1. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Financial Statements and Business Decisions Chapter 1

2. 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.

3. 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).

4. 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)

5. 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

6. 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.

7. 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.

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

9. 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.

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

11. 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.

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

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

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

15. 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

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

17. 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.

18. 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.

19. 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

20. 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.

21. 1-21

22. 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?

23. 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

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

25. 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

26. 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.

27. 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.

28. 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

29. 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.

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

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

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

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

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

35. 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.

36. 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.

37. 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.

38. 1-38 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.

39. 1-39 How are Generally Accepted Accounting Principles (GAAP) 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.

40. 1-40 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 (GAAP)

41. 1-41 Generally Accepted Accounting Principles (GAAP) 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.

42. 1-42 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.

43. 1-43 International Perspective Since 2002, there has been substantial movement to develop international financial reporting standards by the International Accounting Standards Board (IASB).

44. 1-44 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

45. 1-45 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 believe these financial statements are fair.

46. 1-46 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.

47. 1-47 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.

48. 1-48 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