Chapter1

Chapter 1: Financial Statements & Business Decisions


1-1: Recognize the information conveyed in each of the 4 basic financial statements and the way they are used by different decision makers (investors, creditors, managers)


  1. Balance Sheet: Statement of financial position that reports dollar amounts for assets, liabilities & stockholders’ equity @ a stated point in time

    1. Assets = Liabilities + Stockholders’ Equity (Common Stock + Retained Earnings)


  1. Income Statement: Statement of operations that reports revenues, expenses, & net income @ a stated period of time

    1. Revenues - Expenses = Net Income / Net Loss


  1. Statement of Stockholders’ Equity: Explains changes in SHE accounts (common stock & retained earnings) @ stated period of time

    1. Beginning Balance + Increases - Decreases = Ending Balance

    2. Beginning CS + Stock Issuance = Ending CS

    3. Beginning RE + Net Income - Dividends = Ending RE


  1. Statement of Cash Flows: Reports cash inflows & outflows @ a stated period of time

    1. +/Cash Flows from Operating, Investing, Financing Activities = Net Change in Cash


1-2: Identify the role of generally accepted accounting principles (GAAP) in determining financial statement content & managers’, directors’, and auditors’ responsibilities for ensuring accuracy of financial statements


  1. GAAP: Measurement rules used to develop information in financial statements 

  2. Management has the responsibility for the accuracy of a company’s financial information

  3. Auditors have the responsibility to evaluate/verify the fairness of financial statement presentations

  4. Ethical behavior and competence is important for reputations




Questions

  1. Define accounting.

    1. A system that collects & processes (analyzes, measures, and records) financial information about an organization & reports the information to decision makers

  1. Distinguish financial accounting from managerial accounting.

    1. Financial accounting prepares financial reports for external users and follows GAAP

    2. Managerial accounting: provides reports for internal users and doesn’t need to follow GAAP

  1. Identify internal and external users of financial reports. 

    1. External users: investors, creditors, regulators (SEC), suppliers, customers 

    2. Internal users: management, employees

  1. Briefly distinguish investors from creditors.

    1. Investors provide funds in exchange for ownership

      1. Interested in profitability & growth

    2. Creditors lend money to a business

      1. Interested in company’s ability to repay debts

  1. What is an accounting entity? Why is a business treated as a separate entity for accounting purposes?

    1. Any organization for which financial information is collected separately; ensures accurate reporting & avoids mixing personal and business finances

  1. Complete the following:

Statement Name

Alternative Title

Balance Sheet

Statement of Financial Position

Income Statement

Statement of Inc/Earnings/Ops

Statement of Cash Flows

Cash Flow Statement

  1. What information should be included in the heading of each of the four primary financial statements?

    1. Company name

    2. Name of statement

    3. Time period covered (“For the Year Ended”) or Specific date

    4. Unit of measure 

  1. What are the purposes of each of the 4 financial statements?

    1. Balance Sheet: show company’s financial position @ specific date, including assets, liabilities & SHE

    2. Income Statement: report revenues, expenses, and net income/loss @ specific period

    3. Statement of SHE: reports changes in equity accounts (common stock & retained earnings)

    4. Statement of Cash Flows: track cash inflows/outflows from operating, investing, and financing activities

  1. Explain why, for companies whose fiscal years end on December 31, the income statement and the statement of cash flows are dated “For the Year Ended December 31,” whereas the balance sheet is dated “At December 31.”

    1. Income statements & statements of cash flows report activities over a period of time, whereas balance sheets show financial position at a specific date in time

  1. Briefly explain the importance of assets and liabilities to the decisions of investors and creditors.

    1. Assets indicate company resources → show investors ability to generate future income

    2. Liabilities show financial obligations → show creditors ability to repay debts

  1. Briefly define net income and net loss.

    1. Net income: when revenues exceed expenses

    2. Net loss: when expenses exceed revenues

  1. Explain the balance sheet equation.

Assets = Liabilities + Stockholders’ Equity

  1. Assets: Company resources that provide future economic benefits

    1. Cash, accounts receivable, inventory, property, equipment

  2. Liabilities: Company obligations to outsiders (amounts owed)

    1. Accounts payable, loans payable, salaries payable

  3. Stockholders’ Equity: Owners’ claim on assets after liabilities are settled 

    1. Common stock (money investors contribute for shares)

    2. Retained earnings (profits company keeps instead of distributing as dividends)

  1. Explain the income statement equation. 

Net Income = Revenues - Expenses

  1. Revenues: money earned from selling goods/services

    1. Sales, service, interest revenue

  2. Expenses: costs incurred to generate revenue

  3. Net Income/Loss: final result when expenses - revenues

  1. Explain the equation for the statement of cash flows.

Net Change in Cash = Operating CF + Investing CF + Financing CF

  1. Operating Activities: CF from daily business operations

    1. Cash received from customers, cash paid for rent

  2. Investing Activities: CF related to buying/selling long term assets

    1. Purchasing equipment/property, selling investments, lending

  3. Financing Activities: CF from transactions with investors/creditors

    1. Issuing stock, borrowing money, paying dividends

  1. Explain the common stock equation.

Ending CS = Beginning CS + Stock Issuance

  1. Stock Issuance: new shares sold to investors during the period (increases company’s financing)

  1. Explain the retained earnings equation.

Ending RE = Beginning RE + Net Income - Dividends

  1. Ending RE: Total of retained profits after adding net income and subtracting dividends

  2. Beginning RE: Accumulated earnings from previous years

  3. Net Income: Company’s profit/loss during the period

  4. Dividends: Portion of earnings distributed to shareholders

  1. How do a company’s internal managers use financial statements?

    1. Marketing managers: analyze revenue trends

    2. HR managers: assess payroll expenses

    3. Purchasing managers: evaluate inventory/supplier costs

    4. Executives: make strategic decisions

  1. How are accounting rules (GAAP) determined in the US?

    1. GAAP is established by the Financial Accounting Standards Board (FASB) and regulated by the Securities & Exchange Commission (SEC).

  1. (Supplement A) Briefly differentiate between a sole proprietorship, a partnership, and a corporation.

    1. Sole Proprietorship: One owner, personal liability

    2. Partnership: 2+ owners, shared liability

    3. Corporation: separate legal entity, limited liability for shareholders (owners)

  1. (Supplement B) List and briefly explain the three primary services that CPAs in public practice provide.

    1. Audit: examine financial statements for accuracy

    2. Tax: prepare & advise on taxes

    3. Consulting: provide business/financial advice

  1. Provide some examples of notes in financial statements.

    1. More detail about a specific item in the statements

    2. Describing auditor’s opinion of management’s planning

    3. Describe financial disclosures about items not appearing