Financial Statements
and Business Decisions
Chapter 1
McGraw-Hill/Irwin
© 2009 The McGraw-Hill Companies, Inc.
Accounting –
The Language of Business
Accounting is the information system that...
measures business activities,
processes data into reports, and
communicates results to decision makers.
McGraw-Hill/Irwin
Slide 2
Accounting –
The Language of Business

Accounting is the art of recording, classifying and
summarizing transactions, in terms of money, and
interpreting the results.
McGraw-Hill/Irwin
Slide 3
The Flow of Accounting Information
1. People make decisions.
2. Business transactions occur.
3. Businesses prepare reports to show
the results of their operations.
McGraw-Hill/Irwin
Slide 4
The Accounting System
Collects and processes
financial information
McGraw-Hill/Irwin
Reports
information
to decision
makers
Managers
(internal
decision
makers)
Investors
and
Creditors
(external
decision
makers)
Slide 5
External Users of Accounting Information
McGraw-Hill/Irwin
Individuals
Government
regulatory
agencies
Businesses
Taxing
authorities
Investors and
creditors
Nonprofit
organizations
Slide 6
Management Users 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.
McGraw-Hill/Irwin
Slide 7
The Four Basic Financial Statements
1. On a company’s
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
all the revenues earned
from sales to customers are listed along with the expenses incurred
to produce those revenues.
3. On a company’s
accumulated net earnings less the dividends paid to owners
represent reinvestments in the core business.
4. On a company’s
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.
McGraw-Hill/Irwin
Slide 8
The Accounting Equation
A = L + SE
(Assets)
Economic
Resources
(Liabilities)
(Stockholders’
Equity)
Sources of Financing for Economic
Resources
Liabilities: From Creditors
Stockholders’ Equity: From Stockholders
McGraw-Hill/Irwin
Slide 9
The Accounting Equation
Assets are the economic resources
of a business that are expected to
produce a benefit in the future.
Liabilities are “outsider claims,”
or economic obligations
payable to outsiders.
Owners’ equity represents the
“insider claims” of a business.
McGraw-Hill/Irwin
Slide 10
Accounting for Business Transactions
A transaction is any event that both affects
the financial position of the business entity
and can be reliably recorded.
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Slide 11
The Account
Accounting’s main summary device
is the account, a record of like transactions.
Accounts are grouped in three broad categories,
according to the accounting equation:
Cash
McGraw-Hill/Irwin
Slide 12
Typical Accounts
McGraw-Hill/Irwin
Assets
Liabilities
Cash
Short-Term Investment
Accounts Receivable
Notes Receivable
Inventory
Supplies
Prepaid Expenses
Long-Term Investments
Equipment
Buildings
Land
Intangibles
Accounts Payable
Accrued Expenses
Notes Payable
Taxes Payable
Unearned Revenue
Bonds Payable
Stockholders’ Equity
Contributed Capital
Retained Earnings
Slide 13
Generally Accepted Accounting Principles
Our accounting system has a long and
distinguished history. An Italian monk named Luca
Pacioli, published the first elements of doubleentry 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.
McGraw-Hill/Irwin
Slide 14
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.
McGraw-Hill/Irwin
Slide 15
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.
McGraw-Hill/Irwin
Slide 16
International Perspective
Since 2002, there has been substantial
movement to develop international financial
reporting standards (IFRS) by the
International Accounting Standards Board
(IASB).
McGraw-Hill/Irwin
Slide 17
Balance Sheet
MAXIDRIVE CORP.
Balance Sheet
At December 31, 2010
(in thousands of dollars)
2010
ASSETS
Cash
Accounts receivable
Inventories
Plant and equipment
Land
Total assets
LIABILITIES
Accounts payable
Notes payable
Total liabilities
STOCKHOLDERS' EQUITY
Contributed capital
Retained earnings
Total stockholders' equity
Total liabilities and stockholders' equity
McGraw-Hill/Irwin
$
$
$
$
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
Slide 18
The Balance Sheet
Typical Accounts
McGraw-Hill/Irwin
Assets
Liabilities
Cash
Short-Term Investment
Accounts Receivable
Notes Receivable
Inventory (to be sold)
Supplies
Prepaid Expenses
Long-Term Investments
Equipment
Buildings
Land
Intangibles
Accounts Payable
Accrued Expenses
Notes Payable
Taxes Payable
Unearned Revenue
Bonds Payable
Stockholders’ Equity
Contributed Capital
Retained Earnings
Slide 19
Income Statement
MAXIDRIVE CORP.
Income Statement
For the Year Ended December 31, 2010
(in thousands of dollars)
Revenues
Sales revenue
Total revenues
Expenses
Cost of goods sold expense
Selling, general, and administrative expense
Interest expense
Total expenses
Operating income
Income tax expense
Net income
McGraw-Hill/Irwin
$
$
37,436
37,436
26,980
5,606
450
33,036
4,400
1,100
3,300
Slide 20
The Income Statement
Typical Accounts
McGraw-Hill/Irwin
Revenues
Expenses
Sales Revenue
Fee Revenue
Interest Revenue
Rent Revenue
Cost of Goods Sold
Wages Expense
Rent Expense
Interest Expense
Depreciation Expense
Advertising Expense
Insurance Expense
Repair Expense
Income Tax Expense
Slide 21
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
Net income for 2009
McGraw-Hill/Irwin
$6,805
3,300
Dividends for 2009
(1,000)
Retained earnings, December 31, 2010
$9,105
Slide 22
Statement of Retained Earnings
Beginning Retained Earnings
Plus: Net Income
Less: Dividends
Ending Retained Earnings
McGraw-Hill/Irwin
Slide 23
Statement of Cash Flows
MAXIDRIVE CORP.
Statement of Cash Flows
For the Year Ended December 31, 2010
(in thousands of dollars)
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
Investing Activities
Cash used to purchase equipment
Net cash flow from investing activities
Financing Activities
Cash received from bank loan
Cash dividends paid
Net cash provided by financing activities
Net increase in cash
Cash at beginning of year
Cash at end of year
$
McGraw-Hill/Irwin
33,563
(30,854)
(450)
(1,190)
1,069
(1,625)
(1,625)
1,400
(1,000)
400
(156)
5,051
4,895
Slide 24
Statement of Cash Flows
Distinguishes between cash received from or used for:
---Operating activities
---Investing activities and
---Financing activities

McGraw-Hill/Irwin
Slide 25
Notes to Financial Statements
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.
McGraw-Hill/Irwin
Slide 26
Notes to Financial Statements
Descriptions of the key accounting rules
that apply to the company’s statements.
Additional detail supporting reported
numbers.
Relevant financial information not
disclosed on the statements.
McGraw-Hill/Irwin
Slide 27
Information Reported on the Financial
Statements
Question
Answer
Financial
Statement
1. How well did the
Revenues
company perform
Income
– Expenses
(or operate) during
statement
Net income (Net loss)
the period?
2. Why did the company’s
Statement
Beg. retained earnings
retained earnings
of
+ Net income (or – Net loss)
change during the
retained
- Dividends
period?
Ending retained earnings earnings
McGraw-Hill/Irwin
Slide 28
Information Reported on the Financial
Statements
Question
Answer
3. What is the company’s
financial position at the
end of the period?
Assets
= Liabilities
+ Owners’ equity
4. How much cash did
the company generate
and spend during
the period?
McGraw-Hill/Irwin
Financial
Statement
Balance
sheet
Statement
Operating cash flows
of
± Investing cash flows
cash
± Financing cash flows
flows
Increase or decrease in cash
Slide 29
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
(8,500)
Expenses
Net income $ 7,000
McGraw-Hill/Irwin
Statement of Retained Earnings
Beginning retained earnings $ 59,000
Net income
7,000
Dividends
(2,500)
Ending retained earnings
$ 63,500
Slide 30
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
Beginning retained earnings $ 59,000
Net income
7,000
Dividends
(2,500)
Ending retained earnings
$ 63,500
McGraw-Hill/Irwin
Balance Sheet
Cash
Other assets
Total assets
Liabilities
Stockholders' Equity
Common stock
Retained earnings
Total liabilities and equity
$ 14,000
171,500
$ 185,500
$ 42,000
80,000
63,500
$ 185,500
Slide 31
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
Cash flows from operating activities
Cash flows from investing activities
Cash flows from financing activities
Increase in cash
Beginning cash balance
Ending cash balance
McGraw-Hill/Irwin
Balance Sheet
$ 21,000
(16,000)
3,500
$ 8,500
5,500
$ 14,000
Cash
Other assets
Total assets
Liabilities
Stockholders' Equity
Common stock
Retained earnings
Total liabilities and equity
$ 14,000
171,500
$ 185,500
$ 42,000
80,000
63,500
$ 185,500
Slide 32
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.
McGraw-Hill/Irwin
Overall, I believe
these financial
statements are
fair.
Slide 33
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.
McGraw-Hill/Irwin
Slide 34
End of Chapter 1
© 2008 The McGraw-Hill Companies, Inc.