Chapter 1:Business Decisions and Financial Accounting

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. Corporation – a separate entity from both a legal and accounting perspective. Owners of corporations (stockholders) are not personally responsible for debts of the corporation.

The Accounting System (Exhibit 1.1)

Accounting is a system of analyzing, recording, summarizing and reporting the results of a business’s activities.

The Basic Accounting Equation

Assets= Liabilities + Stockholders’ Equity

Separate entity assumption: Requires that a business’s 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. Assets include cash, supplies, furniture, and equipment.

Liabilities are amounts owed by the business to creditors. Liabilities include notes payable and accounts payable.

Stockholders’ Equity represent owners’ claim to the business resources. Stockholders’ equity includes contributed capital and retained earnings.

  • Retained Earnings include the accumulated net income of the company.

Revenues – Expenses = Net Income

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

Dividendsare a distribution of a company’s earnings to its stockholders as a return on their investment.

Assets= Liabilities + Stockholders’ Equity

Dividends are not an expense.

The 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

The Income Statement

Reports the amount of revenues less expenses for a period of time.

The unit of measure assumption states that results of business activities should be reported in an appropriate monetary unit.

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.

The Balance Sheet

Reports at a point in time:

  1. What a business owns (assets).
  2. What it owes to creditors (liabilities).
  3. What is left over for the owners of the company stock (stockholders’ equity).

The Statement of Cash Flows

Summarizes how a business’s operating, investing, and financing activities caused its cash balance to change over a particular period of time.

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

  1. Net income flows from the Income Statement to the Statement of Retained Earnings.
  2. Ending Retained Earnings flows from the Statement of Retained Earnings to the Balance Sheet.
  3. Cash on the Balance Sheet and Cash at End of Year on the Statement of Cash Flows agree.

Using Financial Statements

Creditors are primarily interested in assessing:

  1. Is the company generating enough cash to make payments on its loans?
  2. Does the company have enough assets to cover its liabilities?

Investors are primarily interested in assessing:

  1. What immediate return (through dividends) on my contributions?
  2. What is the long-term return (through stock price increases resulting from the company’s profits)?

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:

Accounting Standards

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 following organizations are responsible for developing accounting rules that are known by the abbreviations shown below.

United States / Where? / World
FASB
(Financial Accounting Standards Board) / Who? / IASB
(International Accounting Standards Board)
GAAP
(Generally Accepted Accounting Principles) / What? / IFRS
(International Financial Reporting Standards)

Exercises

M1-13 Preparing a Statement of Retained Earnings

Stone Culture Corporation was organized on January 1, 2009. For its first two years of operations, it reported the following:

Net income for 2009 / $ 36,000
Net Income for 2010 / 45,000
Dividends for 2009 / 15,000
Dividends for 2010 / 20,000
Total assets at the end of 2009 / 125,000
Total assets at the end of 2010 / 242,000

On the basis of the data given, prepare a statement of retained earnings for 2009 (its first year of operations) and 2010. Show computations.
E1-3 Preparing a Balance Sheet

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 November 1, 2008, contained the following items (in thousands).

Required:

  1. Prepare the balance sheet as of November 1, solving for the missing amount.
  2. As of November 1, did most of the financing for assets come from creditors or stockholders?

E1-6 Preparing an Income Statement and Inferring Missing Values

Regal Entertainment Group operates movie theaters and food concession counters throughout the United States. Its income statement for the quarter ended June 26, 2008, reported the following amounts (in thousands):

Required:

1. Solve for the missing amounts and prepare an Income Statement for the quarter ended June 26, 2008. 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 Regal’s main source of revenue and biggest expense?

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.