Ch.

1 Class notes for Fundamentals of Financial Accounting, 5e

by Phillips/Libby/Libby

Chapter 1
Business Decisions and Financial Accounting
Chapter 1 Learning Objectives
LO 1- 1 Describe various organizational forms and business decision makers.
LO 1- 2 Describe the purpose, structure, and content of the four basic
financial statements.
LO 1- 3 Explain how financial statements are used by decision makers.
LO 1- 4 Describe factors that contribute to useful financial information.

LO 1- 1 Organizational Forms:
Three main types of business organizations:
1. SOLE PROPRIETORSHIP a business organization owned by one person.
The owner is personally liable for all debts of the business.
2. PARTNERSHIP a business organization owned by two or more people.
Each partner is personally liable for all debts of the business.
3. CORPORATIONS a separate entity from both a legal and accounting
perspective. Owners of corporations (stockholders) are not personally
responsible for debts of the corporation. Note a corporations stock can
be publicly traded (over a stock exchange) or privately traded.

Although sole proprietorships make up the majority of businesses in terms of

quantity, the majority of business wealth is held in corporations due to the
limited liability a corporation provides.

The Accounting System (Exhibit 1.1)

Accounting is an information system designed by an organization to capture
(analyze, record, and summarize) the activities affecting its financial
condition and performance and then report the results to decision makers,
both inside and outside the organization
Operating,
Investing and
Financing Activities

evaluate Accounting run the

compan
the System
y
company

External users Accounting Reports

(creditors, investors, Internal users
etc.) Financial Manageria
(managers, etc.)
l

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The accounting system produces two kinds of reports.
1) Managerial accounting reports (For internal use) include detailed
financial plans and continually updated reports about the operating
performance of the company. These reports are made available only to
the companys employees (internal users) so that they can make
business decisions related to production, marketing, human resources,
and finance. For example, managerial accounting reports are needed
when determining whether to build, buy, or rent a building; whether to
continue or discontinue making particular products; how much to pay
employees; and how much to borrow.
2) Financial accounting reports (called financial statements) are
prepared periodically to provide information to people not employed by
the business (external users). These external financial statement users
are not given access to the detailed internal records of the company,
so they rely extensively on the financial statements. The four main
groups of external users are (1) creditors, (2) investors, (3)
directors, and (4) government.

LO 1-2 The 4 Basic Financial Statements

The Basic Accounting Equation

One of the central concepts to understanding financial reports is that what a
company owns must equal what a company owes to its creditors and
stockholders. In accounting, there are special names for the items a
company owns ( assets) and the claims on these items by creditors
( liabilities) and stockholders ( equity), as shown below.
Resources Owned Resources
by the company to creditors to stockholders
Assets = Liabilities + Stockholders Equity
Abbreviated:
A = L +
SE

Separate entity assumption: Requires that a businesss financial reports

include only the activities of the business and not those of its stockholders.
Assets are RESOURCES controlled by the company that have measurable
value and are expected to provide future benefits to the company. Some
examples of account names for Assets include
1. CASH 7. INVESTMENTS
2. TRADING SECURITIES 8. PROPERTY, PLANT, EQUIPMENT
3. NOTES RECEIVABLE 9. INTANGIBLE ASSETS

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4. ACCOUNTS RECEIVABLE 10. OTHER
5. INVENTORY
6. PREPAID ITEMS

Liabilities are AMOUNTS OWED by the business to creditors. . Some

examples of account names for Liabilities include
1. ACCOUNTS PAYABLE
2. NOTES PAYABLE

Note the common ending PAYABLE.

ONE EXCEPTION: UNEARNED REVENUE

Stockholders Equity represents owners claims to the business resources--

Stockholders equity. These claims arise for two reasons.
1. First, the owners have a claim on amounts they contributed directly to the
company in exchange for its stock (CONTRIBUTED CAPITAL).
2. Second, the owners have a claim on amounts the company has earned
through profitable business operations (RETAINED EARNINGS).
The second part of Stockholders Equity (Retained Earnings) can be
further broken down into net income (and its components) and
Dividends

Revenues Expenses = Net Income

o REVENUES arise from sales of goods or services to customers.
They are measured at the amount the business charges the
customer.
o EXPENSES are the costs of business necessary to earn
revenues. They include wages to employees, advertising,
insurance, and utilities.

Dividends are distributions of a companys earnings to its stockholders as a

return on their investment.
Assets = Liabilities + Stockholders Equity
Revenues
Common Stock Expenses
= Net
NOTE: Dividends are not an expense.
Income
Retained (profit
Dividends
Earnings
(profit
The Financial Statements distributed)

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The term financial statements refers to four accounting reports, typically
prepared in the following order:
1. Income Statement
2. Statement of Retained Earnings
3. Balance Sheet
4. Statement of Cash Flows

Income Statement
The purpose of the income statement is to report the amount of revenues
less expenses for a period of time
Income Statement: Net Income = REVENUES EXPENSES.

Account Titles on the Income Statement

Students refer to Exhibit 1.3 and write down the names of the accounts that match
the descriptions below:
SALES REVENUE--Revenue earned from selling apps to customers in September
SERVICE REVENUE--Revenue earned from providing promotional services to other
app developers
TOTAL REVENUES Total amount earned during September
SALARIES/WAGES EXPENSE--Cost of salaries and employee wages for work done in
September
RENT EXPENSE--Cost of rent for the month of September
UTILITIES EXPENSE--Cost of utilities used in September
INSUREANCE EXPENSE--Cost of insurance coverage for September
ADVERTISING EXPENSE--Cost of advertising done in September
INCOME TAX EXPENSE--Cost of taxes on Septembers income
TOTAL EXPENSES--Total expenses incurred in September to generate revenues
NET INCOME--Difference between total revenues and total expenses
Note expenses are for charges used, expired, performed in a particular period.
This type of format is known as a SINGLE STEP Income statement

Statement of Retained Earnings

The statement of retained earnings reports the way that net income and the
distribution of dividends affected the financial position of the company
during the period. For SonicGateway, most changes in stockholders equity relate
to generating and distributing earnings, so a statement of retained earnings is just
as informative as a detailed statement of stockholders equity. .

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Students refer to Exhibit 1.4 and write down the items that match the descriptions
below for the statement of retained earnings P 12 IN TEXTBOOK.
$0 Last periods ending Retained Earnings balance
$2000-- Reported on the income statement +NET INCOME
($1,000)-- Distributions to stockholders in the current period
$1,000--This periods ending Retained Earnings balance (Reported on Balance
Sheet)

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The formula for the Statement of Retained Earnings:

Beginning Retained Earnings + NET INCOME - DIVIDENDS = Ending Retained

Earnings

Which retained earnings is reported on the Balance Sheet? RETAINED

EARNINGS ENDING BALANCE.

Balance Sheet
The balance sheets purpose is to report the amount of a businesss assets,
liabilities, and stockholders equity at a specific point in time. Think of the
balance sheet as a picture or screen capture of SonicGateways resources
and claims to resources at the end of a particular day (in this case,
September 30, 2015).

Assets are listed in order of liquidity, that is, how quickly they are used up or
converted into cash. Likewise, liabilities are listed in order of how soon each
is to be paid or settled.
The balance sheet balances because the resources (assets) equal the
claims to the resources (liabilities and stockholders equity).

Formula for the Balance Sheet:

ASSETS = LIABILITIES + OWNERS EQUITY.

Students refer to Exhibit 1.5 and write down the items that match the descriptions
below for the Balance Sheet
ASSETS -- Resources controlled by the company
$13,000 -- Amount of cash on hand and in the businesss bank account
$2,500 -- Amount due from the businesss customers (Amounts they have a right to
collect from their credit customers
SUPPLIES -- Cost of paper and other supplies on hand
EQUIPMENT-- Cost of computers, desks, etc.
SOFTWARE -- Cost of software and programming code purchased from others
$36,000 -- Total amount of the companys resources
LIABILITIES -- Claims on the companys resources
$25,000 -- Creditors claims on the companys resources
ACCOUNTS PAYABLE -- Amount owed to suppliers for prior credit purchases (on
account) (Generally no interest is charged)
$20,000 NOTE PAYABLE -- Amount of loan owed to the bank (for promissory note)
Interest will be charged on the amount owed
$25,000 -- Total claims on the resources by creditors
COMMON STOCK -- Stockholders claims on the companys resources
$10,000 -- Amount stockholders contributed for company common stock
$1,000 -- Total earnings retained in the business (Exhibit 1.4)
$10,000 -- Total claims on the companys resources by stockholders

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$11,000 -- Total claims on the companys resources
Notes to the Financial Statements
Notes help financial statement users understand how the amounts were
derived and what other information may affect their decisions.

Relationships among the Financial Statements

Here is how the four statements fit together. Review Exhibit 1.7 in your book.
1) The income statement reports the results of business operations for
the accounting period. The net income from the income statement is
a component in determining ending Retained Earnings on the
statement of retained earnings.
2) The ending retained earnings balance for the period is also
reported on the balance sheet. If we did not report the ending
retained earnings balance on the balance sheet, our balance sheet
would not balance. So the statement of retained earnings must be
prepared before the balance sheet may be completed.
The Cash on the balance sheet is equal to the ending Cash reported
on the statement of cash flows.

LO 1-3 Using Financial Statements

Creditors are primarily interested in answers to the following questions: List
the financial statement the user can examine to answer that question
1. Is the company generating enough cash to make payments on its
loans? What financial statement can they examine to answer that
question? CASH FLOWS
2. Does the company have enough assets to cover its liabilities?
Financial statement? BALANCE SHEET
Investors are primarily interested in answers to the following questions: List
the financial statement the user can examine to answer that question
1. What is the immediate return (through dividends) on my contributions?
Financial statement? STATEMENT OF RETAINED EARNINGS

2. What is the long-term return (through stock price increases resulting from
the companys profits)? Financial statement? INCOME STATEMENT

O 1-4 Factors that contribute to useful financial

information.

External Financial Reporting

The main goal is to provide useful financial information to external users
for decision making. The factors that affect whether information is useful are:

Useful

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 Faithful
Relevant
Representa
tion
For financial information to be judged useful, it must be relevant and a
faithful representation. Information is relevant if it makes a difference in
decision making and it is a faithful representation if it fully depicts the
economic substance of business activities.

The usefulness of financial information is enhanced when it is

comparable (to prior periods and other companies), verifiable, timely, and
understandable.

Comparable Verifiable Timely

Understandable
Accounting Standards
The system of financial statement reporting in use today has a long history
all the way back to a publication in 1494 by an Italian monk and
mathematician, Luca Pacioli. Currently, in the United States, the Financial
Accounting Standards Board (FASB) has the primary responsibility for setting
the underlying rules of accounting. As a group, these rules are called
Generally Accepted Accounting Principles, or GAAP for short (pronounced like
the name of the clothing store). The accounting rules in the United States are
similar, for the most part, to those used elsewhere in the world, but some
important differences exist. The FASB is working alongside the International
Accounting Standards Board (IASB) to eliminate these differences. The
accounting rules developed by the IASB are called International Financial
Reporting Standards, or IFRS for short.
United States Where? World
FASB Name of IASB
(Financial Accounting organizat (International
Standards Board) ion? Accounting Standards
Board)
GAAP Abbreviat IFRS
(Generally Accepted ion for (International
Accounting Principles) standard Financial Reporting
Standards)
s?

Ethical Conduct
Ethics refers to the standards of conduct for judging right from wrong, honest
from dishonest, and fair from unfair. Intentional financial misreporting is
both unethical and illegal. As you will see throughout this course, some
accounting and business issues have clear answers that are either right or

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wrong. However, many situations require accountants, auditors, and
managers to weigh the pros and cons of alternatives before making final
decisions. To help ensure these decisions are made in a professional and
ethical manner, the American Institute of Certified Public Accountants
(AICPA) requires all its members to adhere to a Code of Professional Conduct.

Not all ethical dilemmas are clear-cut. Some situations will require you to
weigh one moral principle (e.g., honesty) against another (e.g., loyalty).

When faced with an ethical dilemma, follow these three steps:

1. Identify who will benefit from the situation and how others will be
harmed.
2. Identify the alternative courses of action.
3. Choose the alternative that is the most ethical.

Demonstration of a few Solved Exercises.

You will get more practice in your Connect
Assignments
M1-12 Preparing a Statement of Retained Earnings

Net income for 2014 $ 40,000

Net Income for 2015 45,000
Dividends for 2014 15,000
Dividends
Accountingfor 2015
2013 Class Notes, 5E 20,000
Ch. 1 - p.
Total assets at the end of 2014 125,000 9
Total assets at the end of 2015 242,000
 Stone Culture Corporation was organized on January 1, 2014. For its first two
years of operations, it reported the following:

On the basis of the data given, prepare a statement of retained earnings for
2014 (its first year of operations) and 2015. Show computations.

2014
RETAINED EARNINGS JAN 1, $
2014NET INCOME
ADD 0
$
MINUS DIVIDENDS 4
$
BALANCE DEC 31, 2014 $
2015
RETAINED
EARNINGS $
JAN, 1, 2015
ADD NET
INCOME $
MINUS
DIVIDENDS $
BALANCE
DEC 31, $
2015

Total Liabilities at the end of 2014 50,000

Total liabilities at the end of 2015 100,000
Alternate: Assume the liabilities are:

1. What is the total stockholders equity at the end of 2014? TA TL = SE

$75,000 = $125,000-$50,000.
2. Of the SE, how much is common stock at the end of 2014? SE
LIABILITIES = $25,000 $75,000 -$50,000. 3. What is the total
stockholders equity at the end of 2015? $242,000 - $100,000=
$142,000. ASSETS LIABILITIES.

4. Of the SE, how much is common stock at the end of 2015? $42,000
$142,000 - $100,000.

E1-3 Preparing a Balance Sheet

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 DSW is a designer shoe
warehouse, selling some of the most luxurious and fashionable shoes at
prices that people can actually afford. Its balance sheet, at February 2, 2013,
contained the following items (listed alphabetically in thousands of dollars).

Required:
1. Prepare the balance sheet as of February 2, 2013, solving for the
missing amount.
Assets Liabilities
CASH 313 200 ACCOUNTS PAYABLE 275 300
ACCOUNTS 114 800 NOTES PAYABLE 128 200
RECEIVABLE
INVENTORY 393 800 TOTAL LIABILITIES 403 500
EQUIPMENT 440 300

Stockholders Equity
COMMON STOCK 527 218
ADDITIONAL PAID IN 314 382
RETAINED EARNINGS 17 000
TOTAL ASSETS 1 262 100 TOTAL LIAB + SE 1 262 100
As of Feb 2, did most of the financing for assets come from creditors or
stockholders? STOCKHOLDERS.

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E1- 5 Labeling and Classifying Business Transactions The following items
relate to business transactions involving K Swiss Inc.
Required:
1. Identify an appropriate label ( account name) for each item as it would be
reported in the companys financial statements. Choose from the following:
Accounts Payable, Accounts Receivable, Cash, Common Stock, Dividends,
Land, Notes Payable, Sales Revenue, Supplies, and Supplies Expense.
2. Classify each item as an asset ( A), liability ( L), stockholders equity ( SE),
revenue ( R), or expense ( E).
Account Name
Classification
a. Coins and currency CASH ASSET
b. Amounts K Swiss owes to suppliers of watches ACCOUNTS PAYABLE
LIABILITY
c. Amounts K Swiss can collect from customers ACCOUNTS RECEIVABLE
ASSET
d. Amounts owed to bank for loan to buy building NOTES PAYABLE
LIABILITY
e. Property on which buildings will be built. LAND ASSET
f. Amounts distributed from profits to stockholders DIVIDENDS SE
g. Amounts earned by K Swiss by selling watches SALES REVENUES
REVENUE
h. Unused paper in K Swiss head office SUPPLIES
ASSET
i. Cost of paper used up during month SUPPLIES EXPENSE
EXPENSE
j. Amounts contributed by stockholders for K Swiss stock STOCKHOLDERS EQUITY
EQUITY

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E1-6 Preparing an Income Statement and Inferring Missing Values
Cinemark Holdings operates movie theaters and food concession counters
throughout the United States. Its income statement for the quarter ended
September 30, 2013, reported the following amounts (in thousands):

1. Solve for the missing amounts and prepare an Income Statement for the
quarter ended September 30, 2013. TIP: First put the items in the order they
would appear on the Income Statement and then solve for the missing
values.
2. What is Cinemarks main source of revenue and two biggest expenses?
___________________Revenue_______________________________Expenses

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Exercise 1-6 (Continued)
CINEMARK HOLDINGS
INCOME STATEMENT
FOR QTR ENDING SEPTEMBER 30 2013

REVENUES
ADMISSIONS 479 600
CONCESSIONS 308 000
TOTAL REVENUES 787 600

EXPENSES
CONCESSIONS EXPENSE 39 000
FILM RENTAL EXPENSE 254 800
OFFICE EXPENSES 254 700
SALARIES/WAGES EXPENSE 73 300
RENT EXPENSE 85 100
TOTAL EXPENSES 706 900

NET INCOME 80 700

E1-8 Inferring Values Using the Income Statement and

Balance Sheet Equations
Review the chapter explanations of the income statement and the balance
sheet equations. Apply these equations in each of the following independent
cases to compute the two missing amounts for each case. Assume that it is
the end of the first full year of operations for the company.
TIP: First identify the numerical relations among the columns using the
balance sheet and income statement equations. Then compute the missing
amounts.

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ANSWERS: CASE A $28,000 $80,000 CASE D $30,000
$99,000
CASE B $92,000 $42,000 CASE E $75,000
$101,000
CASE C ($6,000) $78,000

S1-6 (Req. 1) Critical Thinking: Developing a Balance

Sheet
On September 30, Ashley and Jason started arguing about who is better off.
Jason said he was better off because he owned a PlayStation console that he
bought last year for $250. He figures that, if needed, he could sell it to a
friend for $180. Ashley argued that she was better off because she had
$1,000 cash in her bank account and a piece of art that she bought two
years ago for $800 but could now sell for $1,400. Jason countered that
Ashley still owed $250 on her car loan and that Jasons dad promised to buy
him a Porsche if he does really well in his accounting class. Jason said he had
$6,000 cash in his bank account right now because he just received a $4,800
student loan. Ashley knows that Jason also owes a tuition installment of $800
for this term.
Required:
1. Prepare a financial report that compares what Ashley and Jason each own
and owe on September 30. Make a list of any decisions you had to make
when preparing your report.
Assets Ashley Jason
PLAYSTATION CONSOLE 250
CASH 1000 6000
ART 800

Total Assets 1800 6250

Liabilities
AUTO LOAN 250
STUDENT LOAN 4800
TUITION 800

Total Liabilities 250 5600

Equity 1550 650
Total Liabilities & Equity 1800 6250

Test your knowledge on the use of the accounting equation

1. If cash is $35,000, accounts payable is $15,000, how much is owner's

equity $20,000

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 2. If assets decreased $20,000 and liabilities increased $5,000, how much did
owner's equity change (include increase or decrease)
During May, ABC Company reported sales of $70,000, accounts receivable of
$10,000, cost of goods sold of $15,000, wages expense of $10,000 and
wages payable of $2,000. What is net income for May? Sales = $70,000
COGS = ($15,000) GROSS PROFIT = $60,000 MINUS WAGES EXPENSE
$10,000 = NI $50,000.

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