Chapter 1: Introduction to Financial Statements

The Three Principal Types of Business Activity

(1) Financing, (2) Investing, and (3) Operating

Forms of Business Organization

(1) Sole Proprietorship (2) Partnership (3) Corporation

Four Types of Financial Statements

1. Income Statement 2. Retained Earnings Statement 3. Balance Sheet 4. Statement of Cash Flows

Solving an Ethical Dilemma

1. Recognize an ethical situation and the ethical issues involved. 2. Identify and analyze the principal elements in the situation. 3. Identify the alternatives and weigh the impact of each alternative on various stakeholders.

Corporation

A business organized as a separate legal entity owned by stockholders. ⌘ Easier to transfer ownership ⌘ Easier to raise funds ⌘ No personal liability

Sole Proprietorship

A business owned by one person. ⌘ Simple to establish ⌘ Owner controlled ⌘ Tax advantages

Partnership

A business owned by two or more persons associated as partners. ⌘ Simple to establish ⌘ Shared control ⌘ Broader skills and resources ⌘ Tax advantages

Note Payable¹

A note payable is a liability in writing that promises to pay a specific amount of money at future date or on demand. In other words, a note payable is a loan between two entities.

Auditor's report

A report prepared by an independent outside auditor stating the auditor's opinion as to the fairness of the presentation of the financial position and results of operations and their conformance with generally accepted accounting principles. (p. 19). Auditor's opinion as to the fairness of the presentation of the financial position and results of operations and their conformance with generally accepted accounting principles. *Only certified public accountants (CPAs) may perform audits

Annual Report

A report prepared by corporate management that presents financial information including financial statements, a management discussion, and analysis section, notes, and an independent auditor's report. (p. 18). U.S. companies that are publicly traded must provide shareholders with an annual report. → The annual report always includes: → Financial statements. → Management discussion and analysis. → Notes to the financial statements. → Auditor's report.

Management discussion and analysis (MD&A)

A section of the annual report that presents management's views on the company's ability to pay near-term obligations, its ability to fund operations and expansion, and its results of operations. (p. 18).

Common Stock²

A term used to describe the total amount paid in by stockholders for the shares they purchase. (p. 9). → Corporations obtain funds by selling shares of stock to investors.

Users and Uses of Financial Information

Accounting is the information system that identifies, records, and communicates the economics events of an organization to interested users. Users: (1) Internal users (2) External users

Certified Public Accountant (CPA)

An individual who has met certain criteria and is this allowed to perform audits of corporations. (p. 19).

Income Statement¹

Are the company's operations profitable? Definition: A financial statement that reports a company's revenues and expenses and resulting net income or net loss for a specific period of time. (p. 11). → Reports revenues and expenses for a specific period of time. → Net income - revenues exceed expenses. → Net loss - expenses exceed revenues. → Investors are interested in past net income because it provides information for predicting future net income. *Amounts received from issuing stock are not revenues, and amounts paid out as dividends are not expenses.

Basic Accounting Equation

Assets = Liabilities + Owners' Equity / Shareholders Equity

Basic Accounting Equation²

Assets = Liabilities + Stockholder's Equity. (p. 13).

Supplies

Assets used in day-to-day activities.

Bonds Payable¹

Bonds represent an obligation to repay a principal amount at a future date and pay interest, usually on a semi‐annual basis. Unlike notes payable, which normally represent an amount owed to one lender, a large number of bonds are normally issued at the same time to different lenders. These lenders, also known as investors, may sell their bonds to another investor prior to their maturity.

Creditors

Creditors such as suppliers and bankers use accounting information to evaluate the risks of selling on credit or lending money.

Statement of Cash Flows

Does the company generate sufficient cash from operations to fund its operating activities? The statement of cash flows shows the amount of net cash provided or used by operating activities, investing activities, and financing activities. Answers: → Where did cash come from during the period? → How was cash used during the period? → What was the change in the cash balance during the period? *Compare the amount of net cash provided by operating activities with the amount of net cash used by investing activities. Any deficiency in cash from operating activities must be made up with cash from financing activities.

Balance Sheet

Does the company rely primarily on debt or stockholder's equity to finance its assets? The balance sheet reports the company's resources and claims to those resources. There are two types of claims: liabilities and stockholder's equity. → Reports assets and claims to assets at a specific point in time. → Assets = Liabilities + Stockholders' Equity. → Lists assets first, followed by liabilities and stockholders' equity. * Compare the amount of debt versus the amount of stockholder's equity to determine whether the company relies more on creditors or owners for its financing.

Inventory

Goods available for future sales.

External Users

Includes (1) investors, (2) creditors, taxing authorities, customers, labor unions, and regulatory agencies.

Investors

Investors (owners) use accounting information to buy, hold, or sell stock.

Investing Activities

Involve the purchase of resources a company needs to operate. → Computers, delivery trucks, furniture, buildings, etc. → Resources owned by a business are called assets.

Internal Users

Managers who plan, organize and run a business. ⌘ These include marketing managers, production supervisors, finance directors, and company officers. ⌘ For internal users, accounting provides internal reports, such as financial comparisons or operating alternatives, projections of income from new sales campaigns, financial statements, and forecasts of cash needs for the next year.

Operating Activities

Once a business has the assets it needs, it can begin its operations. → Revenues - Amounts earned from the sale of products (sales revenue, service revenue, and interest revenue). → Inventory - Goods available for sale to customers. → Accounts receivable - Right to receive money from a customer, in the future, as the result of a sale.

Dividends²

Payments of cash from a corporation to its stockholders. (p. 9). * In the case of financial difficulty, all creditor claims must be paid before stockholder claims.

Sarbanes-Oxley Act (SOX)

Regulations passed by Congress to reduce unethical corporate behavior. (p. 7).

Assets

Resources owned by a business. (p. 9).

Net Loss

The amount by which expenses exceed revenues. (p. 10).

Net Income

The amount by which revenues exceed expenses. (p. 10).

Retained Earnings

The amount of net income retained in the corporation. (p. 12).

Expenses

The cost of assets consumed or services used in the process of generating revenues. (p.10). → Cost of goods sold (such as the cost of materials), selling expenses (such as the cost of salespersons' salaries), marketing expenses (cost of advertising), administrative expenses (such as the salaries of admin. staff, telephone, and heating costs for the corp. office), interest expenses (amts. of interest paid on various debt), and income taxes (corp. taxes paid to the government).

Revenue

The increase in assets or decrease in liabilities resulting from the sale of goods or the performance of services in the normal course of business. (p. 10) → Sources of revenue common to businesses are (1) sales revenue, (2) service revenue, and (3) interest revenue.

Accounting

The information system that identifies, records, and communicates the economic events of an organization to interested users. (p. 5).

Stockholder's equity

The owner's claim to assets. (p. 13).

Account Receivable

The right to receive money in the future.

Financing Activities

Two primary sources of outside funds are: 1. Borrowing money → Amounts owed are called liabilities. → Party to whom amounts are owed are, creditors. → Notes payable and bonds payable are different types of liabilities. 2. Issuing shares of stock for cash.

Taxing Authorities

Want to know whether the company complies with the tax laws (e. g. the Internal Revenue Service).

Regulatory Agencies

Want to know whether the company is operating within prescribed rules (e. g. Securities and Exchange Commission, ad the Federal Trade Commission).

Labor Unions

Want to know whether the owners have the ability to pay increased wages and benefits.

Retained Earnings Statement²

What is the company's policy toward dividends and growth? Reports how much of this year's income the company paid out in dividends to shareholders. Definition: A financial statement that summarizes the amounts and causes of changes in retained earnings for a specific time period. (p. 12). → The statement shows amounts and causes of changes in retained earnings during the period. → The time period is the same as that covered by the income statement. → Users can evaluate dividend payment practices. *A company striving for rapid growth will pay a low (or no) dividend.

Liabilities arising from expenses

→ Accounts Payable: The obligations to pay for goods bought on credit from suppliers. → Interest Payable: Amounts currently owed in interest (bank). → Wages Payable (employees) → Sales Taxes Payable (gov.) → Property Taxes Payable (gov.) → Income Taxes Payable (gov.)

Limited Liability Company

⌘ Limited liability for all members ⌘ All members can participate in management ⌘ OK vehicle to attract capital because of little risk other than investment ⌘ Filing requirements