1-1 Notes
CHAPTER 1
INTRODUCTION TO BUSINESS ACTIVITIES AND
OVERVIEW OF FINANCIAL STATEMENTS
AND THE REPORTING PROCESS
I. Learning Objectives
1. Understand four principal activities of business entities: (a) establish goals
and strategies, (b) obtain financing, (c) make investments, and (d) conduct
operations.
2. Understand the purpose and content of the principal financial statements:
(a) balance sheet, (b) income statement, and (c) statement of cash flows, and
(d) statement of shareholders’ equity.
3. Understand the roles of participants in the financial reporting process,
including managers and governing boards, accounting standard setters and
regulators, independent external auditors, and financial statement users.
4. Gain an awareness of financial reporting as part of a global system for
providing information for resource allocation decisions, including the
existence of two financial reporting systems (U.S. GAAP and International
Financial Reporting Standards).
5. Understand the difference between the cash basis and the accrual basis of
accounting, and why the latter provides a more informative measure of
performance.
II. Organization of Class Sessions
Coverage of this chapter requires three class sessions. However, if students
have read the first chapter prior to the initial class meeting, one session should
be sufficient. We proceed with the assumption that the latter is generally not
the case and the instructor devotes two class sessions to this chapter.
During the first class session, we overview the principal activities of a
business and the content of the four principal financial statements. We provide
each student with a recent copy of the annual report of a publicly-held
corporation. We select a firm whose annual report is not too complicated and is
likely to be of interest to students (for Example, Microsoft, PepsiCo, Nike,
McDonalds). The annual reports of most corporations are available online.
Students seem to appreciate the immediate link with the real world as they begin
their study of accounting. We consider the four statements separately and
discuss the types of information each attempts to convey, continually relating
each financial statement to the principal activities of a business. Efforts to show
Notes 1-2
the relations among the four financial statements during the first class session
are likely to be ineffective. The students’ subsequent reading of the chapter
serves to reinforce the points made and provides them with a head start as they
prepare for the second class session.
During the second class session, we examine the content of each of the four
principal financial statements in greater depth and the relations between the
statements. Because most students at the introductory accounting level learn by
doing, we use several of the numerical exercises and problems at the end of the
chapter. These exercises and problems emphasize particular concepts within, or
relations between, the four principal financial statements and are
straightforward; by referring to material in the chapter, students would
experience little difficulty in solving them.
During the second class session, we also develop students’ sensitivity to the
financial reporting environment. Most students begin their study of financial
accounting with a sense that accountants follow precise rules and procedures to
develop exact and unambiguous financial statements. We use several questions
at the end of the chapter to communicate the nature of accounting standards and
the standard-setting process.
III. Lecture Outline
1. Understand four principal activities of business entities: (a) establish
goals and strategies, (b) obtain financing, (c) make investments, and
(d) conduct operations.
The initial course in financial accounting serves not only as an
introduction to the concepts, procedures, and uses of financial accounting but
also as an introduction to business. The course introduces students to
business terminology and to the roles of marketing, finance, operations, and
other activities in running a business.
Begin by displaying the diagram of the four principal business activities
(Exhibit 1.1 in this instructor’s manual). Using the company’s annual report
which was distributed to students, raise the following questions:
A. What is the likely goal of the firm? (make the shareholders wealthy,
make the managers wealthy, provide jobs, or enhance community
welfare)
B. What strategies might the firm pursue to accomplish this goal? (price its
products low relative to competitors to achieve dominant market share,
invest in technology to achieve status as a technology leader in the
industry, diversify product lines into high growth product markets, or
diversify geographically into high growth geographical markets)
1-3 Notes
C. What sources of capital, or funds, might the firm access to finance its
activities? (investors who wish to obtain an ownership interest in the
firm [shareholders], lenders who wish their funds returned with interest
either relatively quickly [short-term creditors] or several years later
[long-term creditors])
D. How might the firm use the capital it obtains? (invest in land, buildings,
equipment, products, employees, or advertising)
E. How will the firm use the investments to generate a profit? (conduct
manufacturing, marketing, and related operations to produce and sell a
good or service)
2. Understand the purpose and content of the principal financial
statements: (a) balance sheet, (b) income statement, and (c) statement
of cash flows, and (d) statement of shareholders’ equity.
We use the financial statements distributed to students or the financial
statements of Nordstrom, Inc. from Chapter 1 (Exhibits 1.1, 1.2, 1.3, and 1.4)
to address the following questions:
A. Balance Sheet
1. What information does the statement attempt to convey? (relation
2. Is this statement a report as of a point in time or of activity over time?
3. What are the components or basic classifications within the balance
4. What is the relation between these components? (assets = liabilities +
shareholders’ equity)
5. What is the interpretation of this relation? (investing = financing)
6. Are the assets listed in increasing or decreasing order of liquidity?
7. What valuation methods does the firm use to prepare its balance
sheet? (current cash equivalent valuation or acquisition cost
valuation)
8. What valuable resources of a firm does the balance sheet exclude?
B. Income Statement
1. What information does the income statement convey? (the results of
operating performance)
Notes 1-4
2. Why use net income as the measure of operating performance?
3. Is the income statement a report as of a point in time or of activity
over time? (over time)
4. What are the components of the statement? (revenues, expenses and
net income)
5. What is the numerical relation between these components? (net
6. What is the interpretation of this relation? (operating performance is
a function of accomplishments, or outputs, and efforts, or inputs)
7. How are revenues and expenses measured? (current cash equivalent
amount or allocation of acquisition cost amount)
8. What items affecting profitability does the income statement exclude?
C. Statement of Cash Flows
1. What information does this statement convey? (the principal reasons
2. Is the statement of cash flows a report as of a point in time or of
activity over time? (over time)
3. What are the components of the statement? (net cash flows from
D. Statement of Shareholders’ Equity
1. What information does this statement convey? (displays components
of shareholders’ equity, including common shares and retained
earnings, and changes in those components)
2. Is the statement of shareholders’ equity a report as of a point in time
or of activity over time? (a point in time, a snap shot)
We conclude the first class session at this point. We begin the second class
session by displaying the relation among the four principal financial
1-5 Notes
sequence of topics appears below, with the number of relevant exercises in
parentheses.
1. Balance sheet relations (Exercises 1.18, 1.21, 1.22, 1.29, and 1.30)
2. Income statement relations (Exercises 1.19, 1.23, 1.24)
3. Statement of cash flow relations (Exercises 1.20, 1.27, and 1.28)
Instructors of honors undergraduate or of graduate classes may wish to
substitute problems at the end of the chapter for the exercises noted above.
Problems 1.33, and 1.34 relate to the balance sheet, Problems 1.35, and 1.36
relate to the income statement, Problems 1.37, and 1.38 relate to cash flows
and Problems 1.39, 1.42 and 1.43 relate to the principal financial statements
and require interpretation of the resulting analyses.
3. Understand the roles of participants in the financial reporting
process, including managers and governing boards, accounting
standard setters and regulators, independent external auditors, and
financial statement users.
A. Managers and Governing Boards
i. Role of managers (safeguarding and properly using the firm’s
resources)
ii. Role of governing board (selecting, compensating, and overseeing
managers; setting dividend policy; and making decisions on major
issues)
B. Accounting Standard Setters and Regulators
Role (receive input from all interested constituencies; and make
standard-setting decisions)
C. Independent External Auditors
Role (assessment of financial statements; preparing audit opinion;
and provide a report on internal control effectiveness.)
D. Users of Financial Statements
Includes investors, creditors, and other users.
3. Gain an awareness of financial reporting as part of a global system
for providing information for resource allocation decisions,
including the existence of two financial reporting systems (U.S.
GAAP and International Financial Reporting Standards).
It must be explained to the students that, the applicable accounting
guidance for preparing financial reports of U.S. firms is U.S. GAAP.
The students should know:
Notes 1-6
D. The FASB’s conceptual framework should be explained
5. Understand the difference between the cash basis and the accrual
basis of accounting, and why the latter provides a more informative
measure of performance.
These are the approaches to measure operating performance.
1-7 Notes
EXHIBIT 1.1
PRINCIPAL BUSINESS ACTIVITIES
Conducting
Operations
Obtaining
Financing
Establishing
Goals and
Strategies
Making
Investments
EXHIBIT 1.2
OVERVIEW OF PRINCIPAL FINANCIAL
STATEMENT
Balance Sheet
at Beginning of
Period
Changes in Balance Sheet
During the Period
Balance Sheet
at End of
Period
Assets
Assets
Cash
Statement of Cash Flows
for the Period
Cash Flows from Operating
Investing and Financing
Activities
Cash
+
Other Assets
=
Total Assets
Liabilities
+
Shareholders’
Equity
+
Other Assets
=
Total Assets
Liabilities
+
Shareholders’
Equity
Common Stock
Common Stock
+
Retained
Earnings
Income Statement for the
Period
Revenues – Expenses =
Net Income
Net Income – Dividends
+
Retained
Earnings
=
Total
Liabilities
and
Shareholders’
Equity
=
Total
Liabilities
and
Shareholders’
Equity
1-9 Notes
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