Chapter 1
The Financial
Statements
Financial Statements, Businesses, and
Accounting
The Financial Statements
•Financial statements are business documents companies use
to communicate the results of their activities to various
people and groups
•For example, managers, investors, creditors, and
regulatory agencies
•These people then use this information to make a variety of
decisions
The Financial Statements
The four basic financial statements are:
T Income St
T St of R E
T Balance Sheet
T St of C Flow
What is Accounting and Why it’s
Important?
•Accounting is the process that measures, records, and
communicates a company’s business activities to decision
makers
•Accounting is the language of business
•Accounting is how the activities of a company are measured
and communicated
•The financial statements
Financial vs. Managerial Accounting
•People inside a company and outside of a company use
accounting information
•But each group has different needs
•Financial accounting focuses on measuring, recording, and
communicating a company’s business activities to external
users
Businesses
•Businesses try to create value by selling a product or service
•Many businesses, and what we focus on in this class, are
trying to make a profit
•For example, a business buys or makes products at a cost
(expense) and incurs other costs (expenses) operating the
business
•However, the business will sell their product/service at a
higher value (revenue) than what it cost
Businesses
•There are many forms a business can take
•Our focus will be on corporations
•A corporation is a separate legal entity apart from the
owners (often referred to as stockholders or shareholders)
•An investor can contribute cash to a corporation in exchange
for ownership
•A share or a stock represents a piece of ownership
Businesses
•Most well-known companies are corporations
•Amazon, Google, Apple, Microsoft, Nike, Disney
•All types of entities can be shareholders (owners) of a
corporation
•Individuals, partnerships, other corporations
Businesses
•We will specifically focus on public corporations (also
referred to as public companies)
•Public corporations are corporations that sell their shares of
ownership on the open market (to the public)
GAAP and Conceptual Framework
GAAP
•What rules govern financial accounting?
•Companies have to follow standards for measuring and
communicating financial information
•These standards (rules) are called Generally Accepted
Accounting Principles (GAAP)
•The Financial Accounting Standards Board (FASB) is the
organization responsible for setting these standards
FASB Conceptual Framework
•GAAP has what’s called a conceptual framework
•You can think of the framework as the overall theme that
should be followed when creating GAAP (the accounting
rules)
•Having a framework also helps with overall consistency of
standards
FASB Conceptual Framework
•The framework starts off by saying the main objective of financial
accounting is to provide information useful for users
•What makes information useful?
•FASB says useful information should possess two fundamental
qualities or characteristics:
Relevance Faithful
Representation
QUALITATIVE
CHARACTERISTICS
na
(Eee
Faithful
representation
Confirmatory
Predictive
—
Freedom
Materiality
Completeness§
Neutrality
Cost
effectiveness
(Benefits
exceed
costs)
Overriding
objective
Fundamental
characteristics
Components/
Aspects
Enhancing
characteristics
Constraint
Qualitative Characteristics
Relevance
•For information to be relevant, it should have predictive and
confirmatory value, and be material
•To have predictive value, financial information should help
users anticipate or make predictions about the future
•To have confirmatory value, financial information should help
users check (confirm) their predictions
•Material information is information that is important enough
to affect a user’s decision
•Entity specific
Faithful Representation
•For information to have faithful representation, it should be
complete, neutral, and free from error
•The financial information reported should include everything
a user would need to make decisions (information isn’t
omitted)
•For information to be neutral, it should be unbiased
•Information should be as accurate as possible based on the
best available information
•Estimates
Enhancing Characteristics
•Comparability, timeliness, verifiability, and understandability
support relevance and faithful representation
•Should be maximized individually and in combination
Constraint
•Cost is a pervasive constraint to financial reporting
•Certain information sometime involves more time and effort
than the information is worth
Underlying Principles and Assumptions
GAAP Principles and Assumptions
•In general, GAAP standards refer to the specific, detailed,
rules set that mandate how business transactions are
recognized, measured, recorded and reported
•GAAP principles and assumptions on the other hand,
represent the foundation upon which the rules are
constructed
GAAP Principles and Assumptions
Business Entity/Economic Entity Assumption: assumes all the
transactions accounted for pertain only to the business itself and are
not the personal transactions of the owners
•For example, when you look at financial information for Nike Inc., it is
financial information that pertains only to Nike Inc., the business entity, and
not the personal financial information of the owners
Monetary Unit Assumption: assumes business transactions are
measured in a single monetary unit and is stable over time
•For example, financial information for companies here in the U.S. are
measured and reported in U.S. dollars
GAAP Principles and Assumptions
Time Period Assumption: transactions of a company are broken down
into distinct periods of time and are reported for those periods
•For example, when you look at the financial activities of a company, you
would want to know if these activities were just for one month or for a whole
year
Going Concern Assumption: assumes a business will continue to
operate and not go out of business in the foreseeable future
GAAP Principles and Assumptions
Cost/Historical Cost Principle: When an asset is purchased, it is
recorded at its cost (purchase price). This is seen as an objective and
verifiable way to record assets. In other words, even if an asset might
be worth more in the future, it is reported at its original (historical) cost
•GAAP does require many assets to follow the cost principle.
•However, it should be noted that there are a lot of assets in which GAAP
mandates they are reported at an amount other than their original cost
•This is known as fair value reporting
GAAP Principles and Assumptions
Fair value principle: Indicates that assets and liabilities should be
reported at fair value
•Fair value is the price someone is willing to pay in an orderly transaction to
purchase an asset or transfer a liability; also referred to as market value
•Many financial assets are required to be reported at fair value
•This is because fair value information may be more useful to users than
historical cost
GAAP Principles and Assumptions
•Which is better?
•This is a huge debate in financial accounting
•Generally, FASB requires many assets to follow the cost principle as it
is seen as more reliable
•However, fair value amounts can be more relevant
Elements of Financial Statements
The Accounting Equation
•Accounting and the financial statements are based on what’s called
the accounting equation
Assets = Liabilities + Stockholders’ Equity
•Assets: resources of a business; the business will derive a future benefit from
this resource
•Liabilities: amounts owed to third parties; debt; obligations
•Stockholders’ Equity: amounts provided to the business through an initial
investment by the owners or the retention of profits.
Stockholders’ Equity
•Stockholders’ equity can be broken down into:
•Paid-in Capital
•Retained earnings
Stockholders’ Equity
•Paid-in Capital is the amount stockholders’ have invested
into the corporation
•Common stock is the basic component of paid-in capital
•Retained Earnings is the amount of income earned by the
company and kept (retained)
Stockholders’ Equity
•Therefore, the accounting equation can be expanded:
ASSETS LIABILITIES STOCKHOLDERS’ EQUITY
Common
Stock
Retained
Earnings
Stockholders’ Equity
•Retained Earnings can be further broken down
•There are three main components to Retained Earnings:
•Revenues
•Expenses
•Dividends
Stockholders’ Equity
•Revenues are the amount or price the company earns for
selling their product/services
•Expenses are the costs incurred by a company to generate
revenue and run their business
•Dividends: a company can pay cash to its owners as a
reward/return for their investment. This is known as a
dividend. It is the distribution of a company’s earnings
Stockholders’ Equity
Flow of retained earnings:
Stockholders’ Equity
ASSETS LIABILITIES STOCKHOLDERS’ EQUITY
Common
Stock
Retained
Earnings
+ Revenues
- Expenses
- Dividends
Profit
•The main goal of most businesses is to create a profit
•Profits are the excess of revenues over expenses
•When a company’s total revenues exceed total expenses, this
results in a profit
Profit
•Other terms for profit include:
•Net Income
•Net Profit
•Net Earnings/Earnings
•Anytime you see the word “net” this just means something is
being subtracted from something else
Profit
•This can be summarized into the following formula:
Revenues – Expenses = Net Income
•If expenses are greater than revenues, this results in a net
loss
The Financial Statements
The four basic financial statements are:
T Income St
T St of R E
T Balance Sheet
T St of C Flow
Income Statement
•The income statement is also known as the statement of
earnings or statement of operations
•It reports the revenues and expenses of a company and
shows the net income (or net loss) during a period of time
•The income statement covers a period of time
•The income statement can be represented by this equation:
Revenues – Expenses = Net Income
Income Statement
•Service revenue and sales revenue are two examples of
revenues
•A company can also earn interest revenue, which is a type of
revenue
•Gains are also a type of revenue
Income Statement
There are many different types of expenses, such as:
•Cost of goods sold
•Selling expenses
•Marketing expenses
•Administrative expenses
•Interest expense
•Income tax expense
•Losses
Income Statement
•Helpful reminder: Amounts received from issuing stock are
not revenues
•Helpful reminder: Amounts paid out as dividends are not
expenses
•Therefore, neither are reported on the income statement
SIERRA
CORPORATION
Income
Statement
For
the
Month
Ended
October
31,
2017
Revenues
Service
revenue
$10,600
Expenses
Salaries
and
wages
expense
$5,200
Rent
expense
900
Supplies
expense
1,500
Depreciation
expense
40
Interest
expense
50
Insurance
expense
50
Total
expenses
7,740
Net
income
$
2,860
Balance Sheet
•The balance sheet is also known as the statement of financial
position
•It shows the financial position (the balance) of a company’s
assets, liabilities, and stockholders’ equity as of a certain
date
•For example, as of the last date in the year or quarter
•The balance sheet can be represented by this equation:
Assets = Liabilities + Stockholders’ Equity
Classified Balance Sheet
•Most companies prepare a classified balance sheet to make
them more useful
•Classified balance sheets use long-term (noncurrent) and
short-term (current) categories
Current Assets
Short-term assets include cash and any other assets the
company expects to use up or convert to cash within one year
C & Cash
E R I
S -
Long-Term Assets
Long-term assets are assets the company expects will
last them longer than a year (they will not be converted
to cash or be used up within a year)
L -t
PP&E I Assets
Long-Term Investments
•Companies can invest in stocks and bonds of other
companies
•Bonds are notes payable issued (sold) by companies and
governments, that can be bought by other companies or
investors
•Bonds also pay interest
Property, Plant, and Equipment
(PP&E)
•PP&E includes items such as land, buildings, equipment, and
vehicles
•PP&E is sometimes referred to as tangible assets, or fixed
assets
Intangible Assets
•Intangible assets do not have physical substance like
buildings or equipment
•They represent rights such as patents or copyrights
Current Liabilities
•Short-term liabilities are due within one year
A
I
P
S
I t
Long-term Liabilities
•Long-term liabilities have a due date longer than a year
•Many companies will use the term “long-term debt” to represent all
liabilities with a due date longer than a year
B pa M
L -term
Stockholders’ Equity
•Stockholders’ equity consists of two parts:
Common Stock + Retained Earnings = Stockholders’ Equity
C Stock R
E
SIERRA
CORPORATION
Balance
Sheet
October
31,
2017
Assets
Cash
Accounts
receivable
Supplies
Prepaid
insurance
Equipment,
net
Total
assets
Liabilities
and
Stockholders’
Equity
Liabilities
Notes
payable
$
5,000
Accounts
payable
2,500
Unearned
service
revenue
800
Salaries
and
wages
payable
1,200
Interest
payable
50
Total
liabilities
Stockholders’
equity
Common
stock
10,000
Retained
earnings
2,360
Total
stockholders’
equity
Total
liabilities
and
stockholders’
equity
$
9,550
12,360
$21,910
Statement of Retained Earnings
•The statement of retained earnings reports the changes in
retained earnings during the period
•It will show the beginning balance of retained earnings, its
changes, and the ending balance of retained earnings
•The statement of retained earnings can be represented by
this equation:
Beg. Bal. of R/E + Net Income – Dividends = End. Bal. in R/E
Statement of Retained Earnings
•Remember, retained earnings is the amount of net income
the company has kept (retained) since inception, after
making deductions for dividends to shareholders
SIERRA
CORPORATION
Retained
Earnings
Statement
For
the
Month
Ended
October
31,
2017
Retained
earnings,
October
1
$
0
Add:
Net
income
2,860
2,860
Less:
Dividends
500
Retained
earnings,
October
31
$2,360
Statement of Cash Flows
•The statement of cash flows reports all changes in cash
during a period of time
•It reports all cash inflows and outflows from operating,
financing, and investing activities during the period
•These are the three main activities that all companies are
involved in
Statement of Cash Flows
•Operating activities: cash flows from selling goods and
services to customers
•These activities result in net income or net loss
•Operating activities are most important, and they should
be the company’s main source of cash
•Continuing negative cash flow from operations can lead to
bankruptcy
Statement of Cash Flows
•Investing activities: cash flows from purchasing and selling
long-term assets
•Financing activities: cash flows from borrowing or repaying
funds or equity transactions
•This includes issuing stock, paying dividends, borrowing, and
repayments of borrowed funds
•The company may also repurchase its own stock
c
A
The
Walt
Disney
Company
Consolidated
Statements
of
Cash
Flows
Fiscal
2016
Fiscal
2015
Adapted,
in
Millions
of
$
12
Months
Ended
Oct.
1,
2016
Oct.
3,
2015
OPERATING
ACTIVITIES
Net
income
$
9,391
$
8,382
Adjustments
to
reconcile
net
income
to
net
cash
provided
by
operating
activities
3,822
2,527
Net
cash
provided
by
operating
activities
13,213
10,909
INVESTING
ACTIVITIES
Investments
in
parks,
resorts,
and
other
property
(4,773)
(4,265)
Sales
of
investments/proceeds
from
dispositions
45 166
Acquisitions
and
other
investing
activities
(1,030)
(146)
Net
cash
used
in
investing
activities
(5,758)
(4,245)
FINANCING
ACTIVITIES
Net
proceeds
from
borrowing
6,065
4,926
Reductions
of
borrowings
(3,125)
(2,221)
Repurchases
of
common
stock
(7,499)
(6,095)
Dividends
(2,313)
(3,063)
Proceeds
from
exercise
of
stock
options
and
other
(119)
939
Net
cash
used
in
financing
activities
(6,991)
(5,514)
Effect
of
foreign
exchange
rate
fluctuations
on
cash
(123)
(302)
Net
increase (decrease)
in
cash
and
cash
equivalents
341
848
Cash
and
cash
equivalents
at
beginning
of
period
4,269 3,421
Cash
and
cash
equivalents
at
end
of
period
4610
4269
Statement of Cash Flows
Question
Financial
Statement
Answer
1.
How
well
did
the
Income
statement
Revenues
company
perform
(also
called
the
—
Expenses
during
the
year?
2.
Why
did
the
company’s
retained
earnings
change
during
the
year?
3.
What
is
the
company’s
financial
position
at
fiscal
year
end?
4.
How
much
cash
did
the
company
generate
and
spend
during
the
year?
Statement
of
operations)
Statement
of
retained
earnings
Balance
sheet
(also
called
the
Statement
of
financial
position)
Statement
of
cash
flows
Net
income
(or
Net
loss)
Beginning
retained
earnings
+
Net
income
(or
—
Net
loss)
—
Dividends
declared
Ending
retained
earnings
Assets
=
Liabilities
+
Stockholders’
Equity
Net
Operating
cash
flows
+
Net
Investing
cash
flows
+
Net
Financing
cash
flows
Increase
(decrease)
in
cash
Summary of Financial Statements
Where to Find
Financial Statements
Where to Find Financial Statements
–
Annual Reports
•Annual reports are the reports and information provided by
companies primarily for shareholders and the public
•The annual report includes the financial statements, notes to
the financial statements, and other information often
referred to as supplementary information
•Annual reports are typically available for download off of a
company’s website
Where to Find Financial Statements
–
10-K Reports
•A Company’s 10-K report is similar to the information
provided in a company’s annual report
•It includes the financial statements, notes to the financial
statements, and other supplementary data
•However, this report is required to be filed with the
Securities and Exchange Commission (SEC) and can contain
more detailed information than the annual report
Where to Find Financial Statements
–
10-K Reports
•10-K reports are available to download from SEC’s EDGAR
website
Where to Find Financial Statements
–
10-K Reports
•Since public companies are required to file a 10-K with the
SEC, some companies will not create a separate annual
report, but rather, just use their 10-K
•Thus, the company’s annual report and 10-K are ultimately
the same document
Where to Find Financial Statements
•Whether you are using a company’s annual report or 10-K,
the basic set of data (financial statements, notes, and
required supplementary information), are the same
Reporting Requirements
•Public companies are required to report their financial
information to the public
•Who requires this information to be reported and how?
•Financial statements are prepared in accordance with
Generally Accepted Accounting Principles (GAAP)
•The goal of GAAP is to have financial information of a
company be presented in a way that is useful to users
(understandable, relevant, and reliable)
Reporting Requirements
•The two authorities primarily responsible for establishing
GAAP include:
SEC
F
A
S Boar
(FASB)
Reporting Requirements
•The SEC holds ultimate authority over the financial markets,
but has primarily delegated standard setting to FASB
•FASB sets the standards but cannot enforce GAAP; only the
SEC can enforce GAAP.
Reporting Requirements
The SEC requires U.S. public companies to file:
1. 10-K reports (annual reports)
2. 10-Q reports (quarterly reports)
3. 8-K reports (important events)
•Change in auditor
•Bankruptcy
•Financial restatements
Summary of Usefulness
The financial statements and their notes help to show:
T financial of a com
T success of a co ’ oper
P and s of manageme
I to futu perf of a compan
Ethics in Accounting
Ethics in Accounting
•Ethics plays a major role in accounting
•This is because users rely on the information produced by
accountants to make decisions
•This is particularly critical for public companies
•In the early 2000s, many large public companies had
accounting fraud and scandals occur within their company
•This led to many investors losing confidence in the financial
information being reported by public companies
AICPA
•The American Institute of Certified Public Accountants
(AICPA) is a professional organization representing the
accounting profession
•The AICPA has a code of professional conduct that applies to
all of its members
Other Information Included in an Annual Report and 10-K
(Optional – Not Required)
Auditor’s Report
Auditor’s Report
•Management of the company is required to prepare the
financial statements, including the notes to the financial
statements
•Public companies are required to have these audited by
external auditors
•The report by the auditors attests to the fairness of the
financial statements’ presentation, including the notes to the
financial statements
Auditor’s Report
•Public companies are also required to report about internal
controls
•In the report over internal control, management must state
its responsibility for establishing and maintaining adequate
internal control as well as assess its effectiveness
•The external auditors are required to audit the company’s
internal control as well as the financial statements
Auditor’s Report
•After the external auditors have audited the financial
statements and internal controls of the company, they will
express their opinion over both in a report
Auditor’s Report
•There a different types of audit opinions, or audit reports,
including:
U Q A
D of
U
with
Auditor’s Report
•In an unqualified report, the auditors state that the financial
statements present fairly, in all material respects, the
financial position, the results of operations, and the cash
flows for the accounting period, in conformity with GAAP
•This is the best opinion that can be given by the auditors
Auditor’s Report
•A qualified report means there has been some departure
from GAAP (GAAP was not followed in some area)
•In a qualified report, the auditors will state, “In our opinion,
except for… the financial statements present fairly…”
•This type of report is saying that the company presented
their information fairly and according to GAAP except for a
certain area
Auditor’s Report
•Sometimes the departure from GAAP is significant
•The departure from the rules affects numerous accounts and
financial statement relationships
•In this case, an adverse opinion is issued by the auditors in
their report
•In this report, the auditors will state the financial statements
have not been presented fairly in accordance with GAAP
•Worst opinion that can be given by auditors
Auditor’s Report
•Auditors can also issue a disclaimer of opinion
•This means the auditors have been significantly limited in
their ability to audit
•In a disclaimer of opinion, the auditors cannot evaluate the
fairness of the financial statements, and therefore do not
express an opinion on them
Auditor’s Report
•Auditors can issue what’s called an unqualified opinion with
explanatory language
•In this case, the financial statements are presented fairly in
accordance with GAAP
•However, there is something additional that the auditors
wish to point out
Management Discussion and Analysis (MD&A)
MD&A
•MD&A section of an annual report/10-K often contains
information not in the financial statements
•It is written by management of the company and discusses
any favorable or unfavorable trends, significant events, or
areas of uncertainties
MD&A
The MD&A can help answer:
•Where does the company get its cash from—sales or
borrowing and issuing stock?
•How much is the company planning to spend next year for
investments in property, plant, and equipment or
acquisitions? Why? How will these be paid for?
•Will revenues and expenses be affected in the future by
events not expected in the normal operations of business?
Missing or Hard to Find Information
•Not everything you might want to know about a company is
included in their financial statements
•For example, what is their culture like? What is the morale of
employees? What is the company’s relationship with the
community?
Complexities and the Quality of Financial Reporting
Accounting Choices
•Accounting rules are inherently complex
•This can make interpreting financial statements difficult
•There is also considerable discretion in applying these rules
•Accounting choices and estimates can have a significant
impact on the numbers in the financial statements
•There are often several acceptable methods for accounting
for a transaction
Discretionary Items
•Many expenditures made by a company are discretionary
•Management has control over expenditures for:
•repair and maintenance of machinery and equipment
•marketing and advertising
•research and development
•capital expansion
