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Financial Statements and Business Decisions

chapter 1

Financial Accounting

10e

Libby • Libby • Hodge

©2020 McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.

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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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Learning Objective 1-1

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).

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Understanding the Business

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Exhibit 1.1 The Accounting System and Decision Makers

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Business Activities

Financing Activities

Operating Activities

Investing Activities

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Why Study Financial Accounting?

Decision makers rely on financial information:

Investors

Creditors

Managers within the firm such as:

Marketing managers

Credit managers

Supply chain managers

Human resource managers

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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 Cash Short-Term Investments Accounts Receivable Notes Receivable Inventory (to be sold) Supplies Prepaid Expenses Long-Term Investments Equipment Buildings Land Intangibles

The Balance Sheet is a financial snapshot at a specific point in time.

Liabilities Accounts Payable Accrued Expenses Notes Payable Taxes Payable Unearned Revenue Bonds Payable

Stockholders’ Equity Common Stock Retained Earnings

Elements of the Balance Sheet

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Exhibit 1.2 Balance Sheet

LE-NATURE’S INC. Balance Sheet At December 31, 2015 (in millions of dollars)

Assets:
Cash
Accounts receivable	$ 10.6
Inventories	6.6
Property, plant, and equipment	51.2
Total assets	459.0
Liabilities and stockholders’ equity:	$527.4
Liabilities
Accounts payable	$ 26.0
Notes payable to banks	381.7
Total liabilities	407.7
Stockholders’ equity
Common stock	55.7
Retained earnings	64.0
Total stockholders’ equity	119.7
Total liabilities and stockholders’ equity	527.4
The notes are an integral part of these financial statements.

EXPLANATION

Name of the entity

Title of the statement

Specific date of the statement

Unit of measure

Resources controlled by the company

Amount of cash in the company’s bank accounts

Amounts owed by customers from prior sales

Ingredients and beverages ready for sale

Factories, production equipment, and land

Total amount of company’s resources

Sources of financing for company’s resources

Financing supplied by creditors

Amounts owed to suppliers for prior purchases

Amounts owed to banks on written debt contracts

Financing provided by stockholders

Amounts invested in the business by stockholders

Past earnings not distributed to stockholders

Total sources of financing for company’s resources

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The Accounting Equation

The balance sheet reports a company's assets, liabilities, and stockholders' equity at a specific point in time.

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Income Statement

Revenues Cash and promises received from delivery of goods and services.

Examples:

Sales Revenue Fee Revenue Interest Revenue Rent Revenue

The Income Statement is a measure of performance of the business.

Expenses Resources used to earn period’s revenues.

Examples:

Cost of Goods Sold Wages Expense Rent Expense Depreciation Expense Insurance Expense Repair Expense Income Tax Expense

Elements of the Income Statement

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The Income Statement Equation

If total expenses exceed total revenues, a net loss is reported.

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Exhibit 1.3 Income Statement

LE-NATURE’S INC. Income Statement For the Year Ended December 31, 2015 (in millions of dollars)

Revenues
Sales revenue	$275.1
Expenses
Cost of goods sold	140.8
Selling, general, and administrative expenses	77.1
Interest expense	17.2
Income before income taxes	40.0
Income tax expense	17.1
Net income	$22.9
The notes are an integral part of these financial statements.

EXPLANATION

Name of the entity

Title of the statement

Accounting period

Unit of measure

Cash and promises received from sale of beverages

Cost to produce beverages sold

Other operating expenses (utilities, delivery costs, etc.)

Cost of using borrowed funds

Income taxes on period’s income before income taxes Revenues earned minus expenses incurred

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Statement of Stockholders’ Equity (1 of 2)

Common Stock Amounts invested in the business by stockholders.

Beginning Common Stock

+ Stock Issuance

Ending Common Stock

Retained Earnings Past earnings not distributed to stockholders.

Beginning Retained Earnings

+ Net Income

− Dividends declared

Ending Retained Earnings

The Statement of Stockholders’ Equity reports the change in each stockholders’ equity account during the period.

Elements of the Statement of Stockholders’ Equity

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Exhibit 1.4 Statement of Stockholders’ Equity

LE-NATURE’S INC. Statement of Stockholders’ Equity For the Year Ended December 31, 2015 (in millions of dollars)

	Common Stock	Retained Earnings
Balance December 31, 2014	$55.7	$43.1
Net income for 2015		22.9
Dividends for 2015		(2.0)
Balance December 31, 2015	$55.7	$64.0
The notes are an integral part of these financial statements.

EXPLANATION

Name of the entity

Title of the statement

Accounting period

Unit of measure

Last period’s ending balances

Net income reported on the income statement

Dividends declared during the period

Ending balances on the balance sheet

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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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Statement of Stockholders’ Equity (2 of 2)

Cash Flows from Operating Activities

Cash collected from customers less cash paid for operating expenses such as cash paid to 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.

Elements of the Statement of Cash Flows

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Exhibit 1.5 Statement of Cash Flows

LE-NATURE’S INC. Statement of Cash Flows (Summary) For the Year Ended December 31, 2015 (in millions of dollars)

Cash flows from operating activities	$ 87.5
Cash flows from investing activities	(125.5)
Cash flows from financing activities	47.0
Net increase (decrease) in cash	9.0
Cash balance December 31, 2014	1.6
Cash balance December 31, 2015	$10.6
The notes are an integral part of these financial statements.

EXPLANATION

Name of the entity

Title of the statement

Accounting period

Unit of measure

Cash flows directly related to earning income

Cash flows from purchase/sale of plant, equipment, & investments

Cash flows from investors and creditors

Change in cash during the period

Last period’s cash on the balance sheet

Ending cash on the balance sheet

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Interpreting the Cash Flow Statement

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.

FINANCIAL ANALYSIS

$$$

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Exhibit 1.6 Relationships Among Le-Nature’s Statements

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Notes

The note are an integral part of these financial statements.

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

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Exhibit 1.7 Summary of the Four Basic Financial Statements

Financial Statement	Purpose	Structure	Examples of Content
Balance Sheet (Statement of Financial Position)	Reports the financial position (economic resources and sources of financing) of an accounting entity at a point in time.		Cash, accounts receivable, plant and equipment, long-term debt, common stock
Income Statement (Statement of Income, Statement of Earnings, Statement of Operations)	Reports the accountant’s primary measure of economic performance during the accounting period.		Sales revenue, cost of goods sold, selling expense, interest expense
Statement of Stockholders’ Equity	Reports changes in the company’s common stock and retained earnings during the accounting period.		Beginning and ending stockholders’ equity balances, stock issuances, net income, dividends
Statement of Cash Flows (Cash Flow Statement)	Reports inflows (receipts) and outflows (payments) of cash during the accounting period in the categories of operating, investing, and financing.		Cash collected from customers, cash paid to suppliers, cash paid to purchase equipment, cash borrowed from banks

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Learning Objective 1-2

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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Rules that Determine Content of Financial Statements

Generally Accepted Accounting Principles (GAAP)

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History of Financial Reporting

The accounting system in use today has a long history. Its foundations are normally traced back to the works of an Italian monk and mathematician, Fr. Luca Pacioli, published in 1494.

Prior to 1933, the management teams of most companies were largely free to choose their own financial reporting practices.

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Generally Accepted Accounting Principles (1 of 2)

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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Generally Accepted Accounting Principles (2 of 2)

Companies incur the cost of preparing the financial statements and bear the following economic consequences of their publication:

Effects on the selling price of stock

Effects on the amount of bonuses received by management and other employees

Loss of competitive information to other companies

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International Perspective

Since 2002, there has been substantial movement toward the adoption of International Financial Reporting Standards (IFRS) issued by the International Accounting Standards Board (IASB).

Examples of jurisdictions requiring the use of IFRS:

European Union

Australia and New Zealand

Hong Kong, Malaysia, and Republic of Korea

Israel and Turkey

Brazil and Chile

Canada and Mexico

In the U.S., the SEC now allows foreign companies whose stock is traded in the United States to use IFRS.

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Ethical Conduct

Intentional misreporting of financial statements is unethical and illegal. However many situations are less clear-cut and required individuals to weigh one moral principal (e.g., honesty) against another (e.g., loyalty to a friend).

Three-Step Process for Making Ethical Decisions

Identify the benefits of a decision (often to the manager or employee involved) and who will be harmed (other employees, owners, creditors, the environment).

Identify alternative courses of action.

Choose the one you would like your family and friends to see reported on your local news.

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Consequences of Unethical Behavior

After it was determined that the financial statements for Le-Nature’s Inc. were misleading, the consequences for the defendants were severe.

The Prison Tally

Defendant	Sentence
Gregory Podlucky, CEO	20 years in federal prison
Robert Lynn, President	15 years in federal prison
Andrew Murin, Consultant	10 years in federal prison
Jonathan Podlucky, COO	5 years in federal prison
Karla Podlucky (CEO’s wife)	4¼ years in federal prison
G. Jesse Podlucky (CEO’s son)	9 years in federal prison
Donald Pollinger, Businessman	5 years in federal prison
Tammy Jo Andreycak, Bookkeeper	5 years in federal prison

Crime did not pay for Podlucky and his co-conspirators!

What if the numbers are wrong?

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Responsibility and the Need for Controls

To ensure the accuracy of a company’s financial information, management:

Maintains a system of controls over the records and assets.

Hires external independent auditors.

Forms a committee of the board of directors to review these other two safeguards.

Safe: ©PhotoDisc/Getty Images; Officer: ©LifetimeStock/Shutterstock; Auditor: ©anekoho/ Shutterstock; Board: ©anekoho/Shutterstock

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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

Career Opportunities

Public Accounting

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

PROFESSIONAL DESIGNATIONS

CPA

CMA

CIA

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Understanding the Business Text Alternative

A box at the top reads: Sources of financial resources. This points to 2 boxes below: Stockholders and Creditors. Stockholders points to another box below that reads: Potential return for stockholders: Dividends and higher future stock prices. Creditors points to another box below that reads: Potential return for creditors: Interest.

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Exhibit 1.1 The Accounting System and Decision Makers Text Alternative

At the top is the label Accounting System, which branches into two subsegments: Financial Accounting Reports and Managerial Accounting Reports. Under Financial is the note Periodic financial statements and related disclosures, and this flows to the label External Decision Makers. This label has the note "Evaluate the company" and images and captions of creditors and investors. Under Managerial is the note Detailed plans and continuous performance reports. This flows down to Internal Decision Makers, which is noted as "Run the company" and has an image and caption of Managers.

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The Accounting Equation Text Alternative

The equation starts with A (for Assets) equals L (for Liabilities) plus SE (for Stockholders' Equity). A (Assets) encompasses economic resources. L (Liabilities) encompasses Sources of financing for resources including liabilities: from creditors. SE (Stockholders' Equity) encompasses sources of financing for resources including Stockholders' equity: from stockholders.

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The Income Statement Equation Text Alternative

The equation starts with R (for revenues) minus E (for expenses) equals NI (for net income). R (Revenues) encompasses cash and promises received from delivery of goods and services. E (expenses) encompasses resources used to earn period's revenues. NI (net income) encompasses revenues earned minus expenses incurred. Also called "profit", "net earnings", or "the bottom line."

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Financial Statement Formats Text Alternative

A balance sheet is shown with the following notes.

A note points to the assets section and reads: Assets are listed on the balance sheet by ease of conversion to cash. A note points to the liabilities section and reads: Liabilities are listed by the maturity (due date). A note points to the bottom figures and reads: Place a single underline below the last item in a group before a total or subtotal, and a double underline below the group totals. A note points to the dollars signs in the figures and reads: Include the monetary unit sign ($) beside the first dollar amount in a group of items and by group total.

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Exhibit 1.6 Relationships Among Le-Nature’s Statements Text Alternative

Net income from the income statement appears in the statement of stockholders' equity. Ending retained earnings from the statement of stockholders' equity appears as retained earnings in the balance sheet. The cash at end of period in the statement of cash flows appears as Cash in the balance sheet.

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