Accounting Activities and Financial Statements

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Chapter 1

• Accounting Activities and Financial Statements

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Objectives of the Chapter

• 1. Principal activities of business firms.
• 2. Understanding four financial statements.
• 3. The users of financial statements.
• 4. The financial reporting reform.
• 5. The types of business entity.
• 6. The authorities prescribing accounting
  standards and the need for international
  accounting standards.
• 7. Accounting concepts and principles.

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I. Principal Activities of Business Firms

• Establishing Corporate Goals and Strategies
• Obtaining Financing (from owners and creditors)
• Making Investments (i.e. Investments Purchase
  of Property Plant and Equipment Purchase of
  Intangibles etc.)
• Carrying Out Operations (i.e. purchase of
  materials/inventory production marketing and
  administration)

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2. Understanding Four Financial Statements

• Q1 What is accounting
• An information system to account for business
  transactions and to communicate the financial
  information to users.
• Q2 How do accountants communicate financial
  information to users

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Annual Financial Reports

• Public firms communicate their financial
  information via the annual reports to
  shareholders.
• The content of an annual report includes
• A letter to shareholders from the CEO (i.e. IBM
  2008 Annual Report p1-9).
• Managements Discussion and Analysis (MDA)
  (i.e. IBM 2008 Annual Report p18-57).

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Annual Financial Reports (contd.)

• Report of Management (i.e. on the effectiveness
  of Internal control required by Sarbanes-Oxley
  Act of 2002). (IBM 2008 Annual Report p58)
• Report of Independent Registered Public
  Accounting Firm. (i.e. IBM 2008 Annual Report
  p59)
• Audited Consolidated Financial statements and
  Notes. (i.e. IBM 2008 Annual Report60-119)

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The Four Financial Statements

• 1. Consolidated Income Statement
• 2. Consolidated Statement of Retained
  Earnings
• 3. Consolidated Balance Sheet
• 4. Consolidated Statement of Cash Flows

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The Content of Four Financial Statements

• The Income Statement (Statement of Earnings)
  reports the operating results of a firm for a
  period of time.
• Accounts reported include revenue expenses
  gains losses the net income and the earnings
  per share.

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The Content of Four Financial Statements (Contd.)

• The Statement of Retained Earnings reports the
  earnings not distributed to shareholders.
• Accounts reported include beginning balance of
  retained earnings current years net income
  dividends distributed for the reporting period
  and the ending balance of retained earnings.

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The Content of Four Financial Statements (contd.)

• The Balance Sheet Statement (Statement of
  Financial Position) reports the financial
  position of a firm on a particular date.
• Accounts reported include assets liabilities and
  stockholders equity.

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The Content of Four Financial Statements (contd.)

• The Statement of Cash Flows reports cash flows
  from three business activities and the net
  increase (or decrease) of the cash during the
  year.
• Business activities affect cash flows operating
  investing and financing.

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Exhibit 1-1 (from Financial Accounting by
Harrison and Horngren)
LANDS END INC. SUBSIDIARIES Consolidated
Statement of Earnings

• 
  For the fiscal years ended
• (In thousands)
  2/2/2006 1/27/2005
• 1. Net sales 1031548 992106
• 2. Cost of sales 588017 571265
• 3. Gross profit 443531 420841
• 4. Selling general and admin. exps. 392484
  357516
• 5. Charges from sale of subsidiary 1882 3500
  
• 6. Income from operations 49165 59825
• 7. Other income (expense)
• 8. Interest expense (2771) (1769)
• 9. Interest income 253 307
• 10. Other 4278 1300
• 11. Total other income (expense) net 1760
  (162)
• 12. Income before income taxes 50925 59663
• 13. Income tax provision 20370 23567
• 14. Net income 30555 36096

12
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Exhibit 1-2 (from Financial Accounting by
Harrison and Horngren)
LANDS END INC. SUBSIDIARIES Consolidated
Statement of Retained Earnings

• For the fiscal
  years ended
• (In thousands) 2/2/2006 1/27/2005
• Retained Earnings
• 1. Beginning balance 229554 193460
• 2. Net income 30555 36096
• 3. Cash dividends paid --- ---
• 4. Issuance of treasury stock --- (2)
• 5. Ending balance 260109 229554

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Exhibit 1- 3(from Financial Accounting by
Harrison and Horngren)
LANDS END INC. SUBSIDIARIES Consolidated
Balance Sheet

• (In thousands)
  2/2/2006 1/27/2005
• ASSETS
• Current assets
• 1. Cash 17176 5426
• 2. Receivables 8046 4459
• 3. Inventory 164816 168652
• 4. Prepaid advertising and other exp. 32033
  19631
• 5. Total current assets 222089 198168
• Property plant equip. at cost
• 6. Land and buildings 72248 69798
• 7. Fixtures and equipment 83880 74745
• 8. Leasehold improvements 2912 1862
• 9. Total property plant equipment 159040
  146405
• 10. Less accum. depr. amortization 60055
  49414
• 11. Property plant equipment net 98985
  96991
• 12. Intangibles net 2423 2453
• 13. Total assets 323497 297612

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Exhibit 1- 3 (contd.)

• LIABILITIES AND SHAREHOLDERS INVESTMENT
• Current liabilities
• 14. Interest payable 9319 7539
• 15. Accounts payable 62380 52762
• 16. Salary payable 4555 5011
• 17. Accrued liabilities 23751 25959
• 18. Accrued profit sharing 1483 1679
• 19. Income taxes payable 13256 9727
• 20. Current maturities of long-term debt --- 40
• 21. Total current liabilities 114744 102717
• 22. Deferred income taxes 7212 5379
• 23. Long-term liabilities 349 388
• Shareholders investment
• 24. Com. stock 40221 shares issued 26567
  26219
• 25. Retained earnings 260109 229554
• 26. Other (85484) (66645)
• 27. Total shareholders investment 201192
  189128
• 28. Total liabilities shareholders
  inv. 323497 297612

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Exhibit 1- 4 (from Financial Accounting by
Harrison and Horngren)
LANDS END INC. SUBSIDIARIES Consolidated
Statement of Cash Flows

• 
  For the fiscal years ended
• (In thousands)
  2/2/2006 1/27/2005
• Cash flows from operating activities
• 1. Cash received from customers 1027943
  991291
• 2. Cash received from interest 253 307
• 3. Cash paid to suppliers employees (967075) (9
  26714)
• 4. Cash paid for interest (2833) (2828)
• 5. Cash paid for income taxes (16896) (27595)
• 6. Net cash flows from operating
  activities 41392 34461
• Cash flows from investing activities
• 7. Cash paid for capital additions
• and businesses acquired (13904) (32102)
• 8. Proceeds from divestiture 1665 ---
• 9. Net cash flows used
• for investing activities (12239) (32102)

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Exhibit 1-4 (contd.)

• Cash flows form financing activities
• 10. Proceeds from short-term and
• long-term debt 1780 7539
• 11. Payment of long-term debt (40) (40)
• 12. Purchases of treasury stock (20001) (27979)
• 13. Issuance of treasury stock 858 1978
• 14. Cash dividends paid --- ---
• 15. Net cash flows used
• for financing activities
  (17403) (18502)
• 16. Net increase (decrease) in cash 11750
  (16143)
• 17. Beginning cash 5426 21569
• 18. Ending cash 17176 5426

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Exhibit 1-5 (from Financial Accounting by
Harrison and Horngren)
Income Statement -- Fiscal Year 2006 (Details
given in Exhibit 1-8)

• Net income .. 30555

Statement of Retained Earnings -- Fiscal Year 2006
Beginning retained earnings .. 229554 Net
income 30555 Cash dividends
. --- Ending retained earnings
260109
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Exhibit 1- 5 (contd.)
Statement of Retained Earnings -- Fiscal Year 2006
Beginning retained earnings ... 229554
Net income . 30555 Cash dividends
.. --- Ending retained earnings
. 260109
Balance Sheet Statement - Fiscal Year 2006
ASSETS Cash ... 17176 All
other assets . 306321 Total assets
... 323497 LIABILITIES Total
liabilities ... 122305
STOCKHOLDERS EQUITY Common stock
. 26567 Retained earnings
... 260109 Other equity
.. (85484) Total liabilities
stockholders equity 323497

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Exhibit 1- 5 (contd.)
Balance Sheet Statement -- Fiscal Year 2006
ASSETS Cash ... 17176 All
other assets . 306321 Total assets
... 323497 LIABILITIES Total
liabilities ... 122305
STOCKHOLDERS EQUITY Common stock
. 26567 Retained earnings
... 260109 Other equity
.. (85484) Total liabilities
stockholders equity 323497

Statement of Cash Flows - Fiscal Year 2006
Net cash flows from operating activities
... 41392 Net cash flows used for investing
activities .. (12239) Net cash flows used for
financing activities .. (17403) Net increase in
cash . 11750 Beginning cash
.. 5426 Ending cash
17176
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Definitions of Assets Liabilities and Equity
(all are presented on a balance sheet statement)

• Assets the economic resources of a business that
  are expected to be of benefit to the business
  entity in the future.
• Examples cash office supplies inventories
  accounts receivable buildings equipment etc.)

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Definitions of Assets Liabilities and Equity
(contd.)

• Liabilities claims to assets legal obligations
  required future payments of assets or services as
  a result of a business entitys past
  transactions.
• Examples accounts payable bonds payable
• Equity residual claims to a business entity from
  stockholders.

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Definitions of Revenues and Expenses

• Revenues increase or inflow of assets will
  eventually increase stockholders equity (i.e.
  sales revenue)
• Expenses decrease or outflow of assets will
  eventually decrease stockholders equity.
• Gains increase in assets from incidental
  transactions not related to the major operation.
• Losses decrease in assets from incidental
  transactions.

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The Accounting Equation and the Computation of
Accounting Net Income

• Assets Liabilities Stockholders Equity
• Balance Sheet
• Assets Liabilities
• Equity

• Net Income Revenues - Expenses Gains
• - Losses

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3. Users of Accounting Information

• Internal users mangers managerial accounting
  produce internal accounting reports for mangers
  to make decisions.
• External users investors creditors IRS SEC
  etc. financial accounting produces financial
  statements for these users.

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External Users and Usage of Financial Statements
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Why Are Financial Statements Important

• Assess the risks (i.e. credit risk).
• Provide an economic history.
• Thus financial statement can be used for various
  purposes
• Analytical tool (i.e. to assess liquidity
  efficiency of using financial resources
  profitability and solvency of companies.)
• Management report card
• Early warning signal
• Basis for predictions

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4. The Financial Reporting Reform

• The collapse of Enron and the accounting scandals
  of some high-profile firms severely damaged
  public confidence in the accounting profession
  and the financial reporting.
• At the demand of the public Sarbanes and Oxley
  Act was passed in 2002 to restore the public
  confidence in the credibility of the financial
  reports.

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Key Provisions of Sarbanes and Oxley Act

• Creating the Public Company Accounting Oversight
  Board establish auditing standards.
• Increasing Corporate Executive Accountability.
• Prohibition of Non-Audit Services.
• Evaluation of Internal Control.

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5. Types of Business

• 1. Proprietorships
• 2. Partnerships
• 3. Corporations

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Types of Business (contd.)
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Corporations

• A business entity formed under a state law.
• A corporation is a legal entity by itself. It has
  all the rights of a person (i.e. pay taxes own
  properties can sue or be sued can sign
  contract) except the rights of voting and
  marriage.

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Corporations (contd.)

• The ownership of a corporation is divided by
  shares.
• To be an owner of a corporation an individual
  just need to buy shares from stock markets.
• Owners of a corporation have limited liability.
  The most an owner can lose is what he (she)
  invested.

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Corporations (contd.)

• The stockholders elect board of directors who
  sets business policies for the corporation.
• The board elects a chairman (usually is also the
  chief executive officer (CEO) and designates a
  president who is in charge of daily operations
  (COO).

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Corporations (contd.)

• The board also appoints vice presidents who are
  in charge of different areas (i.e. marketing
  accounting finance...).

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6. The Authorities prescribing the Accounting
Standards

• Financial Statements (F/S) are prepared based on
  generally accepted accounting principles (GAAP).
• The authorities prescribe the accounting
  standards include

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The Authorities prescribing the Accounting
Standards (contd.)

• the Financial Accounting Standards Board (FASB a
  private agency)
• the Securities and Exchange Commission (SEC a
  public agency).

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A Historical Perspective of Authorities
prescribing the Accounting Standards
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The Need for International Accounting Standards

• Companies doing business in more than one nation
  found that it is hard to comply with more than
  one set of accounting standards established by
  authorities in different nations.
• In response to this problem International
  Accounting Standards Committee (IASC) was founded
  in 1973 to develop a single set of global
  accounting standards.

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The History of International Accounting Standard
Setting (cont.)

• 41 International Accounting Standards (IAS) were
  issued by IASC.
• IASC created International Accounting Standards
  Board (IASB) in April 2001 to be in charge of
  prescribing the standards.
• IASB endorsed 41 IAS and named its pronouncement
  as International Financial Reporting Standards
  (IFRS).

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Convergence of the U.S. Accounting Standards and
the International Accounting Standards

• To increase the international comparability and
  the quality of US accounting standards the FASB
  has been engaged in activities toward the
  convergence of the accounting standards.
• The FASB is working closely with the IASB on the
  convergence of accounting standards.

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Short-Term International Convergence (source
FASB Project Updates)

• The FASB started a short term joint project with
  the IASB to eliminate narrow differences between
  US GAAP and IFRS in October 2002.
• Both IASB and FASB acknowledged that convergence
  of IFRS and U.S. GAAP is a primary objective of
  both Boards.

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A Single Global Accounting Language-
International financial reporting standards

• In 2008 the Securities and Exchange Commission
  (SEC) proposed a roadmap for the US issuers to
  prepare financial statements in accordance with
  IFRS for the purposes of their filings with the
  SEC.
• This roadmap if achieved could lead to the
  required use of IFRS by U.S. issuers in 2015 or
  2016.

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The SECs Roadmap Toward Global Accounting
Standards (Source Intermediate Accounting by
Kieso Weygandt and Warfield)
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Current Compliances

• Since there is no single set of high-quality
  accounting standards domestic (U.S.) firms
  filing reports with the SEC must use U.S. GAAP.
• Foreign issuers filing reports with the SEC can
  use U.S. GAAP the international standards or the
  GAAP of its home country.
• If foreign firms chose to use the standards of
  its home country they must file reports with
  reconciliation to U.S. GAAP.

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7. Accounting Concepts and Principles

• 1. The entity concept
• 2. The going-concern concept
• 3. The stable-monetary unit concept
• 4. The cost principle
• 5. The reliability principle