the financial statements

Chapter 1: Overview – The Financial Statements

In Chapter 1, the four basic financial statements are introduced: income statement, statement of retained earnings, balance sheet, and statement of cash flows. Financial information can be used in a variety of ways, but the focus of the chapter is on decision making and how accounting is the language of business. Also, generally accepted accounting principles (GAAP) are discussed.

Individuals, investors and creditors, regulatory bodies, and nonprofit organizations are all shown as users of accounting information. A comparison of financial accounting and management accounting is discussed, as well as the four ways to organize a business – proprietorship, partnership, limited-liability company (LLC), and corporation. A distinction between the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) is made.

The entity assumption, continuity (going-concern) assumption, historical cost principle, and stable-monetary-unit assumption are all introduced. Explanations of assets, liabilities, and equity are given, and the accounting equation (assets = liabilities + equity) is presented.

The four financial statements are discussed in more detail further in the chapter, as well as the information that is derived from each, and an explanation of assets, liabilities, equity, revenues, and expenses occurs.

The end-of-chapter summary problem demonstrates the preparation of the financial statements and an analysis of the results. The review quick check allows the students to test their understanding of the chapter’s concepts, and the accounting vocabulary section defines all of the terms introduced in the chapter. The “assess your progress” section contains short exercises, exercises, a quiz, and problems that will allow the student to gauge their understanding of the chapter. The section “apply your knowledge” includes decision cases, an ethical issue, a focus on the companies Amazon.com, Inc. and RadioShack Corporation, and group projects. Finally, a “Demo Doc” is included at the end of the chapter.

Chapter Opener Application

Chapter 1 spotlights RadioShack Corporation and details the products the corporation sells, its network of stores, and financial information for the year ended December 31, 2010. Additionally, the section introduces the terms “revenues” and “net income.” Discuss with the students the products that “The Shack” sells and prices related to those items. Visit www.radioshack.com and review pricing of those particular products on the company’s website. Explain how these items, once sold, are revenue to the company. From the company’s website, you can also download the most current annual report. Use this report to explain the flow of product sales to the financial statements, as well as how that equates to net income.

Additionally, ask the students what information they would need from the financial statements if they had $5,000 to invest. How would they decide if Radio Shack was a good investment?

Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall1-1

http://www.radioshack.com/

Teaching Outline

I. Accounting – The Language of BusinessA. Users of Financial Information

1. Individuals2. Investors and Creditors3. Regulatory Bodies4. Nonprofit Organizations

B. Financial Accounting vs. Management AccountingC. Organizing a Business

1. Proprietorship2. Partnership3. Limited-Liability company4. Corporation

II. Underlying Accounting Concepts, Assumptions, and PrinciplesA. Financial Accounting Standards Board (FASB)/Generally Accepted Accounting

Principles (GAAP)B. International Accounting Standards Board (IASB)/International Financial Reporting

Standard (IFRS)C. Entity AssumptionD. Continuity (Going-concern) AssumptionE. Historical Cost PrincipleF. Stable-monetary-unit Assumption

III. Application of the Accounting EquationA. AssetsB. LiabilitiesC. Owner’s Equity

IV. Evaluate Business Operations Using the Financial StatementsA. The Income Statement

1. Revenues2. Expenses

B. Statement of Retained EarningsC. Balance Sheet

1. Assets2. Liabilities3. Stockholders’ Equity

D. Statement of Cash FlowsV. Financial Statement Preparation and Analysis of Relationships among Them

VI. Evaluation of Business Decisions EthicallyA. The Role of JudgmentB. Economic FactorsC. Legal Factors


D. Ethical Factors

Chapter 1 Activity

On small slips of paper, list the accounts from a sample chart of accounts and distribute one slip of paper to each student. You can use the following chart of accounts as an example:

CashAccounts ReceivableInventoryPrepaid RentOffice SuppliesLandAutomobilesBuildingsPatentsCopyrightsTrademarkAccounts PayableIncome Taxes PayableInterest PayableNotes PayableSalaries and Wages PayableBonds PayableCapital StockRetained EarningsSalesInterest RevenueRent RevenueAdvertising CommissionsCost of Goods SoldDepreciationIncome TaxInsuranceInterestSalaries and WagesSupplies DividendsDividends Payable


Divide the room up into five areas: assets, liabilities, equity, revenues, and expenses. Ask the students to move to their particular area of the room depending on what account types they have been assigned. Quiz each student to confirm that he or she is in the correct section of the room. Move the students accordingly if they are in the wrong section. Repeat the exercise by dividing the room into a balance sheet section and an income statement section. Again, quiz the students to confirm that they are in the correct area for that particular financial statement and move them, if necessary. Key Topics

Accounting measures business activities, converts data into reports, and communicates results to decision makers. Because of this, accounting is known as “the language of business.” Exhibit 1-1 demonstrates the flow of accounting information from the decisions to the final results of those decisions. Decision makers include individuals, investors and creditors, regulatory bodies, and nonprofit organizations.

Internal and external users of accounting information exist. Financial accounting provides information to those outside of the entity, while management accounting provides information to those within the organization.

Businesses are formed generally either as a proprietorship, partnership, limited-liability company (LLC), or corporation. Proprietorship has a single owner, the proprietor. A partnership has two or more owners, and each owner is called a partner. An LLC is a type of business in which the business (not the owner) is liable for the company’s debts. Its owners are known as members. Finally, a corporation is owned by stockholders, or shareholders, who own stock representing shares in the corporation.

The Financial Accounting Standards Board (FASB) develops the professional guidelines for measurement and disclosure of financial information in the United States that must be adhered to in preparing the financial statements. These rules are known as generally accepted accounting principles (GAAP). The International Accounting Standards Board (IASB) sets International Financial Reporting Standards (IFRS).

Exhibit 1-2 gives an overview of the joint conceptual framework of accounting developed by the FASB and the IASB. To be useful, information must be relevant and faithfully represented. This means that the information must be capable of making a difference to the decision maker, and it is reliable to the user.

Accounting information must have the following qualitative characteristics: comparability, verifiability, timeliness, and understandability. Comparability means that the accounting information must be prepared so that it can be compared with information from other companies in the same period and is consistent with similar information for that company in previous periods. Verifiability states that the information can be checked for accuracy, completeness, and reliability. Timeliness refers to providing the information to users early enough to allow them to make decisions. Finally, understandability means that the information is transparent enough so that a reasonably informed user is able to make sense of it.


Several assumptions exist in the preparation of financial statements and the users who rely on them. The assumption entity states that the business is an organization, which stands apart as a separate economic unit. Each business is treated as a separate, distinct entity to enable the accountant to measure the financial performance of the business.

The continuity (going-concern) assumption states that the entity will continue to operate long enough to use existing assets for their intended use.

The historical cost principle says that assets are to be recorded at their actual cost at the date of purchase. The actual cost must be verifiable and unbiased. Accounting is starting to use the fair market value for assets and liabilities. Fair market value is the amount that the business could sell the asset for, or the amount the business could settle the liability.

Using the stable-monetary-unit assumption, accountants assume that the purchasing power of a dollar does not fluctuate. Inflation is ignored, and dollars from varying years are added or subtracted as though the dollar has a consistent amount of purchasing power over successive years.

The elements of the financial statements are introduced. The financial statements are based on the accounting equation (assets = liabilities + equity), which is shown in Exhibit 1-4. Assets are economic resources that are expected to benefit an organization at some point in the future. Liabilities are debts that are payable to outsiders, or creditors.

Owner’s equity (or stockholders’ equity for a corporation) represents “insider claims” of a business. Equity can also be stated as assets minus liabilities and is made up of two parts: paid-in-capital and retained earnings. Paid-in-capital is the amount that the stockholders have invested in the corporation (the main component of which is common stock, which is issued to shareholders to prove their ownership). Retained earnings are the cumulative amount of income-producing activities over time and kept for use in the business. Revenue, expenses, and dividends affect retained earnings. Revenues are inflows of resources that increase retained earnings by delivering goods or providing services to customers. Expenses are outflows of resources in the operation of the business that decrease retained earnings. Dividends are distributions to stockholders of assets that are generated by net income. Dividends are not considered expenses and do not affect net income. Net income occurs when total revenues exceed total expenses. When expenses exceed revenues, a net loss occurs.

The financial statements present a company to the public in financial terms. The income statement, or statement of operations, shows revenue and expenses for a specific period. The result is net income or net loss for the period.

The statement of retained earnings shows what a company did with its net income. If, over time, revenue exceeds expenses, the result will be a positive balance in retained earnings. If, historically, expenses have exceeded revenues, the result will be an accumulated deficit in retained earnings. Net income (or net loss) flows from the income statement to the statement of retained earnings.


The balance sheet, also called the statement of financial position, reports assets, liabilities, and stockholders’ equity for a specific moment in time. Current assets are assets that are expected to be converted to cash, sold, or consumed during the next 12 months or within the entity’s operating cycle if longer than a year. Cash, short-term investments, accounts receivable, and inventory are all considered current assets. Long-term (non-current) assets would include property and equipment, intangibles, and long-term investments.

Liabilities are also divided into the categories of current and long-term. Current liabilities are debts that are payable within one year. These would include current maturities of long-term debt, accounts payable, accrued expenses, and income taxes payable. Long-term liabilities are payable after one year.

Stockholders’ equity represents the stockholders’ ownership of the entity’s assets. Common stock, additional paid-in-capital, and retained earnings are all components of stockholders’ equity.

The statement of cash flows reports cash receipts and cash payments in the following categories: operating activities, investing activities, and financing activities.

Exhibit 1-11 demonstrates the relationships between the four financial statements.

Good business requires decision making, which also requires the exercise of good judgment. Three factors influence business and accounting decisions: economic, legal, and ethical. The economic factor says that the decision being made should maximize the economic benefits to the decision maker. The legal factor is based on the fact that free societies are governed by laws, and those laws should be taken into consideration when making decisions. The ethical factor recognizes that while actions might be both economically profitable and legal, they still may be wrong. Most companies and individuals have established standards for themselves that impose a higher level of conduct than those imposed by law.


Chapter 1 – Student Summary Handout

I. Accounting – The Language of BusinessA. Users of Financial Information

1. Individuals2. Investors and Creditors3. Regulatory Bodies4. Nonprofit Organizations

B. Financial Accounting vs. Management AccountingC. Organizing a Business

1. Proprietorship2. Partnership3. Limited-Liability Company4. Corporation

II. Underlying Accounting Concepts, Assumptions, and PrinciplesA. Financial Accounting Standards Board (FASB)/Generally Accepted Accounting

Principles (GAAP)B. International Accounting Standards Board (IASB)/International Financial Reporting

Standard (IFRS)C. Entity AssumptionD. Continuity (Going-concern) AssumptionE. Historical Cost PrincipleF. Stable-monetary-unit Assumption

III. Application of the Accounting Equation (Assets = Liabilities + Equity)IV. Evaluate Business Operations Using the Financial Statements

A. The Income Statement (Revenues – Expenses = Net Income (Net Loss))1. Revenues2. Expenses

B. Statement of Retained Earnings (Beginning Retained Earnings + Net Income – Dividends = Ending Retained Earnings)

C. Balance Sheet (Assets = Liabilities + Equity)1. Assets2. Liabilities3. Stockholders’ Equity

D. Statement of Cash Flows (Net Cash Flow of (Operating Activities + Investing Activities + Financing Activities) + Beginning Cash Balance = Ending Cash Balance)

V. Financial Statement Preparation and Analysis of Relationships among ThemVI. Evaluation of Business Decisions Ethically

A. The Role of JudgmentB. Economic FactorsC. Legal FactorsD. Ethical Factors


Chapter 1: Assignment Grid

(Will have an X if available)

Assignment Topic(s) L.O. Estimated Time

(minutes)

Level of Difficulty

Excel Templates

General Ledger

Templates

S1-1 Apply the accounting equation

3 5 Easy

S1-2 Evaluate business decisions ethically

6 5 Easy

S1-3 Explain and differentiate between business organizations

1 5 Easy

S1-4 Explain underlying accounting concepts, assumptions, and principles of accounting

2 5 Easy

S1-5 Explain underlying accounting concepts, assumptions, and principles

2 5 Easy

S1-6 Apply the accounting equation

3 5 Easy

S1-7 Explain accounting language

1 5-10 Easy


1 10-15 Easy


1 10-15 Easy

S1-10 Construct an income statement

4 10-15 Easy

Assignment Topic(s) L.O. Estimated Level of Excel General


Time (minutes)

Difficulty Templates Ledger Templates

S1-11 Construct a statement of retained earnings

4 10-15 Easy

S1-12 Construct a balance sheet 4 10-15 Easy

S1-13 Construct a statement of cash flows

4 10-20 Medium

S1-14 Explain accounting language; construct financial statements

1,4 15-20 Easy

S1-15 Apply accounting concepts; evaluate business activity

2,4 5-10 Easy

E1-16A Apply the accountingequation; evaluate business operations

3,4 10-15 Medium


3,4 5-15 Medium


3,4 5-10 Medium

E1-19A Apply the accountingequation

3 10-15 Medium

E.



(minutes)

Level of Difficulty

Excel Templates

General Ledger

Templates

E1-20A Construct financial statements; evaluate business decisions

5,6 10-20 Medium

E1-21A Apply the accounting equation; construct a balance sheet

3,4 10-20 Medium X X

E1-22A Construct an income statement and a statement of retained earnings

5 10-20 Medium X X

E1-23A Construct a statement of cash flows

5 10-20 Medium

E1-24A Construct an income statement and a statement of retained earnings

5 10-20 Medium X X

E1-25A Construct a balance sheet 5 10-20 Medium X

E1-26A Construct a statement of cash flows

5 10-15 Medium

E1-27A Evaluate business operations; evaluate a business

4,6 10-15 Medium

E1-28B Apply the accounting equation; evaluate business operations

3,4 5-10 Medium


3,4 15-20 Medium


3,4 15-20 Medium



(minutes)

Level of Difficulty

Excel Templates

General Ledger

Templates

E1-31B Apply the accounting equation

3 5-10 Easy

E1-32B Construct financial statements; evaluate business decisions

5,6 5-10 Easy

E1-33B Apply the accounting equation; construct a balance sheet

3,5 5-10 Medium

E1-34B Construct an income statement and statement of retained earnings

5 10-15 Medium X

E1-35B Construct a statement of cash flows

5 5-10 Easy

E1-36B Construct an income statement and a statement of retained earnings

5 10-15 Medium

E1-37B Construct a balance sheet 5 5-10 Medium

E1-38B Prepare a statement of cash flows

4 5-10 Medium

E1-39B Evaluate business operations; evaluate business decisions

4,6 10-15 Medium

Q1-40 to Q1-54

Practice quiz questions All 10-20 Medium

P1-55A Explain accounting vocabulary; explain and apply accounting concepts, assumptions, and principles; construct financial statements

1,2,5 20-30 Medium



(minutes)

Level of Difficulty

Excel Templates

General Ledger

Templates

P1-56A Apply the accounting equation; evaluate business operations

3,4 15 Medium

P1-57A Explain accounting language; apply the accounting equation; evaluate business operations; construct a balance sheet

1,3,4,5

15-30 Medium

P1-58A Apply underlying accounting concepts; evaluate business operations; construct a balance sheet

2,4,5 15-30 Difficult

P1-59A Construct and analyze an income statement, a statement of retained earnings, and a balance sheet; evaluate business operations

4,5 30-40 Medium X

P1-60A Construct a statement of cash flows; evaluate business operations

4,5 20-25 Medium

P1-61A Construct financial statements

5 20-25 Medium

P1-62B Explain accounting vocabulary; explain and apply accounting concepts, assumptions, and principles; construct financial statements

1,2,5 30-45 Medium



(minutes)

Level of Difficulty

Excel Templates

General Ledger

Templates

P1-63B Apply the accounting equation; evaluate business operations

3,4 20 Medium

P1-64B Explain accounting language; apply the accounting equation; evaluate business operations; construct a balance sheet

1,3,4,5

15-30 Medium

P1-65B Apply underlying accounting concepts; evaluate business operations; construct a balance sheet

2,4,5 15-30 Difficult

P1-66B Construct and analyze an income statement, a statement of retained earnings, and a balance sheet; evaluate business operations

4,5 30-40 Medium X

P1-67B Construct a statement of cash flows; evaluate business operations

4,5 20-25 Medium

P1-68B Construct financial statements

5 30-40 Medium

Decision Case 1

Explain accounting language; evaluate business operations through financial statements

1,4 45-60 Medium

Ethical Issue Evaluate ethical decisions 5 45-60 Medium



(minutes)

Level of Difficulty

Excel Templates

General Ledger

Templates

Focus on Financials—Amazon.com

Apply the accounting equation; evaluate business operations

3,4 30-40 Medium

Focus on Analysis—Radio Shack

Apply the accounting equation; evaluate business operations

3,4 15-30 Medium

Group Project 1

Bank Loan All 45-60 Difficult

Group Project 2

Going Public All 45-60 Difficult


Answer Key to Chapter 1 10-Minute Quiz (Quiz on following pages.)

1. C2. B3. A4. D5. A6. B7. C8. C9. B10. A


Name____________________________________ Date_________________ Section_______________

CHAPTER 110-MINUTE QUIZ

Circle the letter of the best response.

1. The Accounting Equation is:A. Assets + Liabilities = Owner’s Equity. B. Assets = Liabilities – Owner’s Equity. C. Assets = Liabilities + Owner’s Equity. D. Assets = Liabilities x Owner’s Equity.

2. Which item is a liability?A. CashB. Accounts PayableC. Accounts Receivable D. Supplies

3. Given that total liabilities decreased by $75,000 and total owner’s equity increased by $90,000 during the same accounting time period, what is the net effect on total assets during this

period?A. $15,000 increaseB. $15,000 decreaseC. $90,000 increaseD. $90,000 decrease

4. Recording accounting goods and services at actual cost is mandated by the: A. Stable-Monetary-Unit Assumption. B. Continuity (Going Concern) Assumption. C. Entity Assumption. D. Historical Cost Principle.

5. Which financial statement formula reflects revenues minus expenses?A. Income StatementB. Statement of Retained Earnings C. Balance SheetD. Statement of Cash Flows

6. The __________________ assumes that the entity will continue to operate long enough to use existing assets for its intended purpose.A. Stable-Monetary-Unit AssumptionB. Continuity (Going Concern) AssumptionC. Entity AssumptionD. Historical Cost Principle


7. Which financial statement reports assets, liabilities, and stockholders’ equity?A. Income StatementB. Statement of Retained EarningsC. Balance SheetD. Statement of Cash Flows

8. Mr. Ronald Smith is the owner of several small businesses. He has decided to save money during his initial years of operation by not hiring a professional accountant. He has one journal and logging book where he intermingles the transactions of all of his businesses to find the net effect of his entrepreneurship. Which accounting principle, concept, or assumption does this violate?A. Stable-Monetary-Unit Assumption B. Continuity (Going Concern) Assumption C. Entity Assumption D. Historical Cost Principle

9. Listed below are the account balances of the Arthur Frank entity:

Accounts Payable 75,000Cash 100,000Common Stock 500,000Dividends 50,000Land 60,000Miscellaneous Expense 3,000Service Revenue 250,000Equipment 40,000Accounts Receivable 125,000Office Supplies 13,000Salaries Expense 110,000

Total Assets are:A. $100,000.B. $338,000.C. $278,000.D. $213,000.


10. Listed below are the account balances of the Arthur Frank entity:

Accounts Payable 75,000Cash 100,000Common Stock 500,000Dividends 50,000Land 60,000Miscellaneous Expense 3,000Service Revenue 250,000Equipment 40,000Accounts Receivable 125,000Office Supplies 13,000Salaries Expense 110,000

The Net Income is:A. $137,000.B. $250,000.C. $363,000.D. $150,000.
