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CHAPTER 1
Introduction to
Financial Statements
Learning 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
Learning 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 (Examples include hair salons,
auto repair shops, and free-lance editors)
▪ Advantages
o simple to establish
o owner controlled
o tax advantages that are more favorable than a corporation
▪ Disadvantages
o proprietor personally liable for all business debts
o financing may be difficult
o transfer of ownership may be difficult
Partnership – a business owned by two or more people (Examples include retail and
service type businesses including professional practices (lawyers,
doctors, etc.)
▪ Advantages
o simple to establish
o shared control
o broader skills and resources
o tax advantages that are more favorable than a corporation
▪ Disadvantages
o partners personally liable for all business debts
o transfer of ownership may be difficult
Corporation – a separate legal entity owned by stockholders (Examples include Coca-
Cola, Exxon-Mobil, General Motors, Citigroup, and Microsoft)
▪ Advantages
o easier to transfer ownership
o easier to raise funds
o no personal liability for stockholders
▪ Disadvantages
o 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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TEACHING TIP
There is a passage in the text that states, “The combined number of proprietorships and
TEACHING TIP
There are hybrid business forms which combine the tax advantages of partnerships with
Learning 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 accounting information fall into two groups—internal users and external
users.
Internal users – users within the organization. Internal users and questions they
may ask:
Marketing
What price will maximize the company’s net income?
Human Resources
Can we afford to give employees pay raises this year?
Finance
Is cash sufficient to pay dividends to stockholders?
Management
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)
Is the company earning satisfactory income?
How does the company compare in size and
profitability with competitors? Should I buy, sell, or
hold this stock?
Creditors (suppliers and
bankers)
come due? How risky is this company?
Will the company be able to stand behind its
warranties?
Will the company be able to pay its debts as they
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Ethics in financial reporting (How would you like to do business or invest in a
business if you couldn’t trust their financial
statements?)
▪ In 2002, Congress passed the Sarbanes-Oxley Act (SOX) to reduce unethical
corporate behavior and decrease the likelihood of future corporate scandals. As
a result of SOX:
o Top management must now certify the accuracy of financial information
o The penalties for fraudulent financial activity are much more severe
TEACHING TIP
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Learning 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 liabilities
o bank loan (note payable)
TEACHING TIP
At this point, ask students to assume they have extra money to invest and ask them how
they would prefer to invest the money. Would they consider loaning money to a corporation
or would they rather buy shares of stock in the company? Then ask students why they made
the decision to lend or buy.
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, furniture, etc.).
Operating activities – Once a business has the assets it needs to get started, it begins
its operations. Operating activities involve revenue and expenses.
▪ Revenue is the increase in assets resulting from the sale of goods or the
performance of services – Sources of revenue common to many businesses are
sales revenue, service revenue, and interest revenue. Assets that result from
TEACHING TIP
Stress the fact that just because a business is making money is no reason to assume that
the business has a lot of money in the bank. Focus students’ attention on the three types of
business activity and let them think about what could have happened to the money the
business has made. You might also ask students how a business reporting a net loss could
have money in the bank.
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TEACHING TIP
Learning Objective 4 – Describe the Content and Purpose of Each of the
Financial Statements.
Accounting information is communicated through four different financial statements:
Income Statement
▪ Reports the success or failure of the company’s operations for a period of time.
▪ 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).
o Dividends are payments to the stockholders and are not expenses.
o Amounts received from issuing stock or obtaining loans are not revenues.
Retained Earnings Statement
▪ Reports the amount paid out in dividends and the amount of net income or net loss
for a specific period of time.
Learning Objective 5 – Explain the Meaning of Assets, Liabilities, and
Stockholders’ Equity, and State the Basic
Accounting
Equation.
Balance Sheet
▪ Shows the relationship between assets and claims on assets which include
liabilities (claims of the creditors) and stockholders’ equity (claims of the owners)
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TEACHING TIP
Give examples of assets (i.e. cash, accounts receivable, inventories, furniture and fixtures,
and equipment. Explain the difference between accounts receivable and notes receivable.
TEACHING TIP
▪ Liabilities – creditors claims on total assets (obligations or debts of the business)
TEACHING TIP
The difference between accounts payable and notes payable should be made clear.
▪ Stockholders’ Equity – ownership claim on total assets
TEACHING TIP
Statement of Cash Flows
▪ Provides information about cash receipts and cash payments for a specific period of
time.
▪ 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 the increase or decrease in cash as well as the ending cash balance.
▪ Provides answers to three important questions:
o Where did the cash come from during the period?
o How was cash used during the period?
o What was the change in the cash balance during the period?
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Interrelationship of Statements
▪ Retained earnings statement uses the results of the income statement.
▪ Balance sheet and retained earnings statement are also interrelated. The retained
earnings amount on the balance sheet is the ending amount on the retained
earnings statement.
▪ Statement of cash flows relates to balance sheet information. It shows how the Cash
account changed during the period.
TEACHING TIP
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Learning Objective 6 – Describe the Components that Supplement the
Financial Statements in an Annual Report.
Publicly traded U.S. Companies that are must 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:
▪ Its ability to pay near-term obligations
▪ Its ability to fund operations and expansion
▪ Its results of operations
Notes to the Financial Statements
▪ Clarify information presented in the financial statements
▪ Provide additional detail (i.e. Describe accounting policies or explain uncertainties
and contingencies)
Auditor’s Report
opinion.
▪ If the auditor doesn’t express an unqualified opinion, users of the financial
statements are skeptical that the statements give an accurate picture of the firm’s
financial health.
TEACHING TIP
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IFRS
A Look at IFRS
Most agree that there is a need for one set of international accounting standards.
Here is why:
Multinational corporations. Today’s companies view the entire world as their
market. For example, Coca-Cola, Intel, and McDonald’s generate more than 50% of
their sales outside the United States, and many foreign companies, such as Toyota,
Nestle, and Sony, find their largest market to be the United States.
Mergers and acquisitions. The mergers between Fiat/Chrysler and
Vodafone/Mannesmann suggest that we will see even more such business
combinations in the future.
KEY POINTS
▪ International standards are referred to as International Financial Reporting
Standards (IFRS), developed by the International Accounting Standards Board
(IASB). Over 115 countries require or permit use of IFRS.
▪ Recent events in the global capital markets have underscored the importance of
financial disclosure and transparency not only in the United States but in markets
around the world. As a result, many are examining which accounting and
financial disclosure rules should be followed.
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the higher costs of SOX compliance are making the U.S. securities markets less
competitive.
▪ The textbook mentions a number of ethics violations, such as Enron,
WorldCom, and AIG. These problems have also occurred internationally, for
example, at Satyam Computer Services (India), Parmalat (Italy), and Royal
Ahold (the Netherlands).
▪ IFRS tends to be simpler in its accounting and disclosure requirements; some
people say it is more “principles–based.” GAAP is more detailed; some people
say it is more “rules–based.” This difference in approach has resulted in a
debate the merits of “principles–based” versus “rules–based” standards.
▪ U.S. regulators have recently eliminated the need for foreign companies that
trade shares in U.S. markets to reconcile their accounting with GAAP.
Assets. A resource controlled by the entity as a result of past events and
from which future economic benefits are expected to flow to the entity.
Liabiliites. A present obligation of the entity arising from past events, the
settlement of which is expected to result in an outflow from the entity of
resources embodying economic benefits. Liabilities may be legally
enforceable via a contract or law, but need not be, i.e., they can arise due to
normal business practice or customs.
Equity. A residual interest in the assets of the entity after deducting all its
liabilities.
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LOOKING TO THE FUTURE
Both the IASB and the FASB are hard at work developing standards that will lead to the
elimination of major differences in the way certain transactions are accounted for and
reported. In fact, at one time the IASB stated that no new major standards would
become effective until 2009. The major reason for this policy was to provide companies
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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.