Chapter 01 – Financial Statements and Business Decisions
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CHAPTER 1
FINANCIAL STATEMENTS AND BUSINESS DECISIONS
Learning Objectives and Related Assignment Materials
Learning Objectives
Mini-
Exercises
Exercises
Problems
Alternate
Problems
Cases and
Projects
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
1, 2, 3, 4,
5, 6, 7, 8,
9, 10, 11,
12, 13
1, 2, 3, 4
1, 2, 3
1, 2, 3, 4
2. Identify the role of generally accepted
accounting principles (GAAP) in
determining the content of financial
statements.
3
1
5, 6
Chapter Supplement A: Types of business
entities
Chapter Supplement B: Employment in
the accounting profession today
Synopsis of Chapter Revisions
Focus Company: Le-Nature’s Inc.
▪ New focus company and coverage of an exciting, but simple, recent accounting fraud. Students are
introduced to the structure, content, and use of the four basic financial statements through the story of
two brothers who founded Le-Nature’s Inc., a natural beverage company. Le-Nature’s financial
statements are used to support increases in borrowing for expansion. When actual sales do not live up
to expectations, the brothers turn to financial statement fraud to cover up their failure. The fact that
banks and other parties involved lost upwards of $700 million and the perpetrators are now spending
a total of 70 years in federal prison emphasizes the importance of controls, responsible ethical
conduct, and accurate financial reporting.
▪ The simple statement of stockholders’ equity replaces the statement of retained earnings to match
current practice.
▪ New GUIDED HELP feature provides all users of the text with free access to step-by-step video
instruction on preparing a simple balance sheet, income statement, and statement of stockholders’
equity for LaCrosse Footwear, a leading outdoor footwear company.
▪ New CONTINUING CASE added to the end-of- chapter problems based on the activities of Penny’s
Pool Service & Supply, Inc. and its supplier, Pool Corporation. These cases summarize key points
emphasized in each chapter in a consistent context throughout the text. In Chapter 1, students prepare
a basic income statement, statement of stockholders’ equity, and balance sheet based on Penny’s
estimates for the first year.
▪ New and updated real companies, as well as modified accounts, names, and amounts for fictional
companies in end-of-chapter exercises, problems, and cases.
Chapter 01 – Financial Statements and Business Decisions
PowerPoint Slides
Learning Objectives
PowerPoint® Slides
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).
1-1 through 1-17
2. Identify the role of generally accepted accounting principles (GAAP) in
determining the content of financial statements.
1-18 through 1-27
Chapter Supplement A: Types of business entities
1-28
Chapter Supplement B: Employment in the accounting profession today
1-29
Related Video Program
Chapter 01 – Financial Statements and Business Decisions
1-3
Chapter Take-Aways
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).
The balance sheet is a statement of financial position that reports dollar amounts for the assets,
liabilities, and stockholders’ equity at a specific point in time.
The income statement is a statement of operations that reports revenues, expenses, and net income
for a stated period of time.
The statement of stockholders’ equity explains changes in stockholders’ equity accounts (common
stock and retained earnings) for a stated period of time.
The statement of cash flows reports inflows and outflows of cash for a stated period of time.
The statements are used by investors and creditors to evaluate different aspects of the firm’s financial
position and performance.
2. Identify the role of generally accepted accounting principles (GAAP) in determining the content
of financial statements.
GAAP are the measurement rules used to develop the information in financial statements. Knowledge
of GAAP is necessary for accurate interpretation of the numbers in financial statements.
Management has primary responsibility for the accuracy of a company’s financial information.
Auditors are responsible for expressing an opinion of the fairness of the financial statement
presentations based on their examination of the reports and records of the company.
Users will have confidence in the accuracy of financial statement numbers only if the people
associated with their preparation and audit have reputations for ethical behavior and competence.
Management and auditors can also be held legally liable for fraudulent financial statements and
malpractice.
Finding Financial Information
Income Statement
Revenues
– Expense
Net Income
Statement of Cash Flows
+/– Cash Flow from Operating Activities
+/– Cash Flow from Investing Activities
+/– Cash Flow from Financing Activities
Net Change in Cash
Chapter 01 – Financial Statements and Business Decisions
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Chapter Outline
Teaching Notes
Provide a learning strategy:
Overview the textbook:
Marginal information
Pause for Feedback (Self-
Study Quizzes)
Demonstration Case
Chapter Take-Aways
Finding Financial
Information
Key Ratio(s)
Key Terms
Highlight and demo the
various components of the
student edition of the
textbook web site at
www.mhhe.com/libby8e
LO 1 – Describe various organizational forms and business decision makers.
I. Understanding the Business
A. Accounting System – collects and processes financial
information about an organization and reports that
information to decision makers:
Illustrated in Exhibit 1.1
Show Video Program #1
1. Managerial accounting – accounting for internal decision
makers
2. Financial accounting – accounting for external decision
makers (focus of this text)
B. Business activities
1. Financing Activities: borrowing or paying back money to
lenders and receiving additional funds from stockholders
or paying them dividends
2. Investing Activities: buying or selling items such as plant
and equipment used in the production of beverages.
3. Operating Activities: the day-to–day process of
purchasing raw tea and other ingredients from suppliers,
manufacturing beverages, delivering them to customers,
collecting cash from customers, and paying suppliers.
II. The Four Basic Financial Statements: An Overview
Use Supplemental
Enrichment Activity #1
Illustrated in Exhibit 1.2
A. Balance Sheet – reports the financial position (assets,
liabilities, and stockholders’ equity) of an accounting entity
at a point in time
1. Structure
a. Heading includes: name of the entity, title of the
statement, specific date of the statement, and unit of
measure
b. Accounting entity – organization for which financial
data are to be collected; must be precisely defined
c. Basic accounting equation: Assets = Liabilities +
Stockholders’ Equity
Use Supplemental
Enrichment Activity #2
Chapter 01 – Financial Statements and Business Decisions
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2. Elements
See Financial Analysis
feature “Interpreting Assets,
Liabilities, and Stockholders’
Equity on the Balance Sheet”
a. Assets – the economic resources owned by the
company; initially measured at total cost incurred to
acquire it
b. Liabilities – amount of financing provided by
creditors; the company’s debts or obligations
c. Stockholders’ equity – the amount of financing
provided by the owners or the business and earnings
i. Common stock – the investment of cash and other
assets in the business by the owners
ii. Retained earnings – the amount of earnings
(profits) reinvested in the business (and thus not
distributed to stockholders in the form of
dividends)
Refer students to Pause for
Feedback – Self-Study Quiz
B. Income Statement (statement of income, statement of
earnings, or statement of operations) – reports the revenues
less the expenses of the accounting period
1. Structure
Illustrated in Exhibit 1.3
a. Heading includes: name of the entity, title of the
statement, specific period of time covered by the
statement, and unit of measure
b. Accounting period – time period covered by the
financial statements
c. Income statement equation: Revenues – Expenses =
Net Income
2. Elements
a. Revenues – earned from sale of goods or services to
customers
b. Expenses – dollar amount of resources the entity used
to earn revenues during the period
See Financial Analysis
feature” Analyzing
the Income Statement:
Beyond the Bottom Line”
c. Net income (or net earnings or the “bottom line”) –
excess of total revenues over total expenses
i. Net loss reported if total expenses exceed total
revenues
ii. Net income does not normally equal the net cash
generated by operations
Refer students to Pause for
Feedback – Self-Study Quiz
C. Statement of Stockholders’ Equity – reports the way that net
income and the distribution of dividends affected the
financial position of the company during the accounting
period.
Illustrated in Exhibit 1.4
1. Structure
a. Heading includes: name of the entity, title of the
statement, specific period of time covered by the
statement, and unit of measure
See Financial Analysis
feature “Interpreting
Retained Earnings”
b. Same time period as income statement
c. Statement of stockholders’ equity equation: Beginning
balance + Increases – Decreases = Ending balance
Chapter 01 – Financial Statements and Business Decisions
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2. Elements
a. Starts with beginning balances in the stockholders’
equity accounts, lists the increases and decreases, and
reports the resulting ending balances
b. Retained earnings portion:
i. Begins with beginning-of-the year retained
earnings
ii. Current year net income reported on the income
statement is added
iii. Current year dividend are subtracted
iv. Ending retained earnings is same as that reported
on balance sheet
Refer students to Pause for
Feedback – Self-Study Quiz
D. Statement of Cash Flows – reports inflows and outflows of
cash during the accounting period in the categories of
operations, investing, and financing.
Illustrated in Exhibit 1.5
1. Structure
a. Heading includes: name of the entity, title of the
statement, specific period of time covered by the
statement, and unit of measure
b. Same time period as income statement
c. Prepared because the income statement does not
provide information concerning cash flows
d. Statement of cash flows equation: +/– Cash Flows
from Operating Activities +/– Cash Flows from
Investing Activities +/– Cash Flows from Financing
Activities = Change in Cash
See Financial Analysis
feature “Interpreting the
Cash Flow Statement”
2. Elements
a. Cash Flows from Operating Activities – cash flows
that are directly related to earning income
Use Supplemental
Enrichment Activity #3
b. Cash Flows from Investing Activities – cash flows
related to the acquisition or sale of the company’s
productive assets
c. Cash Flows from Financing Activities – cash flows
directly related to the receipt or payment of money to
investors and creditors (except for suppliers)
Refer students to Pause for
Feedback – Self-Study Quiz
E. Relationship Among the Statements
Illustrated in Exhibit 1.6
1. Net income from the income statement results in an
increase in ending retained earnings on the statement of
retained earnings
2. Ending retained earnings from the statement of retained
earnings is one of the two components of stockholders’
equity on the balance sheet
3. The change in cash on the cash flow statement added to
the beginning-of-the-year balance in cash equals the end-
of-year balance in cash on the balance sheet
Chapter 01 – Financial Statements and Business Decisions
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F. Notes – provide supplemental information about the
financial condition of a company, without which the
financial statements cannot be fully understood
See Financial Analysis
feature “Management Uses
of Financial Statements”
1. Notes provide supplemental information about the
financial condition of a company without which the
financial statements cannot be fully understood
2. Three basic types of notes:
a. First provides descriptions of the accounting rules
applied in the company’s financial statements
b. Second presents additional detail about a line on the
financial statements
c. Third provides additional financial disclosures about
items not listed on the statements themselves
d. Additional formatting conventions for all four basic
financial statements:
i. Assets are listed on the balance sheet by ease of
conversion to cash; liabilities are listed by their
maturity (due date)
ii. A monetary unit sign (in the U.S., the $) is
included beside the first dollar amount in a group
of items
iii. It is common to place a single underline below the
last item in a group before the total or subtotal
iv. A dollar sign is also placed beside group totals and
a double underline below
G. Summary of the Four Basic Financial Statements
Summarized in Exhibit 1.7
Use Supplemental
Enrichment Activity #3
III. Responsibilities for the Accounting Communication Process
LO 2 – Identify the role of generally accepted accounting principles (GAAP) in determining the
content of financial statements.
A. Generally Accepted Accounting Principles – measurement
rules used to develop the information in financial statements
1. How Are Generally Accepted Accounting Principles
Determined?
a. Securities and Exchange Commission (SEC) – The
U.S. government agency that determines the financial
statements that public companies must provide to
stockholders and the measurement rules that they must
use in producing those statements
See Financial Analysis
feature “The International
Accounting Standards Board
and Global Convergence of
Accounting Standards”
b. Financial Accounting Standards Board – The private
sector body given the primary responsibility to work
out the detailed rules that become generally accepted
accounting principles
Chapter 01 – Financial Statements and Business Decisions
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2. Why is GAAP Important to Managers and External
Users?
a. Companies incur the cost of preparing the statements
b. Companies bear the major economic consequences of
their publication including:
i. Effects on the selling price of a company’s stock
ii. Effects on the amount of bonuses received by
management and employees
iii. Loss of competitive information to other
companies
c. Changes in GAAP are actively debated, political
lobbying takes place, and final rules are a compromise
among the wishes of interested parties
B. Ensuring the Accuracy of Financial Statements
1. What if the numbers are wrong?
2. Ethical conduct
a. Ethics are standards of conduct for judging right from
wrong, honest from dishonest, and fair from unfair
b. Three step process to be followed when you are faced
with an ethical dilemma
i. Identify the benefits of a decision and who will be
harmed
ii. Identify alternative courses of action
iii. Choose the one you would like your family and
friends to see reported on your local news; this is
usually the ethical choice.
3. Responsibility and the Need for Controls
a. Primary responsibility for the information in the
financial statements lies with management
(represented by the highest officer of the company and
the highest financial officer)
a. Three important steps to assure investors that the
company’s records are accurate:
i. Maintain a system of controls over both the records
and the assets of the company
ii. Hire outside independent auditors to verify the
fairness of the financial statements
iii. Form a committee of the board of directors to
oversee the integrity of these other safeguards
Chapter 01 – Financial Statements and Business Decisions
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IV. Chapter Supplement A – Types of Business Entities
A. Sole proprietorship – an unincorporated business owned by
one person; usually small in size and common in service,
retailing, and farming industries
1. Legally, the business and the owner are not separate
entities
2. Business is a separate entity for accounting purposes
B. Partnership – an unincorporated business owned by two or
more persons known as partners
1. Agreements between the owners are specified in a
partnership contract, which deals with division of income
and distribution upon termination of operations
2. Partnership is not legally separate from its owners
3. Each partner in a general partnership is responsible for
the debts of the business (unlimited liability)
4. Partnership is a separate entity for accounting purposes
C. Corporation – business incorporated under the laws of a
particular state
1. Ownership is represented by shares of capital stock
2. Stockholders enjoy limited liability and are liable for the
corporation’s debts only to the extent of their investments
3. Stockholders elect a board of directors, which in turn
employs managers and exercises general supervision of
the corporation
4. Corporation is a separate entity for accounting purposes
5. Dominant form of business organization in the U.S.
a. Advantages include:
i. Limited liability for the stockholders
ii. Continuity of life
iii. Ease in transferring ownership (stock)
iv. Opportunities to raise large amounts of money by
selling shares to a large number of people
b. Primary disadvantage is income may be subject to
double taxation (it is taxed when it is earned and again
when it is distributed to stockholders as dividends)
V. Chapter Supplement B – Employment in the Accounting
Profession Today
Use Supplemental
Enrichment Activity #5 or #6
A. Professional designations:
1. Certified Public Accountant (CPA)
a. CPA designation is granted only on completion of
requirements specified by the state that issues the
license
b. Requirements generally include college degree with a
specified number of accounting courses, good
character, one to five years of professional experience,
and successful completion of the CPA exam
2. Certified Management Accountant (CMA )
3. Certified Internal Auditor (CIA )
Chapter 01 – Financial Statements and Business Decisions
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B. Practice of Public Accounting
1. Audit or assurance services – independent professional
services that improve the quality of information, or its
content, for decision makers
2. Management consulting services – usually accounting
based
a. Encompass such activities as the design and
installation of accounting, data processing, and profit-
planning and control systems; financial advice;
forecasting; inventory controls; cost-effectiveness
studies; and operational analysis
b. To maintain independence, CPAs are prohibited from
performing certain consulting services for the public
companies they audit
3. Tax services
C. Employment by Organizations
1. Depending on size and complexity, an organization may
employ from a few to hundreds of accountants
2. Accountants are typically engaged in a wide variety of
activities; primary function is to provide data useful for
internal managerial decision making and for controlling
operations
D. Employment in the Public and Not-for-Profit Sector
1. Perform functions similar to those performed by those in
private organizations
2. Government Accountability Office (GAO) and regulatory
agencies also use the services of accountants
Chapter 01 – Financial Statements and Business Decisions
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Supplemental Enrichment Activities
Note: These activities would be suitable for individual or group activities.
1. Handout 1-1
Use this handout for an in-class activity designed to review the individual financial statements and the
relationships among the financial statements. The solution follows the handout master.
2. Handout 1-2
Use this handout for an in-class activity designed to review the classification of various account
names on the balance sheet. The solution follows the handout master.
3. Handout 1-3
Use this handout for an in-class activity designed to review the classification of various transactions
on the statement of cash flows. The solution follows the handout master.
4. Handout 1-4
Use this handout for an in-class activity designed to review the classification of various accounts,
elements, or transactions on the financial statements. The solution follows the handout master.
5. Consider showing the first segment of following video in class; most students will be able to identify
with the “fraudster.” Lively discussion of the manner in which the fraud was perpetrated will follow.
The National Association of Certified Fraud Examiners produced a video in 1991 called “Cooking the
Books: What Every Accountant Should Know about Fraud”. If you do not have the tape, the toll free
number to order it is 1-800-245-3321 or visit the web site at www.cfenet.com. At this writing, the
cost to a college or university is $139.00 for nonmembers. Three frauds are overviewed: ZZZZ Best
Carpet, Regina Vacuum Cleaner Company, and ESM Group, Inc. (ESM Government Securities).
ZZZZ Best Carpet might be the best one to use. Barry Minkow, the CEO and major stockholder, is
interviewed in prison. The video segment discusses revenue overstatements, deferred costs, asset
valuations, inadequate disclosures, and horizontal and vertical analysis. It is very well done. (Note
that the discussion of ratio analysis and trends would also be appropriate for Chapter 14 – Analyzing
Financial Statements).
6. Handouts 1-5 and 1-6
“Acronym” Game – The business and accounting arenas are inundated with acronyms. Use Handout
1-5, which contains the list of names/terms, and ask them to derive the acronyms. During the next
class, use handout 1-6, which lists the acronyms and ask them to give the name/term represented by
each. This may help them learn these important terms and acronyms without just sitting down to
memorize them. The solution follows the handout masters.