Uses of Accounting Information and The Financial

Chapter 1
Uses of Accounting
Information and the
Financial Statements
Multimedia Slides by: Gail A. Mestas, MAcc, New Mexico State University
Accounting
… is an information system that

measures
processes
communicates
financial information
about an identifiable, economic entity
Copyright © Houghton Mifflin Company. All rights reserved. 1–2

Accounting
…supplies the information

decision makers need to make
reasoned choices
among alternative uses of
scarce resources
in the conduct of business and
economic activities

Accounting …
• Is a link between business activities and

decision makers
– Decision makers use accounting information
to make informed decisions about available
alternatives
• Measures business activities by recording
data about them for future use
• Is communicated to decision makers
through reports

Accounting as an Information System

Business Goals, Activities, and
Performance Measures
• Business
– An economic unit that aims to sell goods
and services to customers at prices that
will provide an adequate return to its
owners

Business Goals
• Profitability
– The ability to earn enough income to
attract and hold investment capital
• Liquidity
– Having enough cash available to pay debts
when they are due

Business Activities
• Financing Activities
• Investing Activities
• Operating Activities

Financing Activities
• Activities associated with obtaining

adequate funds, or capital, to begin and
continue operations
– Owner investments
– Paying a return to owners
– Obtaining loans from creditors
– Repaying amounts to creditors, plus interest

Investing Activities
• Activities associated with spending

funds to begin and continue operations
– Buying resources such as land, buildings,
and equipment needed in the operation
of the business
– Selling these resources when no longer
needed

Operating Activities
• Activities associated with the course of

running a business
– Selling goods and services
– Employing managers and workers
– Buying goods and services
– Paying taxes

Performance Measures
• Indicators
– Used to determine whether
1. Managers are achieving their business goals
2. Business activities are well managed
• Include
– Earned income
– Cash flow
– Ratio of expenses to revenue
– Ratio of money owed to total resources
controlled

Financial and Management Accounting
• Accounting’s role is divided into two

categories
1. Management accounting
2. Financial accounting
• The functions of both categories
overlap
• Primary difference between the two is
the principal users of the information

Management Accounting
• Focuses on internal decision makers

– Managers and employees
• Reporting format is flexible and based
on the type of information needed, such
as budgets and sales forecasts
• Used to report past performance and
expected future performance

Financial Accounting
• Focuses on external decision makers

– Stockholders
– Banks and other creditors
– Government regulators
• Financial information of company is
reported in the financial statements
– Used to report directly on goals of
profitability and liquidity

Bookkeeping versus Accounting
Bookkeeping Accounting
– Repetitive, – Bookkeeping a small
mechanical process part of accounting
of recording financial – Includes design of an
transactions and information system
keeping financial to meet users’ needs
records
– Goals include the
analysis,
interpretation, and
use of information

Decision Makers
… fall into three categories
1. Those who manage a business

– Finance
– Investment
– Operations and production
– Marketing
– Human resources
– Information systems
– Accounting

Decision Makers (cont’d)
2. Those with a direct financial interest

– Investors
– Creditors
3. Those with an indirect financial interest
– Tax authorities
– Regulatory agencies
– Labor unions
– Financial advisors
– Customers
– Economic planners

Accounting Measurement
Four Basic Questions

1. What is measured?
• Business transactions affecting the
financial position of the business entity
2. When should the measurement be
made?
• Discussed in Chapter 2, The
Recognition Issue

Accounting Measurement (cont’d)
3. What value should be placed on

what is measured?
• Discussed in Chapter 2, The Valuation
Issue
4. How should what is measured be
classified?
• Discussed in Chapter 2, The
Classification Issue

Business Transactions
… are economic events that affect the

financial position of a business entity
– Involve an exchange of value

• Purchase
• Sale
• Payment
• Collection
– Events that have the same effect as an exchange
of value
• Loss from fire, flood, theft
• Physical wear and tear on equipment
• Accumulation of interest

Money Measure
• Recording of all business transactions

in terms of money
• Money is the only factor common to all
business transactions
• Basic unit of money determined by the
country in which business resides
• Exchange rates are used to translate
transactions from one currency to
another

Separate Entity
• A business is distinct from its

– Owner(s)
– Creditors
– Customers
• Its financial records and reports should
refer only to its own financial affairs

Forms of Business Enterprises
• Three basic forms of business

enterprises
– Sole proprietorship
– Partnership
– Corporation

Separate Entities
• All three forms of businesses are

economically separate entities from
their owners
– Financial records and reports refer to the
financial affairs of the business only
• Only the corporation is a legally
separate entity from its owners

Sole Proprietorships
• Business owned by one person

– The owner
• Receives all profits or losses
• Is liable for all obligations of the business
• Not incorporated
• Life of business ends when the owner
– Decides to stop operating business
– Dies
– Is incapacitated

Partnerships
• Business owned by more than one person

– The partners share all profits or losses according
to an agreed upon formula
– At least one partner is liable for all obligations of
the business
• Not incorporated
• Life of business ends when
– Ownership changes
• A partner leaves the business or dies
• A new partner is admitted
A partnership is like a sole proprietorship in
most ways, but with two or more owners
Corporations
• Legally and economically separate from its

owners
– Business unit chartered by the state and legally
separate from owners (incorporated)
– Owners (stockholders) do not directly control
operations
– Elected board of directors run the corporation
– Owners’ risk of loss limited to amount paid for
shares of stock – owners are not liable for the
obligations of the business

Organization of a Corporation
• Stockholders
– Elect the board of directors
• Board of directors
– Set company policies
– Choose corporate officers
• Corporate officers
– Carry out corporate policies by managing
the business

The Corporate Form of Business

Stockholders
• Share of stock
– Unit of ownership in a corporation
– Maximum number of shares the
corporation is authorized to issue is stated
in the articles of incorporation
• Outstanding capital stock
– Number of shares held by stockholders
– May be less than the maximum number
authorized

Stockholders (cont’d)
• To invest in a corporation
– Stockholder transfers cash or other
resources to the corporation
– Stockholder receives shares of stock
representing a proportional share of
ownership in the corporation
• Stockholder may transfer shares at will
Most universal form of capital stock is common stock

Board of Directors
• Duties of the board of directors include

– Authorizing contracts
– Setting executive salaries
– Arranging major loans with banks
– Declaring dividends

Board of Directors (cont’d)
• Dividends
– Distributions of resources to the
stockholders
– Generally in the form of cash
– Reward stockholders for their investment in
the company when a profit has been
earned
Stockholders are also rewarded through
a rise in the market value of the stock

Board of Directors (cont’d)
• Audit committee
– Includes several outside directors
– Helps ensure that the board will be objective in
evaluating management’s performance
– Engages the company’s independent auditors and
reviews their work
– Ensures that
• The proper system exists to safeguard the company’s
assets
• Reliable accounting records are kept

Management
• Carries out the corporation’s policies

• Runs day-to-day operations
• Consists of operating managers
– President
– Vice presidents
– Controller
– Treasurer
– Secretary

Management (cont’d)
• Reports the financial results of its

administration to the
– Board of directors
– Stockholders
• Must make a comprehensive annual
report
– Generally prepare reports more often
The annual reports of large public corporations are available to the public

Financial Position
The economic resources that belong

to a company
and the claims against those resources
at a point in time
Economic Resources = Equities

Developing the Accounting Equation
Economic Resources = Equities

Two types of equities
Creditor’s equities and owner's equities,
therefore,
Assets = Creditor’s
Economic Resources LiabilitiesEquities
+ Owner’s Equities
In accounting terminology
Economic resources are called assets
Creditor’s equities are called liabilities

Accounting Equation
Assets = Liabilities + Owner’s Equity

Two sides of equation are always in balance
• Assets
– Economic resources owned by a company that are expected
to benefit future operations
• Liabilities
– Obligations of a business to pay cash, transfer assets, or
provide services to other entities in the future
– Represent claims of creditors to the assets of the business
• Owner’s Equity
– Represents the claims by owners to the assets of the
business

Owner’s Equity
• Equals the residual interest in a company’s

assets after deducting all liabilities
• Also called residual equity or net assets
• Defined by rearranging the accounting
equation
Assets = Liabilities + Owner’s Equity

Owner’s Equity = Assets – Liabilities

Owner’s Equity (cont’d)
• Stockholders’ equity
– The owners’ equity of a corporation
– Also called shareholders’ equity
– Has two components
• Contributed capital
• Retained earnings
Assets = Liabilities + Stockholders’ Equity

• Contributed capital
– The amount that stockholders invest in the
business
– Represented by shares of capital stock

• Contributed capital has two components

– Par Value
• Amount per share that is entered in the
corporation’s capital stock account
• Minimum amount that can be reported as
contributed capital
– Additional paid-in capital
• The value received for capital stock over its par
value

• Retained earnings
– Represent the equity of the stockholders
– Are generated from income-producing
activities of the business
– Are kept for use in the business

• Retained earnings are affected by three types

of transactions
– Revenues
• Amounts customers agree to pay the company in return
for a service or product
• Increase retained earnings
– Expenses
• Amounts the company pays out in the process of
providing services or manufacturing products
• Decrease retained earnings
– Dividends
• Distributions to stockholders of assets (usually cash)
generated by past earnings
• Decrease retained earnings It is important not to confuse
expenses and dividends
• Net income
– The difference when revenues exceed
expenses
• Net loss
– The difference when expenses exceed
revenues
Generally, a company is successful
if its revenues exceed its expenses
Retained Earnings = Accumulated Net Income (Loss)

− Dividends Over the Life of the Business
Three Types of Transactions That Affect
Retained Earnings

Illustrative Transactions for Shannon Realty
Effects of Transactions
on the Accounting Equation

Owners’ Investments
1. Invested $50,000 in Shannon Realty, Inc., in exchange for
5,000 shares of $10 par value common stock
Common
Cash Stock
1. $50,000
A = $50,000
Assets
$50,000
L + SE = $50,000
Notice that the accounting equation

Assets = Liabilities + Stockholders’ Equity
or
A = L + SE
is always in balance

Purchase of Assets with Cash
2. Purchased a lot for $10,000 and a small building on the lot
for $25,000
Common
Cash Land Building Stock
1. $50,000
2. −35,000
$15,000
$10,000
$10,000
$25,000
$25,000
$50,000
Assets
$50,000
A = $50,000 L + SE = $50,000
This transaction only affects one side of the

accounting equation – Assets
Whenever a transaction affects only one side
of the accounting equation, the total on each
side of the equal sign remains unchanged

Purchase of Assets by Incurring a
Liability
3. Purchased office supplies for $500 on credit
Common
Cash Supplies Land Building A/P Stock
1. $50,000
2. −35,000
3. $500
$10,000 $25,000
$500
$50,000
Assets
$15,000 $500 $10,000 $25,000 $500 $50,000
A = $50,500 L + SE = $50,500

Payment of a Liability
4. Paid $200 of the $500 owed for supplies
Common
Cash Supplies Land Building A/P Stock
1. $50,000
2. −35,000
3. $500
$10,000 $25,000
$500
$50,000
Assets
4. −200 −200
$14,800 $500 $10,000 $25,000 $300 $50,000
A = $50,300 L + SE = $50,300

Revenues
5. Earned and received a commission of $1,500 in cash
Common Retained
Cash Supplies Land Building A/P Stock Earnings
1. $50,000
2. −35,000
3. $500
$10,000 $25,000
$500
$50,000
Assets
4. −200 −200
5. 1,500 $1,500
$16,300 $500 $10,000 $25,000 $300 $50,000 $1,500
A = $51,800 L + SE = $51,800

Revenues
6. Earned a commission of $2,000 to be received at a later
date
Common Retained
Cash A/R Supplies Land Building A/P Stock Earnings
1. $50,000
2. −35,000
3. $500
$10,000 $25,000
$500
$50,000
Assets
4. −200 −200
5. 1,500 $1,500
6. $2,000 2,000
$16,300 $2,000 $500 $10,000 $25,000 $300 $50,000 $3,500
A = $53,800 L + SE = $53,800

Collection of Accounts Receivable
7. Received $1,000 from client for commission earned
earlier in the month
Common Retained
1. $50,000
2. −35,000
3. $500
$10,000 $25,000
$500
$50,000
Assets
4. −200 −200
5. 1,500 $1,500
6. $2,000 2,000
7. 1,000 −1,000
$17,300 $1,000 $500 $10,000 $25,000 $300 $50,000 $3,500
A = $53,800 L + SE = $53,800

Expenses
8. Paid $1,000 to rent equipment for office
Common Retained
1. $50,000
2. −35,000
3. $500
$10,000 $25,000
$500
$50,000
Assets
4. −200 −200
5. 1,500 $1,500
6. $2,000 2,000
7. 1,000 −1,000
8. −1,000 −1,000
$16,300 $1,000 $500 $10,000 $25,000 $300 $50,000 $2,500
A = $52,800 L + SE = $52,800

Expenses
9. Paid $400 in wages to part-time helper
Common Retained
1. $50,000
2. −35,000
3. $500
$10,000 $25,000
$500
$50,000
Assets
4. −200 −200
5. 1,500 $1,500
6. $2,000 2,000
7. 1,000 −1,000
8. −1,000 −1,000
9. −400 −400
$15,900 $1,000 $500 $10,000 $25,000 $300 $50,000 $2,100
A = $52,400 L + SE = $52,400

Expenses
10. Recorded utilities expense of $300 incurred in December
but not yet paid
Common Retained
1. $50,000
2. −35,000
3. $500
$10,000 $25,000
$500
$50,000
Assets
4. −200 −200
5. 1,500 $1,500
6. $2,000 2,000
7. 1,000 −1,000
8. −1,000 −1,000
9. −400 −400
10. 300 −300
$15,900 $1,000 $500 $10,000 $25,000 $600 $50,000 $1,800
A = $52,400 L + SE = $52,400

Dividends
11. Declared and paid a $600 dividend
Common Retained
1. $50,000
2. −35,000
3. $500
$10,000 $25,000
$500
$50,000
Assets
4. −200 −200
5. 1,500 $1,500
6. $2,000 2,000
7. 1,000 −1,000
8. −1,000 −1,000
9. −400 −400
10. 300 −300
11. −600 −600
$15,300 $1,000 $500 $10,000 $25,000 $600 $50,000 $1,200
A = $51,800 L + SE = $51,800
Communications Through Financial
Statements
• Four Major Financial Statements

– Income Statement
– Statement of Retained Earnings
– Balance Sheet
– Statement of Cash Flows

Income Statement
• Summarizes revenues earned and

expenses incurred over a period of time
• Dated “For the Month Ended …”
• Purpose to measure a company’s
performance over a period of time
• Shows whether or not a company
achieved its profitability goal

Income Statement (cont’d)
• Considered by many to be most important

financial statement
• Also called
– Statement of retained earnings
– Statement of operations
– Profit and loss statement
• First financial statement to be prepared in a
sequence
• Net income figure used to prepare statement
of retained earnings

Income Statement Date reflects
revenues and
expenses incurred
over a period of time
For t
Revenues
Net income figure used to prepare
statement of retained earnings
Statement of Retained Earnings
• Shows changes in retained earnings

over a period of time
• Uses net income figure from income
statement
• End of period balance in Retained
Earnings account used to prepare
balance sheet

Statement of Retained Earnings (cont’d)
• Many companies use a statement of

stockholders’ equity or shareholders’
equity in place of the statement of
retained earnings
– Is a more comprehensive statement
• Incorporates changes in all stockholders’ equity
accounts

Statement of Retained Earnings
Date reflects changes in retained

earnings over a period of time
St
For th
Ending retained earnings Net income figure from
figure used to prepare the income statement
balance sheet
Copyright © Houghton Mifflin Company. All rights reserved.

Retained earnings 1–67
Balance Sheet
• Shows the financial position of a company on

a certain date
• Dated as of a certain date
• Also called the statement of financial position
• Presents view of business as holder of assets
that are equal to the claims against those
assets
– Claims consist of liabilities and stockholders’
equity

Balance Sheet Date reflects account
balances as of a
certain date
Assets
Balance in Cash
Retained earnings figure from the
account used in
statement of cash
flows
Cash statement of retained earnings
$1
Accounts receivable
Statement of Cash Flows
• Shows cash flows into and out of a

business over a period of time
• Focuses on whether the business met
its liquidity goal
• Explains how the Cash account
changed during the period

Statement of Cash Flows Date reflects
cash flows
over a period
Sh
of time
Stat
Begins
For the Mon

with net
income
from
income
statement
Cash flows from operating acti

Dividends
Net income from the
statement
Adjustments to reconcile net Cash at end of month

same as Cash account
of retained
earnings
flows from operating activiti

balance on balance sheet
Generally Accepted Accounting
Principles (GAAP)
• The conventions, rules, and procedures

necessary to define accounting practice
at a particular time
• Developed to provide guidelines for
financial accounting
• Are altered as better methods evolve or
circumstances change

Financial Statements, GAAP, and the
Independent CPA’s Report (Audit)
Financial Statements Audit
• Summary of financial affairs of a • Examination of a company's
business financial statements
• Prepared by management of • Prepared by independent

company certified public accountant
(CPA)
• Management has an interest in • CPA should have no
company performance; not compromising ties with
independent company
• Should be prepared in • Ascertains that financial
accordance with GAAP statements prepared in
accordance with GAAP
• Implies that investors and

creditors can rely on financial
statements

How to Read an Annual Report
• The SEC requires the management of

the public to report each year to
stockholders on their companies
performance, this report called annual
report.
• It contains the company’s annual
financial statements and other data.

The components of an annual Report
• Letter to the Stockholders

• Financial highlights
• Description of the company
• Management’s discussion and analysis.
• Financial statements
• Reports of Management responsibilities
• Report of certified Public Accountants.

Financial Statements of Walgreen Co.
• Comparative financial statements

– Present data for two or three years
– Allow reader to compare a company’s
performance from year to year
• Consolidated financial statements
– The combined financial statements of
Walgreens and all companies it owns
Also, notice that Walgreen Co.’s fiscal
year ends on August 31 of each year

Walgreen
Co.’s
Income
Statements

Walgreen
Co.’s
Statements of
Stockholders’
Equity

Walgreen
Co.’s
Balance
Sheets

Walgreen
Co.’s
Statements
of Cash
Flows


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Chapter 1

… is an information system that

Copyright © Houghton Mifflin Company. All rights reserved. 1–2

…supplies the information

Copyright © Houghton Mifflin Company. All rights reserved. 1–3

• Is a link between business activities and

Copyright © Houghton Mifflin Company. All rights reserved. 1–4

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Copyright © Houghton Mifflin Company. All rights reserved. 1–6

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• Activities associated with obtaining

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• Activities associated with spending

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• Activities associated with the course of

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• Accounting’s role is divided into two

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• Focuses on internal decision makers

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• Focuses on external decision makers

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… fall into three categories

1. Those who manage a business

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2. Those with a direct financial interest

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Four Basic Questions

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3. What value should be placed on

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… are economic events that affect the

– Involve an exchange of value

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• Recording of all business transactions

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• A business is distinct from its

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• Three basic forms of business

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• All three forms of businesses are

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• Business owned by one person

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• Business owned by more than one person

• Legally and economically separate from its

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• Duties of the board of directors include

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• Carries out the corporation’s policies

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• Reports the financial results of its

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The economic resources that belong