Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Financial
Statements
and
Business
Decisions
Chapter 1

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

 1-3

Understanding the Business

Founders of the business who also

function as managers are called Owner-
Mangers.
Owner-Managers

Creditors lend money for a specific period

of time and gain by charging interest on
the money they lend.

Creditors

Investors buy ownership in the company

in the form of stock.
Investors
 1-4

Understanding the Business

Investors purchase stock (or ownership) in

businesses hoping to gain in two ways:

Sell
Receive a
ownership
portion of the
interest in the
companys
future for more
earnings in cash
than they
(dividends).
paid.
 1-5

The Business Operations

Manufacturers either make the parts needed to

produce its products or buy the parts from
suppliers.

Manufacturer Final Product Customer

 1-6

Learning Objectives

Recognize
Recognize the the information
information conveyed
conveyed in
in each
each of
of
the
the four
four basic
basic financial
financial statements
statements and
and the
the way
way
that
that itit is
is used
used by by different
different decision
decision makers
makers
(investors,
(investors, creditors,
creditors, and
and managers).
managers).
 1-7

The Accounting System

Managers
(internal
decision
Reports makers)
information
to decision
Collects and processes makers
financial information Investors
and
Creditors
(external
decision
makers)
 1-8

The Accounting System

Accounting System

Financial Accounting System Managerial Accounting System

Periodic financial statements and Detailed plans and continuous
related disclosures performance reports

External Decision Makers Internal Decision Makers

Investors, creditors, Managers throughout the
suppliers, customers, etc. organization
 1-9

The Four Basic Financial Statements

Statement of Cash Flows Statement of Retained Earnings

Balance Sheet Income Statement

Financial statements summarize the financial

activities of the business.
 1-10

The Four Basic Financial Statements

Companies can prepare financial statements

at the end of the year, quarter or month.

Financial statements prepared at the end

of the year are called annual reports.
 1-11

Lets look at
MAXIDRIVE
CORP.s
financial
statements.
 1-12
1. Name of entity
2. Title of statement
3. Specific date
4. Unit of measure

The Balance
Sheet reports
the financial
position of an
entity at a
particular point
in time.
 1-13

The Balance Sheet

Basic Accounting Equation

Assets
Assets == Liabilities
Liabilities ++ Stockholders
Stockholders Equity
Equity

Economic
Resources Sources of Financing for
Economic Resources
 1-14

Assets are
economic
resources
owned by the
business as a
result of past
transactions. Amount of cash in the companys bank
Cash
accounts.
Accounts Amounts owed by customers from prior
receivable sales.
Assets are listed Inventories
Parts and completed but unsold
by their ease of products.
conversion into Plant and
Factories and production machinery.
cash. equipment
Land Land on which factories are built.
 1-15

Liabilities are
debts or
obligations of
the business
that result from
past
transactions.

Accounts Amounts owed to suppliers for prior

payable purchases.
Notes Amounts owed on written debt
payable contracts.
 1-16

Equity is the
amount of
financing
provided by
owners of the
business and
earnings.
Contributed Amounts invested in the business by
capital stockholders.
Retained Past earnings not distributed to
earnings stockholders.
 1-17

Use $ on the
first item in a
group
and on the
group total.

Assets = Liabilities + Stockholders Equity

 1-18

1. Name of entity
2. Title of statement
3. Specific period of time (Unlike the balance
sheet, this statement covers a specified
period of time.)
4. Unit of measure
 1-19

The Income Statement reports the

revenues minus expenses of the
accounting period.
 1-20

Revenues are earnings from the sale of goods or

services to customers. Revenue is recognized in the
period in which goods and services are sold, not
necessarily the period in which cash is received.
 1-21

Revenues

Earnings from the sale of goods or services.

When will the revenue from this

transaction be recognized?

$1,000 sale made Cash from sale

on May 25th. collected on June 10th.
X X
May 2006 June 2006
 1-22

Revenues

Earnings from the sale of goods or services.

When will the revenue from this

transaction be recognized?

$1,000 sale made

on May 25th.
X
May 2006
 1-23

Expenses are the dollar amount of resources used

up by the entity to earn revenues during a period. An
expense is recognized in the period in which
goods and services are used, not necessarily
the period in which cash is paid.
 1-24

Cost of The cost to produce products sold this

goods sold period.
Selling,
Operating expenses not directly related
general and
to production.
administrative
Research and Expenses incurred to develop new
development products.
Interest
The cost of using borrowed funds.
expense
Income tax Income taxes on current periods pretax
expense income.
 1-25

Expenses

The dollar amount of resources used

up by the entity to earn revenues
during a period.

When will the expense for this

transaction be recognized?

May 11 paid $75 cash Ad appears

for newspaper ad. on June 8th.
X X
May 2006 June 2006
 1-26

Expenses

The dollar amount of resources used

up by the entity to earn revenues
during a period.

When will the expense for this

transaction be recognized?

Advertising expense
recorded in June.
X
June 2006
 1-27

If expenses exceed revenues,

we report net loss.
 1-28

1. Name of entity
2. Title of statement
3. Specific period of time (Like the income
statement, this statement covers a specified
period of time.)
4. Unit of measure
 1-29

The Statement of Retained Earnings reports the way that

net income and the distribution of dividends affect the
financial position of the company during a period.
 1-30

Statement of Cash Flows

Because . . . and expenses

revenues reported reported do not
do not always equal always equal
cash collected. . . cash paid . . .

net income is
usually not equal
to the change
in cash for
the period.
 1-31

1. Name of entity
2. Title of statement
3. Specific period of time (Like the income
statement, this statement covers a specified
period of time.)
4. Unit of measure
 1-32

The Statement of Cash Flows reports the inflows and

outflows of cash during the period in the categories of
operating, investing, and financing.
 1-33

Cash flows directly related to

earning income are shown in the
operating section.
 1-34

Cash flows related to the acquisition

or sale of productive assets are
shown in the investing section.
 1-35

Cash flows from or to investors or

creditors are shown in the financing
section.
 1-36

The statement ends with a

reconciliation of Cash.
 1-37

Relationship Among the Financial Statements

Net income from the

income statement
increases ending retained
earnings on the statement
of retained earnings.
 1-38

Relationship Among the Financial Statements

Ending retained earnings

from the statement of
retained earnings is one of
the components of
stockholders equity on the
balance sheet.
 1-39

Relationship Among the Financial Statements

The change in cash on the statement of cash flows added to the

beginning of the year balance in cash equals the ending balance
in cash on the balance sheet.
 1-40

Notes

Notes provide supplemental

information about the financial
condition of a company.
Three basic types of notes:
Description of accounting rules applied.
Presentation of additional detail about an
item on the financial statements.
Provide additional information about an
item not on the financial statements.
 1-41

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 our demand for products.

Employees union and human resource

managers use the companys financial
statements as a basis for contract negotiations
over pay rates.
 1-42

Price/Earnings Ratio

Market Price (of the Company)

Price/Earnings Ratio =
Net Income

This ratio is one method

for estimating the value
of a company.
 1-43

Learning Objectives

Identify
Identify the
the role
role of
of generally
generally accepted
accepted
accounting
accounting principles
principles (GAAP)
(GAAP) inin determining
determining
the
the content
content ofof financial
financial statements.
statements.
 1-44

Responsibilities for the Accounting Communication

Process

Effective communication means that the

recipient understands what the sender
intends to convey.

Decision makers need to understand

accounting measurement rules.
 1-45

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 of most
companies were free to choose the accounting
principles used to keep track of its transactions.
 1-46

Generally Accepted Accounting Principles

(GAAP)
Securities Act of 1933
Securities and Exchange Act of 1934

The Securities and Exchange Commission (SEC)

has been given broad powers to determine
measurement rules for
financial statements.
 1-47

Generally Accepted Accounting Principles

(GAAP)

The SEC has worked closely with the

accounting profession to
work out the detailed rules that have
become known as GAAP.

Currently, the Financial Accounting

Standards Board (FASB) is recognized
as the body to formulate GAAP.
 1-48

Generally Accepted Accounting Principles

(GAAP)

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.
 1-49

International Perspective

Since 2002, there has been substantial movement

to develop international financial reporting
standards by the International Accounting
Standards Board (IASB).
 1-50

Learning Objectives

Distinguish
Distinguish the
the roles
roles of
of managers
managers and
and auditors
auditors
in
in the
the accounting
accounting communication
communication process.
process.
 1-51

Management Responsibility and the

Demand for Auditing
To ensure the accuracy of the companys
financial information, management:
Maintains a system of controls.
Hires outside independent auditors.
Forms a board of directors to review these two
safeguards.
 1-52

Independent Auditors

Auditors express an opinion

as to the fairness of the Overall, I believe
financial statement these financial
statements are
presentation. fair.
Independent auditors have
responsibilities that extend
to the general public.
 1-53

Independent Auditors

An audit involves . . .
Examining the financial reports to
ensure compliance with GAAP.
Examining the underlying
transactions incorporated into the
financial statements.
Expressing an opinion as to the
fairness of presentation of financial
information.
 1-54

Learning Objectives

Appreciate
Appreciate the
the importance
importance of of ethics,
ethics,
reputation,
reputation, and
and legal
legal liability
liability in
in accounting.
accounting.
 1-55

Ethics, Reputation, and Legal Liability

The American Institute of Certified Public

Accountants requires that all members
adhere to a professional code of ethics.
 1-56

Ethics, Reputation, and Legal Liability

A CPAs reputation for honesty and

competence is his/her most important asset.

Like physicians, CPAs have

liability for malpractice.
 1-57

End of Chapter 1