Accounting & Financial Reporting

1. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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

3. 1-3
Understanding the Business
Owner-Managers
Founders of the business who also
function as managers are called Owner-
Mangers.
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.

4. 1-4
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).

5. 1-5
The Business Operations
Manufacturers either make the parts needed to
produce its products or buy the parts from
suppliers.
Manufacturer Final Product Customer

6. 1-6
Learning Objectives
Recognize the information conveyed in each of
the four basic financial statements and the way
that it is used by different decision makers
(investors, creditors, and managers).

7. 1-7
The Accounting System
Collects and processes
financial information
Reports
information
to decision
makers
Managers
(internal
decision
makers)
Investors
and
Creditors
(external
decision
makers)

8. 1-8
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

9. 1-9
The Four Basic Financial Statements
Income Statement
Balance Sheet
Statement of Cash Flows Statement of Retained Earnings
Financial statements summarize the financial
activities of the business.

10. 1-10
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.

11. 1-11
Let’s look at
MAXIDRIVE
CORP.’s
financial
statements.

12. 1-12
MAXIDRIVE CORP.
Balance Sheet
At December 31, 2006
(in thousands of dollars)
Assets
Cash 4,895
$
Accounts receivable 5,714
Inventories 8,517
Plant and equipment 7,154
Land 981
Total assets 27,261
$
Liabilities and Stockholders' Equity
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
$
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.

13. 1-13
The Balance Sheet
Basic Accounting Equation
Assets = Liabilities + Stockholders’ Equity
Economic
Resources Sources of Financing for
Economic Resources

14. 1-14
MAXIDRIVE CORP.
Balance Sheet
At December 31, 2006
(in thousands of dollars)
Assets
Cash 4,895
$
Accounts receivable 5,714
Inventories 8,517
Plant and equipment 7,154
Land 981
Total assets 27,261
$
Liabilities and Stockholders' Equity
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
$
Assets are listed
by their ease of
conversion into
cash.
Cash
Amount of cash in the company’s bank
accounts.
Accounts
receivable
Amounts owed by customers from prior
sales.
Inventories
Parts and completed but unsold
products.
Plant and
equipment
Factories and production machinery.
Land Land on which factories are built.
Assets are
economic
resources
owned by the
business as a
result of past
transactions.

15. 1-15
MAXIDRIVE CORP.
Balance Sheet
At December 31, 2006
(in thousands of dollars)
Assets
Cash 4,895
$
Accounts receivable 5,714
Inventories 8,517
Plant and equipment 7,154
Land 981
Total assets 27,261
$
Liabilities and Stockholders' Equity
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
$
Liabilities are
debts or
obligations of
the business
that result from
past
transactions.
Accounts
payable
Amounts owed to suppliers for prior
purchases.
Notes
payable
Amounts owed on written debt
contracts.

16. 1-16
MAXIDRIVE CORP.
Balance Sheet
At December 31, 2006
(in thousands of dollars)
Assets
Cash 4,895
$
Accounts receivable 5,714
Inventories 8,517
Plant and equipment 7,154
Land 981
Total assets 27,261
$
Liabilities and Stockholders' Equity
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
$
Contributed
capital
Amounts invested in the business by
stockholders.
Retained
earnings
Past earnings not distributed to
stockholders.
Equity is the
amount of
financing
provided by
owners of the
business and
earnings.

17. 1-17
MAXIDRIVE CORP.
Balance Sheet
At December 31, 2006
(in thousands of dollars)
Assets
Cash 4,895
$
Accounts receivable 5,714
Inventories 8,517
Plant and equipment 7,154
Land 981
Total assets 27,261
$
Liabilities and Stockholders' Equity
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
$
Use $ on the
first item in a
group
and on the
group total.
Assets = Liabilities + Stockholders’ Equity

18. 1-18
MAXIDRIVE CORP.
Income Statement
For the Year Ended December 31, 2006
(in thousands of dollars)
Revenues
Sales revenue 37,436
$
Expenses
Cost of goods sold 26,980
$
Selling, general and administrative 3,624
Research and development 1,982
Interest expense 450
Total expenses 33,036
Pretax income 4,400
$
Income tax expense 1,100
Net income 3,300
$
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

19. 1-19
MAXIDRIVE CORP.
Income Statement
For the Year Ended December 31, 2006
(in thousands of dollars)
Revenues
Sales revenue 37,436
$
Expenses
Cost of goods sold 26,980
$
Selling, general and administrative 3,624
Research and development 1,982
Interest expense 450
Total expenses 33,036
Pretax income 4,400
$
Income tax expense 1,100
Net income 3,300
$
The Income Statement reports the
revenues minus expenses of the
accounting period.

20. 1-20
MAXIDRIVE CORP.
Income Statement
For the Year Ended December 31, 2006
(in thousands of dollars)
Revenues
Sales revenue 37,436
$
Expenses
Cost of goods sold 26,980
$
Selling, general and administrative 3,624
Research and development 1,982
Interest expense 450
Total expenses 33,036
Pretax income 4,400
$
Income tax expense 1,100
Net income 3,300
$
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.

21. 1-21
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?
Earnings from the sale of goods or services.

22. 1-22
Revenues
Earnings from the sale of goods or services.
When will the revenue from this
transaction be recognized?
May 2006
$1,000 sale made
on May 25th.
X

23. 1-23
MAXIDRIVE CORP.
Income Statement
For the Year Ended December 31, 2003
(in thousands of dollars)
Revenues
Sales revenue 37,436
$
Expenses
Cost of goods sold 26,980
$
Selling, general and administrative 3,624
Research and development 1,982
Interest expense 450
Total expenses 33,036
Pretax income 4,400
$
Income tax expense 1,100
Net income 3,300
$
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.

24. 1-24
MAXIDRIVE CORP.
Income Statement
For the Year Ended December 31, 2006
(in thousands of dollars)
Revenues
Sales revenue 37,436
$
Expenses
Cost of goods sold 26,980
$
Selling, general and administrative 3,624
Research and development 1,982
Interest expense 450
Total expenses 33,036
Pretax income 4,400
$
Income tax expense 1,100
Net income 3,300
$
Cost of
goods sold
The cost to produce products sold this
period.
Selling,
general and
administrative
Operating expenses not directly related
to production.
Research and
development
Expenses incurred to develop new
products.
Interest
expense
The cost of using borrowed funds.
Income tax
expense
Income taxes on current period’s pretax
income.

25. 1-25
Expenses
May 2006 June 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.
When will the expense for this
transaction be recognized?

26. 1-26
Expenses
Advertising expense
recorded in June.
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?
June 2006
X

27. 1-27
MAXIDRIVE CORP.
Income Statement
For the Year Ended December 31, 2006
(in thousands of dollars)
Revenues
Sales revenue 37,436
$
Expenses
Cost of goods sold 26,980
$
Selling, general and administrative 3,624
Research and development 1,982
Interest expense 450
Total expenses 33,036
Pretax income 4,400
$
Income tax expense 1,100
Net income 3,300
$
If expenses exceed revenues,
we report net loss.

28. 1-28
MAXIDRIVE CORP.
Statement of Retained Earnings
For the Year Ended December 31, 2006
(in thousands of dollars)
Retained earnings, January 1, 2006 6,805
$
Net income for 2006 3,300
Dividends for 2006 (1,000)
Retained earnings, December 31, 2006 9,105
$
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 Retained Earnings reports the way that
net income and the distribution of dividends affect the
financial position of the company during a period.
MAXIDRIVE CORP.
Statement of Retained Earnings
For the Year Ended December 31, 2006
(in thousands of dollars)
Retained earnings, January 1, 2006 6,805
$
Net income for 2006 3,300
Dividends for 2006 (1,000)
Retained earnings, December 31, 2006 9,105
$

30. 1-30
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.

31. 1-31
MAXIDRIVE CORP.
Statement of Cash Flows
For the Year Ended December 31, 2006
(in thousands of dollars)
Cash flows from 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
$
Cash flow from investing activities:
Cash paid to purchase equipment (1,625)
$
Net cash flow from investing activities (1,625)
Cash flow from financing activities:
Cash received from bank loan 1,400
$
Cash paid for dividends (1,000)
Net cash flow from financing activities 400
Net decrease in cash during the year (156)
$
Cash at beginning of the year 5,051
Cash at end of the year 4,895
$
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

32. 1-32
MAXIDRIVE CORP.
Statement of Cash Flows
For the Year Ended December 31, 2006
(in thousands of dollars)
Cash flows from 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
$
Cash flow from investing activities:
Cash paid to purchase equipment (1,625)
$
Net cash flow from investing activities (1,625)
Cash flow from financing activities:
Cash received from bank loan 1,400
$
Cash paid for dividends (1,000)
Net cash flow from financing activities 400
Net decrease in cash during the year (156)
$
Cash at beginning of the year 5,051
Cash at end of the year 4,895
$
The Statement of Cash Flows reports the inflows and
outflows of cash during the period in the categories of
operating, investing, and financing.

33. 1-33
MAXIDRIVE CORP.
Statement of Cash Flows
For the Year Ended December 31, 2006
(in thousands of dollars)
Cash flows from 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
$
Cash flow from investing activities:
Cash paid to purchase equipment (1,625)
$
Net cash flow from investing activities (1,625)
Cash flow from financing activities:
Cash received from bank loan 1,400
$
Cash paid for dividends (1,000)
Net cash flow from financing activities 400
Net decrease in cash during the year (156)
$
Cash at beginning of the year 5,051
Cash at end of the year 4,895
$
Cash flows directly related to
earning income are shown in the
operating section.

34. 1-34
MAXIDRIVE CORP.
Statement of Cash Flows
For the Year Ended December 31, 2006
(in thousands of dollars)
Cash flows from 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
$
Cash flow from investing activities:
Cash paid to purchase equipment (1,625)
$
Net cash flow from investing activities (1,625)
Cash flow from financing activities:
Cash received from bank loan 1,400
$
Cash paid for dividends (1,000)
Net cash flow from financing activities 400
Net decrease in cash during the year (156)
$
Cash at beginning of the year 5,051
Cash at end of the year 4,895
$
Cash flows related to the acquisition
or sale of productive assets are
shown in the investing section.

35. 1-35
MAXIDRIVE CORP.
Statement of Cash Flows
For the Year Ended December 31, 2006
(in thousands of dollars)
Cash flows from 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
$
Cash flow from investing activities:
Cash paid to purchase equipment (1,625)
$
Net cash flow from investing activities (1,625)
Cash flow from financing activities:
Cash received from bank loan 1,400
$
Cash paid for dividends (1,000)
Net cash flow from financing activities 400
Net decrease in cash during the year (156)
$
Cash at beginning of the year 5,051
Cash at end of the year 4,895
$
Cash flows from or to investors or
creditors are shown in the financing
section.

36. 1-36
MAXIDRIVE CORP.
Statement of Cash Flows
For the Year Ended December 31, 2006
(in thousands of dollars)
Cash flows from 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
$
Cash flow from investing activities:
Cash paid to purchase equipment (1,625)
$
Net cash flow from investing activities (1,625)
Cash flow from financing activities:
Cash received from bank loan 1,400
$
Cash paid for dividends (1,000)
Net cash flow from financing activities 400
Net decrease in cash during the year (156)
$
Cash at beginning of the year 5,051
Cash at end of the year 4,895
$
The statement ends with a
reconciliation of Cash.

37. 1-37
Relationship Among the Financial Statements
MAXIDRIVE CORP.
Income Statement
For the Year Ended December 31, 2006
(in thousands of dollars)
Revenues
Sales revenue 37,436
$
Expenses
Cost of goods sold 26,980
$
Selling, general and administrative 3,624
Research and development 1,982
Interest expense 450
Total expenses 33,036
Pretax income 4,400
$
Income tax expense 1,100
Net income 3,300
$
MAXIDRIVE CORP.
Statement of Retained Earnings
For the Year Ended December 31, 2006
(in thousands of dollars)
Retained earnings, January 1, 2006 6,805
$
Net income for 2006 3,300
Dividends for 2006 (1,000)
Retained earnings, December 31, 2006 9,105
$
Net income from the
income statement
increases ending retained
earnings on the statement
of retained earnings.

38. 1-38
MAXIDRIVE CORP.
Balance Sheet
At December 31, 2006
(in thousands of dollars)
Assets
Cash 4,895
$
Accounts receivable 5,714
Inventories 8,517
Plant and equipment 7,154
Land 981
Total assets 27,261
$
Liabilities and Stockholders' Equity
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
$
MAXIDRIVE CORP.
Statement of Retained Earnings
For the Year Ended December 31, 2006
(in thousands of dollars)
Retained earnings, January 1, 2006 6,805
$
Net income for 2006 3,300
Dividends for 2006 (1,000)
Retained earnings, December 31, 2006 9,105
$
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.

39. 1-39
MAXIDRIVE CORP.
Balance Sheet
At December 31, 2006
(in thousands of dollars)
Assets
Cash 4,895
$
Accounts receivable 5,714
Inventories 8,517
Plant and equipment 7,154
Land 981
Total assets 27,261
$
Liabilities and Stockholders' Equity
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
$
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.
MAXIDRIVE CORP.
Statement of Cash Flows
For the Year Ended December 31, 2006
(in thousands of dollars)
Cash flows from 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
$
Cash flow from investing activities:
Cash paid to purchase equipment (1,625)
$
Net cash flow from investing activities (1,625)
Cash flow from financing activities:
Cash received from bank loan 1,400
$
Cash paid for dividends (1,000)
Net cash flow from financing activities 400
Net decrease in cash during the year (156)
$
Cash at beginning of the year 5,051
Cash at end of the year 4,895
$

40. 1-40
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.

41. 1-41
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 our demand for products.
Employees’ union and human resource
managers use the company’s financial
statements as a basis for contract negotiations
over pay rates.

42. 1-42
Price/Earnings Ratio
Price/Earnings Ratio =
Market Price (of the Company)
Net Income
This ratio is one method
for estimating the value
of a company.

43. 1-43
Learning Objectives
Identify the role of generally accepted
accounting principles (GAAP) in determining
the content of financial statements.

44. 1-44
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.

45. 1-45
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 of most
companies were free to choose the accounting
principles used to keep track of its transactions.

46. 1-46
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
(GAAP)

47. 1-47
Generally Accepted Accounting Principles
(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.

48. 1-48
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.

49. 1-49
International Perspective
Since 2002, there has been substantial movement
to develop international financial reporting
standards by the International Accounting
Standards Board (IASB).

50. 1-50
Learning Objectives
Distinguish the roles of managers and auditors
in the accounting communication process.

51. 1-51
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

52. 1-52
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.

53. 1-53
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.

54. 1-54
Learning Objectives
Appreciate the importance of ethics,
reputation, and legal liability in accounting.

55. 1-55
Ethics, Reputation, and Legal Liability
The American Institute of Certified Public
Accountants requires that all members
adhere to a professional code of ethics.

56. 1-56
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

57. 1-57
End of Chapter 1