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CHAPTER 1
Introduction to Financial Statements
Study Objectives
- Describe the primary forms of business organization.
- Identify the users and uses of accounting information.
- Explain the three principal types of business activity
- Describe the content and purpose of each of the financial statements.
- Explain the meaning of assets, liabilities, and stockholders’ equity and state the basic accounting equation.
- Describe the components that supplement the financial statements in an annual report.
7. Explain the basic assumptions and principles underlying financial statements.
Study Objective 1 - Describe the Primary Forms of Business Organization
A business may be organized as a sole proprietorship , partnership , or corporation.
♦ Sole proprietorship - a business owned by one person Advantages
- simple to establish
- owner controlled
- tax advantages
Disadvantages
- proprietor personally liable
- financing may be difficult
- transfer of ownership may be difficult
♦ Partnership - a business owned by two or more people Advantages
- simple to establish
- shared control
- broader skills and resources
- tax advantages
Disadvantages
- partners personally liable
- transfer of ownership may be difficult
♦ Corporation - a separate legal entity owned by stockholders Advantages
- easy to transfer ownership
- greater capital raising potential
- lower legal liability
Disadvantages
- unfavorable tax treatment
Study Objective 2 - Identify the Users and Uses of Accounting
The primary function of accounting is to
A. provide financial information for decision making. The users of financial information fall into two categories-- internal users and external users.
♦ Internal users - users within the organization. ♦ Marketing managers, production supervisors, finance directors and company officers ♦ Questions asked by internal users – What is the cost of manufacturing each unit of product? Which product is the most profitable?
Study Objective 4 - Describe the Content and Purpose of Each of the Financial Statements
Accountants communicate with users through four financial statements :
♦ Income Statement Summarizes all revenue and expenses for period--month, quarter, or year. (Income is measured from…to i.e. over a period of time) If revenues exceed expenses , the result is a net income. If expenses exceed revenue , the result is a ( net loss ). The difference between Revenues and Expenses is indicative of the success or failure of the company's operations during the period reported.
♦ Retained Earnings Statement Represents the totality of revenues less expenses less dividends +- the effects of prior period adjustments and quasi-reorganizations of a business from the first day of operations through the current period. The Statement of Retained Earnings will reflect the amount paid out in dividends and amount of net income or net loss for the current period. Shows changes in retained earnings balance during period covered by statement. Format: Retained Earnings at beginning of year: $5,000, Add: Net Income (or deduct net loss) 1,000, Less: Dividends Declared: (700,000) +- Effects of a prior period adjustment (200,000) Less: Adjustment due to Quasi-Reorganization (150,000) Retained Earnings at End of Year: $4,950, o Balance Sheet o The Balance sheet is a position statement…shows the position of the business at a point in time o Compare this to the Income Statement that measures performance over time. o The Balance Sheet shows relationship between assets and equities -- assets=equities --on a particular date. Assets and equities ( liabilities and stockholders' equity) must balance.
♦ Statement of Cash Flows Reports the cash effects of a company's operations for a period of time. Shows cash increases and decreases from investing and financing activities. Indicates increase or decrease in cash balance as well as ending cash balance.
- Interrelationship of Statements
- Retained earnings statement is dependant on results of the income statement
- Balance sheet and retained earnings statement are interrelated.
- Statement of cash flows and balance sheet are interrelated.
Study Objective 5 - Explain the Meaning of Assets, Liabilities, and Stockholders ' Equity and State the Basic Accounting Equation
♦ Assets - resources owned by the business.
♦ Assets will benefit the business for more that the immediate short term…usually at least 1 year ♦ This is opposed to an expense…items which benefit the business only for the immediate short term ♦ For example: if a business buys a delivery truck, the truck is an asset. The gas an oil used to operate the truck are expenses
♦ Liabilities - creditors claims on total assets (obligations or debts of the business).
♦ Stockholders' Equity - ownership claim on total assets. ♦ Stockholders equity is what’s left over after all the liabilities are satisfied ♦ The accounting equation : Assets = Liabilities + Stockholders' Equity
Study Objective 6 - Describe the Components that Supplement the Financial Statements in an Annual Report
Companies traded on an organized exchange like the New York Stock Exchange or The American Stock Exchange are required to provide shareholders with an annual report which always includes financial statements. In addition, the annual report includes the following information:
♦ Management Discussion and Analysis - covers three aspects of a company: liquidity, capital resources, and results of operation.
♦ Notes to Financial Statements Clarify information presented in the financial statements. Describe accounting policies or explain uncertainties and contingencies.
♦ Auditor's Report Auditor, a professional accountant, who conducts an independent examination of the financial accounting data presented by a company. Auditor gives an unqualified opinion if the financial statements present the financial position, results of operations, and cash flows in accordance with accepted accounting standards.
Study Objective 7 - Explain the Basic Assumptions and Principles Underlying Financial Statements
The preparation of financial statements relies on the following key assumptions and principles:
♦ Monetary unit assumption States that only transactions expressed in terms of money be included in accounting records. Assumes that unit of measure remains constant over time.
♦ Economic entity assumption Assumes economic events can be identified with a particular unit of accountability. Requires economic activities of an entity be kept separate from those of owner and separate from all other
Chapter 1 Review
9 Name the three primary forms of business organization.
9 Identify the users of accounting information. How do they use this information?
9 Explain the three types of business activity.
9 Describe the content and usefulness of each of the financial statements.
9 Explain the meaning of assets, liabilities, and stockholders equity and state the basic accounting equation.
9 Describe the components that supplement the financial statements in an annual report.
9 Explain the basic assumptions and principles underlying financial statements.
Reading Comprehension Check I Name _______________
Chapter 1
In deciding which organizational form to choose, you must consider such issues as taxes, liability concerns, and
ease of financing. _______________ and _______________ get favorable tax treatment relative to
_______________. A disadvantage of _______________ and _______________ is that _______________ and
_______________ are personally liable for all debts of the business, where as _______________
_______________ are not. The _______________ form also has the advantage that transfer of ownership simply
requires the sale of shares, which often is accomplished on an organized stock exchange like the New York Stock
Exchange. Selling a _______________ or _______________ interest is more involved. Consequently, obtaining
financing may be easier for a _______________ than for a _______________ or _______________.
Although the combined number of _______________ and _______________ in the United States is more
than five times the number of _______________ , the revenue produced by _______________ is eight times
greater. Most of the largest enterprises in the United States--for example, Coca-Cola, General Motors, Citigroup, and
Microsoft are _______________.
Reading Comprehension Check II Name _______________
Chapter 1
For business purposes, it is customary to arrange the data in the format of four different _______________
_______________ , which form the backbone of financial accounting. For example, to present a picture at a point in
time of what your business owns (its _______________ ) and what it owes (its _______________ ), you would present
a _______________ _______________. To inform the loan officer how successfully your business performed during
a period of time, you would reports its _______________ and _______________ in the _______________
_______________. To indicate how much of previous income was distributed to you and the other owners of your
business in the form of _______________ , and how much was retained in the business to allow for future growth, you
would present a _______________ _______________ _______________. And finally, of particular interest to
your bankers and other creditors, you would present a _______________ of _______________ _______________.
Solutions to Reading Comprehension Check II
Chapter 1
For business purposes, it is customary to arrange the data in the format of four different
___ financial statements , which form the backbone of financial accounting. For example, to present a
picture at a point in time of what your business owns (its assets ) and what it owes (its ____ liabilities
), you would present a balance sheet. To inform the loan officer how successfully your
business performed during a period of time, you would reports its revenues ____ and expenses in the
income statement. To indicate how much of previous income was distributed to you and the
other owners of your business in the form of dividends , and how much was retained in the business to allow
for future growth, you would present a retained ___ ____ earnings statement. And finally, of
particular interest to your bankers and other creditors, you would present a statement of cash
flows.
Solutions to Vocabulary Quiz
Chapter 1
- Cost principle
- Liabilities
- Assets
- Net loss
- Partnership
- Retained earnings
- Accounting equation
- Dividends
- Expenses
- Balance sheet
Multiple Choice Quiz Name _______________
Chapter 1
- All of the following are characteristics of a sole proprietorship except: a. a business owned by one person. b. owner has control of the business. c. a separate legal entity. d. small owner-operated business.
- All of the following are characteristics of a corporation except: a. a separate legal entity b. ownership evidenced by shares of stock. c. produce eight times more revenue than sole proprietorships and partnerships in the United States. d. owners have unlimited liability.
- Corporations may issue several classes of stock, but the stock representing the primary ownership interest is: a. common stock. b. retrained earnings. c. financing activity. d. dividends.
- Resources owned by a business and used in carrying out its operating activities are: a. liabilities b. stockholders' equity. c. revenues. d. assets.
- Acquiring long-term assets necessary to operate the business is called a(n): a. financing activity. b. operating activity. c. revenue activity. d. investing activity.
- Debt securities sold to investors and due to be repaid at a particular date some years in the future are called: a. bonds payable. b. accounts payable. c. wages payable. d. notes payable.
- The term used to describe the total assets that Starbucks receives in exchange for its coffee is: a. cash. b. revenue. c. inventory. d. accounts receivable.
Solutions to Multiple Choice Quiz
Chapter 1
- c
- d
- a
- d
- d
- a
- b
- c
- b
- a
Exercise 1 - Research and Communication Activity
Chapter 1
You and your college roommate have decided to go into business together after graduation. Your roommate contends that you have always gotten along and therefore do not need a partnership agreement. You, however, feel somewhat uncomfortable about not having a formal partnership agreement. Not wanting to argue, you decide to write the roommate a memo to (1) explain why you need a formal agreement and (2) outline the issues that need to be addressed in the agreement.
Solution:
DATE: 5/1/0X
TO: My Roommate
FROM: Marketing Student
SUBJECT: Partnership Agreement
After conducting research, speaking with a number of professionals, and considering the venture we are about to undertake, I am even more confident that we need a partnership agreement. Although we have remained friends during the four years of college, a misunderstanding concerning the partnership could jeopardize our friendship.
At a minimum, the partnership agreement should address:
- Exact name of the business
- Specific nature of the venture
- Names and addresses of partners
- Duties and responsibilities of partners
- Division of profits or losses
- Addition of new partners
- Withdrawal of existing partner
- Additional investments
If there are other issues you would like to see addressed, please let me know. I am excited about our new business undertaking. However, I am more concerned that our friendship stay intact.
Exercise 3 - Financial Statement and Creative Activity
Chapter 1
Assume that you own a business (small or large) in Campus Town USA. Assume further that you are considering a project (enlarging the parking lot, redecorating the interior, etc.) that will require you to borrow money from a local bank. The lending officer has told you that she will need to know how much money the business is making, how much money the business owes suppliers and other creditors, and how much cash and inventory you have on hand.
As part of your exercise, you are required to do the following:
- Complete the form on the next page outlining: a. The type of business you own. b. The amount of money you need to borrow. c. The detail of the project that will require you to borrow money. d. Any additional information you think would help in applying for the loan.
- Complete the attached loan application form for your fictitious business. Remember: You may be creative on this exercise. The numbers don't have to be real, just realistic.
Note: The attached form and loan application do not need to be typed. However, forms should be neatly handwritten.
(This activity is intended for group assignment. Also, you may want to retain students' work. After studying later chapters and learning to analyze financial statements, students can play the role of loan officer and determine whether to grant the loan.)
Exercise 3 - Financial Statement and Creative Activity (Continued)
Chapter 1
Name of Company
Type of Business
Amount Need to Borrow
Reason for Applying the Loan
