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The balance sheet helps users determine if the company relies on debt or stockholders’ equity to fi nance its assets.To present a picture at a point in time of what your business owns (its assets) and what it owes (its liabilities), you prepare a balance sheet. The balance sheet reports assets and claims to assets at a specifi c point in time. Claims to assets are subdivided into two categories: claims of creditors and claims of owners. As noted earlier, claims of creditors are called liabilities. The owners’ claim to assets is called stockholders’ equity. Creditors analyze a company’s balance sheet to determine the likelihood that they will be repaid. They carefully evaluate the nature of the company’s assets and liabilities. the balance sheet will be used to determine whether cash on hand is sufficient for immediate cash needs. The balance sheet will also be used to evaluate the relationship between debt and stockholders’ equity to determine whether the company has a satisfactory proportion of debt and common stock fi nancing.
Assets:
Current assets
-cash
-debt investment
-accounts receivable/notes
receivable
-Inventory
-Supplies
- patents
-trademark
-copyright
Liabilities
Current liabilities
-notes payale
-accounts payable
-Unearned Service Revenue
-unearned sales
-salaries and wages payables
-interest payable
Long term liabilities
-mortgage payable
-notes payable
-Bonds payable
-Premium on Bonds Payable
-Dividends Payable
Stockholder’s equity
-Common Stock
-Paid-in Capital in Excess of Par Value Common Stock
- Preferred Stock
- Paid-in Capital in Excess of Par Value—Preferred Stock
-Treasury Stock
-Retained Earnings
-Dividends
-Income Summary
-Prepaid insurance
-prepaid rent
-Allowance for Doubtful Accounts
-Interest receivable
Long term investment
- Non-marketable equity investments
-stock investment
-investment in real state
-buildings-(Accumulated Depreciation— Buildings)
Property, plant and equipment
-land
-equipment-(Accumulated Depreciation— Equipment)
Intangible assets
-Goodwill
Current assets are assets that a company expects to convert to cash or use up within one year or its operating cycle, whichever is longer. The operating cycle of a company is the average time required to go from cash to cash in producing revenue—to purchase inventory, sell it on account, and then collect cash from customers. For most businesses, this cycle takes less than a year, so they use a one-year cutoff. But for some businesses, such as vineyards or airplane manufacturers, this period may be longer than a year. Except where noted, we will assume that companies use one year to determine whether an asset or liability is current or long-term. Companies list current assets in the order in which they expect to convert them into cash.
Long-term investments are generally (1) investments in stocks and bonds of other corporations that are held for more than one year, (2) long-term assets such as land or buildings that a company is not currently using in its operating activities, and (3) long-term notes receivable.
Property, plant, and equipment are assets with relatively long useful lives that are currently used in operating the business.
- Depreciation is the allocation of the cost of an asset to a number of years. Companies do this by systematically assigning a portion of an asset’s cost as an expense each year (rather than expensing the full purchase price in the year of purchase). The assets that the company depreciates are reported on the balance sheet at cost less accumulated depreciation. The accumulated depreciation account shows the total amount of depreciation that the company has expensed thus far in the asset’s life. What is the “depreciation”?
Depreciation is the process of allocating to expense the cost of a plant asset over its useful (service) life in a rational and systematic manner.Depreciation affects the balance sheet through accumulated depreciation, which companies report as a deduction from plant assets.
Depreciatin last year: (months that had passeed/112)*depreciation expense.
PERIOD BOOK VALUE BEGINNING ANNUAL DEPRECIATION
ACCOMULATED DEPRECIATION BOOK VALUE
Many companies have assets that do not have physical substance and yet often are very valuable. We call these assets intangible assets. that give the company exclusive right of use for a specifi ed period of time
In the liabilities and stockholders’ equity section of the balance sheet, the fi rst grouping is current liabilities. Current liabilities are obligations that the company is to pay within the next year or operating cycle, whichever is longer.
Long-term liabilities (long-term debt) are obligations that a company expects to pay after one year
Stockholders’ equity consists of two parts: common stock and retained earnings. Companies record as common stock the investments of assets into the business by the stockholders. They record as retained earnings the income retained for use in the business
To show how successfully your business performed during a period of time, you report its revenues and expenses in an income statement. The income statement reports a company’s revenues and expenses and resulting net income or loss for a period of time. To indicate that its income statement reports the results of operations for a specifi c period of time. Investors are interested in a company’s past net income because it provides useful information for predicting future net income. Investors buy and sell stock based on their beliefs about a company’s future performance. The income statement helps users determine if the company’s operations are profi table. Creditors also use the income statement to predict future earnings. When a bank loans money to a company, it believes that it will be repaid in the future. If it didn’t think it would be repaid, it wouldn’t loan the money. Therefore, prior to making the loan the bank loan offi cer uses the income statement as a source of information to predict whether the company will be profi table enough to repay its loan. Thus, reporting a strong profi t will make it easier for Sierra to raise additional cash either by issuing shares of stock or borrowing. Amounts received from issuing stock are not revenues, and amounts paid out as dividends are not expenses. The income statement reveals how successful the company is at generating a profi t from its sales. The income statement reports the amount earned during the period (revenues) and the costs incurred during the period (expenses).
Revenues:
-Service Revenue
-Sales Revenue
-Sales Discounts
-Sales Returns and Allowances
-Interest Revenue
-Gain on Disposal of Plant Assets
Expenses
-Administrative Expenses
-Amortization Expense
-Bad Debt Expense Cost of Goods Sold
-Depreciation Expense
-Freight-Out Income
-Tax Expense
-Insurance Expense
-Interest Expense
-Loss on Disposal of Plant Asset
-Maintenance and Repairs Expense
- Rent Expense Salaries and Wages Expense
-Selling Expenses
-Supplies Expense
-Utilities Expense
Net income/net loss
To indicate how much of previous income was distributed to you and the other owners of your business in the form of dividends, and how much was retained in the business to allow for future growth, you present a retained earnings statement. Retained earnings is the net income retained in the corporation. The retained earnings statement shows the amounts and causes of changes in retained earnings for a specifi c time period. The time period is the same as that covered by the income statement. The beginning retained earnings amount appears on the fi rst line of the statement. Then, the company adds net income and deducts dividends to determine the retained earnings at the end of the period.
By monitoring the retained earnings statement, fi nancial statement users can evaluate dividend payment practices. The retained earnings statement helps users determine the company’s policy toward dividends and growth.
Reatined earnings initial
Add: net income
OTHER ELEMENTS OF AN ANNUAL REPORT
The annual report also includes other important information such as a management discussion and analysis section, notes to the fi nancial statements, and an independent auditor’s report. No analysis of a company’s fi nancial situation and performance is complete without a review of these items.
The annual report always includes:
- Financial statements.
- Management discussion and analysis.: presents management’s views on the company’s ability to pay near-term obligations, its ability to fund operations and expansion, and its results of operations. Management must highlight favorable or unfavorable trends and identify signifi cant events and uncertainties that affect these three factors. This discussion obviously involves a number of subjective estimates and opinions
- Notes to the financial statements: Explanatory notes and supporting schedules accompany every set of fi nancial statements and are an integral part of the statements. The notes to the fi nancial statements clarify the fi nancial statements and provide additional detail. Information in the notes does not have to be quantifi able (numeric). Examples of notes are descriptions of the signifi cant accounting policies and methods used in preparing the statements, explanations of uncertainties and contingencies, and various statistics and details too voluminous to be included in the statements. The notes are essential to understanding a company’s operating performance and fi nancial position
- (^) Auditor's report: An auditor’s report is prepared by an independent outside auditor. It states the auditor’s opinion as to the fairness of the presentation of the fi nancial position and results of operations and their conformance with generally accepted accounting principles. An auditor is an accounting professional who conducts an independent examination of a company’s fi nancial statements. Only accountants who meet certain criteria and thereby attain the designation certifi ed public accountant (CPA) may perform audits. If the auditor is satisfi ed that the fi nancial statements provide a fair representation of the company’s fi nancial position and results of operations in accordance with generally accepted accounting principles, then the auditor expresses an unqualifi ed opinion. If the auditor expresses anything other than an unqualifi ed opinion, then readers should only use the fi nancial statements with caution. That is, without an unqualifi ed opinion, we cannot have complete confi dence that the fi nancial statements give an accurate picture of the company’s fi nancial health
-Certifi ed public accountant (CPA) An individual who has met certain criteria and is thus allowed to perform audits of corporations.
-Sarbanes-Oxley Act (SOX) Regulations passed by Congress to reduce unethical corporate behavior.
-The primary types of financial statements required by International Financial Reporting Standards (IFRS) and U.S. generally accepted accounting principles (GAAP) are the same.
Forms of business organization
SOLE PROPRIETORSHIP : You might choose the sole proprietorship form for your
outdoor guide service. A business owned by one person is a sole proprietorship. It is
simple to set up and gives you control over the business. Small owneroperated
businesses such as barber shops, law offi ces, and auto repair shops are often sole
proprietorships, as are farms and small retail stores.
PARTNERSHIP :Another possibility is for you to join forces with other
individuals to form a partnership. A business owned by two or more persons
associated as partners is a partnership. Partnerships often are formed because one
individual does not have enough economic resources to initiate or expand the
business. Sometimes partners bring unique skills or resources to the
partnership. You and your partners should formalize your duties and
contributions in a written partnership agreement. Retail and service-type
businesses, including professional practices (lawyers, doctors, architects,
and certifi ed public accountants), often organize as partnerships.
CORPORATION: As a third alternative, you might organize as a
corporation. A business organized as a separate legal entity owned by
stockholders is a corporation. Investors in a corporation receive shares of
stock to indicate their ownership claim. Buying stock in a corporation is
often more attractive than investing in a partnership because shares of
stock are easy to sell (transfer ownership). Selling a proprietorship or
partnership interest is much more involved. Also, individuals can become
stockholders by investing relatively small amounts of money. Therefore,
it is easier for corporations to raise funds. Successful corporations often
have thousands of stockholders, and their stock is traded on organized
stock exchanges like the New York Stock Exchange. Many businesses
start as sole proprietorships or partnerships and eventually incorporate.
Other factors to consider in deciding which organizational form to choose are taxes and
legal liability. If you choose a sole proprietorship or partnership, you generally receive
more favorable tax treatment than a corporation. However, proprietors and partners are
personally liable for all debts and legal obligations of the business; corporate
stockholders are not. In other words, corporate stockholders generally pay higher taxes
but have no personal legal liability. We will discuss these issues in more depth in a later
chapter. Finally, while sole proprietorships, partnerships, and corporations represent the
main types of business organizations, hybrid forms are now allowed in all states. These
hybrid business forms combine the tax advantages of partnerships with the limited
liability of corporations. Probably the most common among these hybrids types are
limited liability companies (LLCs) and subchapter S corporations. These forms are
discussed extensively in business law classes.
USERS AND USES OF FINANCIAL INFORMATION
The purpose of financial information is to provide inputs for decision-making.
Accounting is the information system that identifi çes, records, and communicates the
economic events of an organization to interested users. Users of accounting information
can be divided broadly into two groups: internal users and external users.
Internal Users : are managers who plan, organize, and run a business. These include
marketing managers, production supervisors, fi nance directors, and company offi cers.
In running a business, managers must answer many important questions, as shown in
Illustration 1-1. For internal users, accounting provides internal reports, such as fi
nancial comparisons of operating alternatives, projections of income from new sales
campaigns, and forecasts of cash needs for the next year. In addition, companies present
summarized fi nancial information in the form of fi nancial statements.
lines. Labor unions, such as the Major League Baseball Players Association, want to
know whether the owners have the ability to pay increased wages and benefi ts.
Regulatory agencies, such as the Securities and Exchange Commission or the Federal
Trade Commission, want to know whether the company is operating within prescribed
rules. For example, Enron, Dynegy, Duke Energy, and other big energy-trading
companies reported record profi ts at the same time as California was paying extremely
high prices for energy and suffering from blackouts. This disparity caused regulators to
investigate the energy traders to make sure that the profi ts were earned by legitimate
and fair practices.
ETHICS IN FINANCIAL REPORTING
All businesses are involved in three types of activity—financing, investing, and
operating.The accounting information system keeps track of the results of each of the
various business activities—financing, investing, and operating.
FINANCING ACTIVITIES :
It takes money to make money. The two primary sources of outside funds for
corporations are borrowing money (debt fi nancing) and issuing (selling) shares of stock
in exchange for cash (equity fi nancing). Columbia Sportswear may borrow money in a
variety of ways. For example, it can take out a loan at a bank or borrow directly from
investors by issuing debt securities called bonds. Persons or entities to whom Columbia
owes money are its creditors. Amounts owed to creditors—in the form of debt and other
obligations— are called liabilities. Specifi c names are given to different types of
liabilities, depending on their source. Columbia may have a note payable to a bank for
the money borrowed to purchase delivery trucks. Debt securities sold to investors that
must be repaid at a particular date some years in the future are bonds payable.
Corporations also obtain funds by selling shares of stock to investors. Common stock is
the term used to describe the total amount paid in by stockholders for the shares they
purchase. The claims of creditors differ from those of stockholders. If you loan money
to a company, you are one of its creditors. In lending money, you specify a payment
schedule (e.g., payment at the end of three months). As a creditor, you have a legal right
to be paid at the agreed time. In the event of nonpayment, you may legally force the
company to sell property to pay its debts. In the case of fi nancial diffi culty, creditor
claims must be paid before stockholders’ claims. Stockholders, on the other hand, have
no claim to corporate cash until the claims of creditors are satisfi ed. Suppose you buy
a company’s stock instead of loaning it money. You have no legal right to expect any
payments from your stock ownership until all of the company’s creditors are paid
amounts currently due. However, many corporations make payments to stockholders on
a regular basis as long as there is suffi cient cash to cover required payments to
creditors. These cash payments to stockholders are called dividends.
INVESTING ACTIVITIES Once the company has raised cash through fi nancing
activities, it uses that cash in investing activities. Investing activities involve the
purchase of the resources a company needs in order to operate. A growing company
purchases many resources, such as computers, delivery trucks, furniture, and buildings.
Resources owned by a business are called assets. Different types of assets are given
different names. For example, Columbia Sportswear’s sewing equipment is a type of
asset referred to as property, plant, and equipment. Cash is one of the more important
assets owned by Columbia or any other business. If a company has excess cash that it
does not need for a while, it might choose to invest in securities (stocks or bonds) of
other corporations. Investments are another example of an investing activity
OPERATING ACTIVITIES Once a business has the assets it needs to get started, it
begins operations. Columbia Sportswear is in the business of selling outdoor clothing
and footwear. We call amounts earned on the sale of these products revenues. Revenue
is the increase in assets or decrease in liabilities resulting from the sale of goods or the
performance of services in the normal course of business. For example, Columbia
records revenue when it sells a footwear product. Revenues arise from different sources
and are identifi ed by various names depending on the nature of the business. For
various comparisons to shed light on company performance: 1. Intracompany comparisons
covering two years for the same company. 2. Industry-average comparisons based on average
ratios for particular industries. 3. Intercompany comparisons based on comparisons with a
competitor in the same industry.
INCOME STATMENT: Profi tability ratios, such as earnings per share, measure the
operating success of a company for a given period of time. Earnings per share (EPS) measures
the net income earned on each share of common stock. Stockholders usually think in terms of
the number of shares they own or plan to buy or sell, so stating net income earned as a per share
amount provides a useful perspective for determining the investment return. Advanced
accounting courses present more refi ned techniques for calculating earnings per share. By
comparing earnings per share of a single company over time, we can evaluate its relative
earnings performance from the perspective of a stockholder— that is, on a per share basis. It is
very important to note that comparisons of earnings per share across companies are not
meaningful because of the wide variations in the numbers of shares of outstanding stock among
companies.
In the statement of cash fl ows, net cash provided by operating activities is intended to indicate the cash-generating capability of the company. Analysts have noted, however, that net cash provided by operating activities fails to take into account that a company must invest in new property, plant, and equipment (capital expenditures) just to maintain its current level of operations. Companies also must at least maintain dividends at current levels to satisfy investors. A measurement to provide additional insight regarding a company’s cash- generating ability is free cash fl ow. Free cash fl ow describes the net cash provided by operating activities after adjusting for capital expenditures and dividends paid. Free cash fl ow helps users determine the amount of cash a company generated to expand operations, pay off debts, or increase dividends
THE STANDARD-SETTING ENVIRONMENT
Generally accepted accounting principles (GAAP). Standardsetting bodies, in consultation with
the accounting profession and the business community, determine these accounting standards.
Generally Accepted Accounting Principles (GAAP) - A set of rules and practices, having substantial authoritative support, that the accounting profession recognizes as a general guide for financial reporting purposes.
Standard-setting bodies determine these guidelines:
- Securities and Exchange Commission (SEC)
- Financial Accounting Standards Board (FASB)
- International Accounting Standards Board (IASB)
- Public Company Accounting Oversight Board (PCAOB)
QUALITIES OF USEFUL INFORMATION
Recently, the FASB and IASB completed the fi rst phase of a joint project in which they developed a conceptual framework to serve as the basis for future accounting standards. The framework begins by stating that the primary objective of fi nancial reporting is to provide fi nancial information that is useful to investors and creditors for making decisions about providing capital. According to the FASB, useful information should possess two fundamental qualities, relevance and faithful representation
Enhancing Qualities In addition to the two fundamental qualities, the FASB and IASB also describe a number of enhancing qualities of useful information. These include comparability, verifi ability, timeliness, and understandability.
ASSUMPTIONS IN FINANCIAL REPORTING
To develop accounting standards, the FASB relies on some key assumptions
