Chapter 1

Accounting Activities and

Financial Statements

ACCT 100
Objectives of the Chapter
1. Principal activities of business firms.
2. Understanding four financial statements.
3. The users of financial statements.
4. The financial reporting reform.
5. The types of business entity.
6. The authorities prescribing accounting standards
and the need for international accounting
standards.
7. Accounting concepts and principles.
The Financial Statements 2
I. Principal Activities of Business Firms

Establishing Corporate Goals and Strategies

Obtaining Financing (from owners and creditors)

Making Investments (i.e., Investments, Purchase
of Property, Plant and Equipment, Purchase of
Intangibles, etc.)

Carrying Out Operations (i.e., purchase of
materials/inventory, production, marketing and
administration)
1.

Overview of Financial Statements 3

2. Understanding Four Financial
Statements
Q1: What is accounting?
An information system to account for
business transactions and to
communicate the financial information
to users.
Q2: How do accountants communicate
financial information to users?

Overview of Financial Statements 4

Annual Financial Reports

Public firms communicate their financial
information via the annual reports to
shareholders.

The content of an annual report includes:
1. A letter to shareholders from the CEO (i.e.,
IBM 2008 Annual Report, p1-9).

2. Management’s Discussion and Analysis

(MD&A) (i.e., IBM 2008 Annual Report, p18-57).

Overview of Financial Statements 5

Annual Financial Reports (contd.)
3. Report of Management (i.e., on the
effectiveness of Internal control; required by
Sarbanes-Oxley Act of 2002). (IBM 2008 Annual
Report, p58)
4. Report of Independent Registered Public
Accounting Firm. (i.e., IBM 2008 Annual Report,
p59)

5. Audited Consolidated Financial

statements and Notes. (i.e., IBM 2008 Annual
Report60-119)

Overview of Financial Statements 6

The Four Financial Statements

1. Consolidated Income Statement

2. Consolidated Statement of Retained
Earnings

3. Consolidated Balance Sheet

4. Consolidated Statement of Cash Flows

Overview of Financial Statements 7

The Content of Four Financial
Statements

The Income Statement (Statement of
Earnings): reports the operating results
of a firm for a period of time.

Accounts reported include revenue,
expenses, gains, losses, the net
income and the earnings per share.

Overview of Financial Statements 8

The Content of Four Financial
Statements (Contd.)

The Statement of Retained Earnings:
reports the earnings not distributed to
shareholders.

Accounts reported include beginning
balance of retained earnings, current
year’s net income, dividends distributed
for the reporting period and the ending
balance of retained earnings.

Overview of Financial Statements 9

The Content of Four Financial
Statements (contd.)

The Balance Sheet Statement
(Statement of Financial Position) :
reports the financial position of a firm
on a particular date.

Accounts reported include assets,
liabilities and stockholders’ equity.

Overview of Financial Statements 10

The Content of Four Financial
Statements (contd.)

The Statement of Cash Flows:
reports cash flows from three business
activities and the net increase (or
decrease) of the cash during the year.

Business activities affect cash flows:
operating, investing and financing.

Overview of Financial Statements 11

 Exhibit 1-1 (from Financial Accounting by Harrison and Horngren)
LANDS’ END, INC. & SUBSIDIARIES
Consolidated Statement of Earnings
For the fiscal years ended
(In thousands) 2/2/2006 1/27/2005
1. Net sales $1,031,548 $992,106
2. Cost of sales 588,017 571,265
3. Gross profit 443,531 420,841
4. Selling, general, and admin. exps. 392,484 357,516
5. Charges from sale of subsidiary 1,882 3,500
6. Income from operations 49,165 59,825
7. Other income (expense):
8. Interest expense (2,771)(1,769)
9. Interest income 253 307
10. Other 4,278 1,300
11. Total other income (expense), net 1,760 (162)
12. Income before income taxes 50,925 59,663
13. Income tax provision 20,370 23,567
14. Net income $ 30,555 $ 36,096

The Financial Statements 12

Exhibit 1-2 (from Financial Accounting by Harrison
and Horngren)

LANDS’ END, INC. & SUBSIDIARIES

Consolidated Statement of Retained Earnings
For the fiscal years ended
(In thousands) 2/2/2006 1/27/2005
Retained Earnings
1. Beginning balance $229,554 $193,460
2. Net income 30,555 36,096
3. Cash dividends paid --- ---
4. Issuance of treasury stock --- (2)
5. Ending balance $260,109 $229,554

The Financial Statements 13

 Exhibit 1- 3(from Financial Accounting by Harrison and Horngren)
LANDS’ END, INC. & SUBSIDIARIES
Consolidated Balance Sheet
(In thousands) 2/2/2006 1/27/2005
ASSETS
Current assets:
1. Cash $17,176 $5,426
2. Receivables 8,046 4,459
3. Inventory 164,816 168,652
4. Prepaid advertising and other exp. 32,033 19,631
5. Total current assets 222,089 198,168
Property, plant & equip., at cost:
6. Land and buildings 72,248 69,798
7. Fixtures and equipment 83,880 74,745
8. Leasehold improvements 2,912 1,862
9. Total property, plant & equipment 159,040 146,405
10. Less accum. depr. & amortization 60,055 49,414
11. Property, plant, & equipment, net 98,985 96,991
12. Intangibles, net 2,423 2,453
13. Total assets $323,497 $297,612
The Financial Statements 14
 Exhibit 1- 3 (contd.)
LIABILITIES AND SHAREHOLDERS’ INVESTMENT
Current liabilities:
14. Interest payable $ 9,319 $7,539
15. Accounts payable 62,380 52,762
16. Salary payable 4,555 5,011
17. Accrued liabilities 23,751 25,959
18. Accrued profit sharing 1,483 1,679
19. Income taxes payable 13,256 9,727
20. Current maturities of long-term debt --- 40
21. Total current liabilities 114,744 102,717
22. Deferred income taxes 7,212 5,379
23. Long-term liabilities 349 388
Shareholders’ investment:
24. Com. stock, 40,221 shares issued 26,567 26,219
25. Retained earnings 260,109 229,554
26. Other (85,484) (66,645)
27. Total shareholders’ investment 201,192 189,128
28. Total liabilities & shareholders’ inv. $323,497 $297,612
The Financial Statements 15
 Exhibit 1- 4 (from Financial Accounting by Harrison
and Horngren)
LANDS’ END, INC. & SUBSIDIARIES
Consolidated Statement of Cash Flows
For the fiscal years ended
(In thousands) 2/2/2006 1/27/2005
Cash flows from operating activities:
1. Cash received from customers $1,027,943 $991,291
2. Cash received from interest 253 307
3. Cash paid to suppliers & employees (967,075)(926,714)
4. Cash paid for interest (2,833)(2,828)
5. Cash paid for income taxes (16,896)(27,595)
6. Net cash flows from operating activities 41,39234,461
Cash flows from investing activities:
7. Cash paid for capital additions
and businesses acquired (13,904)(32,102)
8. Proceeds from divestiture 1,665 ---
9. Net cash flows used
for investing activities (12,239)(32,102)
The Financial Statements 16
 Exhibit 1-4 (contd.)

Cash flows form financing activities:

10. Proceeds from short-term and
long-term debt 1,780 $7,539
11. Payment of long-term debt (40) (40)
12. Purchases of treasury stock (20,001) (27,979)
13. Issuance of treasury stock 858 1,978
14. Cash dividends paid --- ---
15. Net cash flows used
for financing activities (17,403) (18,502)
16. Net increase (decrease) in cash 11,750 (16,143)
17. Beginning cash 5,426 21,569
18. Ending cash $ 17,176 $ 5,426

The Financial Statements 17

Exhibit 1-5 (from Financial Accounting by Harrison and Horngren)
Income Statement -- Fiscal Year 2006
(Details given in Exhibit 1-8)

Net income …………………………….. $ 30,555

Statement of Retained Earnings -- Fiscal Year 2006 

Beginning retained earnings ………….. $229,554

Net income ……………………………… 30,555
Cash dividends …………………………. ---
Ending retained earnings ……………… $260,109
The Financial Statements 18
Exhibit 1- 5 (contd.)
Statement of Retained Earnings -- Fiscal Year 2006
Beginning retained earnings ……………... $229,554
Net income …………………………………. 30,555
Cash dividends …………………………….. ---
Ending retained earnings …………………. $260,109

Balance Sheet Statement - Fiscal Year 2006

ASSETS
Cash ……………………………………... $ 17,176
All other assets …………………………. 306,321 
Total assets ……………………………... 323,497
LIABILITIES
Total liabilities …………………………... $122,305
STOCKHOLDERS’ EQUITY
Common stock …………………………. 26,567
Retained earnings ……………………... 260,109
Other equity …………………………….. (85,484)
Total liabilities & stockholders’Theequity …
Financial Statements
$323,497 19
 Exhibit 1- 5 (contd.)
Balance Sheet Statement -- Fiscal Year 2006
ASSETS
Cash ……………………………………... $ 17,176
All other assets …………………………. 306,321
Total assets ……………………………... 323,497
LIABILITIES
Total liabilities …………………………... $122,305
STOCKHOLDERS’ EQUITY
Common stock …………………………. 26,567
Retained earnings ……………………... 260,109
 Other equity ……………………………..
Total liabilities & stockholders’ equity …
(85,484)
$323,497
Statement of Cash Flows - Fiscal Year 2006
Net cash flows from operating activities …... $41,392
Net cash flows used for investing activities .. (12,239)
Net cash flows used for financing activities .. (17,403)
Net increase in cash …………………………. 11,750
Beginning cash ……………………………….. 5,426
Ending cash …………………………………… $17,176
The Financial Statements 20
Definitions of Assets, Liabilities and Equity
(all are presented on a balance sheet statement)

Assets: the economic resources of a
business that are expected to be of
benefit to the business entity in the
future.

Examples: cash, office supplies,
inventories, accounts receivable,
buildings, equipment, etc.)

The Financial Statements 21

Definitions of Assets, Liabilities and Equity
(contd.)

Liabilities: claims to assets; legal
obligations required future payments of
assets or services as a result of a
business entity’s past transactions.

Examples: accounts payable, bonds
payable…

Equity: residual claims to a business
entity from stockholders.
The Financial Statements 22
Definitions of Revenues and Expenses

Revenues: increase or inflow of assets; will
eventually increase stockholders’ equity (i.e.,
sales revenue)

Expenses: decrease or outflow of assets; will
eventually decrease stockholders’ equity.

Gains: increase in assets from incidental
transactions not related to the major operation.

Losses: decrease in assets from incidental
transactions.

The Financial Statements 23

The Accounting Equation and the Computation
of Accounting Net Income

Assets = Liabilities + Stockholders’ Equity

Balance Sheet
Assets Liabilities
Equity


Net Income = Revenues - Expenses + Gains
- Losses
The Financial Statements 24
3. Users of Accounting Information

Internal users: mangers; managerial
accounting produce internal accounting
reports for mangers to make decisions.

External users: investors, creditors,
IRS, SEC, etc.; financial accounting
produces financial statements for these
users.

The Financial Statements 25

External Users and Usage of Financial Statements
Mainly
Group What They Look for
Interestd In Reaseon

Stockholders enhance their personal wealth

Steadily rising level of net income
through an increase in market price of the
Stockholders Net Income over time means the company's
company's stock, and dividends received. Net
profits look solid
income affects both stock prices and dividends.

Cash flows report how the company generates

Operating activities should be the
Cash Flows and uses its cash. Wise use of cash produces
main source of cash.
net income and more cash.
Liabilities indicate how much the company
owes other creditors. Assets show what the Assets far in excess of liabilities,
Bankers and Assets and
company can pledge as collateral that a or assets increasing faster than
other creditors liabilities
creditor can take if the company fails to pay its liabilities over time.
debts.
Profitable companies can usually pay their
Same as for stockholders.
Net income debts
same as for stockholders Same as for stockholders.
Cash flows
The Financial Statements 26
Why Are Financial Statements Important ?

Assess the risks (i.e., credit risk).

Provide an economic history.

Thus, financial statement can be used for
various purposes:
 Analytical tool (i.e., to assess liquidity, efficiency
of using financial resources, profitability and
solvency of companies.)
 Management report card
 Early warning signal
 Basis for predictions

27
4. The Financial Reporting Reform

The collapse of Enron and the accounting
scandals of some high-profile firms
severely damaged public confidence in the
accounting profession and the financial
reporting.

At the demand of the public, Sarbanes and
Oxley Act was passed in 2002 to restore
the public confidence in the credibility of
the financial reports.
Overview of Financial Statements 28
Key Provisions of Sarbanes and Oxley Act


Creating the Public Company
Accounting Oversight Board: establish
auditing standards.

Increasing Corporate Executive
Accountability.

Prohibition of Non-Audit Services.

Evaluation of Internal Control.
Overview of Financial Statements 29
5. Types of Business

1. Proprietorships

2. Partnerships

3. Corporations

The Financial Statements 30

Types of Business (contd.)
Proprietorship Partnership Corporation
Stockholders --
Proprietor -- one partners -- two or
Owner(s) generally many
owner more owners
owners
Limited by owner's Limited by owners'
Life of entity Indefinite
choice or death choice or death
personal liability Stockholders are
Proprietor is Partners are
of owner(s) for not personally
personally liable personally liable
business debts liable
Accounting entity is Accounting entity is Accounting entity
Accounting
separate from separate from is separate from
status
proprietor partners stockholders
The Financial Statements 31
Corporations

A business entity formed under a state
law.

A corporation is a legal entity by itself.
It has all the rights of a person (i.e.,
pay taxes, own properties, can sue or
be sued, can sign contract,…) except
the rights of voting and marriage.

The Financial Statements 32

Corporations (contd.)

The ownership of a corporation is divided
by shares.

To be an owner of a corporation, an
individual just need to buy shares from
stock markets.

Owners of a corporation have limited
liability. The most an owner can lose is
what he (she) invested.
The Financial Statements 33
Corporations (contd.)

The stockholders elect “board of
directors” who sets business policies for
the corporation.

The board elects a chairman (usually is
also the chief executive officer (CEO),
and designates a president who is in
charge of daily operations (COO).

The Financial Statements 34

Corporations (contd.)

The board also appoints vice
presidents who are in charge of
different areas (i.e., marketing,
accounting, finance...).

The Financial Statements 35

6. The Authorities prescribing the
Accounting Standards

Financial Statements (F/S) are
prepared based on generally accepted
accounting principles (GAAP).

The authorities prescribe the
accounting standards include:

The Financial Statements 36

The Authorities prescribing the
Accounting Standards (contd.)
 the Financial Accounting Standards
Board (FASB, a private agency),
 the Securities and Exchange
Commission (SEC, a public agency).

The Financial Statements 37

A Historical Perspective of Authorities prescribing
the Accounting Standards
1934 Congreess Official Prouncements
Regulation S-X, ASR , FRR and Staff
SEC Accounting Bulletins
1938 Accounting Profession
AICPA
1938-1959 CAP ARBs(51)
1959-1973 APB APB Opinion (31)
1. Statements of Financial Accounting
1973 FASB Standard
2. Interpretations
3. Concepts of Financial Accounting
4. Technique Bulletins
5. Statement of EITF
The Financial Statements 38
The Need for International Accounting Standards

Companies doing business in more than
one nation found that it is hard to comply
with more than one set of accounting
standards established by authorities in
different nations.

In response to this problem, International
Accounting Standards Committee (IASC)
was founded in 1973 to develop a single
set of global accounting standards.

Environment and Theoretical Structure of Financial Accounting 39

The History of International Accounting Standard
Setting (cont.)

41 International Accounting Standards
(IAS) were issued by IASC.

IASC created International Accounting
Standards Board (IASB) in April, 2001 to
be in charge of prescribing the standards.

IASB endorsed 41 IAS and named its
pronouncement as International Financial
Reporting Standards (IFRS).

Environment and Theoretical Structure of Financial Accounting 40

Convergence of the U.S. Accounting Standards and
the International Accounting Standards

To increase the international
comparability and the quality of US
accounting standards, the FASB has been
engaged in activities toward the
convergence of the accounting standards.

The FASB is working closely with the
IASB on the convergence of accounting
standards.

Environment and Theoretical Structure of Financial Accounting 41

Short-Term International Convergence (source:
FASB Project Updates)

The FASB started a short term joint
project with the IASB to eliminate narrow
differences between US GAAP and IFRS
in October 2002.

Both IASB and FASB acknowledged that
convergence of IFRS and U.S. GAAP is a
primary objective of both Boards.

Environment and Theoretical Structure of Financial Accounting 42

A Single Global Accounting Language
- International financial reporting standards?
 In 2008, the Securities and Exchange
Commission (SEC) proposed a
roadmap for the US issuers to prepare
financial statements in accordance
with “IFRS” for the purposes of their
filings with the SEC.
 This roadmap, if achieved, could lead
to the required use of IFRS by U.S.
issuers in 2015 or 2016.
43
The SEC’s Roadmap Toward Global Accounting
Standards (Source: Intermediate Accounting by Kieso, Weygandt and
Warfield)

The Financial Statements 44

Current Compliances

Since there is no single set of high-quality
accounting standards, domestic (U.S.)
firms filing reports with the SEC must use
U.S. GAAP.

Foreign issuers filing reports with the SEC
can use U.S. GAAP, the international
standards or the GAAP of its home
country.

If foreign firms chose to use the standards
of its home country, they must file reports
with reconciliation to U.S. GAAP.
Environment and Theoretical Structure of Financial Accounting 45
7. Accounting Concepts and Principles

1. The entity concept

2. The going-concern concept
3. The stable-monetary unit concept
4. The cost principle
5. The reliability principle

The Financial Statements 46