Financial Statements and Business Decisions Chapter 1 Mc

Accounting – The Language of Business Accounting is the information system that. . . measures business activities, processes data into reports, and communicates results to decision makers. Mc. Graw-Hill/Irwin Slide 2

Accounting – The Language of Business Accounting is the art of recording, classifying and summarizing transactions, in terms of money, and interpreting the results. Mc. Graw-Hill/Irwin Slide 3

The Flow of Accounting Information 1. People make decisions. 2. Business transactions occur. 3. Businesses prepare reports to show the results of their operations. Mc. Graw-Hill/Irwin Slide 4

The Accounting System Collects and processes financial information Mc. Graw-Hill/Irwin Reports information to decision makers Managers (internal decision makers) Investors and Creditors (external decision makers) Slide 5

External Users of Accounting Information Mc. Graw-Hill/Irwin Individuals Government regulatory agencies Businesses Taxing authorities Investors and creditors Nonprofit organizations Slide 6

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. Mc. Graw-Hill/Irwin Slide 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. Mc. Graw-Hill/Irwin Slide 8

The Accounting Equation A = L + SE (Assets) Economic Resources (Liabilities) (Stockholders’ Equity) Sources of Financing for Economic Resources Liabilities: From Creditors Stockholders’ Equity: From Stockholders Mc. Graw-Hill/Irwin Slide 9

The Accounting Equation Assets are the economic resources of a business that are expected to produce a benefit in the future. Liabilities are “outsider claims, ” or economic obligations payable to outsiders. Owners’ equity represents the “insider claims” of a business. Mc. Graw-Hill/Irwin Slide 10

Accounting for Business Transactions A transaction is any event that both affects the financial position of the business entity and can be reliably recorded. Mc. Graw-Hill/Irwin Slide 11

The Accounting’s main summary device is the account, a record of like transactions. Accounts are grouped in three broad categories, according to the accounting equation: Cash Mc. Graw-Hill/Irwin Slide 12

Typical Accounts Mc. Graw-Hill/Irwin Assets Liabilities Cash Short-Term Investment Accounts Receivable Notes Receivable Inventory Supplies Prepaid Expenses Long-Term Investments Equipment Buildings Land Intangibles Accounts Payable Accrued Expenses Notes Payable Taxes Payable Unearned Revenue Bonds Payable Stockholders’ Equity Contributed Capital Retained Earnings Slide 13

Generally Accepted Accounting Principles Our accounting system has a long and distinguished history. An Italian monk named Luca Pacioli, published the first elements of doubleentry 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. Mc. Graw-Hill/Irwin Slide 14

Generally Accepted Accounting Principles Securities Act of 1933 Securities and Exchange Act of 1934 The Securities and Exchange Commission (SEC) has been given broad powers to determine measurement rules for financial statements. Mc. Graw-Hill/Irwin Slide 15

Generally Accepted Accounting Principles The SEC has worked closely with the accounting profession to work out the detailed rules that have become known as GAAP. Currently, the Financial Accounting Standards Board (FASB) is recognized as the body to formulate GAAP. Mc. Graw-Hill/Irwin Slide 16

International Perspective Since 2002, there has been substantial movement to develop international financial reporting standards (IFRS) by the International Accounting Standards Board (IASB). Mc. Graw-Hill/Irwin Slide 17

Balance Sheet Mc. Graw-Hill/Irwin Slide 18

The Balance Sheet Typical Accounts Mc. Graw-Hill/Irwin Assets Liabilities Cash Short-Term Investment Accounts Receivable Notes Receivable Inventory (to be sold) Supplies Prepaid Expenses Long-Term Investments Equipment Buildings Land Intangibles Accounts Payable Accrued Expenses Notes Payable Taxes Payable Unearned Revenue Bonds Payable Stockholders’ Equity Contributed Capital Retained Earnings Slide 19

Income Statement Mc. Graw-Hill/Irwin Slide 20

The Income Statement Typical Accounts Mc. Graw-Hill/Irwin Revenues Expenses Sales Revenue Fee Revenue Interest Revenue Rent Revenue Cost of Goods Sold Wages Expense Rent Expense Interest Expense Depreciation Expense Advertising Expense Insurance Expense Repair Expense Income Tax Expense Slide 21

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 Net income for 2009 Mc. Graw-Hill/Irwin $6, 805 3, 300 Dividends for 2009 (1, 000) Retained earnings, December 31, 2010 $9, 105 Slide 22

Statement of Retained Earnings Beginning Retained Earnings Plus: Net Income Less: Dividends Ending Retained Earnings Mc. Graw-Hill/Irwin Slide 23

Statement of Cash Flows Mc. Graw-Hill/Irwin Slide 24

Statement of Cash Flows Distinguishes between cash received from or used for: ---Operating activities ---Investing activities and ---Financing activities Mc. Graw-Hill/Irwin Slide 25

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. Mc. Graw-Hill/Irwin Slide 26

Notes to Financial Statements Descriptions of the key accounting rules that apply to the company’s statements. Additional detail supporting reported numbers. Relevant financial information not disclosed on the statements. Mc. Graw-Hill/Irwin Slide 27

Information Reported on the Financial Statements Question Answer Financial Statement 1. How well did the Revenues company perform Income – Expenses (or operate) during statement Net income (Net loss) the period? 2. Why did the company’s Statement Beg. retained earnings of + Net income (or – Net loss) change during the retained - Dividends period? Ending retained earnings Mc. Graw-Hill/Irwin Slide 28

Information Reported on the Financial Statements Question Answer 3. What is the company’s financial position at the end of the period? Assets = Liabilities + Owners’ equity 4. How much cash did the company generate and spend during the period? Mc. Graw-Hill/Irwin Financial Statement Balance sheet Statement Operating cash flows of ± Investing cash flows cash ± Financing cash flows Increase or decrease in cash Slide 29

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 (8, 500) Expenses Net income $ 7, 000 Mc. Graw-Hill/Irwin Statement of Retained Earnings Beginning retained earnings $ 59, 000 Net income 7, 000 Dividends (2, 500) Ending retained earnings $ 63, 500 Slide 30

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 Beginning retained earnings $ 59, 000 Net income 7, 000 Dividends (2, 500) Ending retained earnings $ 63, 500 Mc. Graw-Hill/Irwin Balance Sheet Cash Other assets Total assets Liabilities Stockholders' Equity Common stock Retained earnings Total liabilities and equity $ 14, 000 171, 500 $ 185, 500 $ 42, 000 80, 000 63, 500 $ 185, 500 Slide 31

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 Cash flows from operating activities Cash flows from investing activities Cash flows from financing activities Increase in cash Beginning cash balance Ending cash balance Mc. Graw-Hill/Irwin Balance Sheet $ 21, 000 (16, 000) 3, 500 $ 8, 500 5, 500 $ 14, 000 Cash Other assets Total assets Liabilities Stockholders' Equity Common stock Retained earnings Total liabilities and equity $ 14, 000 171, 500 $ 185, 500 $ 42, 000 80, 000 63, 500 $ 185, 500 Slide 32

Independent Auditors l Auditors express an opinion as to the fairness of the financial statement presentation. l Independent auditors have responsibilities that extend to the general public. Mc. Graw-Hill/Irwin Overall, I believe these financial statements are fair. Slide 33

Independent Auditors An audit involves. . . l Examining the financial reports to ensure compliance with GAAP. l Examining the underlying transactions incorporated into the financial statements. l Expressing an opinion as to the fairness of presentation of financial information. Mc. Graw-Hill/Irwin Slide 34