MANAGEMENT DECISIONS AND FINANCIAL

ACCOUNTING REPORTS Baginski & Hassell

Electronic presentation adaptation byDr. Barbara L. Hassell & Dr. Harold O. Wilson

Chapter 1

Management Decisions and Financial Statements

• Focus: Managerial decisions (document how financial statements reflect managerial decisions)

• Three types of activities reflected in financial statements

• Generally accepted accounting principles (GAAP)

• Four primary financial statements

Decisions and Data

• Managers’ decisions affect financial statements (which are designed to report results).

• Managers improve performance by understanding and using GAAP-based financial statements

that reflect the effects of managerial decisions.• External financial statement users strive to

understand the effects of managers’ decisions (by scrutinizing financial statements).

Three Types of Activities Are Reflected in Financial Statements

• Financing Activities: Raising funds (capital) to support the firm’s investing and operating activities– Issue and retire debt– Issue stock and repurchase stock– Pay dividends

• Investing Activities: Purchasing or creating productive service capacity to deliver products or services to customers– Purchase or create and dispose of property,

plant and equipment, and intangible assets

• Operating Activities: Selling products or providing services to customers; acquiring needed products/services from vendors.

Generally Accepted Accounting Principles (GAAP)

• GAAP: The set of prescribed general guidelines, rules, historical precedents and accepted conventions that underlie the preparation of accrual-basis financial statements.

.

• FASB (The Financial Accounting Standards Board) is the private sector organization that prescribes accounting rules.

• SEC (The Securities and Exchange Commission) is the public sector organization with statutory authority to prescribe accounting rules.

To some extent, the SEC has delegated the responsibility for GAAP to the FASB.

• Cash Based– Statement of cash flows

• Accrual Based– Income statement (statement of earnings)– Balance sheet (statement of financial position)– Statement of changes in owners’ equity

Four Primary Financial Statements

A separate statement of comprehensive income is optional.

Ten Fundamental Elements of Accrual Financial Statements

• Assets• Liabilities• Equity• Revenues• Expenses

• Gains• Losses• Contributions by owners• Distributions to owners• Comprehensive income*

*discussed later in text

• Balance Sheet

– Assets: Probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.

RESOURCES!

(Sources of Resources:)

– Liabilities: Probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.

(Sources of Resources:)

– Equity: Residual interest in assets of an entity that remains after deducting its liabilities. (In a business enterprise, “equity” refers to the ownership interest.)

• Statement of [changes in] Owners’ Equity

– Investments by Owners: Increases in net assets of a particular entereprise resulting from transfers of something of value to it from other entities, in order to obtain or increase ownership interest/equity in that particular enterprise.

• The assets are most commonly received as investments by owners.• Assets may also be in the form of services or satisfaction (or conversion) of liabilities of the enterprise.

– Distributions to Owners: Decreases in net assets of a particular enterprise resulting from transferring assets, rendering services, or incurring liabilities by the enterprise to owners. (Distributions to owners decrease the net assets and decrease the ownership interest/equity in the particular enterprise.)

• Income Statement– Revenues: Inflows or other enhancements of

assets of an entity or settlement of its liabilities (or a combination of both) during a defined period from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major or central operations.

– Expenses: Outflows or other using up of assets or incurrences of liabilities (or a combination of both) during a defined period from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major or central operations.

– Gains: Increases in equity (net assets) from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity during a period except those that result from revenues or investments by owners.

– Losses: Decreases in equity (net assets) from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity during a period except those that result from expenses or distributions to owners.

• Statement of cash flows– Reflects cash inflows and outflows

(categorized sources and uses of cash)

– Each cash flow is categorized as• Operating activity• Financing Activity• Investing Activity

How Accrual Financial Statement Elements and Cash Flows are Related

• Simultaneous cash flows and revenue and expense recognition

• Accruals: Revenues and expense recognition preceding cash flows

• Deferrals: Cash flows preceding revenue and expense recognition

Possibilities in accounting report timing:

• Simultaneous cash flows and revenue and expense recognition

– Revenue example: A company makes a sale (delivery) for cash.

– Expense example: A company makes a cash purchase (e.g., paying for the current month’s expense item).

• Accruals: Revenue and Expense Recognition Preceding Cash Flows– Revenue example: A company makes a sale

“on account” (i.e., an accounts receivable), agreeing to later cash collection from the customer.

– Expense example: A company incurs an obligation to pay for an expense, with payment to be made at a future date (e.g., a company is billed for CPA services rendered during March, but the payment is not due until April 10th).

• Deferrals: Cash Flows Preceding Revenue and Expense Recognition– Revenue example: A company receives cash in

advance for services to be rendered in the future (e.g., an attorney collects a retainer in March for legal services to be provided in May).

– Expense example: A company pays cash in advance for services to be provided later (e.g., a company pays three months’ rent in advance)

A Closer Look at the Balance Sheet and Income Statement

• Balance sheet account format versus report format• Balance sheet categories, subtotals• Measurement attributes reported in balance sheet• Income statement multiple step format versus single

step format• Income statement categories, subtotals• Capital maintenance approach to income

measurement• Transitory earnings versus permanent earnings

Balance Sheet Presentations: Report Format Versus Account

Format

Both are equally acceptable in practice.

Balance Sheet Report Format

Assets

Current assets

Investments and funds

Property, plant and equipment

Intangible assets

Other assets

Total assets

$XX

XX

XX

XX

XX

$XX(continuing down the page)

Liabilities

Current liabilities $XX

Long-term liabilities XX XX

Owners’ Equity

Contributed capital XX

Retained earnings XX XX

Total liabilities & owners’ equity $XX

(end)

Balance Sheet Account Format

Assets

Total assets

Liabilities

Owners’ equity

Total liabilities &owners’ equity

Balance Sheet Categories• Current assets

– Cash and equivalents– Short-term investments– Receivables (accounts, notes, less allowance for

doubtful accounts)– Income taxes receivable– Inventories– Prepaid expenses and other assets– Assets held for sale– Deferred income taxes

• Long-term investments (may be shown in other asset category below)– Investments in stocks and bonds– Notes receivable

• Property, plant and equipment– Land– Buildings– Furniture, vehicles and equipment– Leasehold improvements– Less: allowance for accumulated depreciation

• Intangible assets (may be shown in other asset category below)

– Patents

– Trademarks and tradenames

– Goodwill

– Less: allowance for accumulated amortization (*)

(*) Some theorists do not use this account; they would credit the intangible asset directly as it is used up.

• Other assets

– Long-term prepayments

– Investments (*)

– Intangible assets (*)

– Deferred income taxes

(*) If not shown in a separate section

Liabilities and Stockholders’ Equity

• Liabilities– Current liabilities

• Accounts payable• Accrued expenses payable• Current maturities of long-term debt

– Long-term liabilities• Notes and bonds payable• Deferred income taxes payable

• Stockholders’ Equity– Contributed capital

• Common stock• Preferred stock• Additional contributed capital

– Retained earnings

– Accumulated other comprehensive income(*)

(*) To be discussed later

Measurement Attributes Shown in the Balance Sheet

The balance sheet accounts reflect one of the following measurement attributes, which will be discussed more fully later:

• Historical cost: Amount originally paid for the asset (e.g., property, plant and equipment). [A price aggregate!]

• Net realizable value (NRV): Amount expected to be realized from assets’ sale (and cash collection), less any costs to complete or dispose of the item.

• Replacement cost: Current cost to replace the item, per se (e.g., certain marketable securities).

• Present value (as applied to monetary assets and liabilities): Amount of estimated future cash flows, less an interest component (e.g., bid price of a bond investment).

• Market value (or FMV): A general term.

FAQ?

Is there a precise definition of fair market value (FMV)?

In technical terms, FMV may be defined as the price a willing seller and a willing buyer would agree upon to conclude a deal, neither under duress or undue stress. In very informal lingo, “What’s something worth?” may well refer to such a definition.

Income Statement Presentations:

Multiple Step Format versus Single Step Format

The multiple step format is most often used.

Income Statement: Single Step FormatRevenues

Sales $XX

Other income XX $XX

Expenses

Cost of goods sold XX

Selling, general, and administrative XX

Income taxes XX

Other expenses XX XX

Net income $XX

Earning per share $XX

Income Statement: Multiple Step FormatSales $XX

Cost of goods sold XX

Gross profit (margin) XX

Operating expenses

Selling expenses $XX

General and administrative expenses XX XX

Operating income XX

(continuing down the page)

(Continued)

Operating income XX

Financial revenues, (expenses), gains, and (losses) XX

Income before income taxes XX

Income tax expense XX

Net income $XX

Earnings per share $XX

FAQ?What is a major objection to the simplicity of the single step format of the income statement?

It’s too simple! The absence of meaningful, titled subtotals is effectively omitting the art work of accountancy, where the objective is to help create understanding of the business enterprise.

Special Items at the Bottom of an Income Statement

Both multiple and single step financial statements may have special items, which are shown net of income tax effect, at the bottom of the income statement.

Starting with Income before income taxes, the income statement looks as follows:

Income Statement: Special Net of Tax Items

Income before income taxes

Income tax expense

Income from continuing operations

Discontinued operations gain (loss), net of tax

Extraordinary gain (loss), net of tax

Cumulative effect of accounting principle, net of tax: gain (loss)

Net Income

$XX

XX

XX

XX

XX

XX

$XX(continuing down the page)

EPS Presentation: Special Net of Tax Items

Net income

Earnings per share

From continuing operations

Discontinued operations gain (loss), net of tax

Extraordinary gain (loss), net of tax

Cumulative effect of accounting principle, net of tax: gain (loss)

Net income

$XX

$XX

XX

XX

XX

$XX

Special Items at the Bottom of an Income Statement

• Discontinued operations

This topic is discussed in a later chapter.

For now, remember that if a company disposes of a complete business segment, the results are reported, net of tax, as attributable to discontinued operations.

• Extraordinary itemsItems that are both unusual and infrequent are shown, net of tax, as extraordinary items.(*)

Also, any items may be shown as extraordinary, if mandated by FASB (e.g., gain/loss on early extinguishment of debt)

(*) “Ask ABNER:” Abnormal and Not Expected to Recur?

• Cumulative effects of accounting changeThis topic is discussed in a later chapter.

For now, know that if a company adopts a new accounting principle (method), (e.g., change from the SL depreciation method to the DDB method), the general rule is to show the effect of the change, net of tax, on the income statement.

Capital Maintenance Approach to Income Determination

• The concept underlying the computation of net income is that of capital maintenance, based on economic theory.

• During an accounting period, the capital maintenance approach measures income (loss) as the amount of change in net assets, exclusive of any investment/distribution dealings with owners, per se.

• If the firm is “better off” at the end of the period (i.e., net assets have increased), then the firm generated income.

• If the firm is “worse off,” then the firm incurred a loss.

FAQ?

What is the preferable balance sheet measurement tool or attribute in assessing whether an entity is better off or worse off?

“Ah, there’s the rub!” Very controversial! That’s exactly why ...

Accountants use the transactions approach to measure income, which records the effect of each transaction on income.

What’s happening?

Theory ...

• Theoretically, two capital maintenance approaches are possible: Financial capital maintenance and physical capital maintenance.

GAAP-based financial statements reflect a financial capital maintenance approach.

Transitory versus Permanent Earnings

Some earnings components are considered permanent and some are considered transitory:– Transitory earnings component: A one-time

event or situation not expected to be repeated.– Permanent earnings component: A level of

[current] earnings that is expected to continue into the future.

Knowing the difference could make you rich!

• Economic theory relates the level of permanent earnings to stock prices.

• Many believe that current stock price reflects the present value of future permanent earnings.

End of Chapter 1