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 1,031,548 992,106
• 2. Cost of sales 588,017 571,265
• 3. Gross profit 443,531 420,841
• 4. Selling, general, and admin. exps. 392,484
  357,516
• 5. Charges from sale of subsidiary 1,882 3,500
  
• 6. Income from operations 49,165 59,825
• 7. Other income (expense)
• 8. Interest expense (2,771) (1,769)
• 9. Interest income 253 307
• 10. Other 4,278 1,300
• 11. Total other income (expense), net 1,760
  (162)
• 12. Income before income taxes 50,925 59,663
• 13. Income tax provision 20,370 23,567
• 14. Net income 30,555 36,096

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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 229,554 193,460
• 2. Net income 30,555 36,096
• 3. Cash dividends paid --- ---
• 4. Issuance of treasury stock --- (2)
• 5. Ending balance 260,109 229,554

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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 17,176 5,426
• 2. Receivables 8,046 4,459
• 3. Inventory 164,816 168,652
• 4. Prepaid advertising and other exp. 32,033
  19,631
• 5. Total current assets 222,089 198,168
• Property, plant equip., at cost
• 6. Land and buildings 72,248 69,798
• 7. Fixtures and equipment 83,880 74,745
• 8. Leasehold improvements 2,912 1,862
• 9. Total property, plant equipment 159,040
  146,405
• 10. Less accum. depr. amortization 60,055
  49,414
• 11. Property, plant, equipment, net 98,985
  96,991
• 12. Intangibles, net 2,423 2,453
• 13. Total assets 323,497 297,612

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Exhibit 1- 3 (contd.)

• LIABILITIES AND SHAREHOLDERS INVESTMENT
• Current liabilities
• 14. Interest payable 9,319 7,539
• 15. Accounts payable 62,380 52,762
• 16. Salary payable 4,555 5,011
• 17. Accrued liabilities 23,751 25,959
• 18. Accrued profit sharing 1,483 1,679
• 19. Income taxes payable 13,256 9,727
• 20. Current maturities of long-term debt --- 40
• 21. Total current liabilities 114,744 102,717
• 22. Deferred income taxes 7,212 5,379
• 23. Long-term liabilities 349 388
• Shareholders investment
• 24. Com. stock, 40,221 shares issued 26,567
  26,219
• 25. Retained earnings 260,109 229,554
• 26. Other (85,484) (66,645)
• 27. Total shareholders investment 201,192
  189,128
• 28. Total liabilities shareholders
  inv. 323,497 297,612

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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 1,027,943
  991,291
• 2. Cash received from interest 253 307
• 3. Cash paid to suppliers employees (967,075) (9
  26,714)
• 4. Cash paid for interest (2,833) (2,828)
• 5. Cash paid for income taxes (16,896) (27,595)
• 6. Net cash flows from operating
  activities 41,392 34,461
• Cash flows from investing activities
• 7. Cash paid for capital additions
• and businesses acquired (13,904) (32,102)
• 8. Proceeds from divestiture 1,665 ---
• 9. Net cash flows used
• for investing activities (12,239) (32,102)

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Exhibit 1-4 (contd.)

• Cash flows form financing activities
• 10. Proceeds from short-term and
• long-term debt 1,780 7,539
• 11. Payment of long-term debt (40) (40)
• 12. Purchases of treasury stock (20,001) (27,979)
• 13. Issuance of treasury stock 858 1,978
• 14. Cash dividends paid --- ---
• 15. Net cash flows used
• for financing activities
  (17,403) (18,502)
• 16. Net increase (decrease) in cash 11,750
  (16,143)
• 17. Beginning cash 5,426 21,569
• 18. Ending cash 17,176 5,426

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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 .. 30,555

?
Statement of Retained Earnings -- Fiscal Year 2006
Beginning retained earnings .. 229,554 Net
income 30,555 Cash dividends
. --- Ending retained earnings
260,109
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Exhibit 1- 5 (contd.)
Statement of Retained Earnings -- Fiscal Year 2006
Beginning retained earnings ... 229,554
Net income . 30,555 Cash dividends
.. --- Ending retained earnings
. 260,109
Balance Sheet Statement - Fiscal Year 2006
ASSETS Cash ... 17,176 All
other assets . 306,321 Total assets
... 323,497 LIABILITIES Total
liabilities ... 122,305
STOCKHOLDERS EQUITY Common stock
. 26,567 Retained earnings
... 260,109 Other equity
.. (85,484) Total liabilities
stockholders equity 323,497
?
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Exhibit 1- 5 (contd.)
Balance Sheet Statement -- Fiscal Year 2006
ASSETS Cash ... 17,176 All
other assets . 306,321 Total assets
... 323,497 LIABILITIES Total
liabilities ... 122,305
STOCKHOLDERS EQUITY Common stock
. 26,567 Retained earnings
... 260,109 Other equity
.. (85,484) Total liabilities
stockholders equity 323,497
?
Statement of Cash Flows - Fiscal Year 2006
Net cash flows from operating activities
... 41,392 Net cash flows used for investing
activities .. (12,239) Net cash flows used for
financing activities .. (17,403) Net increase in
cash . 11,750 Beginning cash
.. 5,426 Ending cash
17,176
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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