Chapter 1: Financial Statements and Business Decisions
Individuals and groups who provide the initial capital to a business are called investors. Creditors provide the company with resources but do not own a share of the company. For example, a bank may lend funds to the company that must be repaid in the future along with interest. The bank is a creditor of the company. Most companies hire managers to oversee the day-to-day operations of the business. The managers are responsible to the owners of the company. For a manufacturing company, business operations begin when materials are purchased from suppliers, and workers are paid for labor. The materials and workers are used to manufacture a product. That product is sold to customers of the company. Finally, cash is collected from the customers for the products sold which allows creditors and workers to be paid.
The accounting system begins by collecting and processing financial information. This financial information is organized into reports that are distributed to decision-makers. The decision-makers may rely on the reports to make certain important determinations about the future.
The accounting system collects and processes financial information about an organization and reports that information to decision makers. The accounting system provides financial accounting reports which include periodic financial statements and related disclosures to external decision makers. These decision-makers include investors, creditors, suppliers, customers, union representatives, and all other interested parties. The accounting system also provides managerial accounting reports including detailed plans and continuous performance reports. These reports are used by internal decision makers throughout the organization to make decisions about pricing, production, quality, and numerous other day-to-day activities.
Companies usually publish four basic financial statements, as follows: BALANCE SHEET – reports the amount of assets, liabilities, and stockholders’ equity of an accounting entity at a point in time. INCOME STATEMENT – reports the revenues less the expenses of the accounting period. STATEMENT OF RETAINED EARNINGS – reports the way that net income and distribution of dividends affected the financial position of the company during the accounting period. STATEMENT OF CASH FLOWS – reports inflows and outflows of cash during the accounting period in the categories of operating, investing, and financing.
The basic accounting equation shows a company’s financial position: the economic resources (assets) that the company owns and the sources of financing for those assets (liabilities and stockholders’ equity) are always equal. Assets are economic resources of the company that have some future economic benefit. Liabilities are the company’s debts or obligations. Stockholders’ equity indicates the amount of financing provided by owners of the business and earnings of the company since inception.
The purpose of the balance sheet is to report the financial position (assets, liabilities and stockholders’ equity) of an entity at a particular point in time. Here is a list of balance sheet accounts grouped into categories. These categories on the balance sheet, also known as elements, are assets, liabilities, and stockholders’ equity. Assets are economic resources owned by the company. The exact list of assets depends on the individual company, but this is a representative list. All assets are expected to provide future benefits to the company. Liabilities are the company’s debts or obligations. Stockholders’ equity generally consists of two parts. First, contributed capital indicates the amount of financing provided by owners of the business. Next, retained earnings is the amount of income that has been earned by the company that has been reinvested in the business. A portion of income is typically distributed to stockholders in the form of dividends and the remainder is retained by the business. In this course we will discuss all of these accounts in detail.
Here is a sample balance sheet. Notice the four-line heading for our balance sheet. The heading includes the name of the company (Maxidrive Corp.), the title of the financial statement (Balance Sheet), the specific date of the statement (at December 31, 2010), and a unit of measure (in thousands of dollars). When preparing the balance sheet, the basic accounting equation of assets equal liabilities plus shareholders’ equity holds true. On this balance sheet, total assets are equal to total liabilities and stockholders’ equity, at an amount of $27,261.
The income statement reports the revenues less the expenses of the accounting period. Here is a list of typical account titles on the income statement, grouped into the categories of revenues and expenses. The first category, or element, is revenues. Companies earn revenues from the sale of goods and services to customers. A few examples of revenues include sales revenue, interest revenue and rent revenue. Expenses represent the dollar amount of resources used to earn revenues during the period. Examples are wages expense, rent expense, and advertising expense. When revenues exceed expenses for the period, the company has earned net income. If expenses are greater than revenues in the period, the company incurred a net loss. As with the balance sheet accounts, we will discuss each of these revenue and expense accounts as we move through the course.
Here is an example of an income statement. Notice our standard four-line heading. The first line contains the name of the company. The second line is the name of the financial statement, in this case the words “income statement.” The third line is the accounting period covered by the income statement, for example, “for the year ended December 31, 2010.” While the balance sheet has a date for a point in time, the income statement covers of period of time. The fourth line indicates the unit of measure, in this case, thousands of dollars. On the income statement, we subtract expenses from revenues to arrive at net income.
The purpose of the statement of retained earnings is to report the reinvestment of earnings from the company gained during the current period less the dividends paid to shareholders of the company. The statement begins with last period’s ending retained earnings, and then adds net income reported on the income statement for this year. Next, any dividends declared during the period are subtracted to arrive at ending retained earnings.
Here is an example of a statement of retained earnings for Maxidrive Corporation for the year ended December 31, 2010. Notice that when a formal statement of retained earnings is prepared, the format of the title is similar to the other financial statements. The first line contains the name of the company. The second line is the name of the financial statement, in this case the words “statement of retained earnings.” The third line is the accounting period covered, for example “for the year ended December 31, 2010.” Like the income statement, the statement of retained earnings covers of period of time. Some companies show dollar amounts in thousands or millions.
The Statement of Cash Flows reports inflows and outflows of cash during the accounting period using three categories: operating, investing, and financing activities. On the statement of cash flows, operating activities involve the cash provided and used in the normal business operations of the company. This section of the statement includes cash collected from the sale of products to customers, cash paid to suppliers for materials and to employees for the labor to manufacture and distribute the product. In addition, we show cash paid for interest and taxes. Investing activities involve the purchase or sale of long-term productive assets, the lending of monies to others, and the receiving principal payments back from those loans. When we purchase a long-term productive asset, it’s a cash outflow; when we sell a productive asset, it’s a cash inflow. When we loan funds to others, it’s a cash outflow; when we receive principal payments on those loans, it’s a cash inflow. Financing activities involve borrowing and repaying amounts from financial institutions and the sale or repurchase of the company’s stock. In addition, the payment of a cash dividend is classified as a financing activity. When we borrow money from a financial institution, it’s a cash inflow; repaying the principal amount is a cash outflow. When the company sells stock, it’s a cash inflow; if the company repurchases its own stock, it’s a cash outflow. The payment of cash dividends is always a cash outflow. Notice that our three-line heading contains the name of the company, the name of the financial statement and the time period covered by the statement. In addition, Maxidrive shows dollar amounts in thousands. The income statement, statement of retained earnings, and statement of cash flows cover a period of time.
Several relationships exist among the individual financial statements. First, net income reported on the income statement flows to the statement of retained earnings and increases the retained earnings account balance. In this example, the $3,300 net income reported on the income statement increases retained earnings on the statement of retained earnings.
Another relationship that exists among the financial statements is that ending retained earnings from the statement of retained earnings is one of the two components of stockholders’ equity on the balance sheet. In this example, the $9,105 ending retained earnings from the statement of retained earnings also appears on the Balance Sheet.
On the Statement of Cash Flows, the total increase or decrease in cash from the three categories of activities is added to the beginning of the year cash balance to arrive at the end of the year cash balance. This amount also appears on the Balance Sheet. In this example, the decrease of cash during the period of $156 is subtracted from the beginning cash balance of $5,051, to arrive at end-of-period cash balance of $4,895. The end-of-period cash balance of $4,895 also appears on the balance sheet.
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. These notes provide supplemental information about the financial condition of a company, without which the financial statements cannot be fully understood. There are three basic types of notes. The first type provides descriptions of the accounting rules applied in the company’s financial statements. The second presents additional detail about a line on the financial statement. For example, it is common to find a note that describes the details of a long-term debt agreement. The last type of note provides additional financial disclosures about items not listed in the financial statements. For example, a company may lease, rather than purchase, major pieces of machinery and equipment.
Financial statements provide information to investors and creditors. Managers within the company also use the information on the financial statements. The Marketing and credit managers use financial information for preparing budgets or for determining whether or not to extend credit to a customer. A purchasing manager may use a supplier’s financial statement to see whether or not the supplier has the resources necessary to meet the company’s demands. Employees and union representatives may use financial information in contract negotiations.
We have learned a great deal about the content of the four basic financial statements. This slide provides a summary by listing each financial statement, its purpose, structure, and examples of content. 1-
Decision makers need to understand the measurement rules applied in computing the numbers on the financial statements. These rules are called Generally Accepted Accounting Principles, or GAAP.
Luca Pacioli, an Italian monk and mathematician, first published the elements of our double-entry bookkeeping system in 1494. Until the stock market crash of 1929, most companies decided on their own accounting principles. There was little uniformity or comparability of accounting information. Congress stepped in to regulate accounting measurement in 1933.
Following the dramatic stock market decline of 1929, the Securities Act of 1933 and the Securities Exchange Act of 1934 were passed into law by the U.S. Congress. These acts created the Securities and Exchange Commission (SEC) and gave it broad powers to determine the measurement rules for financial statements that companies issuing stock to the public must provide to stockholders.
The Securities and Exchange Commission has worked with organizations of professional accountants to establish groups that are given the primary responsibilities to work out the detailed rules that become generally accepted accounting principles. Currently, the Financial Accounting Standards Board (FASB) has the responsibility to formulate generally accepted accounting principles.
Generally accepted accounting principles (GAAP) are of great interest to the companies that must prepare financial statements, their auditors, and the readers of the statements. Companies and their managers and owners are most directly affected by the information presented in financial statements. Companies incur the cost of preparing the statements and bear the major economic consequences of their publication, which include, among others, 1. Effects on the selling price of a company’s stock. 2. Effects on the amount of bonuses received by management and employees. 3. Loss of competitive information to other companies.
Since 2002, there has been substantial movement toward the adoption of International Financial Reporting Standards (IFRS) issued by the International Accounting Standards Board (IASB). The use of IFRS is increasing, with many countries or jurisdictions either currently requiring IFRS or committed to require IFRS by 2012. In the United States, the Securities and Exchange Commission now allows foreign companies whose stock is traded in the U.S. to use IFRS and is considering requiring the use of IFRS for U.S. domestic companies by 2014. To prepare you for this eventuality, we will point out key differences between IFRS and U.S. GAAP starting in Chapter 6. The basic principles and practices we discuss in Chapters 1 through 5 apply equally to both sets of standards.
Primary responsibility for the information in the financial statements lies with management, represented by the highest officer of the company and the highest financial officer. Companies take three important steps to assure investors that the company’s records are accurate: (1) they maintain a system of controls over both the records and the assets of the company, (2) they hire outside independent auditors to verify the fairness of the financial statements, and (3) they form a committee of the board of directors to oversee the integrity of these other two safeguards. These responsibilities are often reiterated in a formal report of management or management certification in the annual report. These three safeguards and a management certification are required for companies with publicly traded stock.
Management prepares the financial statements for a company and an independent auditor is hired to express an opinion as to the fairness of the financial statement presentation. They are responsible to the general public for the opinions they render. The Public Company Accounting Oversight Board (PCAOB) is the private sector body given the primary responsibility to issue detailed auditing standards. They work in consultation with the SEC to set standards for the audits of public companies.
An independent audit involves the examination of the financial reports (prepared by the management of the entity) to ensure that they represent what they claim to and conform with generally accepted accounting principles (GAAP). In performing an audit, the independent CPA examines the underlying transactions and the accounting methods used to account for these transactions. Because of the enormous number of transactions, the CPA does not examine each of these transactions. Rather, professional approaches are used to ascertain beyond reasonable doubt that transactions were measured and reported properly. Based on the audit, the independent auditor issues a report expressing an opinion as to the fairness of the presentation of the financial information.
If financial statements are to be of any value to decision makers, users must have confidence in the fairness of the information they present. Users will have greater confidence in the information if they know that the people who audited the statements were required to meet professional standards of ethics and competence. The American Institute of Certified Public Accountants (AICPA) requires all of its members to adhere to a professional code of ethics and professional auditing standards, and auditors of public companies must register with and comply with standards set by the Public Company Accounting Oversight Board (PCAOB). Failure to comply with the rules of conduct can result in serious professional penalties. CPAs’ reputations for honesty and competence are their most important assets. The potential economic effects of damage to reputation, malpractice liability, and potential fines provide even stronger incentives to abide by professional standards.
Like physicians and lawyers, a CPA’s reputation for honesty and competency is his or her most important asset. Like physicians and lawyers, CPAs are liable for malpractice.
This textbook emphasizes accounting for profit-making business entities. Supplement A discusses three types of business entities: sole proprietorship, partnership, and corporation. A sole proprietorship is owned by one person; it usually is small in size and is common in the service, retailing, and farming industries. A partnership is owned by two or more persons known as partners. A partnership is not legally separate from its owners and each general partner has unlimited liability. In a corporation ownership is represented by shares of stock. The owners are called stockholders or shareholders. In terms of economic importance, the corporation is the dominant form of business organization in the United States. This dominance is caused by the many advantages of the corporate form: (1) limited liability for the stockholders, (2) continuity of life, (3) ease in transferring ownership (stock), and (4) opportunities to raise large amounts of money by selling shares to a large number of people. The primary disadvantage of a corporation is that its income may be subject to double taxation (income is taxed when it is earned and again when it is distributed to stockholders as dividends). 1-
Supplement B discusses employment opportunities in the accounting profession. An accountant may be licensed as a certified public accountant, or CPA. An accountant may also be licensed as a certified management accountant, or CMA, or a certified internal auditor, or CIA. Career opportunities include careers in public accounting firms. Accounting firms usually render three types of services: audit or assurance services, management consulting services, and tax services. Another option for employment for accountants is working with individual profit-making and nonprofit organizations. A primary function of the accountants in organizations is to provide data that are useful for internal managerial decision making and for controlling operations. The functions of external reporting, tax planning, control of assets, and a host of related responsibilities normally are also performed by accountants in industry. There are also career opportunities for accountants in governmental units, from the local to the international level. The same holds true for other not-for-profit organizations such as hospitals and universities. 1-
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
The Accounting System Collects and processes financial information Managers (internal decision makers) Investors and Creditors (external decision makers) Reports information to decision makers
The Accounting System Accounting System External Decision Makers Investors, creditors, suppliers, customers, etc. Internal Decision Makers Managers throughout the organization Financial Accounting Reports Periodic financial statements and related disclosures Managerial Accounting Reports Detailed plans and continuous performance reports
BALANCE SHEET – reports the amount of assets, liabilities, and stockholders’ equity of an accounting entity at a point in time.
INCOME STATEMENT – reports the revenues less the expenses of the accounting period.
STATEMENT OF RETAINED EARNINGS – reports the way that net income and distribution of dividends affected the financial position of the company during the accounting period.
STATEMENT OF CASH FLOWS – reports inflows and outflows of cash during the accounting period in the categories of operating, investing, and financing.
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
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, 2010 (in thousands of dollars) Retained earnings, January 1, 2010 $6,805 Net income for 2010 3,300 Dividends for 2010 (1,000) Retained earnings, December 31, 2010 $9,105
Net income from the income statement results in an increase in ending retained earnings on the statement of retained earnings.
Income Statement Revenues $ 37,436 Statement of Retained Earnings Expenses 34,136 Beginning retained earnings $ 6,805 Net income $ 3,300 Net income 3,300 Dividends (1,000) Ending retained earnings $ 9,105
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 over pay rates.
Responsibilities for the Accounting Communication Process Generally Accepted Accounting Principles (GAAP) The Rules
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 largely free to choose their own financial reporting practices.
Generally Accepted Accounting Principles 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
Generally Accepted Accounting Principles 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.
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 International Financial Reporting Standards Since 2002, there has been substantial movement toward the adoption of International Financial Reporting Standards (IFRS) issued by the International Accounting Standards Board (IASB). Examples of jurisdictions requiring the use of IFRS either currently or by 2012 include: • European Union • Australia and New Zealand • Hong Kong, India, Malaysia, and South Korea • Israel and Turkey • Brazil and Chile • Canada and Mexico In the United States, the Securities and Exchange Commission now allows foreign companies whose stock is traded in the U.S. to use IFRS and is considering requiring the use of IFRS for U.S. domestic companies by 2014.
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 committee of the board of directors to review these two safeguards.