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

Financial
Statements
and
Business
Decisions
Chapter 1

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

 1-3

Understanding the Business

Founders of the business who also

function as managers are called Owner-
Mangers.
Owner-Managers

Creditors lend money for a specific

period of time and gain by charging
interest on the money they lend.

Creditors

Investors buy ownership in the company

in the form of stock.
Investors
 1-4

Understanding the Business

Investors purchase stock (or ownership) in

businesses hoping to gain in two ways:

Sell
Receive a
ownership
portion of the
interest in the
company’s
future for more
earnings in cash
than they
(dividends).
paid.
 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

 1-6

Learning Objectives

Recognize
Recognize the the information
information conveyed
conveyed in
in each
each of
of
the
the four
four basic
basic financial
financial statements
statements and
and the
the way
way
that
that itit is
is used
used by by different
different decision
decision makers
makers
(investors,
(investors, creditors,
creditors, and
and managers).
managers).
 1-7

The Accounting System

Managers
(internal
decision
Reports makers)
information
to decision
Collects and processes makers
financial information Investors
and
Creditors
(external
decision
makers)
 1-8

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
 1-9

The Four Basic Financial Statements

Statement of Cash Flows Statement of Retained Earnings

Balance Sheet Income Statement

Financial statements summarize the financial

activities of the business.
 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.
 1-11

Let’s look at
MAXIDRIVE
CORP.’s
financial
statements.
 1-12
1. Name of entity MAXIDRIVE CORP.
2. Title of statement Balance Sheet
3. Specific date At December 31, 2006
4. Unit of measure (in thousands of dollars)
Assets
Cash $ 4,895
Accounts receivable 5,714
The Balance Inventories 8,517
Plant and equipment 7,154
Sheet reports Land 981
the financial Total assets $ 27,261
position of an Liabilities and Stockholders' Equity
Liabilities
entity at a
Accounts payable $ 7,156
particular point Notes payable 9,000
in time. 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
 1-13

The Balance Sheet

Basic Accounting Equation

Assets
Assets == Liabilities
Liabilities ++ Stockholders’
Stockholders’ Equity
Equity

Economic
Resources Sources of Financing for
Economic Resources
 1-14
MAXIDRIVE CORP.
Balance Sheet
At December 31, 2006
(in thousands of dollars)
Assets are Assets
Cash $ 4,895
economic
Accounts receivable 5,714
resources Inventories 8,517
owned by the Plant and equipment 7,154
business as a Land 981
result of past Total assets $ 27,261

transactions. Amount
Liabilities and of cash
Stockholders' in the company’s bank
Equity
Cash Liabilities
accounts.
Accounts payable
Accounts $ 7,156from prior
Amounts owed by customers
Notes payable
receivable sales. 9,000
Total liabilities
Parts and completed but unsold$ 16,156
Assets are listed Inventories
Stockholders' Equity
by their ease of products.
Contributed capital $ 2,000
Plant and
conversion into Retained earnings Factories and production 9,105
machinery.
cash. equipment
Total stockholders' equity 11,105
Total Land Land
liabilities and on which factories
stockholders' equity are built.
$ 27,261
 1-15
MAXIDRIVE CORP.
Balance Sheet
At December 31, 2006
(in thousands of dollars)
Assets
Cash $ 4,895
Liabilities are Accounts receivable 5,714
debts or Inventories 8,517
obligations of Plant and equipment 7,154
the business Land 981
Total assets $ 27,261
that result from
Liabilities and Stockholders' Equity
past Liabilities
transactions. Accounts payable $ 7,156
Notes payable 9,000
Total liabilities $ 16,156

Accounts Amounts owed to Stockholders'

suppliers forEquity
prior
Contributed capital $ 2,000
payable purchases.
Retained earnings 9,105
Notes Amounts owed on written debt
Total stockholders' equity 11,105
payable contracts.
Total liabilities and stockholders' equity $ 27,261
 1-16
MAXIDRIVE CORP.
Balance Sheet
At December 31, 2006
Equity is the (in thousands of dollars)
Assets
amount of
Cash $ 4,895
financing Accounts receivable 5,714
provided by Inventories 8,517
owners of the Plant and equipment 7,154
Land 981
business and
Total assets $ 27,261
earnings. Liabilities and Stockholders' Equity
Liabilities
Contributed Amounts invested in the business by
capital Accounts payable
stockholders. $ 7,156
Retained Notesnot
Past earnings payable
distributed to 9,000
earnings Total liabilities
stockholders. $ 16,156
Stockholders' Equity
Contributed capital $ 2,000
Retained earnings 9,105
Total stockholders' equity 11,105
Total liabilities and stockholders' equity $ 27,261
 1-17
MAXIDRIVE CORP.
Balance Sheet
At December 31, 2006
(in thousands of dollars)
Assets
Cash $ 4,895
Use $ on the Accounts receivable 5,714
first item in a Inventories 8,517
group Plant and equipment 7,154
and on the Land 981
Total assets $ 27,261
group total.
Liabilities and Stockholders' Equity
Liabilities
Accounts payable $ 7,156
Notes payable 9,000
Assets = LiabilitiesTotal
+ Stockholders’
liabilities Equity $ 16,156
Stockholders' Equity
Contributed capital $ 2,000
Retained earnings 9,105
Total stockholders' equity 11,105
Total liabilities and stockholders' equity $ 27,261
 1-18

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
 1-19

The Income Statement reports the

revenues minus expenses of the
accounting period.
 1-20

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.
 1-21

Revenues

Earnings from the sale of goods or services.

When will the revenue from this

transaction be recognized?

$1,000 sale made Cash from sale

on May 25th. collected on June 10th.
X X
May 2006 June 2006
 1-22

Revenues

Earnings from the sale of goods or services.

When will the revenue from this

transaction be recognized?

$1,000 sale made

on May 25th.
X
May 2006
 1-23

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.
 1-24

Cost of The cost to produce products sold this

goods sold period.
Selling,
Operating expenses not directly related
general and
to production.
administrative
Research and Expenses incurred to develop new
development products.
Interest
The cost of using borrowed funds.
expense
Income tax Income taxes on current period’s pretax
expense income.
 1-25

Expenses

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?

May 11 paid $75 cash Ad appears

for newspaper ad. on June 8th.
X X
May 2006 June 2006
 1-26

Expenses

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?

Advertising expense
recorded in June.
X
June 2006
 1-27

If expenses exceed revenues,

we report net loss.
 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

1. Name
Net incomeof entity
for 2006 3,300
2. Title of for
Dividends statement
2006 (1,000)
3. Specific
Retained period ofDecember
earnings, time (Like31,
the2006
income$ 9,105
statement, this statement covers a specified
period of time.)
4. Unit of measure
 1-29

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

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.
 1-30

Statement of Cash Flows

Because . . . and expenses

revenues reported reported do not
do not always equal always equal
cash collected. . . cash paid . . .

net income is
usually not equal
to the change
in cash for
the period.
 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
[Link]
Namepaid of entity and employees
to suppliers (30,854)
Cash paid for interest (450)
[Link]
Title of statement
paid for taxes (1,190)
[Link]
Specific
cash flowperiod of time
from operating (Like the income $ 1,069
activities
Cashstatement, this activities:
flow from investing statement covers a specified
Cash paid to purchase equipment $ (1,625)
period
Net of from
cash flow time.)
investing activities (1,625)
4. Unit
Cash of measure
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
 1-32
MAXIDRIVE CORP.
Statement of Cash Flows
The Statement of Cash Flows reports the inflows and
For the Year Ended December 31, 2006
outflows of cash during the period
(in thousands in the categories of
of dollars)
operating, investing, and financing.
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
 1-33
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 flows directly related
Cash paid to purchase equipment$ (1,625) to
Net cash flow from investing activities (1,625)
earning income are shown in the
Cash flow from financing activities:
Cash received from bank loan $ 1,400
operating section.(1,000)
Cash paid for dividends
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
 1-34
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 flows
Cash received related
from bank loan to the$acquisition
1,400
Cash paid for dividends (1,000)
or sale of productive assets are 400
Net cash flow from financing activities
shown
Net decrease in cashin thetheinvesting
during year section$ . (156)
Cash at beginning of the year 5,051
Cash at end of the year $ 4,895
 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 flows from or to investors or
Cash paid for taxes (1,190)
Net cash flow from operating activities
$ 1,069
creditors are shown in the financing
Cash flow from investing activities:

section.
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
 1-36
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:
The statement ends$with
Cash received from bank loan a
1,400

reconciliation
Cash paid for dividends
of
Net cash flow from financing activities
Cash .
(1,000)
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
 1-37

Relationship Among the Financial Statements

Net income from the

income statement
increases ending retained
earnings on the statement
of retained earnings.

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
 1-38

Relationship Among the Financial Statements

MAXIDRIVE CORP.
Balance Sheet
At December 31, 2006
(in thousands of dollars)
Ending retained earnings
Cash
Assets
$ 4,895
from the statement of
Accounts receivable
Inventories
5,714
8,517
retained earnings is one of
Plant and equipment 7,154 the components of
Land 981
Total assets $ 27,261 stockholders’ equity on the
Liabilities and Stockholders' Equity
Liabilities balance sheet.
Accounts payable $ 7,156
Notes payable 9,000
MAXIDRIVE CORP.
Total liabilities $ 16,156
Stockholders' Equity
Statement of Retained Earnings
Contributed capital $ 2,000 For the Year Ended December 31, 2006
Retained earnings 9,105
(in thousands of dollars)
Total stockholders' equity 11,105
Total liabilities and stockholders' equity $ 27,261
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
 1-39

Relationship Among the Financial Statements

MAXIDRIVE CORP.
Balance Sheet
MAXIDRIVE CORP.
At December 31, 2006
Statement of Cash Flows
(in thousands of dollars)
For the Year Ended December 31, 2006
Assets
(in thousands of dollars)
Cash $ 4,895
Accounts receivable 5,714
Cash flows from operating activities:
Inventories 8,517
Cash collected from customers $ 33,563
Plant and equipment 7,154 Cash paid to suppliers and employees (30,854)
Land 981 Cash paid for interest (450)
Total assets $ 27,261 Cash paid for taxes (1,190)
Liabilities and Stockholders' Equity Net cash flow from operating activities $ 1,069
Cash flow from investing activities:
Liabilities Cash paid to purchase equipment $ (1,625)
Accounts payable $ 7,156 Net cash flow from investing activities (1,625)
Notes payable 9,000 Cash flow from financing activities:
Cash received from bank loan $ 1,400
Total liabilities $ 16,156
Cash paid for dividends (1,000)
Stockholders' Equity
Net cash flow from financing activities 400
Contributed capital $ 2,000
Net decrease in cash during the year $ (156)
Retained earnings 9,105
Cash at beginning of the year 5,051
Total stockholders' equity 11,105
Cash at end of the year $ 4,895
Total liabilities and stockholders' equity $ 27,261

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.
 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.
 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.
 1-42

Price/Earnings Ratio

Market Price (of the Company)

Price/Earnings Ratio =
Net Income

This ratio is one method

for estimating the value
of a company.
 1-43

Learning Objectives

Identify
Identify the
the role
role of
of generally
generally accepted
accepted
accounting
accounting principles
principles (GAAP)
(GAAP) inin determining
determining
the
the content
content ofof financial
financial statements.
statements.
 1-44

Responsibilities for the Accounting Communication

Process

Effective communication means that the

recipient understands what the sender
intends to convey.

Decision
Decision makers
makers need
need to
to understand
understand
accounting
accounting measurement
measurement rules.
rules.
 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.
 1-46

Generally Accepted Accounting Principles

(GAAP)
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.
 1-47

Generally Accepted Accounting Principles

(GAAP)

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.
 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.
 1-49

International Perspective

Since 2002, there has been substantial movement

to develop international financial reporting
standards by the International Accounting
Standards Board (IASB).
 1-50

Learning Objectives

Distinguish
Distinguish the
the roles
roles of
of managers
managers and
and auditors
auditors
in
in the
the accounting
accounting communication
communication process.
process.
 1-51

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.
 1-52

Independent Auditors

 Auditors express an opinion

as to the fairness of the Overall, I believe
financial statement these financial
statements are
presentation. fair.
 Independent auditors have
responsibilities that extend
to the general public.
 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.
 1-54

Learning Objectives

Appreciate
Appreciate the
the importance
importance of of ethics,
ethics,
reputation,
reputation, and
and legal
legal liability
liability in
in accounting.
accounting.
 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.
 1-56

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.
 1-57

End of Chapter 1