MANAGEMENT DECISIONS AND FINANCIAL ACCOUNTING REPORTS

Chapter 1

Baginski & Hassell

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 firms 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.

Four Primary Financial Statements

Cash Based
Statement of cash flows

Ten Fundamental Elements of Accrual Financial Statements

Assets Liabilities Equity Revenues Expenses Gains Losses Contributions by owners Distributions to owners Comprehensive income*

Accrual Based
Income statement (statement of earnings) Balance sheet (statement of financial position) Statement of changes in owners equity
A separate statement of comprehensive income is optional.

*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.

(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.

RESOURCES!

(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 enterprise 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.

Income Statement
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.) 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 entitys 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 entitys 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.

 Statement of cash flows

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.

Reflects cash inflows and outflows (categorized sources and uses of cash) Each cash flow is categorized as
Operating activity Investing Activity Financing Activity

How Accrual Financial Statement Elements and Cash Flows are Related
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 months expense item).

Simultaneous cash flows and revenue and expense recognition Accruals: Revenues and expense recognition preceding cash flows Deferrals: Cash flows preceding revenue and expense recognition

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
(continuing down the page)

Liabilities Current liabilities $XX XX XX

$XX XX XX XX XX $XX

Long-term liabilities Owners Equity Contributed capital Retained earnings Total liabilities & owners equity
(end)

XX XX XX $XX

Balance Sheet Account Format

Assets Liabilities

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

Owners equity Total liabilities & owners equity

Total assets

 Long-term investments (may be shown in other asset category below)

Investments in stocks and bonds Notes receivable

Property, plant, and equipment

Buildings Furniture, vehicles and equipment Leasehold improvements Less: allowance for accumulated depreciation Land

Intangible assets (may be shown in other asset category below) Patents Trademarks and tradenames Less: allowance for accumulated amortization (*) Goodwill
(*) 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

Liabilities and Stockholders Equity

Liabilities
Current liabilities
Accounts payable Accrued expenses payable Current maturities of long-term debt

Long-term liabilities
(*) If not shown in a separate section

Notes and bonds payable Deferred income taxes payable

Stockholders Equity
Contributed capital
Preferred stock Common stock Additional contributed capital

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:

Retained earnings Accumulated other comprehensive income(*)

(*) To be discussed later

 Historical cost: Amount originally paid for the asset (e.g., property, plant and equipment). Net realizable value (NRV): Amount expected to be realized from the assets sale (and cash collection), less any costs to complete or dispose of the item.

Replacement cost: Current cost to replace the item (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, Whats 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 Format

Revenues Sales Other income Expenses Cost of goods sold Selling, general, and administrative Income taxes Other expenses Net income Earning per share $XX XX XX XX XX XX

Income Statement: Multiple Step Format

Sales $XX XX XX Cost of goods sold Gross profit (margin) Operating expenses Selling expenses $XX XX XX XX

$XX

XX $XX $XX

General and administrative expenses Operating income

(continuing down the page)

(Continued)
Operating income Financial revenues, (expenses), gains, and (losses) Income before income taxes Income tax expense Net income Earnings per share XX

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

XX XX XX $XX $XX

Its 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 change in accounting principle, net of tax: gain (loss) Net Income
(continuing down the page)

$XX XX XX XX XX XX $XX

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 change in 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 business component, the results are reported, net of tax, as attributable to discontinued operations.

 Extraordinary items
Items 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

Cumulative effects of an accounting change

This 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.

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

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.

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?

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

Ah, theres the rub! Very controversial! Thats exactly why ...

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

End of Chapter 1

price reflects the present value of future permanent earnings.

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