CHAPTER 4

The Financial Statements

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ACCOUNTING - THE BASIS OF DECISION MAKING
• Accounting is the “language of business” • Accounting is the information system that
– Measures business activities – Processes that information into reports – Communicates the results to decision makers
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THE ACCOUNTING SYSTEM: THE FLOW OF INFORMATION
1. People make decisions

2. Business transactions occur

3. Businesses prepare reports to show the results of their operations

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ACCOUNTING VS. BOOKKEEPING
• Bookkeeping is the procedural element of accounting that processes the accounting data

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DECISION MAKERS WHO USE ACCOUNTING INFORMATION
• • • • • • Individuals Businesses Investors and Creditors Government Regulatory Agencies Taxing Authorities Nonprofit Organizations
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FINANCIAL ACCOUNTING AND MANAGEMENT ACCOUNTING
• Financial accounting provides information to managers and people outside the firm
– Financial accounting information must meet certain standards of relevance and reliability

• Management accounting generates confidential information for internal decision makers, e.g.,
– Top executives – Department heads
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ETHICAL CONSIDERATIONS
• Ethical standards in accounting are designed to produce accurate information for decision making • The result of ethical behavior by accountants is information that people can rely on for decision making

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TYPES OF BUSINESS ORGANIZATIONS
• Proprietorships
– Have a single owner who is generally the manager – Are business entities, but not legal entities – Have debt for which the proprietor is personally liable

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TYPES OF BUSINESS ORGANIZATIONS
• Partnerships
– Join two or more persons together as coowners – Are business entities, but not legal entities – Have debt for which each partner is personally liable

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TYPES OF BUSINESS ORGANIZATIONS
• Corporations
– Are owned by stockholders or shareholders – Are business entities and legal entities – Are liable for all debts
• Stockholders have no personal obligation for corporation debts

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ACCOUNTING PRINCIPLES AND CONCEPTS
• Generally accepted accounting principles (GAAP) are
– The rules that govern how accountants operate – Based upon a conceptual framework written by the Financial Accounting Standards Board (FASB)

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ACCOUNTING PRINCIPLES AND CONCEPTS
• The FASB works with the SEC (Securities and Exchange Commission) and the AICPA (American Institute of Certified Public Accountants)

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KEY ACCOUNTING ORGANIZATIONS
Public Sector Law creates the SEC to regulate the stock and bond market in the U.S.

Private Sector Accountants apply GAAP through the AICPA

GAAP governs accounting information

Private Sector The FASB determines generally accepted accounting principles

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ACCOUNTING PRINCIPLES AND CONCEPTS
• The entity concept – States that an organization is an economic entity that keeps its affairs separate from those of the owner(s) • The reliability (objective) principle
– States that accounting records and statements are based on the most reliable data available and documented by objective evidence
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ACCOUNTING PRINCIPLES AND CONCEPTS
• The cost principle
– States that acquired assets and services should be recorded at their actual (historical) cost and should maintain that historical cost for as long as they are owned

• The going-concern concept
– States that the entity will remain in operation for the foreseeable future
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ACCOUNTING PRINCIPLES AND CONCEPTS
• The stable-monetary-unit concept
– States that each dollar has the same purchasing power as any other dollar at any other time

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THE ACCOUNTING EQUATION
• The accounting equation presents the resources of the business and the claims to those resources
Economic Resources = Claims to Economic Resources or Assets = Liabilities + Owners’ Equity
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THE ACCOUNTING EQUATION
• Assets are the economic resources of a business that are expected to be of benefit in the future • Claims to assets come from
– Liabilities
• Economic obligations - debts payable to outsiders, called creditors

– Owners’ equity (capital)
• Assets held by the owners of the business
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THE ACCOUNTING EQUATION
• For a corporation, stockholders’ (owners’) equity consists of two main categories
– Paid-in capital – Retained earnings
Assets = Liabilities + Stockholders’ Equity or Assets = Liabilities + Paid-in Capital + Retained Earnings
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THE ACCOUNTING EQUATION
• Paid-in (contributed) capital is
– The amount invested in the corporation by its owners – Comprised basically of common stock

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THE ACCOUNTING EQUATION
• Retained earnings
– Is the amount earned by income-producing activities and kept for use in the business – Is affected by
• Revenues - increases in retained earnings from delivering goods or services • Expenses - decreases in retained earnings that result from operations

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THE ACCOUNTING EQUATION
• Net income (net earnings)
– Total revenues exceed total expenses

• Net loss
– Total expenses exceed total revenues

• Dividends
– Distributions to stockholders (usually cash) generated by net income
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COMPONENTS OF RETAINED EARNINGS
Revenues for the Period

-

Expenses for the Period

Start of the Period Beginning Balance of Retained Earnings + -

=

End of the Period Ending Balance of Retained Earnings 1-23

Net Income (Loss) for the Period

-

Dividends for the Period

=

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THE ACCOUNTING EQUATION
• The owners’ equity of proprietorships and partnerships
– Makes no distinction between paid-in capital and retained earnings – Accounts for the equity of each owner under the single heading of Capital

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INFORMATION REPORTED ON THE FINANCIAL STATEMENTS

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Question
1. How well did the
company perform during the period?

Answer
Revenues -Expenses Net income (loss)

Financial Statement
Income statement (Statement of operations or Statement of earnings) Statement of retained earnings (Statement of stockholders’ equity) Balance sheet (Statement of financial position)

2. Why did the

company’s retained earnings change during the period?

Beginning R.E. +Net income (-loss) -Dividends Ending R.E.

3. What is the

Assets = Liabilities + company’s financial Owners’ position at the end of Equity the period?

4. How much cash did

the company generate and spend during the period?

Operating cash flows Statement of cash + Investing cash flow flows +Financing cash flow Increase (decrease) in cash during the period
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INCOME STATEMENT
• The income statement (statement of earnings) reports the company’s revenues, expenses, and net income or net loss for the period

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INCOME STATEMENT
AIR & SEA TRAVEL, INC. Income Statement Month Ended April 30, 2001

Revenue: Service revenue Expenses: Salary expense Rent expense Utilities Total expenses Net Income

$8,500

$1,200 1,100 400 2,700 $5,800
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INCOME STATEMENT
• Revenues are
– Increases in retained earnings from delivering goods or services to customers or clients

• Expenses are
– Decreases in retained earnings that result from operations

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INCOME STATEMENT
• Expenses include
– Cost of goods sold (cost of sales)
• The cost of the goods that a company sold to its customers

– Operating expenses
• The costs of operating the business

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INCOME STATEMENT
• Operating expenses
– Advertising
• The cost to promote the company’s products

– Depreciation
• The expense of using company-owned buildings, equipment, and furniture

– Other operating expenses
• The costs of salaries, utilities, rent, and supplies

– Interest expense
• The cost of borrowed money
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STATEMENT OF RETAINED EARNINGS
• The statement of retained earnings reports that portion of net income the company has retained, or kept for use in the business
– Net income increases retained earnings – Dividends paid to stockholders decrease retained earnings

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STATEMENT OF RETAINED EARNINGS
AIR & SEA TRAVEL, INC. Statement of Retained Earnings Month Ended April 30, 2001 Retained earnings, April 1, 2001 Add: Net income for the month Less: Dividends Retained Earnings, April 30, 2001 $ 0 5,800 $5,800 (2,100) $3,700

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BALANCE SHEET
• The balance sheet (statement of financial position) reports the company’s assets, liabilities, and owners’ equity

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BALANCE SHEET
AIR & SEA TRAVEL, INC. Balance Sheet April 30, 2001 Assets Cash $33,300 Accounts receivable 2,000 Office supplies 500 Land 18,000 Liabilities Accounts payable $ 100

Total assets

$53,800

Stockholders’ Equity Common stock 50,000 Retained earnings 3,700 Total stockholders’ equity 53,700 Total liabilities and stockholders’ equity $53,800
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ASSETS
• Current assets are
– Those assets which the company expects to convert to cash, sell, or consume during the next 12 months or within the business's normal operating cycle if longer than a year

• Current assets include
– Cash – Accounts receivable – Merchandise inventory – Prepaid expenses
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ASSETS
• Long-term assets are
– Those assets which the company expects to hold longer then the next 12 months or the business’s normal operating cycle if longer than one year

• Long-term assets include
– Property – Equipment
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ASSETS
• Intangible assets are
– Those with no physical form
• Trademarks • Patents

• Other assets are
– Those with small values which do not fall within any other standard asset category

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LIABILITIES
• Current liabilities are
– Debts payable within one year or within the business’s normal operating cycle if longer than a year

• Current liabilities include
– Notes payable, short term – Accounts payable – Accrued expenses payable – Income taxes payable
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LIABILITIES
• Long-term liabilities are
– Debts not payable within one year or within the business’s normal operating cycle if longer than a year

• Long-term liabilities include
– Notes payable, long term – Bonds payable
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OWNERS’ EQUITY
• Owners’ equity
– Represents the shareholders’ ownership of the assets of the business

• Owners’ equity of a corporation consists of
– Common stock – Retained earnings
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STATEMENT OF CASH FLOWS
• The statement of cash flows reports the company’s cash inflows and outflows from operating, investing, and financing activities

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AIR & SEA TRAVEL, INC. Statement of Cash Flows Month Ended April 30, 2001 Cash flows from operating activities: Collections from customers Payments to suppliers and employees Net cash inflow from operating activities Cash flows from investing activities: Acquisition of land $(40,000) Sale of land 22,000 Net cash outflow from investing activities Cash flows from financing activities: Issuance (sale) of stock $ 50,000 Payment of dividends (2,100) Net cash inflow from financing activities Net increase in cash Cash balance, April 1, 2001 Cash balance, April 30, 2001
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$ 6,500 (3,100) 3,400

(18,000)

47,900 $ 33,300 0 $ 33,300
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STATEMENT OF CASH FLOWS
• Operating activities
– Companies operate by buying goods and services, which are sold to customers

• Investing Activities
– Companies invest in long-term assets that are used to run the business

• Financing Activities
– Companies finance themselves by issuing stock and borrowing money
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RELATIONSHIPS AMONG THE FINANCIAL STATEMENTS

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AIR & SEA TRAVEL, INC. Statement of Cash Flows Month Ended April 30, 2001 Cash flows from operating activities: Collections from customers Payments to suppliers and employees Net cash inflow from operating activities Cash flows from investing activities: Acquisition of land $(40,000) Sale of land 22,000 Net cash outflow from investing activities Cash flows from financing activities: Issuance (sale) of stock $ 50,000 Payment of dividends (2,100) Net cash inflow from financing activities Net increase in cash Cash balance, April 1, 2001 Cash balance, April 30, 2001

AIR & SEA TRAVEL, INC. Income Statement Month Ended April 30, 2001
$ 6,500 (3,100) 3,400

Revenue: Service revenue Expenses: Salary expense Rent expense Utilities Total expenses Net Income

$8,500

(18,000)

$1,200 1,100 400 2,700 $5,800

47,900 $ 33,300 0 $ 33,300

AIR & SEA TRAVEL, INC. Statement of Retained Earnings Month Ended April 30, 2001

AIR & SEA TRAVEL, INC. Balance Sheet April 30, 2001 Assets Cash $33,300 Accounts receivable 2,000 Office supplies 500 Land 18,000 Liabilities Accounts payable $ 100

Retained earnings, April 1, 2001 Add: Net income for the month

$ 0 5,800 $5,800 Less: Dividends (2,100) Retained Earnings, April 30, 2001 $3,700

Total assets

_______ $53,800

Stockholders’ Equity Common stock 50,000 Retained earnings 3,700 Total stockholders’ equity 53,700 Total liabilities and _______ stockholders’ equity $53,800

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END OF CHAPTER 3

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