Financial
Statements
and
Business
Decisions
Chapter 1
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
1-2
Understanding the Business
Founders of the business who also
function as managers are called OwnerMangers.
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
1-3
The Business Operations
Manufacturers either make the parts needed to
produce its products or buy the parts from
suppliers.
Manufacturer
Final Product
Customer
1-4
The Accounting System
Collects and processes
financial information
Reports
information
to decision
makers
Managers
(internal
decision
makers)
Investors
and
Creditors
(external
decision
makers)
1-5
The Accounting System
Accounting System
Financial Accounting System
Managerial Accounting System
Periodic financial statements and
related disclosures
Detailed plans and continuous
performance reports
External Decision Makers
Internal Decision Makers
Investors, creditors,
suppliers, customers, etc.
Managers throughout the
organization
1-6
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.
1-7
MAXIDRIVE CORP.
Balance Sheet
At December 31, 2006
(in thousands of dollars)
Assets
Cash
Accounts receivable
Inventories
Plant and equipment
Land
Total assets
Liabilities and Stockholders' Equity
Liabilities
Accounts payable
Notes payable
$
4,895
5,714
8,517
7,154
981
$ 27,261
$ 7,156
9,000
Total liabilities
Stockholders' Equity
Contributed capital
Retained earnings
Total stockholders' equity
Total liabilities and stockholders' equity
$ 16,156
$ 2,000
9,105
11,105
$ 27,261
Assets are
economic
resources
owned by the
business as a
result of past
transactions.
MAXIDRIVE CORP.
Balance Sheet
At December 31, 2006
(in thousands of dollars)
Assets
1-8
Cash
$ 4,895
Accounts receivable
5,714
Inventories
8,517
Plant and equipment
7,154
Land
981
Total assets
$ 27,261
Liabilities andAmount
Stockholders'
Equity
of cash
in the company’s bank
Cash
Liabilities
accounts.
Accounts
payable
$ 7,156from prior
Accounts
Amounts owed by customers
Notes
payable
receivable
9,000
sales.
Total liabilities
Parts and completed but unsold$ 16,156
Assets are listed
Inventories
Stockholders'
Equity
products.
by their ease of
Contributed capital
$ 2,000
Plant
and
conversion into Retained earnings
Factories and production 9,105
machinery.
equipment
cash.
Total stockholders' equity
11,105
Land
on which factories
Total Land
liabilities and
stockholders'
equity are built.
$ 27,261
1-9
MAXIDRIVE CORP.
Balance Sheet
At December 31, 2006
(in thousands of dollars)
Assets
Liabilities are
debts or
obligations of
the business
that result from
past
transactions.
Cash
Accounts receivable
Inventories
Plant and equipment
Land
Total assets
Liabilities and Stockholders' Equity
Liabilities
Accounts payable
Notes payable
$
4,895
5,714
8,517
7,154
981
$ 27,261
$ 7,156
9,000
Total liabilities
Accounts Amounts owed to Stockholders'
suppliers forEquity
prior
Contributed capital
payable purchases.
Retained earnings
Notes
Amounts owed on written debt
Total stockholders' equity
payable contracts.
Total liabilities and stockholders' equity
$ 16,156
$ 2,000
9,105
11,105
$ 27,261
Equity is the
amount of
financing
provided by
owners of the
business and
earnings.
Contributed
capital
Retained
earnings
1-10
MAXIDRIVE CORP.
Balance Sheet
At December 31, 2006
(in thousands of dollars)
Assets
Cash
Accounts receivable
Inventories
Plant and equipment
Land
Total assets
Liabilities and Stockholders' Equity
Liabilities
Amounts invested in the business by
Accounts payable
stockholders.
Notesnot
payable
Past earnings
distributed to
Total liabilities
stockholders.
Stockholders' Equity
Contributed capital
Retained earnings
Total stockholders' equity
Total liabilities and stockholders' equity
$
4,895
5,714
8,517
7,154
981
$ 27,261
$ 7,156
9,000
$ 16,156
$ 2,000
9,105
11,105
$ 27,261
1-11
MAXIDRIVE CORP.
Balance Sheet
At December 31, 2006
(in thousands of dollars)
Assets
Use $ on the
first item in a
group
and on the
group total.
Cash
Accounts receivable
Inventories
Plant and equipment
Land
Total assets
Liabilities and Stockholders' Equity
Liabilities
Accounts payable
Notes payable
$
4,895
5,714
8,517
7,154
981
$ 27,261
$ 7,156
9,000
Assets = LiabilitiesTotal
+ Stockholders’
Equity
liabilities
Stockholders' Equity
Contributed capital
Retained earnings
Total stockholders' equity
Total liabilities and stockholders' equity
$ 16,156
$ 2,000
9,105
11,105
$ 27,261
1-12
MAXIDRIVE CORP.
Income Statement
For the Year Ended December 31, 2006
(in thousands of dollars)
Revenues
1. Name
of entity
Sales
revenue
$ 37,436
2. Title of statement
Expenses
3. Specific
balance
Cost
of goodsperiod
sold of time (Unlike the
$ 26,980
sheet,
this statement
covers a specified
Selling,
general
and administrative
3,624
periodand
of time.)
Research
development
1,982
4. Unit expense
of measure
Interest
450
Total expenses
33,036
Pretax income
Income tax expense
Net income
$ 4,400
1,100
$ 3,300
1-13
MAXIDRIVE CORP.
The Income Statement reports the
Income Statement
revenues
minus expenses of the
For the Year Ended December 31, 2006
accounting
period.
(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
Income tax expense
Net income
$ 4,400
1,100
$ 3,300
1-14
MAXIDRIVE CORP.
Income Statement
For the Year Ended December 31, 2006
(in thousands of dollars)
Revenues
Sales revenue
$ 37,436
Expenses
Revenues are earnings from the sale of goods or
Cost of goods sold
$ 26,980
services
to customers. Revenue is recognized
in the
Selling, general and administrative
3,624
period
in which
goods and services1,982
are sold, not
Research
and development
necessarily
the period in which cash450
is received.
Interest expense
Total expenses
33,036
Pretax income
Income tax expense
Net income
$ 4,400
1,100
$ 3,300
1-15
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.
May 2006
X
Cash from sale
collected on June 10th.
X
June 2006
1-16
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.
May 2006
X
1-17
MAXIDRIVE CORP.
Income Statement
For the
Endedamount
December
31, 2003 used
Expenses
areYear
the dollar
of resources
of dollars)
up by the entity(intothousands
earn revenues
during a period. An
expense is recognized in the period in which
goods and services are used, not necessarily
Revenues
the period in which cash is paid. $ 37,436
Sales revenue
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
Income tax expense
Net income
$ 4,400
1,100
$ 3,300
1-18
MAXIDRIVE CORP.
Income Statement
For the Year Ended December 31, 2006
(in thousands of dollars)
Revenues
Cost of
The cost to produce products sold this
Sales
revenue
$ 37,436
goods
sold period.
Expenses
Selling,
Operating expenses not
directly related
Cost
of
goods
sold
$
26,980
general and
production.
Selling,
generaltoand
administrative
3,624
administrative
Research and development
1,982
Research and Expenses incurred to develop new
Interest expense
450
development products.
Total expenses
33,036
Interest
Pretax income The cost of using borrowed funds.
$ 4,400
expense
Incometax
tax expense
1,100
Income
Income taxes on current period’s pretax
Netexpense
income
$ 3,300
income.
1-19
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
for newspaper ad.
X
May 2006
Ad appears
on June 8th.
X
June 2006
1-20
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
1-21
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
If expenses exceed revenues,
Pretax income
$ 4,400
we report net loss.
Income tax expense
Net income
1,100
$ 3,300
1-22
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
of entity
Net
income
for 2006
3,300
2. Title of statement
Dividends
for 2006
(1,000)
3. Specific
period ofDecember
time (Like31,
the2006
income$ 9,105
Retained
earnings,
statement, this statement covers a specified
period of time.)
4. Unit of measure
1-23
MAXIDRIVE CORP.
Statement of Retained Earnings
For the Year Ended December 31, 2006
(in thousands of dollars)
Retained earnings, January 1, 2006
Net income for 2006
Dividends for 2006
Retained earnings, December 31, 2006
$ 6,805
3,300
(1,000)
$ 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.
1-24
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.
1-25
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
paid of
to suppliers
(30,854)
1.Cash
Name
entity and employees
paid for interest
(450)
2.Cash
Title
of
statement
Cash paid for taxes
(1,190)
3.Net
Specific
of time
(Like the income $ 1,069
cash flowperiod
from operating
activities
Cashstatement,
flow from investing
this activities:
statement covers a specified
Cash paid to purchase equipment
$
(1,625)
period of time.)
Net cash flow from investing activities
(1,625)
4. Unit
of measure
Cash
flow from
financing activities:
Cash received from bank loan
Cash paid for dividends
$
1,400
(1,000)
Net cash flow from financing activities
Net decrease in cash during the year
400
$
Cash at beginning of the year
Cash at end of the year
(156)
5,051
$
4,895
1-26
MAXIDRIVE CORP.
of Cash Flows
The Statement ofStatement
Cash Flows
reports the inflows and
For the Year Ended December 31, 2006
outflows of cash during
the period in the categories of
(in thousands of dollars)
operating, investing, and financing.
Cash flows from operating activities:
Cash collected from customers
Cash paid to suppliers and employees
Cash paid for interest
Cash paid for taxes
Net cash flow from operating activities
Cash flow from investing activities:
Cash paid to purchase equipment
Net cash flow from investing activities
Cash flow from financing activities:
Cash received from bank loan
Cash paid for dividends
$
33,563
(30,854)
(450)
(1,190)
$
$
(1,625)
(1,625)
$
1,400
(1,000)
Net cash flow from financing activities
Net decrease in cash during the year
400
$
Cash at beginning of the year
Cash at end of the year
1,069
(156)
5,051
$
4,895
1-27
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
Cash paid to suppliers and employees
Cash paid for interest
Cash paid for taxes
Net cash flow from operating activities
Cash flow from investing activities:
Cash paid to purchase equipment
Net cash flow from investing activities
Cash flow from financing activities:
$
33,563
(30,854)
(450)
(1,190)
$
1,069
$
(1,625) to
Cash flows directly related
(1,625)
earning income are shown in the
Cash received from bank loan
$
1,400
operating section.(1,000)
Cash paid for dividends
Net cash flow from financing activities
Net decrease in cash during the year
400
$
Cash at beginning of the year
Cash at end of the year
(156)
5,051
$
4,895
1-28
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
Cash paid to suppliers and employees
Cash paid for interest
Cash paid for taxes
Net cash flow from operating activities
Cash flow from investing activities:
Cash paid to purchase equipment
Net cash flow from investing activities
Cash flow from financing activities:
$
33,563
(30,854)
(450)
(1,190)
$
$
1,069
(1,625)
(1,625)
Cash
flows
related
to the$ acquisition
Cash received
from bank
loan
1,400
Cash paid for dividends
(1,000)
or
sale
of
productive
assets
are 400
Net cash flow from financing activities
Net decrease
in cashin
during
year
$
(156)
shown
thetheinvesting
section.
Cash at beginning of the year
Cash at end of the year
5,051
$
4,895
1-29
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
Cash paid to suppliers and employees
Cash paid for interest
Cash paid for taxes
Net cash flow from operating activities
Cash flow from investing activities:
Cash paid to purchase equipment
Net cash flow from investing activities
Cash flow from financing activities:
$
33,563
(30,854)
(450)
(1,190)
Cash flows from or to investors or
$
1,069
creditors are shown in the financing
$
(1,625)
section.
(1,625)
Cash received from bank loan
Cash paid for dividends
$
1,400
(1,000)
Net cash flow from financing activities
Net decrease in cash during the year
400
$
Cash at beginning of the year
Cash at end of the year
(156)
5,051
$
4,895
1-30
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
Cash paid to suppliers and employees
Cash paid for interest
Cash paid for taxes
Net cash flow from operating activities
Cash flow from investing activities:
Cash paid to purchase equipment
Net cash flow from investing activities
Cash flow from financing activities:
$
33,563
(30,854)
(450)
(1,190)
$
$
1,069
(1,625)
(1,625)
The statement ends$with
a
1,400
Cash paid for
dividends
(1,000)
reconciliation
of Cash.
Cash received from bank loan
Net cash flow from financing activities
Net decrease in cash during the year
400
$
Cash at beginning of the year
Cash at end of the year
(156)
5,051
$
4,895
1-31
Relationship Among the Financial Statements
MAXIDRIVE CORP.
Income Statement
For the Year Ended December 31, 2006
(in thousands of dollars)
Revenues
Sales revenue
Expenses
Cost of goods sold
Selling, general and administrative
Research and development
Interest expense
Total expenses
Pretax income
Income tax expense
Net income
$ 37,436
$ 26,980
3,624
1,982
450
Net income from the
income statement
increases ending retained
earnings on the statement
of retained earnings.
33,036
$ 4,400
1,100
$ 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
1-32
Relationship Among the Financial Statements
MAXIDRIVE CORP.
Balance Sheet
At December 31, 2006
(in thousands of dollars)
Assets
Cash
Accounts receivable
Inventories
Plant and equipment
Land
Total assets
Liabilities and Stockholders' Equity
Liabilities
Accounts payable
Notes payable
$
4,895
5,714
8,517
7,154
981
$ 27,261
$ 7,156
9,000
Total liabilities
Stockholders' Equity
Contributed capital
Retained earnings
Total stockholders' equity
Total liabilities and stockholders' equity
Ending retained earnings
from the statement of
retained earnings is one of
the components of
stockholders’ equity on the
balance sheet.
$ 16,156
$ 2,000
9,105
11,105
MAXIDRIVE CORP.
Statement of Retained Earnings
For the Year Ended December 31, 2006
(in thousands of dollars)
$ 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
1-33
Relationship Among the Financial Statements
MAXIDRIVE CORP.
Balance Sheet
At December 31, 2006
(in thousands of dollars)
Assets
MAXIDRIVE CORP.
Statement of Cash Flows
For the Year Ended December 31, 2006
Cash
Accounts receivable
Inventories
Plant and equipment
Land
Total assets
Liabilities and Stockholders' Equity
Liabilities
Accounts payable
Notes payable
4,895
5,714
8,517
7,154
981
$ 27,261
$ 7,156
9,000
Total liabilities
Stockholders' Equity
Contributed capital
Retained earnings
Total stockholders' equity
Total liabilities and stockholders' equity
(in thousands of dollars)
$
$ 16,156
Cash flows from operating activities:
Cash collected from customers
Cash paid to suppliers and employees
Cash paid for interest
Cash paid for taxes
Net cash flow from operating activities
Cash flow from investing activities:
Cash paid to purchase equipment
Net cash flow from investing activities
Cash flow from financing activities:
Cash received from bank loan
Cash paid for dividends
$
33,563
(30,854)
(450)
(1,190)
$
$
(1,625)
(1,625)
$
1,400
(1,000)
Net cash flow from financing activities
$ 2,000
9,105
Net decrease in cash during the year
11,105
400
$
Cash at beginning of the year
Cash at end of the year
1,069
(156)
5,051
$
4,895
$ 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.
1-34
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.
1-35
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.
1-36
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.
1-37
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.
1-38
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.
1-39
International Perspective
Since 2002, there has been substantial movement
to develop international financial reporting
standards by the International Accounting
Standards Board (IASB).
1-40
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.
1-41
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.
1-42
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.
1-43
Ethics, Reputation, and Legal Liability
The American Institute of Certified Public
Accountants requires that all members
adhere to a professional code of ethics.
1-44
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.
1-45
End of Chapter 1