2. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Financial Statements and Business Decisions

3. 1-2 Understanding the Business - Stakeholders Owner-Managers Founders of the business who also function as managers are called Owner- Managers. 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.

4. 1-3 Understanding the Business Investors purchase stock (or ownership) in businesses hoping to gain in two ways: Sell ownership interest in the future for more than they paid. Receive a portion of the company’s earnings in cash (dividends).

5. 1-4 The Accounting System Collects and processes financial information Reports information to decision makers Managers (internal decision makers) Investors and Creditors (external decision makers)

6. 1-5 The Accounting System Accounting System Financial Accounting System Periodic financial statements and related disclosures Managerial Accounting System Detailed plans and continuous performance reports External Decision Makers Investors, creditors, suppliers, customers, etc. Internal Decision Makers Managers throughout the organization

7. 1-6 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.

8. 1-7 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.

9. 1-8 Let’s look at MAXIDRIVE CORP.’s financial statements.

10. 1-9 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.

11. 1-10 The Balance Sheet Basic Accounting Equation Assets = Liabilities + Stockholders’ Equity Economic Resources Sources of Financing for Economic Resources

12. 1-11 Assets are listed by their ease of conversion into cash. Assets are listed by their ease of conversion into cash. Assets are economic resources owned by the business as a result of past transactions.

13. 1-12 Liabilities are debts or obligations of the business that result from past transactions.

14. 1-13 Equity is the amount of financing provided by owners of the business and earnings.

15. 1-14 Use $ on the first item in a group and on the group total. Assets = Liabilities + Stockholders’ Equity

16. 1-15 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

17. 1-16 The Income Statement reports the revenues minus expenses of the accounting period.

18. 1-17 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.

19. 1-18 Revenues June 2006 Cash from sale collected on June 10th. X May 2006 $1,000 sale made on May 25th. X When will the revenue from this transaction be recognized? When will the revenue from this transaction be recognized? Earnings from the sale of goods or services.

20. 1-19 Revenues Earnings from the sale of goods or services. When will the revenue from this transaction be recognized? When will the revenue from this transaction be recognized? May 2006 $1,000 sale made on May 25th. X

21. 1-20 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.

22. 1-21

23. 1-22 Expenses May 2006June 2006 May 11 paid $75 cash for newspaper ad. X Ad appears on June 8th. X The dollar amount of resources used up by the entity to earn revenues during a period. 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? When will the expense for this transaction be recognized?

24. 1-23 Expenses Advertising expense recorded in June. The dollar amount of resources used up by the entity to earn revenues during a period. 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? When will the expense for this transaction be recognized? June 2006 X

25. 1-24 If expenses exceed revenues, we report net loss.

26. 1-25 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

27. 1-26 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.

28. 1-27 Statement of Cash Flows Because revenues reported do not always equal cash collected...... and expenses reported do not always equal cash paid... net income is usually not equal to the change in cash for the period.

29. 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

30. 1-29 The Statement of Cash Flows reports the inflows and outflows of cash during the period in the categories of operating, investing, and financing.

31. 1-30 Cash flows directly related to earning income are shown in the operating section.

32. 1-31 Cash flows related to the acquisition or sale of productive assets are shown in the investing section.

33. 1-32 Cash flows from or to investors or creditors are shown in the financing section.

34. 1-33 The statement ends with a reconciliation of Cash.

35. 1-34 Relationship Among the Financial Statements Net income from the income statement increases ending retained earnings on the statement of retained earnings.

36. 1-35 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.

37. 1-36 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.

38. 1-37 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.  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.

39. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Operating Decisions and the Income Statement

40. 1-39 Elements on the Income Statement Losses Decreases in assets or increases in liabilities from peripheral transactions. Losses Revenues Increases in assets or settlement of liabilities from ongoing operations. Revenues Expenses Decreases in assets or increases in liabilities from ongoing operations. Expenses Gains Increases in assets or settlement of liabilities from peripheral transactions. Gains

41. 1-40 Papa John’s Primary Operating Activity is selling pizza and selling franchises. Operating Activities Peripheral Activities

42. 1-41 Papa John’s Primary Operating Expenses Cost of sales (used inventory) Salaries and benefits to employees Other costs (like advertising, insurance, and depreciation)

43. 1-42 Earnings Per Share Net Income Weighted Average Number of Common Shares Outstanding

44. 1-43 Corporations are taxable entities. Income tax expense is Income Before Income Taxes × Tax Rate (Federal, State, Local and Foreign).

45. 1-44 How are Financial Statements Prepared? Income Statement Revenues – Expenses = Net Income Statement of Retained Earnings Beginning Retained Earnings + Net Income - Dividends Declared Ending Retained Earnings Balance Sheet Assets = Liabilities + Stockholders’ Equity Contributed Capital Retained Earnings Statement of Cash Flows Change in Cash = Cash from Operating Activities + Cash from Investing Activities + Cash from Financing Activities

46. 1-45  Income Statement

47. 1-46  Statement of Retained Earnings The net income comes from the Income Statement just prepared.

48. 1-47 The ending cash balance agrees with the amount on the Balance Sheet.  Statement of Cash Flows

49. 1-48  Balance Sheet The ending RE balance from the Statement of Retained Earnings and the ending Cash balance from the Statement of Cash Flows feed into the asset and equity sections of the Balance Sheet.

50. 1-49 Judging Earnings Quality Companies that make relatively pessimistic estimates that reduce current income are judged to follow conservative financial reporting strategies, and experienced analysts give these reports more credence. These companies are viewed as having “higher quality” earnings. Companies that make relatively pessimistic estimates that reduce current income are judged to follow conservative financial reporting strategies, and experienced analysts give these reports more credence. These companies are viewed as having “higher quality” earnings.

51. 1-50 Financial Statement Formats Let’s take a closer look at the asset section of the balance sheet!

52. 1-51

53. 1-52 Current assets are assets that will be turned into cash or expire (be used up) within the longer of one year or the operating cycle.

54. 1-53 Property, plant and equipment includes assets with useful lives of more than one year acquired for use in the business rather than for resale. The amount is reported net of accumulated depreciation.

55. 1-54 Intangible assets have no physical existence and a long life. They include patents, copyrights, trademarks, etc.

56. 1-55 Let’s now look at the liability section of a classified balance sheet.

57. 1-56

58. 1-57 Current liabilities are obligations that will be paid with current assets, normally within one year.

59. 1-58 Long-term liabilities are debts that have maturity dates extending beyond one year from the balance sheet date.

60. 1-59 Finally, we get to the stockholders’ equity section of a classified balance sheet.

61. 1-60 Contributed capital is often shown in two separate accounts 1.Common stock. 2.Additional paid-in capital. Contributed capital is often shown in two separate accounts 1.Common stock. 2.Additional paid-in capital.

62. 1-61 Retained earnings is the total earnings of the company less the total dividends declared since inception of operations.

63. 1-62 Classified Income Statement Income statements may contain five sections: 1.Continuing operations 2.Discontinued operations 3.Extraordinary items 4.Cumulative effect of changes in accounting methods 5.Earnings per share Income statements may contain five sections: 1.Continuing operations 2.Discontinued operations 3.Extraordinary items 4.Cumulative effect of changes in accounting methods 5.Earnings per share

64. 1-63 Classified Income Statement General Format for the Classified Income Statement Gross sales minus any discounts, returns, and allowances during the period.

65. 1-64 General Format for the Classified Income Statement Classified Income Statement Cost of inventory sold.

66. 1-65 General Format for the Classified Income Statement Classified Income Statement Not related to the company’s primary operations. Usually includes interest income or expense and any gains or losses from the retirement of equipment.

67. 1-66 Common-Size Income Statement Total revenue is equal to 100%.

68. 1-67 Earnings Per Share EPS = Net Income Available to Common Shareholders Weighted Average Number of Shares Outstanding During the Reporting Period Basic EPS

69. 1-68 Earnings Per Share EPS = Net Income Available to Common Shareholders Weighted Average Number of Shares Outstanding During the Reporting Period Diluted EPS Stock options, debt securities, equity securities are assumed to be converted into common stock at the beginning of the period.

70. 1-69 Statement of Cash Flows Recall that the Statement of Cash Flows is divided into three major sections. Recall that the Statement of Cash Flows is divided into three major sections. 1.Cash flows from operating activities. 2.Cash flows from investing activities. 3.Cash flows from financing activities. We will examine the indirect method of preparing the statement. This format begins with a reconciliation of accrual income to cash flows from operations. We will examine the indirect method of preparing the statement. This format begins with a reconciliation of accrual income to cash flows from operations. Recall that the Statement of Cash Flows is divided into three major sections. Recall that the Statement of Cash Flows is divided into three major sections. 1.Cash flows from operating activities. 2.Cash flows from investing activities. 3.Cash flows from financing activities. We will examine the indirect method of preparing the statement. This format begins with a reconciliation of accrual income to cash flows from operations. We will examine the indirect method of preparing the statement. This format begins with a reconciliation of accrual income to cash flows from operations.

71. 1-70 This is the operating activities section of Callaway using the indirect method. Begin with accounting net income and arrive at cash provided by operating activities.

72. 1-71 While these items are on the income statement, they have no current cash effect.

73. 1-72 This table provides guidance for adjustments related to changes in current assets and current liabilities.

74. 1-73 Here is the rest of Callaway’s Statement of Cash Flows showing the cash balance on the company’s balance sheet.

75. 1-74 Other Items Reported on the Income Statement

76. 1-75 General Format for the Classified Income Statement Classified Income Statement In addition, companies may have nonrecurring items. These nonrecurring items may include: 1. Discontinued operations, 2. Extraordinary items, 3. Cumulative effect of changes in accounting methods. These items are reported separately because they are not useful in predicting future income of the company. In addition, companies may have nonrecurring items. These nonrecurring items may include: 1. Discontinued operations, 2. Extraordinary items, 3. Cumulative effect of changes in accounting methods. These items are reported separately because they are not useful in predicting future income of the company.

77. 1-76 Discontinued Operations Income or loss on segment’s operation for the period. Gain or loss on disposal of the segment. Gain or loss on disposal of the segment. Sale or abandonment of a segment of a business. Show net of applicable taxes.

78. 1-77 Extraordinary Items UnusualInfrequent Show net of applicable taxes.

79. 1-78 Cumulative Effect of Changes in Accounting Methods The change must be to a preferable method and must be disclosed in notes to financial statements. GAAP Method Change to Alternative GAAP Method Show net of applicable taxes.