Because learning changes everything.

Chapter 1

A Framework for
Financial Accounting

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 PART A
ACCOUNTING AS A MEASUREMENT/COMMUNICATION
PROCESS.

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 Learning Objective 1
LO 1-1 Describe the two primary functions of financial
accounting.

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 Illustration 1-1
Decisions People Make About Companies.

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 Financial Accounting
Accounting information provided to external users is referred
to as financial accounting.
The two functions of financial accounting are
• to measure business activities of a company, and
• to communicate those measurements to external parties for
decision-making purposes.

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 Illustration 1-2
Framework for Financial Accounting.

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 Key Point 1

The two primary functions of financial accounting are to

measure business activities of a company and to
communicate information about those activities to investors
and creditors and other outside users for decision-making
purposes.

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 Learning Objective 2
LO 1-2 Understand the business activities that financial
accounting measures.

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 Business Activities
• Financing activities: transactions the company has with
investors and creditors.
• Investing activities: transactions involving the purchase
and sale of resources that are expected to benefit the
company for several years.
• Operating activities: transactions that relate to the
primary operations of the company.

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 Types of Business Organizations
A corporation is a company that is legally separate from its
owners.
• The advantage of being legally separate is that the stockholders
have limited liability.

A sole proprietorship is a business owned by one person.

A partnership is a business owned by two or more persons.
• Neither sole proprietorships nor partnerships offer limited
liability.

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 Illustration 1-3
The Accounting Equation.

• Assets = total resources of the company.

• Liabilities = amounts owed to creditors.
• Stockholders’ equity = owners’ claims to resources.

The accounting equation illustrates a fundamental model

of business valuation.
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 Revenues, Expenses, and Dividends
Revenues are the amounts recognized when the company
sells products or provides services to customers.
Expenses are the costs of providing products and services
and other business activities during the current period.
Net income is the difference between revenues and
expenses. Other common names for net income include
earnings or profit.
Dividends are cash payments to stockholders.
• Dividends are not expenses.

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 Illustration 1-4
Business Activities and Their Measurement.

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 Key Point 2

• The measurement role of accounting is to create a record

of the activities of a company.
• To make this possible, a company must maintain an
accurate record of its assets, liabilities, stockholders’
equity, revenues, expenses, and dividends.

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 Learning Objective 3
LO 1-3 Determine how financial accounting information is
communicated through financial statements.

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 Communicating through Financial Statements

Financial statements are periodic reports published by the

company for the purpose of providing information to external
users.
Primary financial statements include:
• Income statement.
• Statement of stockholders’ equity.
• Balance sheet.
• Statement of cash flows.
• Statement of comprehensive income (when necessary).

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 Income Statement
Reports the company’s revenues and expenses over an
interval of time (for example, a month, quarter, or year).
• If revenues > expenses, then net income.
• If revenues < expenses, then net loss.

Key Point: The income statement compares revenues and

expenses for the current period to assess the company’s
ability to earn a profit from running its operations.

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 Illustration 1-5
Income Statement for Eagle Robotics.

EAGLE ROBOTICS
Income Statement
For the month ended December 31, 2024

Revenue $ 375,000
Cost of goods sold 250,000
Gross profit 125,000
Operating expenses 60,000
Operating income 65,000
Interest expense 5,000
Pretax income 60,000
Income tax expense 15,000
Net income $ 45,000

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 Statement of Stockholders’ Equity
Summarizes the changes in stockholders’ equity over an
interval of time.

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 Illustration 1-6
Statement of Stockholders’ Equity for Eagle Robotics.

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 Common Mistake
• Dividends represent the payment of cash but are not
considered an expense in running the business.
• Students sometimes mistakenly include the amount of
dividends as an expense in the income statement, rather
than as a distribution of net income in the statement of
stockholders’ equity.

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 Key Point 3

• The statement of stockholders’ equity reports information

related to changes in common stock and retained earnings
each period.
• The change in retained earnings equals net income less
dividends for the period.

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 Balance Sheet
Presents the financial position of the company on a particular
date.

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 Illustration 1-7
Balance Sheet for Eagle Robotics.

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 Key Point 4

The balance sheet demonstrates that the company’s

resources (assets) equal creditors’ claims (liabilities) plus
owners’ claims (stockholders’ equity) to those resources on a
particular date.

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 Statement of Cash Flows
Measures activities involving cash receipts and cash
payments over an interval of time.

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 Illustration 1-8
Statement of Cash Flows for Eagle Robotics.

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 Key Point 5

The statement of cash flows reports cash transactions from

operating, investing, and financing activities for the period.

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 Statement of Comprehensive Income
Measures changes in equity that arise from non-owner
sources.

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 Illustration 1-9
Links among Financial Statements.

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 Key Point 6

All transactions that affect revenues or expenses reported in

the income statement ultimately affect the balance sheet
through the balance in retained earnings.

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 PART B
THE DEMAND FOR FINANCIAL ACCOUNTING
INFORMATION.

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 Learning Objective 4
LO 1-4 Describe the role that financial accounting plays in
the decision-making process.

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 Illustration 1-10
Pathways Commission Visualization: "THIS is Accounting!"

• Accounting serves an
important role in a
prosperous society by
measuring economic
activity and communicating
useful information to help
investors and creditors
make good decisions.
• The practice of accounting
requires judgment and
critical thinking skills.
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 Illustration 1-11
Professional User Perceptions of Financial Statement Usefulness.

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 Key Point 7

Financial accounting serves an important role by providing

information useful in investment and lending decisions.

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 Illustration 1-12
Relationship between Changes in Stock Prices and Changes
in Net Income over a 10-Year Period.

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 Key Point 8

• No single piece of company information better explains

companies’ stock price performance than does financial
accounting net income.
• A company’s debt level is an important indicator of
management’s ability to respond to business situations and
the possibility of bankruptcy.

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 Learning Objective 5
LO 1-5 Explain the need for accounting standards and the
demand by investors and creditors for audited
financial statements.

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 Financial Accounting Standards

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 Standard Setting and the Objectives of Financial
Reporting

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 Key Point 9

• The rules of financial accounting are called generally

accepted accounting principles (GAAP).
• The Financial Accounting Standards Board (FASB) is an
independent, private body that has primary responsibility
for the establishment of GAAP in the United States.

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 Illustration 1-13
Objectives of Financial Accounting.

Financial accounting should provide information that:

1. Is useful to investors and creditors in making decisions.
2. Helps to predict cash flows.
3. Tells about economic resources, claims to resources, and
changes in resources and claims.

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 The Demand for Credible Accounting Information

Trained individuals hired by a company as an independent party to

express a professional opinion of the extent to which financial
statements are prepared in compliance with GAAP and are free of
material misstatement.

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 Auditor Reports
Auditors formally state their professional opinion about the
financial statements in a report called the “Report of
Independent Auditors,” also called the auditor’s opinion.
Types of auditor reports:
• Unqualified.
• Unqualified with an explanatory or emphasis paragraph.
• Qualified.
• Adverse.

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 Illustration 1-14
Excerpts from the Independent Auditor’s Report of Tesla.

Tesla Report of Independent Auditors (excerpt)

To the Board of Directors and Stockholders of Tesla. Inc.
Opinions on the Financial Statements and Internal Control over Financial Reporting
We have audited the accompanying consolidated balance sheets of Tesla, Inc. and its subsidiaries (the
"Company") as of December 31. 2020 and 2019 and the related consolidated statements of operations, of
comprehensive loss, of redeemable noncontrolling interests and equity, and of cash flows for each of the
three years in the period ended December 31. 2020. including the related notes (collectively referred to as
the "consolidated financial statements").
In our opinion, the consolidated financial statements referred to above present fairly. in all material
respects, the financial position of the Company as of December 31. 2020 and 2019. and the results of its
operations and its cash flows for each of the three years in the period ended December 31. 2020 in
conformity with accounting principles generally accepted in the United States of America.
/s/PricewaterhouseCoopers LLP
San Jose. California
February 8. 2021
We have served as the Company's auditor since 2005.

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 Key Point 10

Auditors play a major role in investors’ and creditors’

decisions by adding credibility to a company’s financial
statements.

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 Sarbanes-Oxley Act (SOX)
• Provides for the regulation of auditors and the types of
services they furnish to clients,
• Increases accountability of corporate executives,
• Addresses conflicts of interest for securities analysts, and
• Provides for stiff criminal penalties for violators.
• These increased requirements have increased the need for
good accounting and highlighted the value of accounting
information to investors and creditors.

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 Key Point 11

The primary objective of financial accounting is to provide

useful information to investors and creditors in making
decisions.

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 PART C
THE SUPPLY OF FINANCIAL ACCOUNTING
INFORMATION.

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 Learning Objective 6
LO 1-6 Understand the types of financial statement
disclosures that companies provide in annual and
quarterly reports.

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 The Annual Report
Companies with public securities are required to provide
stockholders with an annual report in a Form 10-K at the end
of each fiscal year.
Annual report includes:
• Balance sheet.
• Income statement.
• Statement of cash flow.
• Statement of stockholders’ equity.
• Statement of comprehensive income.
• Additional disclosures.

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 Disclosure Notes
Disclosure notes are the most common means of providing
disaggregated information or other additional information.
Disclosure notes must include:
• Summary of significant accounting policies.
• Descriptions of subsequent events.
• Related third-party transactions.
• management discussion and analysis, and
• information about executive compensation.

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 Illustration 1-15
Excerpt from Tesla’s Annual Report.

Tesla
Notes to the Financial Statements (excerpt)
($ in millions) December 31, 2020
Raw materials $1,508
Work in process 493
Finished goods 1,666
Service parts 434
Total $4,101

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 Summary of Significant Accounting Policies

Summary of significant accounting policies discloses some of

the financial accounting choices the company makes,
including:
• Management’s choice between different methods of accounting
for inventory, depreciation, etc.
• Policies regarding the timing of recognizing revenue.

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 Illustration 1-16
Excerpt from Tesla’s Summary of Accounting Policies.
Tesla
Summary of Accounting Policies (excerpt)
Revenue Recognition
We recognize revenue on automotive sales
upon delivery to the customer, which is when
the control of a vehicle transfers.
Cash and Cash Equivalents
All highly liquid investments with an original
maturity of three months or less at the date of
purchase are considered cash equivalents.
Our cash equivalents are primarily comprised
of money market funds.
Property, Plant and Equipment
Property, plant and equipment, including
leasehold improvements, are recognized at
cost less accumulated depreciation.
Depreciation is generally computed using the
straight-line method over the estimated useful
lives of the respective assets.
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Research and Development Costs
Research and development costs are expensed
as incurred.
Warranties
We provide a manufacturer's warranty on all
new and used vehicles, production powertrain
components and systems and energy storage
products we sell. In addition, we also provide a
warranty on the installation and components of
the solar energy systems we sell for periods
typically between 10 to 25 years. We accrue a
warranty reserve for the products sold by us,
which includes our best estimate of the
projected costs to repair or replace items under
warranties and recalls when identified.
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 Management’s Discussion and Analysis

Each annual report includes a discussion and analysis

provided by the company’s management.
This section of the annual report includes management’s
views on significant events, trends and uncertainties
pertaining to the company’s:
• Operations,
• Liquidity,
• Capital resources,
• Off-balance sheet arrangements, and
• Critical accounting estimates.

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 Illustration 1-17
Excerpt from Tesla’s Management Discussion and Analysis.
Tesla
Management Discussion and Analysis (excerpt)
Overview and 2020 Highlights
Our mission is to accelerate the world's transition to
sustainable energy. We design. develop.
manufacture, lease and sell high-performance fully
electric vehicles, solar energy generation systems
and energy storage products. We also offer
maintenance, installation, operation and other
services related to our products.
Automotive
We recently announced updated versions of Model S
and Model X featuring a redesigned powertrain and
other improvements. In 2021, we are focused on
ramping these models on new manufacturing
equipment, as well as production rates of Model 3
and Model Y, to at least the capacity that we have
installed. The next phase of production growth will
depend on the construction of Gigafactory Berlin and
Gigafactory Texas, each of which is progressing as
planned for deliveries beginning in 2021.
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Liquidity and Capital Resources
As of December 31, 2020. we had $19.38 billion of cash and
cash equivalents. Balances held in foreign currencies had a
U.S. dollar equivalent of $6.76 billion and consisted primarily
of euros, Chinese yuan and Canadian dollars. Our sources of
cash are predominantly from our deliveries of vehicles, sales
and installations of our energy storage products and solar
energy systems, proceeds from debt facilities, proceeds from
financing funds and proceeds from equity offerings.
2020 Compared to 2019
Automotive sales revenue increased $6.23 billion, or 31%, in
the year ended December 31, 2020 as compared to the year
ended December 31, 2019, primarily due to an increase of
129,268 Model 3 and Model Y cash deliveries despite
production limitations as a result of temporary suspension of
production at the Fremont Factory and Gigafactory Nevada
during the first half of 2020. We were able to increase
deliveries year over year from production ramping at both
Gigafactory Shanghai and the Fremont Factory.
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 Compensation of Directors and Top Executives

The SEC requires disclosures on compensation to directors

and executives.
This section includes:
• Proxy statement including compensation information for
directors and top executives.
• Invitation to stockholders to the annual meeting to elect board
members and to vote on issues.

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 Illustration 1-18
Excerpt from Tesla’s Proxy Statement.

Tesla
Compensation Table
Name and Principal Position Salary Option Awards Total
Elon Musk,
Chief Executive Officer $ 56,380 $2,283,988,504 $2,284,044,884
Jeffrey B. Straubel,
Chief Technology Officer 250,560 11,416,860 11,667,420
Jerome Guillen,
President Automotive 301,154 17,450,897 17,752,051
Deepak Ahuja,
Former Chief Financial Officer 501,923 5,708,430 6,210,353

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 Quarterly Reports
Public companies are required to file quarterly statements
with the SEC on Form 10-Q.
The quarterly report includes:
• Full set of financial statements.
• Management discussion and analysis.
• Limited financial notes.

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 Key Point 12

• In addition to providing the primary financial statements,

companies must also provide additional financial
disclosures that provide disaggregated information and
other additional information that supports the amounts
reported in the financial statements.
• These additional disclosures also include a summary of
significant accounting policies, descriptions of subsequent
events, discussion of any related third-party transactions,
management discussion and analysis, and information
about executive compensation.
• For public companies, this information is provided annually
to the SEC in a Form 10-K, and a subset of this information
is pro-vided each quarter to the SEC in a Form 10-Q.
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 Learning Objective 7
LO 1-7 Understand the types of financial statement
disclosures that companies provide in current reports.

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 Current Reports
In addition to filing annual reports on Form 10-K and Form 10-
Q, “current reports” are filed with the S EC on a Form 8-K to
report certain major events on a more timely basis.
Types of events that should be reported in a current report:
• Publicly announced the results of quarterly and annual operations.
• Filed its quarterly or annual financial statements with the S EC.
• Entered into an agreement to acquire another company.
• Completed the acquisition or divestiture of another company.
• Delisted a security from a public exchange.
• Restated previously filed financial statements.
• A director or key officer that is departing.
• Declared bankruptcy.
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 Illustration 1-19 and 1-20
Excerpt from a Current Report of Tesla.

Tesla Current Report (excerpt)

Results of Operations and Financial Condition
On October 21, 2020, Tesla, Inc. released its financial results for the quarter
ended September 30, 2020, by posting its Third Quarter 2020, Update on its
website. The full text of the update is attached hereto as Exhibit 99.1 and is
incorporated herein by reference.

Tesla Current Report (excerpt)

On December 9, 2020, Tesla, Inc. completed the sale of $5.0 billion (before
commissions) of its common stock through its "at-the-market" offering program
previously disclosed on December 8, 2020. The final settlement of the shares
sold is expected to be completed by December 11, 2020.

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 Key Point 13

• Public companies are required to disclose significant

corporate events to the SEC within four days of occurrence
in a current report called a Form 8-K.
• Common examples of significant corporate events include
the announcement of financial results, the acquisition of a
company, the divestiture of a company, or the departure of
a director or key executive.

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 Learning Objective 8
LO 1-8 Understand the types of sustainability disclosures
that companies provide.

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 Sustainability Disclosures
Many public companies voluntarily provide sustainability
disclosures that detail their policies, practices, and
performance related to the sustainability of business
operations.
• Environmental disclosures focus on a company’s
environmental impact.
• Social disclosures focus on issues of interest to broader
stakeholders and society at large.
• Governance disclosures include the company’s actions and
policies related to the division of power within the company.

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 Illustration 1-21
Examples of Environmental Issues.

Environment
• Greenhouse gas (GHG) • Water and waste
emissions. management.
• Air quality. • Hazardous materials
management.
• Energy and fuel management.

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 Illustration 1-22
Examples of Social and Human Capital Issues.

Social & Human Capital:

• Labor relations. • Human rights.
• Fair labor practices. • Access and affordability.
• Diversity and inclusion. • Customer welfare.
• Employee health and safety. • Data security and customer privacy.
• Compensation and benefit. • Fair advertising.
• Recruitment and retention.

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 Illustration 1-23
Examples of Governance Issues.

Governance:
• Board independence. • Competitive behavior.
• Business ethics. • Political influence.
• Conflicts of interest. • Illegal practices.

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 Illustration 1-24
Excerpt from Target’s Disclosure of Data Security and Privacy.

Information Security, Cybersecurity and Data Privacy Risks (in part)

We regularly receive and store information about our guests, team members,
vendors, and other third parties. We have programs in place to detect, contain,
and respond to data security incidents. However, because the techniques used to
obtain unauthorized access, disable or degrade service, or sabotage systems
change frequently and may be difficult to detect for long periods of time, we may
be unable to anticipate these techniques or implement adequate preventive
measures. In addition, hardware, software, or applications we develop or procure
from third parties may contain defects in design or manufacture or other problems
that could unexpectedly compromise information security, cybersecurity, and data
privacy. Unauthorized parties may also attempt to gain access to our systems or
facilities, or those of third parties with whom we do business, through fraud,
trickery, or other forms of deceiving our team members, contractors, and vendors.

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 Key Point 14

• Many public companies voluntarily disclose information

about their policies, practices, and performance related to
the sustainability of business operations.
• This information generally relates to environmental issues,
social issues, and governance issues.

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 APPENDIX

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 Learning Objective 9
LO 1-9 Explain the nature of the conceptual framework used
to develop generally accepted accounting principles.

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 Conceptual Framework
The conceptual framework:
• Is established by the FASB.
• Provides standard setters with a benchmark for creating a
consistent set of financial reporting rules now and in the future.
• Provides others with a written framework so that everyone
understands the underlying concepts that accountants are to
consider in preparing and interpreting financial accounting
information.

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 Key Point 15

The conceptual framework provides an underlying foundation

for the development of accounting standards and
interpretation of accounting information.

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 Illustration 1-25
Qualitative Characteristics of Useful Financial Information.

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 Key Point 16

To be useful for decision making, accounting information

should have relevance and faithful representation.

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 Key Point 17

Four characteristics of financial reporting enhance its

usefulness.
These characteristics include:
• Comparability.
• Verifiability.
• Timeliness.
• Understandability.

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 Illustration 1-26
Assumptions That Underlie GAAP.

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 End of Main Content

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