends.
 A company with healthy cash flow is in a good position to repay debts as they come due and is usually a low-risk
borrower.
RELATIONSHIPS AMONG THE STATEMENTS
(LEARNING OBJECTIVE 1.8)

 Articulation: Describes the linkages between the financial statements.

 The income statement links the beginning and ending balance sheet through retained earnings.
 The statement of shareholders’ equity links the beginning and ending balances of equity.
 The statement of cash flows links the beginning and ending balances of cash.
EXHIBIT 1.13—
RELATIONSHIPS
AMONG THE
FINANCIAL
STATEMENTS
KNOWLEDGE CHECK

The income statement links the beginning and ending balance sheet through which of the following?
a) Retained earnings
b) Revenues generated
c) Statement of cash flows
d) Statement of shareholders’ equity
KNOWLEDGE CHECK DEBRIEF

The income statement links the beginning and ending balance sheet through which of the following?
a) Retained earnings
The income statement links the beginning and ending balance sheet through retained earnings. The
statement of shareholders’ equity links the beginning and ending balances of equity. The statement of
cash flows links the beginning and ending balances of cash.
b) Revenues generated
c) Statement of cash flows
d) Statement of shareholders’ equity
SUMMARY

 Regardless of which functional area in which you are employed in a company, you will use financial statement data.
 You also will be evaluated based on the impact of your decisions on your company’s financial statement data.
 For financial statements are to be of value to the wide range of users, they must have confidence in the
information they present.
 Therefore, it is important to understand the elements in each statement and how these elements are interrelated
through the key linkages between statements.