Chapter 1: Introduction to Financial Statements Study Guide (Vocabulary Flashcards)

Chapter 1: Introduction to Financial Statements

• Learning Objectives

  • Identify the forms of business organization and the uses of accounting information.
  • Explain the three principal types of business activity.
  • Describe the four financial statements and how they are prepared.

• Main idea: 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.

• Users of accounting information

  • Internal: Managers, directors, supervisors
  • Use: Answer questions relevant to their jobs
  • External: Investors, creditors, government authorities
  • Use: Make investing decisions, evaluate lending risks, ensure regulatory compliance

• Data Analytics in accounting

  • Involves analyzing data using software and statistics to draw inferences.
  • Four types of data analytics:
  1. Descriptive
  2. Diagnostic
  3. Predictive
  4. Prescriptive

• Ethics in Financial Reporting (SOX)

  • Sarbanes-Oxley Act (SOX) purpose and key provisions:
  1. Top management must certify financial statements.
  2. Increased penalties for fraudulent activity.
  3. Increased independence of outside auditors.
  • Effective financial reporting depends on sound ethical behavior.

• Learning Objective 2: Explain the three principal types of business activity

  • Three types of business activities and examples:
  • Financing: Raising money from outside sources.
    • Primary sources: Debt financing (Borrowing Money), Equity financing (Issuing Stock)
  • Investing: Purchasing the resources (assets) needed to operate
    • Examples: Land, equipment
  • Operating: Day-to-day operations to produce/sell a product or service
    • Examples: Selling products/services (revenues) and Incurring costs (expenses)

• Matching terms with definitions (Assets, Liabilities, Stockholders’ Equity) [[Definition A-F]]

  • Assets → C. Resources owned by a business
  • Liabilities → E. Amounts owed to creditors in the form of debts and other obligations
  • Stockholders’ Equity → B. The Owners’ claim to assets
  • Revenues → F. An increase in assets or decrease in liabilities resulting from the sale of goods or the performance of services in the normal course of business
  • Expenses → A. The cost of assets consumed or services used in the process of generating revenues
  • Dividends → D. Payment of cash from a corporation to its stockholders

• Learning Objective 3: Describe the four financial statements and how they are prepared

  • Name, Definition, Components, Time span
  • Income Statement
    • Definition: Shows how successful your business performed, i.e., reports revenues, expenses, and net income (or net loss).
    • Components: Revenues, Expenses, Net Income (Net Loss)
    • Time span: For a period
  • Statement of Retained Earnings
    • Definition: Indicates how much of previous income was distributed to owners and how much was retained for future growth.
    • Components: Beginning Retained Earnings, Add: Net Income, Less: Dividends, Ending Retained Earnings
    • Time span: For a period
  • Balance Sheet
    • Definition: Gives a picture at a point in time of what your business owns and what it owes.
    • Components: Assets, Liabilities, Stockholders’ Equity
    • Time span: At a date
  • Statement of Cash Flows
    • Definition: Reports about cash receipts and cash payments.
    • Components: Cash flows from Operating, Investing, Financing; Net increase/decrease in cash
    • Time span: For a period

• Basic accounting equation

  • ext{Assets} = ext{Liabilities} + ext{Stockholders' Equity}

• Review DO IT! prompts mentioned in the chapter (1a, 1b, 3a, 3b) as practice exercises on forms of business, use of financial information, and components of the annual report.

• Elements of the Annual Report (Definition and purpose)

  • 1. Financial Statements
  • The four financial statements that should be in an annual report: Income Statement, Statement of Retained Earnings, Balance Sheet, Statement of Cash Flows
  • 2. Management’s Discussion and Analysis (MD&A)
  • Management’s views on:
    • Ability to pay short-term obligations
    • Ability to fund operations and expansion
    • Results of Operations
  • 3. Notes to the financial statements
  • Notes clarify financial statements and provide additional information
  • 4. Auditor’s Report
  • Report prepared by independent outside auditors as to the fairness of the presentation of the financial statements

• Shaw’s Garden in-class exercise (P1-3B)

  • Scenario: Shaw’s Garden started on May 1 with an investment of $45,000 cash.

  • Given (as of May 31, 2025):

  • Assets: Accounts Receivable $8,400; Equipment $58,800; Cash $10,800

  • Liabilities: Notes Payable $26,000; Accounts payable $4,400

  • Stockholders’ Equity: Common stock $45,000

  • Revenues: Service Revenue $10,400

  • Expenses: Salaries and wages $1,900; Advertising $1,800; Maintenance and repairs $2,100; Insurance $400

  • Dividends: $1,600

  • Instructions:

  • (a) Prepare an income statement and a retained earnings statement for May, and a balance sheet as of May 31, 2025.

  • (b) Discuss whether May was a successful first month of operations.

  • (c) Discuss the company’s decision to distribute a dividend.

  • Calculations and solutions (worked outline below):

  • Revenues: $10,400

  • Expenses: $1,900 + $1,800 + $2,100 + $0? + $400 = $6,200

    • Note: Insurance expense is included in expenses; there is no other expense listed.

  • Net Income: ext{Net Income} = ext{Revenues} - ext{Expenses} = 10{,}400 - 6{,}200 = 4{,}200

  • Beginning Retained Earnings (May 1, 2025) = $0 (new company)

  • Dividends = 1{,}600

  • End Retained Earnings = Beginning RE + Net Income − Dividends = 0 + 4{,}200 - 1{,}600 = 2{,}600

  • Balance Sheet as of May 31, 2025 (Assets = Liabilities + Stockholders’ Equity)

    • Assets: Cash $10,800; Accounts Receivable $8,400; Equipment $58,800
    • Total Assets = 10{,}800 + 8{,}400 + 58{,}800 = 78{,}000
    • Liabilities: Notes Payable $26,000; Accounts payable $4,400
    • Total Liabilities = 26{,}000 + 4{,}400 = 30{,}400
    • Stockholders’ Equity: Common stock $45,000; Retained earnings $2,600
    • Total SE = 45{,}000 + 2{,}600 = 47{,}600
    • Verification: Assets (78,000) = Liabilities (30,400) + SE (47,600) → 78,000 = 78,000

• Summary takeaway from Shaw’s Garden exercise

  • The first month shows a positive net income of $4,200, indicating operational earning capability.
  • Dividends of $1,600 reduce retained earnings and reflect distribution of profits to shareholders.
  • The balance sheet reflects the initial investment plus subsequent activity, keeping the accounting equation in balance.

• Additional notes

  • Note the connection between the three activities (Financing, Investing, Operating) and how they impact the four financial statements over time.
  • Recognize that the four financial statements provide a complete view when analyzed together: the income statement shows performance, the retained earnings statement shows distribution vs. retention, the balance sheet shows financial position at a date, and the statement of cash flows shows cash movements.