AFM 101 Chapter 1 Reading Notes
Chapter 1 Financial Statements and Business Decisions
Objectives of Financial Statements: - used by businesses as the primary means to communicate financial
information to parties outside the organization.
Managers – use and interpret financial statements when making business decisions.
Accountants – prepare financial statements.
Understanding the Business
The Player – buy a portion of the company to earn money
1) Cash payments – dividends
2) Sell their share at higher price
The Business Operations
- Purchase ingredients and labours
- Produce specialty beers
- Sell beer to customers
- Collect cash from customers and pay supplies
The Accounting System
Accounting is a system that collects and processes (analyzes, measures, and records) financial
information about an organization and reports that information to decision makers.
Managerial/ Management Accounting: developing accounting information for internal decision makers.
(Detailed plans and continuous performance reports -> Internal decision makers -> Managers)
Financial Accounting: accounting for external decision makers.
(Periodical financial statements and related disclosures -> External decision makers -> Creditors,
investors, suppliers, customers)
The Four Basic Financial Statements
1) Balance Sheet
2) Income Statement
3) Statement of Retained Earnings
4) Cash Flow Statement
All four basic financial statements can be prepared at any point in time and can apply to any time span.
They are used by investors, creditors and other external decisions makers.
An Accounting Entity is the organization for which financial data are to be collected.
Page 1 of 7 A Balance Sheet (Statement of Financial Position) reports the financial position (assets, liabilities, and
shareholders’ equity) of an accounting entity at a point in time.
Heading of the Balance Sheet includes:
1) Name of the entity
2) Title of the statement
3) Specific date of the statement (as of date)
4) Unit of measure
Basic Accounting Equation/ Balance Sheet Equation:
Assets = Liabilities + Shareholders’ Equity
Assets: economic resources (cash, inventory etc.)
Liabilities and Shareholders’ Equity: source of financing for the economic resources
Liabilities: from creditors
Shareholders’ Equity: from shareholders
Elements of Balance Sheet
Assets are economic resources controlled by the entity as a result of past transactions and from which
future economic benefits can be obtained.
Liabilities are the entity’s obligations that result from past transactions. They arise primarily from the
purchase of goods and services on credit and through cash borrowings to finance the business.
Shareholders’ equity indicates the amount of financing provided by owners of the business and earnings.
1) share capital (investment by owners)
2) retained earnings (amount reinvested, no dividends)
Total of Shareholders’ equity = share capital + retained earnings
Assets are listed by ease of conversion into cash.
Liabilities are listed by their maturity (due date).
Page 2 of 7 The Income Statement
The income statement (statement of income, statement of earnings, or statement of operations) reports
the accountant’s primary measure of performance of a business: revenues generated less expense
incurred during the accounting period.
Heading: similar to Balance Sheet. Date: For the year ended + date
The Accounting Period is the time period covered by the financial statements.
Income Statement has three major captions: revenues, expenses, and net income.
Income Statement Equation:
Revenues – Expenses = Net Income
Elements of Income Statement
Companies earn revenues from the sale of goods or services to customers. Revenues are normally
reported on the income statement when the goods or services are sold to customers whether or not they
have been paid for.
Expenses represent the dollar amount of resources the entity used up, or consumed, to earn revenues
during the period. Expenses may require the immediate payment of cash, a payment of cash at a future
date, or the use of some other resource such as an inventory item that may have been paid for in a
previous period. For accounting purposes, the expense reported in one accounting period may actually
be paid for in another accounting period.
Net income or net earnings (often called profit or the bottom line) is the excess of total revenues over
total expenses. If total expenses exceed total revenues, a net loss is reported. Net income normally does
not equal the net cash generated by operations.
The 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 accounting period.
Like the Income Statement, the Statement of Retained Earnings covers a specific period of time (the
Net income earned during the year increases the balance of retained earnings. The declaration of
dividends to the shareholders decreases retained earnings.
Heading: name of the entity, the title of the statement, and the unit of measure used.
The Retained Earnings Equation:
Beginning Retained Earnings + Net Income – Dividends = Ending Retained Earnings
The statement of retained earnings shows the relationship between the income statement and the
Page 3 of 7 The Cash Flow Statement
Three primary categories of cash flows in a typical business: cash flows from operating, investing, and
Accountants prepare the cash flow statement to report inflows and outflows of cash.
Heading: the name of the entity, the title of the statement, and the unit of measure used.
Like the income statement, the cash flow statement covers a specified period of time (the accounting
The cash flow statement equation describes the causes of the change in cash reported on the balance
sheet from the end of the last period to the end of the current period:
Change in Cash = Cash Flows from Operating Activities
+ Cash Flows from Investing Activities
+ Cash Flows from Financing Activities
*each of the three cash flow sources can be positive or negative
Elements of Cash Flow Statement
Cash flows from operating activities are cash flows that are directly related to earning income.
Cash flows from investing activities include cash flows related to the acquisition or sale of the
company’s productive assets.
Cash flows from financing activities are directly related to the financing of the company itself.
Relationships Among the Statements
1. Net income from the income statement results in an increase in ending retained earnings on the
statement of retained earnings.
2. Ending retained earnings from the statement of retained earnings is one of the two components
of shareholders’ equity on the balance sheet.
3. The change in cash on the cash flow statement added to the cash balance at the beginning of the
year equals the balance of cash at the end of the year, which appears on the balance sheet.
Thus, as external users, we can think of the income statement as explaining, through the statement of
retained earnings, how the operations of the company improved its financial position during the year.
The cash flow statement explains how the operating, investing, and financing activities of the company
affected the cash balance on the balance sheet during the year.
Notes (Footnotes) provide supplemental information about the financial condition of a company,
without which the financial statements cannot be fully understood.
Three basic types of Notes:
1) Provides descriptions of the accounting rules applied in the company’s statements.
2) Additional detail about a line on the financial statements.
3) Presents additional financial disclosures about items not listed on the statements themselves.
Page 4 of 7 Financial Analysis
Interpreting Assets, Liabilities, and Shareholders’ Equity on the Balance Sheet
Assessment of assets is important to creditors and investors, because assets provide a basis for judging
whether the company has sufficient resources available to operate the business.
Debts are also relevant to bankers’