Financial Statements and Business Decisions Chapter 1 McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, Inc.

Financial Statements and Business Decisions

Chapter 1

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

McGraw-Hill/Irwin Slide 2McGraw-Hill/Irwin Slide 2

Accounting is the information system that...Accounting is the information system that...

measures business activities,measures business activities,

processes data into reports, andprocesses data into reports, and

communicates results to decision makers.communicates results to decision makers.

Accounting –The Language of Business

McGraw-Hill/Irwin Slide 3

Accounting –The Language of Business Accounting is the art of recording, classifying and

summarizing transactions, in terms of money, and interpreting the results.

McGraw-Hill/Irwin Slide 4McGraw-Hill/Irwin Slide 4

The Flow of Accounting Information

3. Businesses prepare reports to show the results of their operations.

2. Business transactions occur.

1. People make decisions.

McGraw-Hill/Irwin Slide 5McGraw-Hill/Irwin Slide 5

Accounting for Business Transactions

A transaction is any event that both affectsthe financial position of the business entity

and can be reliably recorded.

McGraw-Hill/Irwin Slide 6McGraw-Hill/Irwin Slide 6

The Account

Cash

Accounting’s main summary deviceis the account, a record of like transactions.

Accounts are grouped in three broad categories,according to the accounting equation:

McGraw-Hill/Irwin Slide 7McGraw-Hill/Irwin Slide 7

The Accounting Equation

A = L + SE(Assets) (Liabilities) (Stockholders’

Equity)

Economic Resources

Sources of Financing for Economic Resources

Liabilities: From CreditorsStockholders’ Equity: From Stockholders

McGraw-Hill/Irwin Slide 8McGraw-Hill/Irwin Slide 8

The Accounting Equation

Assets are the economic resourcesof a business that are expected toproduce a benefit in the future.

Liabilities are “outsider claims,”or economic obligations

payable to outsiders.

Owners’ equity represents the“insider claims” of a business.

McGraw-Hill/Irwin Slide 9McGraw-Hill/Irwin Slide 9

Typical Accounts—The Balance Sheet

Assets

CashShort-Term InvestmentAccounts ReceivableNotes ReceivableInventory SuppliesPrepaid ExpensesLong-Term InvestmentsEquipmentBuildingsLandIntangibles

Assets

CashShort-Term InvestmentAccounts ReceivableNotes ReceivableInventory SuppliesPrepaid ExpensesLong-Term InvestmentsEquipmentBuildingsLandIntangibles

Liabilities

Accounts PayableAccrued ExpensesNotes PayableTaxes PayableUnearned Revenue Bonds Payable

Liabilities

Accounts PayableAccrued ExpensesNotes PayableTaxes PayableUnearned Revenue Bonds Payable

Stockholders’ Equity

Contributed CapitalRetained Earnings

Stockholders’ Equity

Contributed CapitalRetained Earnings

McGraw-Hill/Irwin Slide 10McGraw-Hill/Irwin Slide 10

Typical Accounts--The Income Statement

RevenuesSales RevenueFee RevenueInterest RevenueRent Revenue

RevenuesSales RevenueFee RevenueInterest RevenueRent Revenue

ExpensesCost of Goods SoldWages ExpenseRent ExpenseInterest ExpenseDepreciation ExpenseAdvertising ExpenseInsurance ExpenseRepair ExpenseIncome Tax Expense

ExpensesCost of Goods SoldWages ExpenseRent ExpenseInterest ExpenseDepreciation ExpenseAdvertising ExpenseInsurance ExpenseRepair ExpenseIncome Tax Expense

McGraw-Hill/Irwin Slide 11McGraw-Hill/Irwin Slide 11

The Four Basic Financial Statements

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

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

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

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

McGraw-Hill/Irwin Slide 12McGraw-Hill/Irwin Slide 12

Notes to Financial Statements

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.

McGraw-Hill/Irwin Slide 13McGraw-Hill/Irwin Slide 13

Notes to Financial Statements

Descriptions of the key accounting rules that apply to the company’s statements.Descriptions of the key accounting rules that apply to the company’s statements.

Additional detail supporting reported numbers.

Additional detail supporting reported numbers.

Relevant financial information not disclosed on the statements.

Relevant financial information not disclosed on the statements.

McGraw-Hill/Irwin Slide 14McGraw-Hill/Irwin Slide 14

The Accounting System

Collects and processesfinancial information

Reportsinformationto decision

makers

Managers(internaldecisionmakers)

Investors and

Creditors(externaldecisionmakers)

McGraw-Hill/Irwin Slide 15McGraw-Hill/Irwin Slide 15

Individuals

External Users of Accounting Information

Businesses

Investors andcreditors

Governmentregulatoryagencies

Taxingauthorities

Nonprofitorganizations

McGraw-Hill/Irwin Slide 16McGraw-Hill/Irwin Slide 16

Management Users 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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Generally Accepted Accounting Principles

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.

McGraw-Hill/Irwin Slide 18McGraw-Hill/Irwin Slide 18

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

measurement rules for financial statements.

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

measurement rules for financial statements.

Securities Act of 1933Securities and Exchange Act of 1934

Securities Act of 1933Securities and Exchange Act of 1934

Generally Accepted Accounting Principles

McGraw-Hill/Irwin Slide 19McGraw-Hill/Irwin Slide 19

Generally Accepted Accounting Principles

Currently, the Financial AccountingStandards Board (FASB) is recognized

as the body to formulate GAAP.

Currently, the Financial AccountingStandards Board (FASB) is recognized

as the body to formulate GAAP.

The SEC has worked closely with theaccounting profession to

work out the detailed rules that havebecome known as GAAP.

The SEC has worked closely with theaccounting profession to

work out the detailed rules that havebecome known as GAAP.

McGraw-Hill/Irwin Slide 20McGraw-Hill/Irwin Slide 20

International Perspective

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

reporting standards (IFRS) by the International Accounting Standards Board

(IASB).

© 2008 The McGraw-Hill Companies, Inc.

End of Chapter 1

McGraw-Hill/Irwin Slide 22

More About Financial Statements

McGraw-Hill/Irwin Slide 23McGraw-Hill/Irwin Slide 23

2010ASSETSCash 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, 2010

Balance Sheet

McGraw-Hill/Irwin Slide 24McGraw-Hill/Irwin Slide 24

The Balance Sheet

Assets

CashShort-Term InvestmentAccounts ReceivableNotes ReceivableInventory (to be sold)SuppliesPrepaid ExpensesLong-Term InvestmentsEquipmentBuildingsLandIntangibles

Assets

CashShort-Term InvestmentAccounts ReceivableNotes ReceivableInventory (to be sold)SuppliesPrepaid ExpensesLong-Term InvestmentsEquipmentBuildingsLandIntangibles

Liabilities

Accounts PayableAccrued ExpensesNotes PayableTaxes PayableUnearned Revenue Bonds Payable

Liabilities

Accounts PayableAccrued ExpensesNotes PayableTaxes PayableUnearned Revenue Bonds Payable

Stockholders’ Equity

Contributed CapitalRetained Earnings

Stockholders’ Equity

Contributed CapitalRetained Earnings

Typical Accounts

McGraw-Hill/Irwin Slide 25McGraw-Hill/Irwin Slide 25

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, 2010

McGraw-Hill/Irwin Slide 26McGraw-Hill/Irwin Slide 26

The Income Statement

Revenues

Sales RevenueFee RevenueInterest RevenueRent Revenue

Revenues

Sales RevenueFee RevenueInterest RevenueRent Revenue

Expenses

Cost of Goods SoldWages ExpenseRent ExpenseInterest ExpenseDepreciation ExpenseAdvertising ExpenseInsurance ExpenseRepair ExpenseIncome Tax Expense

Expenses

Cost of Goods SoldWages ExpenseRent ExpenseInterest ExpenseDepreciation ExpenseAdvertising ExpenseInsurance ExpenseRepair ExpenseIncome Tax Expense

Typical Accounts

McGraw-Hill/Irwin Slide 27McGraw-Hill/Irwin Slide 27

Statement of Retained Earnings

MAXIDRIVE CORP.

Statement of Retained Earnings

For the Year Ended December 31, 2010

(in thousands of dollars)

Retained earnings, January 1, 2010 $6,805

Net income for 2009 3,300

Dividends for 2009 (1,000)

Retained earnings, December 31, 2010 $9,105

McGraw-Hill/Irwin Slide 28McGraw-Hill/Irwin Slide 28

Statement of Retained Earnings

Beginning Retained EarningsPlus: Net IncomeLess: DividendsEnding Retained Earnings

McGraw-Hill/Irwin Slide 29McGraw-Hill/Irwin Slide 29

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 year 5,051 Cash at end of year 4,895$

MAXIDRIVE CORP.Statement of Cash Flows

(in thousands of dollars)For the Year Ended December 31, 2010

McGraw-Hill/Irwin Slide 30

Statement of Cash Flows Distinguishes between cash received from or used for:---Operating activities---Investing activities and---Financing activities

McGraw-Hill/Irwin Slide 31McGraw-Hill/Irwin Slide 31

Information Reported on the Financial Statements

1. How well did the company perform (or operate) during the period?

Revenues– Expenses Net income (Net loss)

Incomestatement

Question AnswerFinancialStatement

2. Why did the company’s retained earnings change during the period?

Beg. retained earnings+ Net income (or – Net loss)- Dividends Ending retained earnings

Statementof

retainedearnings

McGraw-Hill/Irwin Slide 32McGraw-Hill/Irwin Slide 32

Information Reported on the Financial Statements

3. What is the company’s financial position at the end of the period?

Assets= Liabilities

+ Owners’ equity

Balancesheet

Question AnswerFinancialStatement

4. How much cash did the company generate and spend during the period?

Operating cash flows± Investing cash flows± Financing cash flowsIncrease or decrease in cash

Statementof

cashflows

McGraw-Hill/Irwin Slide 33McGraw-Hill/Irwin Slide 33

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 EarningsExpenses (8,500) Beginning retained earnings $ 59,000 Net income $ 7,000 Net income 7,000 Dividends (2,500) Ending retained earnings $ 63,500

McGraw-Hill/Irwin Slide 34McGraw-Hill/Irwin Slide 34

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

McGraw-Hill/Irwin Slide 35McGraw-Hill/Irwin Slide 35

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