Financial Statements Financial Statements and Business Decisionsand Business Decisions

Chapter 1

McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, Inc.

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Understanding the BusinessThe PlayersThe Players

Investors Creditors

ManagersManagers

The The BusinessBusiness

OperationsOperations

1. Purchase partsand labor

2. Manufactureproduct

3. Sell productsto customers

4. Collect cash fromcustomers and pay

creditors

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The Accounting System

Collects and processesfinancial information

Reportsinformationto decision

makers

Managers(internaldecisionmakers)

Investors and

Creditors(externaldecisionmakers)

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The Accounting System

Accounting System

Financial Accounting SystemPeriodic financial statements and

related disclosures

Managerial Accounting SystemDetailed plans and continuous

performance reports

External Decision MakersInvestors, creditors,

suppliers, customers, etc.

Internal Decision MakersManagers throughout the

organization

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The Accounting System and Decision Makers

Cash

Equipment

Inventory

Notes Payable

An organized format used by companies to accumulate the dollar effects of

transactions.

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The Four Basic Financial Statements

1.1. On a company’s On a company’s BALANCE SHEETBALANCE SHEET, all resources owned and , all resources owned and amounts owed are listed in order of liquidity. The difference between amounts owed are listed in order of liquidity. The difference between the resources owned and the amounts owed, represents the the resources owned and the amounts owed, represents the stockholders’ equity in the business.stockholders’ equity in the business.

2.2. On a company’s On a company’s INCOME STATEMENTINCOME STATEMENT, all the revenues earned , all the revenues earned from sales to customers are listed along with the expenses incurred from sales to customers are listed along with the expenses incurred to produce those revenues.to produce those revenues.

3.3. On a company’s On a company’s STATEMENT OF RETAINED EARNINGS STATEMENT OF RETAINED EARNINGS accumulated net earnings less the dividends paid to owners accumulated net earnings less the dividends paid to owners represent reinvestments in the core business.represent reinvestments in the core business.

4.4. On a company’s On a company’s STATEMENT OF CASH FLOWS, STATEMENT OF CASH FLOWS, all sources and all sources and uses of cash are listed. Cash is generated by the company’s uses of cash are listed. Cash is generated by the company’s operations. Cash is spent on investments in buildings, manufacturing operations. Cash is spent on investments in buildings, manufacturing equipment, and other assets. Financing activities involve amounts equipment, and other assets. Financing activities involve amounts borrowed from long-term creditors and sale of stock to owners.borrowed from long-term creditors and sale of stock to owners.

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The Accounting Equation

AA = = LL + + SESE(Assets) (Liabilities) (Stockholders’

Equity)

Economic Economic ResourcesResources

Sources of Financing for Economic Sources of Financing for Economic ResourcesResources

Liabilities: From CreditorsLiabilities: From CreditorsStockholders’ Equity: From StockholdersStockholders’ Equity: From Stockholders

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The Balance Sheet

AssetsAssetsCashCashShort-Term InvestmentShort-Term InvestmentAccounts ReceivableAccounts ReceivableNotes ReceivableNotes ReceivableInventory (to be sold)Inventory (to be sold)SuppliesSuppliesPrepaid ExpensesPrepaid ExpensesLong-Term InvestmentsLong-Term InvestmentsEquipmentEquipmentBuildingsBuildingsLandLandIntangiblesIntangibles

LiabilitiesLiabilitiesAccounts PayableAccounts PayableAccrued ExpensesAccrued ExpensesNotes PayableNotes PayableTaxes PayableTaxes PayableUnearned Revenue Unearned Revenue Bonds PayableBonds Payable

Stockholders’ EquityStockholders’ EquityContributed CapitalContributed CapitalRetained EarningsRetained Earnings

Typical Account Titles

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2009ASSETSCash 4,895$ Accounts receivable 5,714 Inventories 8,517 Plant and equipment 7,154 Land 981 Total assets 27,261$ LIABILITIESAccounts payable 7,156$ Notes payable 9,000 Total liabilities 16,156 STOCKHOLDERS' EQUITYContributed capital 2,000 Retained earnings 9,105 Total stockholders' equity 11,105 Total liabilities and stockholders' equity 27,261$

MAXIDRIVE CORP.Balance Sheet

(in thousands of dollars)At December 31, 2009

Balance Sheet

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The Income Statement

RevenuesRevenuesSales RevenueSales RevenueFee RevenueFee RevenueInterest RevenueInterest RevenueRent RevenueRent Revenue

ExpensesExpensesCost of Goods SoldCost of Goods SoldWages ExpenseWages ExpenseRent ExpenseRent ExpenseInterest ExpenseInterest ExpenseDepreciation ExpenseDepreciation ExpenseAdvertising ExpenseAdvertising ExpenseInsurance ExpenseInsurance ExpenseRepair ExpenseRepair ExpenseIncome Tax ExpenseIncome Tax Expense

Typical Account Titles

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Income Statement

Revenues Sales revenue 37,436$ Total revenues 37,436 Expenses Cost of goods sold expense 26,980 Selling, general, and administrative expense 5,606 Interest expense 450 Total expenses 33,036 Operating income 4,400 Income tax expense 1,100 Net income 3,300$

MAXIDRIVE CORP.Income Statement

(in thousands of dollars)For the Year Ended December 31, 2009

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Statement of Retained Earnings

Beginning Retained EarningPlus: Net IncomeLess: DividendsEnding Retained Earnings

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Statement of Retained Earnings

MAXIDRIVE CORP.Statement of Retained Earnings

For the Year Ended December 31, 2009(in thousands of dollars)

Retained earnings, January 1, 2009 $6,805 Net income for 2009 3,300 Dividends for 2009 (1,000)

Retained earnings, December 31, 2009 $9,105

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Statement of Cash Flows

Operating activities Cash collected from customers 33,563$ Cash paid to suppliers and employees (30,854) Cash paid for interest (450) Cash paid for taxes (1,190) Net cash flow from operating activities 1,069 Investing Activities Cash used to purchase equipment (1,625) Net cash flow from investing activities (1,625) Financing Activities Cash received from bank loan 1,400 Cash dividends paid (1,000) Net cash provided by financing activities 400 Net increase in cash (156) Cash at beginning of month 5,051 Cash at end of month 4,895$

MAXIDRIVE CORP.Statement of Cash Flows

(in thousands of dollars)For the Year Ended December 31, 2009

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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.

Income Statement

Revenues $ 15,500 Statement of Retained Earnings

Expenses (8,500)

Beginning retained earnings $ 59,000

Net income $ 7,000 Net income 7,000

Dividends (2,500) Ending retained earnings $ 63,500

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Relationships Among the Statements

2. Ending retained earnings from the statement of retained earnings is one of the two components of stockholders’ equity on the balance sheet.

Statement of Retained Earnings Balance SheetBeginning retained earnings $ 59,000 Cash $ 14,000 Net income 7,000 Other assets 171,500 Dividends (2,500) Total assets $ 185,500 Ending retained earnings $ 63,500 Liabilities $ 42,000 Stockholders' Equity Common stock 80,000 Retained earnings 63,500 Total liabilities and equity $ 185,500

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Relationships Among the Statements

3. The change in cash on the statement of cash flows is added to the beginning-of-year balance in cash to arrive at end-of-year cash on the balance sheet.

Statement of Cash Flows Balance SheetCash flows from operating activities $ 21,000 Cash $ 14,000 Cash flows from investing activities (16,000) Other assets 171,500 Cash flows from financing activities 3,500 Total assets $ 185,500 Increase in cash $ 8,500 Liabilities $ 42,000 Beginning cash balance 5,500 Stockholders' Equity Ending cash balance $ 14,000 Common stock 80,000 Retained earnings 63,500 Total liabilities and equity $ 185,500

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Notes

All financial statements should be accompanied by

notes which provide the reader with supplemental

information about the financial condition and

results of operations of the company.

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Management Uses of Financial Statements

Marketing managers and credit managers use customers’ financial statements to decide

whether to extend credit.

Purchasing managers use suppliers’ financial statements to decide whether suppliers have the

resources to meet the demand for products.

Employees’ union and human resource managers use the company’s financial

statements as a basis for contract negotiations pay rates.

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Decision makers need to understandDecision makers need to understandaccounting measurement rules.accounting measurement rules.

Responsibilities for the Accounting Communication Process

Effective communication means that Effective communication means that the recipient understands what the the recipient understands what the

sender intends to convey.sender intends to convey.

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How are Generally Accepted Accounting Principles Determined?

Our accounting system has a long and distinguished history. An Italian monk named Luca

Pacioli, published the first elements of double-entry bookkeeping in 1494.

Prior to 1933, the management teams of most companies were free to choose the accounting principles used to keep track of its transactions.

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The The Securities and Exchange CommissionSecurities and Exchange Commission (SEC) (SEC)has been given broad powers to determine has been given broad powers to determine

measurement rules for measurement rules for financial statements.financial statements.

Securities Act of 1933Securities Act of 1933Securities and Exchange Act of 1934Securities and Exchange Act of 1934

Generally Accepted Accounting Principles

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Generally Accepted Accounting Principles

Currently, the Currently, the Financial AccountingFinancial AccountingStandards Board (FASB) Standards Board (FASB) is recognizedis recognized

as the body to formulate GAAP.as the body to formulate GAAP.

The SEC has worked closely with theThe SEC has worked closely with theaccounting profession toaccounting profession to

work out the detailed rules that havework out the detailed rules that havebecome known as GAAP.become known as GAAP.

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Generally Accepted Accounting Principles

Companies incur the cost of preparing the financial statements and bear the

following economic consequences . . .

Effects on the selling price of stock. Effects on the amount of bonuses received by managers and other employees. Loss of competitive information to other companies.

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International Perspective

Since 2002, there has been substantial Since 2002, there has been substantial movement to develop international financial movement to develop international financial

reporting standards by the International reporting standards by the International Accounting Standards Board (IASB).Accounting Standards Board (IASB).

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To ensure the accuracy of the company’sfinancial information, management:

Maintains a system of controls. Hires outside independent auditors. Forms a board of directors to review these two safeguards.

Management Responsibility and the Demand for Auditing

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Auditors express an Auditors express an opinion as to the opinion as to the fairnessfairness of the financial statement of the financial statement presentation.presentation.

Independent auditors Independent auditors have responsibilities that have responsibilities that extend to the general extend to the general public.public.

Independent Auditors

Overall, I believethese financialstatements are

fair.

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Independent Auditors

An audit involves . . .An audit involves . . .Examining the financial reports to Examining the financial reports to

ensure compliance with GAAP.ensure compliance with GAAP.Examining the underlying transactions Examining the underlying transactions

incorporated into the financial incorporated into the financial statements.statements.

Expressing an opinion as to the Expressing an opinion as to the fairness of presentation of financial fairness of presentation of financial information. information.

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Ethics, Reputation, and Legal Liability

The The American Institute of Certified Public American Institute of Certified Public AccountantsAccountants requires that all members requires that all members adhere to a professional code of ethics.adhere to a professional code of ethics.

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A CPA’s reputation for honesty and competence is his/her most important asset.

Like physicians, CPAs haveLike physicians, CPAs haveliability for malpractice.liability for malpractice.

Ethics, Reputation, and Legal Liability

© 2009 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

End of Chapter 1