1 CHAPTER Introduction to Financial Statements
Study Objectives
1. Describe the primary forms of business organization. 2. Identify the users and uses of accounting information. 3. Explain the three principal types of business activity. 4. Describe the content and purpose of each of the financial statements. 5. Explain the meaning of assets, liabilities, and stockholders' equity, and state the basic accounting equation. 6. Describe the components that supplement the financial statements in an annual report.
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Chapter Outline
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 that are more favorable than a corporation Disadvantages proprietor personally liable for all business debts 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 that are more favorable than a corporation Disadvantages partners personally liable for all business debts transfer of ownership may be difficult
Corporation - a separate legal entity owned by stockholders Advantages easier to transfer ownership easier to raise funds lower legal liability no personal liability for stockholders Disadvantages unfavorable tax treatment resulting in higher taxes paid by stockholders
The emphasis of this text is the corporate form of business.
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Study Objective 2 - Identify the Users and Uses of Accounting Information.
The purpose of financial information is to provide inputs for decision making. Accounting is the information system that identifies, records, and communicates the economic events of an organization to interested users. The users of financial information fall into two groups--internal users and external users. Internal users - users within the organization. Internal users and questions they may ask: Marketing Human Resources Finance Management What price will maximize the company's net income? Can we afford to give employees pay raises this year? Is cash sufficient to pay dividends to stockholders? Which product line is most profitable? What should be eliminated?
External users - users who are outside the organization. External users and questions they may ask: Investors (current and potential) Creditors (suppliers and bankers) IRS, SEC, FTC, labor unions, customers Is the company earning satisfactory income? How does the company compare in size and profitability with competitors? Will the company be able to pay its debts as they come due? Is the company complying with rules and regulations? Is the company properly paying its taxes?
Ethics in financial reporting In 2002, Congress passed the Sarbanes-Oxley Act (SOX) to reduce unethical corporate behavior and decrease the likelihood of future corporate scandals. Effective financial reporting depends on sound ethical behavior. Steps for solving ethical dilemmas: 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.
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Study Objective 3 - Explain the Three Principal Types of Business Activity.
All businesses are involved in three types of activity. The accounting information system keeps track of the results of each of these activities. Financing activities Cash is often obtained from outside sources to start or expand a business. The two primary sources are: Borrowing from creditors which creates a liability bank loan (note payable) debt securities (bonds payable) goods on credit from suppliers (accounts payable) Issuing ownership interests in the corporation to investors (selling stock to shareholders)
In addition, financing activities include using cash to pay dividends to stockholders.
Investing activities Cash raised through financing activities is used for investing in resources (assets) needed to operate the business (i.e., land, buildings, delivery trucks, equipment, computers, etc.). furniture, Operating activities Once a business has the assets it needs to get started, it begins its operations (the reason it is in business). Operating activities involve revenue and expenses. Revenue is generated from sales or services related assets include accounts receivable, inventory, supplies, prepaid insurance Expenses are incurred in earning revenue related liabilities include accounts payable, wages payable, interest payable, sales taxes payable, income taxes payable
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Study Objective 4 - Describe the Content and Purpose of Each of the Financial Statements.
Accounting information is communicated through four financial statements: Income Statement Reports success or failure of the company's operations during the period. Summarizes all revenue and expenses for period--month, quarter, or year. If revenues exceed expenses, the result is a net income. If expenses exceed revenue, the result is a (net loss). Dividends are payments to the stockholders and are not expenses. Amounts received from issuing stock or obtaining loans are not revenues. Retained Earnings Statement Indicates amount paid out in dividends and amount of net income or net loss for period. Shows changes in the retained earnings balance during period covered by statement. Ending retained earnings represents net income since the inception of the business that has not been paid out as dividends. Balance Sheet Shows relationship between assets and equities at a specific point in time. Equities include liabilities (claims of the creditors) and stockholders' equity (claims of the owners). Assets and equities (liabilities and stockholders' equity) must balance. Statement of Cash Flows Provides information about cash receipts and cash payments for the accounting period. 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 depends on results of the income statement. Balance sheet and retained earnings statement are interrelated. Statement of cash flows and balance sheet are interrelated.
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Study Objective 5 - Explain the Meaning of Assets, Liabilities, and Stockholders' Equity, and State the Basic Accounting Equation.
Assets - resources owned by the business (things of value) Liabilities - creditors claims on total assets (obligations or debts of the business) Stockholders' Equity - ownership claim on total assets 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: 1. Its ability to pay near-term obligations (liquidity) 2. Its ability to fund operations and expansion (capital resources) 3. It results of operations Notes to Financial Statements Clarify information presented in the financial statements Describe accounting policies or explain uncertainties and contingencies Auditor's Report An auditor, a CPA, conducts an independent examination of the company's financial statements. An auditor gives an unqualified opinion if the financial statements present the financial position, results of operations, and cash flows in accordance with generally accepted accounting principles.
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Chapter 1 Review
Describe the three primary forms of business organization and list advantages and disadvantages of each.
Identify the users of accounting information. How do they use this information?
Explain the three types of business activity.
Describe the content and purpose of each of the financial statements.
Define assets, liabilities, and stockholders' equity, and state the basic accounting equation.
Describe the components that supplement the financial statements in an annual report.
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