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

31-3 Understanding the Business The Players Investors Creditors Managers The Business Operations 1. Purchase parts and labor 2. Manufacture product 3. Sell products to customers 4. Collect cash from customers and pay creditors

41-4 The Accounting System Collects and processes financial information Reports information to decision makers Managers (internal decision makers) Investors and Creditors (external decision makers)

51-5 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

61-6 The Accounting System and Decision Makers CashEquipmentInventory Notes Payable An organized format used by companies to accumulate the dollar effects of transactions.

71-7 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. 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.

81-8 The Accounting Equation A = L + SE (Assets) (Liabilities) (Stockholders’ Equity) Economic Resources Sources of Financing for Economic Resources Liabilities: From Creditors Stockholders’ Equity: From Stockholders

91-9 The Balance Sheet Assets Cash Short-Term Investment Accounts Receivable Notes Receivable Inventory (to be sold) Supplies Prepaid Expenses Long-Term Investments Equipment Buildings Land Intangibles Liabilities Accounts Payable Accrued Expenses Notes Payable Taxes Payable Unearned Revenue Bonds Payable Stockholders’ Equity Contributed Capital Retained Earnings Typical Account Titles Liabilities Accounts Payable Accrued Expenses Notes Payable Taxes Payable Unearned Revenue Bonds Payable Stockholders’ Equity Contributed Capital Retained Earnings

Balance Sheet

The Income Statement Revenues Sales Revenue Fee Revenue Interest Revenue Rent Revenue Expenses Cost of Goods Sold Wages Expense Rent Expense Interest Expense Depreciation Expense Advertising Expense Insurance Expense Repair Expense Income Tax Expense Typical Account Titles

Income Statement

Statement of Retained Earnings Beginning Retained Earning Plus: Net Income Less: Dividends Ending Retained Earnings

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 ,300 Dividends for 2009 (1,000) Retained earnings, December 31, 2009 $9,105

Statement of Cash Flows

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

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 Sheet Beginning 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

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 Sheet Cash 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

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.

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.

Decision makers need to understand accounting measurement rules. Decision makers need to understand accounting measurement rules. Responsibilities for the Accounting Communication Process Effective communication means that the recipient understands what the sender intends to convey. Effective communication means that the recipient understands what the sender intends to convey.

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

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 1933 Securities and Exchange Act of 1934 Securities Act of 1933 Securities and Exchange Act of 1934 Generally Accepted Accounting Principles

Generally Accepted Accounting Principles Currently, the Financial Accounting Standards Board (FASB) is recognized as the body to formulate GAAP. Currently, the Financial Accounting Standards Board (FASB) is recognized as the body to formulate GAAP. The SEC has worked closely with the accounting profession to work out the detailed rules that have become known as GAAP. The SEC has worked closely with the accounting profession to work out the detailed rules that have become known as GAAP.

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.

International Perspective Since 2002, there has been substantial movement to develop international financial reporting standards by the International Accounting Standards Board (IASB).

To ensure the accuracy of the company’s financial 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

Auditors express an opinion as to the fairness of the financial statement presentation. Auditors express an opinion as to the fairness of the financial statement presentation. Independent auditors have responsibilities that extend to the general public. Independent auditors have responsibilities that extend to the general public. Independent Auditors Overall, I believe these financial statements are fair.

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

1-30 Ethics, Reputation, and Legal Liability The American Institute of Certified Public Accountants requires that all members adhere to a professional code of ethics. The American Institute of Certified Public Accountants requires that all members adhere to a professional code of ethics.

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

© 2009 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin End of Chapter 1