copyright © 2007 by the mcgraw-hill companies, inc. all rights reserved

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

FinancialStatements

andBusiness

Decisions

Chapter 1

1-3

Understanding the Business

Owner-Managers

Founders of the business who also function as managers are called Owner-Mangers.

Creditors

Creditors lend money for a specific period of time and gain by charging interest on the money they lend.

Investors

Investors buy ownership in the company in the form of stock.

1-4

Understanding the Business

Investors purchase stock (or ownership) in businesses hoping to gain in two ways:

Sellownership

interest in thefuture for more

than they paid.

Receive aportion of thecompany’s

earnings in cash(dividends).

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 the information conveyed in each of the four basic financial statements and the way

that it is used by different decision makers (investors, creditors, and managers).

Recognize the information conveyed in each of the four basic financial statements and the way

that it is used by different decision makers (investors, creditors, and managers).

1-7

The Accounting System

Collects and processesfinancial information

Reportsinformationto decision

makers

Managers(internaldecisionmakers)

Investors and

Creditors(externaldecisionmakers)

1-8

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

1-9

The Four Basic Financial Statements

Income StatementBalance Sheet

Statement of Cash Flows Statement of Retained Earnings

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

Let’s look at MAXIDRIVE

CORP.’s financial

statements.

1-12MAXIDRIVE CORP.Balance Sheet

At December 31, 2006(in thousands of dollars)

AssetsCash 4,895$ Accounts receivable 5,714 Inventories 8,517 Plant and equipment 7,154 Land 981 Total assets 27,261$

Liabilities and Stockholders' Equity

Liabilities

Accounts 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$

1. Name of entity2. Title of statement3. Specific date4. Unit of measure

The Balance Sheet reports the financial

position of an entity at a

particular point in time.

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 = Liabilities + Stockholders’ EquityAssets = Liabilities + Stockholders’ Equity

EconomicResources Sources of Financing for

Economic Resources





Liabilities


Notes payable 9,000




Assets are listed Assets are listed by their ease ofby their ease ofconversion into conversion into

cash.cash.

Assets are listed Assets are listed by their ease ofby their ease ofconversion into conversion into

cash.cash.

CashAmount of cash in the company’s bank accounts.

Accounts receivable

Amounts owed by customers from prior sales.

InventoriesParts and completed but unsold products.

Plant and equipment

Factories and production machinery.

Land Land on which factories are built.

AssetsAssets are are economic economic resources resources

owned by the owned by the business as a business as a result of past result of past transactions.transactions.

AssetsAssets are are economic economic resources resources

owned by the owned by the business as a business as a result of past result of past transactions.transactions.





Liabilities


Notes payable 9,000




LiabilitiesLiabilities are are debts or debts or

obligations of obligations of the business the business

that result from that result from past past

transactions.transactions.

LiabilitiesLiabilities are are debts or debts or

obligations of obligations of the business the business

that result from that result from past past

transactions.transactions.

Accounts payable

Amounts owed to suppliers for prior purchases.

Notes payable

Amounts owed on written debt contracts.





Liabilities


Notes payable 9,000




Contributed capital

Amounts invested in the business by stockholders.

Retained earnings

Past earnings not distributed to stockholders.

EquityEquity is the is the amount of amount of financing financing

provided by provided by owners of the owners of the business and business and

earnings.earnings.

EquityEquity is the is the amount of amount of financing financing

provided by provided by owners of the owners of the business and business and

earnings.earnings.





Liabilities


Notes payable 9,000




Use Use $$ on the on the first item in a first item in a

groupgroupand on the and on the group total.group total.

Assets = Liabilities + Stockholders’ Equity

1-18

1. Name of entity2. 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 The Income StatementIncome Statement reports the reports the revenues minus expenses of the revenues minus expenses of the

accounting period.accounting period.

The The Income StatementIncome Statement reports the reports the revenues minus expenses of the revenues minus expenses of the

accounting period.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.

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

June 2006

Cash from salecollected on June 10th.

XMay 2006

$1,000 sale madeon May 25th.

X

When will the revenue from thistransaction be recognized?


Earnings from the sale of goods or services.Earnings from the sale of goods or services.

1-22

Revenues

Earnings from the sale of goods or services.Earnings from the sale of goods or services.



May 2006

$1,000 sale madeon May 25th.

X

1-23

Expenses are the dollar amount of resources usedExpenses are the dollar amount of resources usedup by the entity to earn revenues during a period. An up by the entity to earn revenues during a period. An

expense is recognized in the period in whichexpense is recognized in the period in whichgoods and services are goods and services are usedused, not necessarily, not necessarily

the period in which cash is paid.the period in which cash is paid.

1-24

Cost of goods sold

The cost to produce products sold this period.

Selling, general and

administrative

Operating expenses not directly related to production.

Research and development

Expenses incurred to develop new products.

Interest expense

The cost of using borrowed funds.

Income tax expense

Income taxes on current period’s pretax income.

1-25

Expenses

May 2006 June 2006

May 11 paid $75 cashfor newspaper ad.

X

Ad appearson June 8th.

X

The dollar amount of resources usedThe dollar amount of resources usedup by the entity to earn revenuesup by the entity to earn revenues

during a period.during a period.



When will the expense for thisWhen will the expense for thistransaction be recognized?transaction be recognized?


1-26

Expenses

Advertising expenseAdvertising expenserecorded in June.recorded in June.







June 2006X

1-27

If expenses exceed revenues,If expenses exceed revenues,we report net loss.we report net loss.

1-28

MAXIDRIVE CORP.Statement of Retained Earnings

For the Year Ended December 31, 2006(in thousands of dollars)

Retained earnings, January 1, 2006 6,805$ Net income for 2006 3,300 Dividends for 2006 (1,000) Retained earnings, December 31, 2006 9,105$

1. Name of entity2. 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 The Statement of Retained EarningsStatement of Retained Earnings reports the way that net reports the way that net income and the distribution of dividends affect the financial income and the distribution of dividends affect the financial

position of the company during a period.position of the company during a period.

The The Statement of Retained EarningsStatement of Retained Earnings reports the way that net reports the way that net income and the distribution of dividends affect the financial income and the distribution of dividends affect the financial

position of the company during a period.position of the company during a period.




1-30

Statement of Cash Flows

Because revenues reported do not always equal

cash collected. . .

. . . and expensesreported do not

always equalcash paid . . .

net income isusually not equal

to the changein cash forthe period.

1-31

MAXIDRIVE CORP.


For the Year Ended December 31, 2006

(in thousands of dollars)

Cash flows from 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$ Cash flow from investing activities: Cash paid to purchase equipment (1,625)$ Net cash flow from investing activities (1,625)

Cash flow from financing activities:

Cash received from bank loan 1,400$

Cash paid for dividends (1,000)

Net cash flow from financing activities 400

Net decrease in cash during the year (156)$

Cash at beginning of the year 5,051

Cash at end of the year 4,895$

1. Name of entity2. 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

MAXIDRIVE CORP.












The The Statement of Cash FlowsStatement of Cash Flows reports the inflows and reports the inflows and outflows of cash during the period in the categories of outflows of cash during the period in the categories of

operatingoperating, , investinginvesting, and , and financingfinancing..

The The Statement of Cash FlowsStatement of Cash Flows reports the inflows and reports the inflows and outflows of cash during the period in the categories of outflows of cash during the period in the categories of

operatingoperating, , investinginvesting, and , and financingfinancing..

1-33

MAXIDRIVE CORP.












Cash flows directly related to Cash flows directly related to earning income are shown in the earning income are shown in the

operating sectionoperating section..

Cash flows directly related to Cash flows directly related to earning income are shown in the earning income are shown in the

operating sectionoperating section..

1-34

MAXIDRIVE CORP.












Cash flows related to the acquisition Cash flows related to the acquisition or sale of productive assets are or sale of productive assets are shown in the shown in the investing sectioninvesting section..

Cash flows related to the acquisition Cash flows related to the acquisition or sale of productive assets are or sale of productive assets are shown in the shown in the investing sectioninvesting section..

1-35

MAXIDRIVE CORP.












Cash flows from or to investors or Cash flows from or to investors or creditors are shown in the creditors are shown in the financing financing

sectionsection..

Cash flows from or to investors or Cash flows from or to investors or creditors are shown in the creditors are shown in the financing financing

sectionsection..

1-36

MAXIDRIVE CORP.












The statement ends with a The statement ends with a reconciliation of Cashreconciliation of Cash..

The statement ends with a The statement ends with a reconciliation of Cashreconciliation of Cash..

1-37

Relationship Among the Financial Statements




Net incomeNet income from the from the income statement income statement

increases ending retained increases ending retained earningsearnings on the statement on the statement

of retained earnings.of retained earnings.

1-38

MAXIDRIVE CORP.Balance Sheet




Liabilities


Notes payable 9,000








Ending retained earningsEnding retained earnings from the statement of from the statement of

retained earnings is one of retained earnings is one of the components of the components of

stockholders’ equitystockholders’ equity on the on the balance sheet.balance sheet.

1-39

MAXIDRIVE CORP.Balance Sheet




Liabilities


Notes payable 9,000





The The change in cashchange in cash on the statement of cash flows added to the on the statement of cash flows added to the beginning of the year balancebeginning of the year balance in cash equals the in cash equals the ending balance ending balance

in cashin cash on the balance sheet. on the balance sheet.

MAXIDRIVE CORP.












1-40

Notes

Notes provide supplemental Notes provide supplemental information about the financial information about the financial condition of a company.condition of a company.

Three basic types of notes:Three basic types of notes: Description of accounting rules applied.Description of accounting rules applied. Presentation of additional detail about an Presentation of additional detail about an

item on the financial statements.item on the financial statements. Provide additional information about an Provide additional information about an

item not on the financial statements.item not on the financial statements.

Notes provide supplemental Notes provide supplemental information about the financial information about the financial condition of a company.condition of a company.

Three basic types of notes:Three basic types of notes: Description of accounting rules applied.Description of accounting rules applied. Presentation of additional detail about an Presentation of additional detail about an

item on the financial statements.item on the financial statements. Provide additional information about an Provide additional information about an

item not on the financial statements.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 company’s financial

statements as a basis for contract negotiations over pay rates.

1-42

Price/Earnings Ratio

Price/Earnings Ratio =Market Price (of the Company)

Net Income

This ratio is one method This ratio is one method for estimating the value for estimating the value

of a company.of a company.

This ratio is one method This ratio is one method for estimating the value for estimating the value

of a company.of a company.

1-43

Learning Objectives

Identify the role of generally accepted accounting principles (GAAP) in determining

the content of financial statements.

Identify the role of generally accepted accounting principles (GAAP) in determining

the content of financial statements.

1-44

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

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

Responsibilities for the Accounting Communication Process

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

intends to convey.intends to convey.

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

intends to convey.intends to convey.

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

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.

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

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

Generally Accepted Accounting Principles (GAAP)

1-47


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

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

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

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.

1-48


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 the roles of managers and auditors in the accounting communication process.

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

1-51

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

1-52

Independent Auditors

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

Independent auditors have responsibilities that extend to the general public.

Overall, I believethese financialstatements are

fair.

1-53

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 Examining the underlying

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

1-54

Learning Objectives

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

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

1-55

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.

1-56

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

Like physicians, CPAs have

liability for malpractice.

Ethics, Reputation, and Legal Liability

1-57

End of Chapter 1

copyright © 2007 by the mcgraw-hill companies, inc. all rights reserved

Documents

organization slide

earnings financial statements

unit of measure slide

financial position

financial activities

investors investors

creditors creditors

business decisions chapter