CHAPTER 1

CHAPTER 1

FINANCIAL STATEMENTSAND BUSINESS DECISIONS

I. The Accounting System

a.Managerial accounting systems prepare reports for internal decision

makers (managers).

b.Financial accounting systems prepare reports for external decision makers (investors, creditors, suppliers, and customers).

IITHE FOUR BASIC FINANCIAL STATEMENTS: AN OVERVIEW

A.The Balance Sheet

1.Structure

a.Company name - the accounting entity (separate entity assumption).

b.Title - Balance Sheet or Statement of Financial Position.

c.Date - at a point in time.

d.Unit of measure - U.S. dollars, Mexican pesos, etc., which may be presented in thousands, millions of dollars, pesos, etc.

2.Formats

a.Side by side - Assets on the left and liabilities & stockholders' equity on the right.

b.Top down - Assets at the top and liabilities & stockholders' equity at the bottom.

c. Assets are presented in the order of liquidity. Liabilities are listed in the order of their maturity dates.

d. Use of dollar signs, underscores, and double underscores on all financial statements.

3. Basic Accounting Equation (Balance Sheet Equation)

A=L + SE

Economic resources=Sources of financing

What you have=Where it came from

A L=SE

Net assets=Owners equity or residual equity

4.Elements

a.Assets (A)

Assets are economic resources owned by the company as a result of past transactions.

They represent economic resources expected to provide future benefits to the company. Examples - cash, accounts receivable, inventories, plant and equipment, etc.

Initial recording is at the original cost to acquire it (cost principle).

b.Liabilities (L)

Liabilities are amounts owed by the company as a result of past transactions.

c.Stockholders' Equity (SE)

Stockholders' Equity results from two basic categories:

Contributed Capital (CC) - amounts invested by the owners.

Retained Earnings (RE) - accumulations of undistributed earnings(amounts earned by the company reduced by previous dividends).

Owners of corporate stock are generally not personally liable for the company's debts.

B.The Income Statement

1.Structure

a.Company name -the accounting entity (separate entity assumption).

b.Title - Income Statement or Statement of Earnings or Profit & Loss Statement.

c. Date - for a specified time period ended on the balance sheet date (an accounting period).

d. Unit of measure - U. S. dollars, Mexican pesos, etc., which may be expressed in thousands, millions of dollars, pesos, etc.

2.The income statement equation is: NI =R - E

3.Elements

a.Revenues (R)

These are inflows of net assets from the sale of goods or services in the normal course of business. The inflows may be cash or accounts receivable (the promise of future payments from customers).

Revenue recognition is in the period that goods or services are sold. This may not be the same period as the collection for those goods or services.

b. Expenses (E)

These are outflows of net assets representing resources used to earn the revenues during the period.

Examples:

Cost of Goods Sold (CGS) expenses - the costs to buy goods for

resale or to make the goods that are sold.

Selling, General & Administrative expenses - other expenses incurred by the company not directly related to the product costs.

- Expense recognition is in the period incurred to earn revenues (the matching principle). This may not be the same period that the payment for the expense is made.

c. Net Income (NI)

This is also called net earnings, profits, or bottom line.

If revenues exceed expenses, net income (NI) results.

If revenues are less than expenses, net loss (NL) results.

If revenues equal expenses, breakeven results.

C.The Statement of Retained Earnings (this information may be contained in the Statement of Stockholders Equity)

1.Structure

a.Company name - the accounting entity (separate entity assumption)

b.Title - Statement of Retained Earnings

c.Date - for a specified time period ended on the balance sheet date (an accounting period)

d.Unit of measure - U.S. dollars, Mexican pesos, etc., which may be expressed in thousands, millions of dollars, pesos, etc.

e.This statement shows increases and decreases to the retained earnings account for the period.

2. Elements

Ending RE = Beginning RE + NI or ( -NL) - Dividends Declared

D.The Statement of Cash Flows

1.Structure

a.Company name - the accounting entity (separate entity assumption)

b.Title - Statement of Cash Flows

c.Date - for a specified time period ended on the balance sheet date (an accounting period)

d.Unit of measure - U.S. dollars, Mexican pesos, etc., which may be expressed in thousands, millions of dollars, pesos, etc.

e. This is the only financial statement prepared on the cash basis rather than on the accrual basis.

2.Elements

a.This statement shows cash inflows (receipts) and cash outflows (payments).

b. Three categories are used to classify these cash flows.

Operating activities - directly related to normal business activities.

Investing activities - acquisitions and sales of plant and equipment, intangibles, and other investment assets.

Financing activities - involves dealings with the company owners and lenders.

3. Combining the three categories of net cash inflows and outflows indicates the change in cash during the period.

E. Relationships Among the Statements

1.The four financial statements are related to one another.

a.Net income from the income statement is shown as an increase to RE (or net loss is a decrease to retained earnings).

b.Ending retained earnings from the statement of retained earnings appears in the SE section of the balance sheet.

c.The statement of cash flows relates to last year's balance sheet (beginning cash balance) and to the current balance sheet (ending cash balance).

F.The Notes

1.These are an integral part of the financial statements. The statements cannot be adequately interpreted without reading the supplemental information in these notes (footnotes).

2.There are three basic types of notes.

a.Descriptions of accounting rules applied in the financial statements.

b.Details about line items in the statements.

c.Disclosures about items not listed in the statements.