CHAPTER 1

FINANCIAL STATEMENTS
AND BUSINESS DECISIONS
I.

II

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).

THE 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.
b.
c.
d.

3.

4.

Side by side - Assets on the left and liabilities & stockholders' equity
on the right.
Top down - Assets at the top and liabilities & stockholders' equity at
the bottom.
Assets are presented in the order of liquidity. Liabilities are listed in
the order of their maturity dates.
Use of dollar signs, underscores, and double underscores on all
financial statements.

Basic Accounting Equation (Balance Sheet Equation)

A
Economic resources
What you have

=
=
=

L + SE
Sources of financing
Where it came from

AL
Net assets

=
=

SE
Owners equity or residual equity

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.
b.
c.
d.

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

Title - Income Statement or Statement of Earnings or Profit & Loss
Statement.
Date - for a specified time period ended on the balance sheet date
(an accounting period).
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:

3.

Elements
a.

NI =

R-E

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:

c.

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.

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.
b.
c.
d.
e.

2.

Company name - the accounting entity (separate entity assumption)

Title - Statement of Retained Earnings
Date - for a specified time period ended on the balance sheet date
(an accounting period)
Unit of measure - U.S. dollars, Mexican pesos, etc., which may be
expressed in thousands, millions of dollars, pesos, etc.
This statement shows increases and decreases to the retained
earnings account for the period.

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

D.

The Statement of Cash Flows

1.

Structure
a.
b.
c.
d.
e.

2.

Company name - the accounting entity (separate entity assumption)

Title - Statement of Cash Flows
Date - for a specified time period ended on the balance sheet date
(an accounting period)
Unit of measure - U.S. dollars, Mexican pesos, etc., which may be
expressed in thousands, millions of dollars, pesos, etc.
This is the only financial statement prepared on the cash basis rather
than on the accrual basis.

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.
a
b

F.

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).

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.
b.
c.

Descriptions of accounting rules applied in the financial statements.

Details about line items in the statements.
Disclosures about items not listed in the statements.