Chapter 1: Business Decisions and Financial Accounting — Study Notes (Organizational Forms to External Reporting)

Organizational Forms

  • Partnership: A business organization owned by two or more people. Each partner is personally liable for all debts of the business.
  • Corporation: A separate legal entity. Owners of corporations (stockholders) are not personally liable for debts of the corporation.
  • Sole Proprietorship: A business organization owned by one person. The owner is personally liable for all debts of the business.
  • Source reference: IRS information (as noted in the slides).

The Accounting System

  • The accounting system covers three activities: Operating, Investing, and Financing.
  • External users (creditors, investors, etc.) use Financial accounting information; internal users (managers, supervisors, etc.) use Managerial accounting information.
  • Definition: Accounting is a system of analyzing, recording, summarizing, and reporting the results of a business’s activities.

Four Basic Financial Statements

  • The four basic financial statements and their purpose:
    • Income Statement: Reports revenues minus expenses for a period of time.
    • Statement of Retained Earnings (SRE): Shows how net income and the distribution of dividends affect retained earnings during the period.
    • Balance Sheet: Reports assets, liabilities, and stockholders’ equity at a point in time.
    • Statement of Cash Flows (SCF): Summarizes how operating, investing, and financing activities caused cash balance to change over a period.
  • Ordering note: Financial statements are typically prepared in this order: Income Statement → Statement of Retained Earnings → Balance Sheet → Statement of Cash Flows.

The Basic Accounting Equation and the Separate Entity Assumption

  • Separate Entity Assumption: Financial reports include the results of only the business’s activities, not its owners’ personal activities.
  • Basic Accounting Equation (Balance Sheet):
    ext{Assets} = ext{Liabilities} + ext{Stockholders’ Equity} ag{1}
  • Assets: Resources the company controls and expects to benefit from in the future (examples:
    • Cash,
    • Supplies,
    • Furniture,
    • Equipment).
  • Liabilities: Measurable amounts the company expects to give up in the future to settle what it presently owes to creditors (examples:
    • Notes Payable,
    • Accounts Payable).
  • Stockholders’ Equity: Owners’ claims to the business resources (components include
    • Common Stock (equity paid in by stockholders),
    • Retained Earnings (equity earned by the company)).
  • Key notes:
    • Revenues and Expenses affect Net Income (NI) but are not the same as Dividends.
    • Dividends: Distributions of a company’s earnings to its stockholders as a return on their investments; Dividends are not an expense.
    • Retained Earnings link to the Income Statement via Net Income and Dividends.

Revenues, Expenses, and Net Income

  • Revenues: Sales of goods or services to customers, measured at the amount the business charges the customer.
  • Expenses: Costs of doing business necessary to earn revenues (e.g., wages, advertising, insurance, utilities, and supplies used in the office).
  • Net Income (NI):
    ext{Revenues} - ext{Expenses} = ext{Net Income}
  • Important distinctions:
    • Revenues and Expenses are tied to a period of time (time-bence) while the Balance Sheet is a snapshot at a point in time.
    • Dividends reduce Return on Equity but are not expenses.

The Statement of Retained Earnings and the Balance Sheet

  • Statement of Retained Earnings (SRE) shows how net income and dividends affect retained earnings during the period.
  • Example (NOODLECAKE STUDIOS, INC. projected):
    • Retained Earnings, September 30, 2021 =
    • Add: Net Income = 2{,}000
    • Subtract: Dividends = 1{,}000
    • Retained Earnings, September 30, 2021 = 1{,}000
  • Balance Sheet (projected) as of September 30, 2021 shows:
    • Assets: Cash, Accounts Receivable, Supplies, Equipment, Software (sum to Total Assets)
    • Liabilities: Accounts Payable, Notes Payable (sum to Total Liabilities)
    • Stockholders’ Equity: Common Stock, Retained Earnings (sum to Total Stockholders’ Equity)
    • Total Liabilities and Stockholders’ Equity equals Total Assets (A = L + SE).
  • In the NOODLECAKE example:
    • Total Assets = 36{,}000
    • Total Liabilities = 25{,}000
    • Total Stockholders’ Equity = 11{,}000
    • Balance Sheet equation holds: 36{,}000 = 25{,}000 + 11{,}000

The Balance Sheet: A Point-in-Time View

  • Reports what a business owns (Assets) and what it owes (Liabilities) plus what remains for owners (Stockholders’ Equity).
  • The Balance Sheet emphasizes the accounting equation and the snapshot nature of assets, liabilities, and equity at a specific date (e.g., September 30, 2021).

The Statement of Cash Flows

  • Purpose: Shows how cash changed during the period due to operating, investing, and financing activities.
  • Operating Activities: Cash inflows/outflows from core business operations (e.g., cash received from customers, cash paid to employees and suppliers).
  • Investing Activities: Cash flows from buying/selling long-term assets (e.g., equipment, software).
  • Financing Activities: Cash flows from transactions with owners and lenders (e.g., stock issuances, dividends paid, loans).
  • Example (NOODLECAKE STUDIOS, INC.):
    • Cash Flows from Operating Activities: Cash received from customers $9,500; Cash paid to employees and suppliers $(5,500); Net cash from operating activities $4,000.
    • Cash Flows from Investing Activities: Cash used to buy equipment and software $(20,000).
    • Cash Flows from Financing Activities: Cash issued from stock issuance $10,000; Cash dividends paid $(1,000); Cash borrowed from bank $20,000; Net cash from financing activities $29,000.
    • Change in Cash = $13,000; Beginning Cash Balance = $0; Ending Cash Balance = $13,000.

Relationship Among the Financial Statements

  • Net income from the Income Statement is a component in determining ending Retained Earnings on the Statement of Retained Earnings.
  • Ending Retained Earnings from the SRE is reported on the Balance Sheet under Stockholders’ Equity.
  • Cash on the Balance Sheet equals the ending cash reported on the Statement of Cash Flows.
  • Relationship example (NOODLECAKE, INC.):
    • Income Statement: Net Income = 2{,}000
    • SRE: Retained Earnings, September 30, 2021 = 1{,}000
    • Balance Sheet: Retained Earnings = 1{,}000 (in Stockholders’ Equity)
    • SCF: Ending Cash = 13{,}000 (matches Balance Sheet Cash)

Learning Objective 1-3: How Financial Statements Are Used by Decision Makers

  • Creditors’ concerns:
    • Is the company generating enough cash to pay what it owes?
    • Does the company have enough assets to cover its liabilities?
  • Investors’ concerns:
    • Immediate return (dividends) on contributions.
    • Long-term return (stock price appreciation) driven by profits.
  • Conceptual links: Financial statements feed decisions via the interlinked sets: SCF, Balance Sheet, SRE, and Income Statement (SCF → B/S → SRE/NI → I/S).

Factors Contributing to Useful Financial Information (Learning Objective 1-4)

  • External Financial Reporting Main Goal: Provide useful financial information to external users for decision making.
  • Attributes of useful information:
    • Relevance: Information must be capable of making a difference in a decision.
    • Faithful Representation: Information faithfully represents economic phenomena.
    • Timely: Available in time to influence decisions.
    • Verifiable: Users can reach a consensus about the information.
    • Comparable: Information can be compared across time and with other entities.
    • Understandable: Users with reasonable knowledge can understand it.
  • Note: The slides list these attributes in order under the umbrella of external reporting.

World Accounting Standards

  • Major bodies:
    • IASB (International Accounting Standards Board) which develops IFRS (International Financial Reporting Standards).
    • FASB (Financial Accounting Standards Board) which develops US GAAP (Generally Accepted Accounting Principles in the United States).
  • Global accounting standards involve convergence and ongoing coordination between IFRS and US GAAP.

Ethical Conduct in Accounting

  • A simple framework for ethical decisions:
    • Identify who will be affected by the situation.
    • Identify and evaluate the alternative courses of action.
    • Choose the alternative that is the most ethical.

Chapter 1 Supplement A: Careers Dependent on Accounting Knowledge

  • Supplement describes how accounting knowledge supports other business careers.
  • Learning objective: 1-S1 describes examples where accounting supports different business roles.

Chapter 1 Supplement B: Public Companies

  • Supplement describes the decision to become a public company and the accounting implications.
  • Learning objective: 1-S2 describes the decision and its accounting impact.
  • Going Public – Pros:
    • The company keeps the money raised when issuing shares.
    • Easier to raise money in the future by issuing additional shares.
    • Can compensate employees with company shares, not just cash.
    • Provides a mechanism for founders and stockholders to sell shares.
    • Enables the company to acquire other companies by paying with shares.
  • Going Public – Cons:
    • Greater public reporting of significant events.
    • Increased accounting disclosures.
    • Greater risk of litigation for misstatements and omissions in reports.
  • Public Company Reporting channels:
    • Press releases
    • Financial statement reports
    • Securities and Exchange Commission (SEC) filings

Chapter 1 Solved Exercises (selected highlights)

  • M1-12: Preparing a Statement of Retained Earnings (Stone Culture Corporation)
    • Given net incomes for 2020 and 2021 and dividends for those years; compute Retained Earnings for year-end 2020 and year-end 2021.
    • Example results (projected):
    • Retained Earnings, December 31, 2020 = $25,000
    • Retained Earnings, December 31, 2021 = $50,000
  • E1-3: Preparing a Balance Sheet (Designer Brands, Inc.)
    • Balance Sheet as of August 3, 2019 (in millions):
    • Assets: Cash $75; Accounts Receivable $85; Inventory $700; Buildings $1,700; Total Assets $2,560
    • Liabilities: Accounts Payable $650; Notes Payable $1,180; Total Liabilities $1,830
    • Stockholders’ Equity: Common Stock $460; Retained Earnings $270; Total Stockholders’ Equity $730
    • Total Liabilities and Stockholders’ Equity $2,560
    • Financing sources as of Aug 3, 2019: creditors financed $1,830 million; stockholders financed $730 million.
  • E1-6: Inferring Values – Cinemark Holdings, Inc. (quarter ended June 30, 2019)
    • Income Statement components (all numbers in thousands):
    • Revenues: Admissions Revenue $521,000; Concessions Revenue $345,000; Total Revenues $866,000
    • Expenses: Film Rental Expense $171,000; Office Expense $109,000; Salaries & Wages Expense $89,000; Rent Expense $63,000; Concessions Expense $38,000; Income Tax Expense $295,000
    • Total Expenses $765,000
    • Net Income $101,000
    • Main revenue sources: Admissions Revenue and Concessions Revenue.
    • Two biggest expenses: Film Rental Expense ($171,000) and Office Expense ($109,000) (followed by Salaries & Wages $89,000).
  • E1-8: Inferring Values Using the Income Statement and Balance Sheet Equations
    • Core relations:
    • ext{Total Revenues} - ext{Total Expenses} = ext{Net Income (NI)}
    • ext{Assets} = ext{Liabilities} + ext{Stockholders’ Equity}$$
    • The problem provides multiple independent cases (A, B, C, D or E, C, B, A) with various knowns/unknowns and asks to determine missing values for either NI, assets, liabilities, or equity using the two fundamental equations above.
    • Approach: identify numerical relations among columns via the balance sheet and income statement equations, then solve for the missing amounts.
  • S1-6 Critical Thinking: Developing a Balance Sheet
    • Scenario: Ashley and Jason compare their net worth at a date (Sept 30).
    • Key elements to consider when preparing the report:
    • What is owned (assets) vs what is owed (liabilities).
    • Net worth (equity) = Assets − Liabilities.
    • Items shown include cash, vehicles or other possessions, loans (car loan, tuition, student loan), and other assets.
    • The activity demonstrates constructing a personal balance sheet and identifying decisions required when presenting a financial report for individuals.

End of Chapter 1

  • The chapter introduces the core concepts of accounting, the structure and use of financial statements, and basic ethical and global considerations in financial reporting.
  • It provides a practical set of exercises and supplements that connect accounting to real-world business decisions and personal financial literacy, including public-company considerations.