Chapter 1 Notes: Financial Statements and Decision Makers

Learning Objectives

• After studying this chapter, you should be able to:
  • 1-1 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 Identify the role of generally accepted accounting principles (GAAP) in determining financial statement content.

The Four Basic Financial Statements: An Overview

• Balance Sheet – reports the financial position (amounts of assets, liabilities, and stockholders’ equity) of an accounting entity at a point in time.
• Income Statement – reports the revenues less the expenses during the accounting period.
• Statement of Stockholders’ Equity – reports the changes in each of the company’s stockholders’ equity accounts, including the change in the retained earnings balance caused by net income and dividends, during the reporting period.
• Statement of Cash Flows – reports inflows and outflows of cash during the accounting period in the categories of operating, investing, and financing.
• The notes are an integral part of these financial statements.

Business Activities

• Financing Activities
• Investing Activities
• Operating Activities

Why Study Financial Accounting?

• Decision makers rely on financial information:
  • Investors
  • Creditors
  • Managers within the firm such as:
  • Marketing managers
  • Credit managers
  • Supply chain managers
  • Human resource managers

Your Goals for Chapter 1

• Focus your attention on learning the:
  • Content: the categories, or elements, reported on each of the four statements.
  • Structure: the equation that shows how the elements within the statement are organized and related.
  • Use: how the information is used by stockholders and creditors to make investment and lending decisions.
• Note: Rather than trying to memorize the definitions of every term used in this chapter, focus on learning the general content, structure, and use of the statements.

The Four Basic Financial Statements: An Overview (continued)

• Balance Sheet – financial position at a point in time; assets, liabilities, stockholders’ equity.
• Income Statement – revenues minus expenses over a period.
• Statement of Stockholders’ Equity – changes in stockholders’ equity accounts during the period.
• Statement of Cash Flows – cash inflows and outflows categorized as operating, investing, financing.
• The notes are an integral part of these statements.

Time Period & Structure

• The four basic financial statements can be prepared at any point in time such as:
  • End of the year (for the year ended, annual reports)
  • Quarterly (for the quarter ended, quarterly reports)
  • Monthly (for the month ended, monthly reports)
• The financial statement heading includes:
  • Name of the entity (Company name)
  • Title of the statement (e.g., Balance Sheet)
  • Specific date of the statement (e.g., At December 31, 2020)
  • Unit of measure (in millions of dollars)

Balance Sheet

• Elements of the Balance Sheet:
  • Assets: Cash, Short-Term Investments, Accounts Receivable, Notes Receivable, Inventories, Supplies, Prepaid Expenses, Long-Term Investments, Equipment, Buildings, Land, Intangibles
  • Liabilities: Accounts Payable, Accrued Expenses, Notes Payable, Taxes Payable, Unearned Revenue, Bonds Payable
  • Stockholders’ Equity: Common Stock, Retained Earnings
• The Balance Sheet is a financial snapshot at a specific point in time.

The Basic Accounting Equation

• The basic accounting equation refers to a company’s financial position: the economic resources that the company owns and the sources of financing for those resources.
• Core representation:
  • $Assets = Liabilities + Stockholders' Equity.$

Interpreting the Balance Sheet

• Creditors and shareholders analyze assets to determine if the company has sufficient resources available to operate.
• Assets can be sold for cash if the company goes out of business.
• Creditors are concerned about whether the company has sufficient sources of cash to pay its liabilities (debts).
• If a company does not pay its creditors, the creditors can force the sale of assets.
• Stockholders’ Equity is a protective “cushion” to creditors because the creditors’ claims legally come before those of the owners.
• If the company goes out of business and its assets are sold, the creditors are paid back before the shareholders receive any money.

Income Statement

• Revenues: cash and promises received from delivery of goods and services. Examples include:
  • Sales Revenue, Service Revenue, Rental Revenue, Interest Revenue
• Expenses: resources used to earn period’s revenues. Examples include:
  • Cost of Goods Sold, Wages Expense, Rent Expense, Depreciation Expense, Insurance Expense, Repair Expense, Income Tax Expense
• Elements of the Income Statement – the Income Statement is a measure of performance of the business.

The Income Statement Equation

• $Revenues - Expenses = Net Income$
• Resources earned from delivery of goods and services
• If total expenses exceed total revenues, a net loss is reported.
• Revenues earned minus expenses incurred. Also called “profit”, “net earnings”, or “the bottom line.”

Interpreting the Income Statement

• Investors and creditors closely monitor a firm’s net income because it indicates the firm’s ability to sell goods and services for more than they cost to produce and deliver.
• Investors buy stock when they believe that future earnings will improve and lead to dividends and the ability to sell their stock for more than they paid.
• Lenders rely on future earnings to provide the resources to repay loans.
• The income statement helps investors and creditors estimate the company’s future earnings.

Statement of Stockholders’ Equity

• Common Stock:
  • Beginning Common Stock, + Stock Issuance, Ending Common Stock
• Retained Earnings:
  • Beginning Retained Earnings + Net Income − Dividends = Ending Retained Earnings
• Elements of the Statement of Stockholders’ Equity – the statement reports the change in each stockholders’ equity account during the period.

Exhibit 1.4 Statement of Stockholders’ Equity

Interpreting Retained Earnings

• Reinvestment of earnings, or retained earnings, is an important source of financing for companies.
• Creditors closely monitor a firm’s statement of stockholders’ equity because the company’s policy on dividend payments affects its ability to repay its debts.
  • Every dollar the company pays to stockholders as a dividend is not available for use in paying back its debt.
• Investors examine retained earnings to determine whether the company is reinvesting a sufficient portion of earnings to support future growth.

Exhibit 1.5 Relationship Among LeNature’s Statements

Statement of Cash Flows (1 of 2)

• +/− Cash Flows from Operating Activities (CFO)
• +/− Cash Flows from Investing Activities (CFI)
• +/− Cash Flows from Financing Activities (CFF)
• Change in Cash + Beginning Cash Balance Ending Cash Balance
• Note that each of the three cash flow sources can be positive (net cash inflow) or negative (net cash outflow)
• +/−

Statement of Cash Flows (2 of 2)

• Cash Flows from Operating Activities: Cash flows directly related to earning income, such as cash collected from customers less cash paid for operating expenses, such as cash paid to suppliers and employees.
• Elements of the Statement of Cash Flows
  • Cash Flows from Investing Activities: Cash flows related to acquisition or sale of the company’s plant and equipment and investments.
  • Cash Flows from Financing Activities: Cash flows directly related to the financing of the enterprise, such as the receipt or payment of money to investors and creditors (except suppliers)
• The Statement of Cash Flows reports inflows and outflows of cash during the accounting period.

Exhibit 1.6 Statement of Cash Flows

Interpreting the Cash Flow Statement

• Analyze operating cash flow to check the company’s ability to:
  • Pay back bank debt
  • Expand the company
  • Distribute cash dividends to shareholders
• The Operating Activities section is thought to be the most important because it indicates the company’s ability to generate cash from sales to meet its current cash needs.

Notes (or Footnotes)

• Did you notice this sentence at the bottom of each financial statement?
  • “The notes are an integral part of these financial statements.”
• All financial statements should be accompanied by notes that provide the reader with supplemental information to help the reader better understand the financial statements.

Financial Statement Formats

• Place a single underline below the last item in a group before a total or subtotal, and a double underline below the group totals.
• Assets are listed on the balance sheet by ease of conversion to cash.
• Liabilities are listed by the maturity (due date).
• Include the monetary unit sign ($) beside the first dollar amount in a group of items and by group total.

Exhibits

• Exhibit 1.2 Balance Sheet
• Exhibit 1.3 Income Statement
• Exhibit 1.4 Statement of Stockholders’ Equity
• Exhibit 1.5 Relationship Among LeNature’s Statements
• Exhibit 1.6 Statement of Cash Flows
• Exhibit 1.7 Summary of the Four Basic Financial Statements

Notes Summary

• The four basic financial statements, their purpose, structure, and users.
• How they interrelate through the basic accounting equation and retained earnings.
• The importance of notes and format conventions for accurate interpretation.
• How decision makers use each statement to assess liquidity, solvency, profitability, and financial flexibility.

Key Formulas

• Basic Accounting Equation: $Assets = Liabilities + Stockholders' Equity.$
• Income Statement: $Revenues - Expenses = Net Income.$
• Retained Earnings: Ending
  etained ext{ Earnings} = Beginning
  etained ext{ Earnings} + Net ext{ Income} - Dividends.
• Common Stock movement: $Beginning ext{ Common Stock} + Stock ext{ Issuance} = Ending ext{ Common Stock}.$
• Cash Flow: $Ending ext{ Cash} = Beginning ext{ Cash} + CFO + CFI + CFF.$