Financial Statements

and Business Decisions

Chapter 1

McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, Inc.

Understanding the Business
The Players
Investors Creditors

Managers

1. Purchase parts 2. Manufacture

and labor product

The
Business
Operations
4. Collect cash from 3. Sell products
customers and pay to customers
creditors

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 The Accounting System

Managers
(internal
decision
Reports makers)
information
to decision
Collects and processes makers
financial information Investors
and
Creditors
(external
decision
makers)

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 The Accounting System

Accounting System

Financial Accounting System Managerial Accounting System

Periodic financial statements and Detailed plans and continuous
related disclosures performance reports

External Decision Makers Internal Decision Makers

Investors, creditors, Managers throughout the
suppliers, customers, etc. organization

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The Accounting System and Decision Makers
An organized format used by companies
to accumulate the dollar effects of
transactions.

Cash Inventory

Notes
Equipment Payable

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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.

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The Accounting Equation

A = L + SE
(Assets) (Liabilities) (Stockholders’
Equity)

Economic Sources of Financing for Economic

Resources Resources
Liabilities: From Creditors
Stockholders’ Equity: From Stockholders

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The Balance Sheet
Typical Account Titles

Assets Liabilities
Cash Accounts Payable
Short-Term Investment Accrued Expenses
Accounts Receivable Notes Payable
Notes Receivable Taxes Payable
Inventory (to be sold) Unearned Revenue
Supplies Bonds Payable
Prepaid Expenses
Long-Term Investments Stockholders’ Equity
Equipment Contributed Capital
Buildings Retained Earnings
Land
Intangibles
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Balance Sheet
MAXIDRIVE CORP.
Balance Sheet
At December 31, 2009
(in thousands of dollars)
2009
ASSETS
Cash $ 4,895
Accounts receivable 5,714
Inventories 8,517
Plant and equipment 7,154
Land 981
Total assets $ 27,261
LIABILITIES
Accounts payable $ 7,156
Notes payable 9,000
Total liabilities 16,156
STOCKHOLDERS' EQUITY
Contributed capital 2,000
Retained earnings 9,105
Total stockholders' equity 11,105
Total liabilities and stockholders' equity $ 27,261

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The Income Statement
Typical Account Titles

Revenues Expenses
Sales Revenue Cost of Goods Sold
Fee Revenue Wages Expense
Interest Revenue Rent Expense
Rent Revenue Interest Expense
Depreciation Expense
Advertising Expense
Insurance Expense
Repair Expense
Income Tax Expense

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Income Statement
MAXIDRIVE CORP.
Income Statement
For the Year Ended December 31, 2009
(in thousands of dollars)
Revenues
Sales revenue $ 37,436
Total revenues 37,436
Expenses
Cost of goods sold expense 26,980
Selling, general, and administrative expense 5,606
Interest expense 450
Total expenses 33,036
Operating income 4,400
Income tax expense 1,100
Net income $ 3,300

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Statement of Retained Earnings

Beginning Retained Earning

Plus: Net Income
Less: Dividends
Ending Retained Earnings

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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 2009 3,300
Dividends for 2009 (1,000)
Retained earnings, December 31, 2009 $9,105

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Statement of Cash Flows
MAXIDRIVE CORP.
Statement of Cash Flows
For the Year Ended December 31, 2009
(in thousands of dollars)
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
Investing Activities
Cash used to purchase equipment (1,625)
Net cash flow from investing activities (1,625)
Financing Activities
Cash received from bank loan 1,400
Cash dividends paid (1,000)
Net cash provided by financing activities 400
Net increase in cash (156)
Cash at beginning of month 5,051
Cash at end of month $ 4,895

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 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
(8,500)
Expenses Beginning retained earnings $ 59,000
Net income $ 7,000 Net income 7,000
Dividends (2,500)
Ending retained earnings $ 63,500

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 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

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 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

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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.

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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.

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Responsibilities for the Accounting
Communication Process

Effective communication means that

the recipient understands what the
sender intends to convey.

Decision makers need to understand

accounting measurement rules.

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

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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.

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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.

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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.

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International Perspective

Since 2002, there has been substantial

movement to develop international financial
reporting standards by the International
Accounting Standards Board (IASB).

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Management Responsibility and the Demand for
Auditing

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.

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Independent Auditors

 Auditors express an
Overall, I believe
opinion as to the fairness these financial
of the financial statement statements are
presentation. fair.

 Independent auditors have

responsibilities that
extend to the general
public.

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 Independent Auditors

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

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Ethics, Reputation, and Legal Liability

The American Institute of Certified Public

Accountants requires that all members
adhere to a professional code of ethics.

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Ethics, Reputation, and Legal Liability

A CPA’s reputation for honesty and

competence is his/her most important asset.

Like physicians, CPAs have

liability for malpractice.

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 End of Chapter 1

McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, Inc.