ACCT 100 Chapter 1 Accounting Activities and Financial Statements

The Financial Statements2 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.

Overview of Financial Statements3 I. Principal Activities of Business Firms n Establishing Corporate Goals and Strategies n Obtaining Financing (from owners and creditors) n Making Investments (i.e., Investments, Purchase of Property, Plant and Equipment, Purchase of Intangibles, etc.) n Carrying Out Operations (i.e., purchase of materials/inventory, production, marketing and administration) 1.

Overview of Financial Statements4 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?

Overview of Financial Statements5 Annual Financial Reports n Public firms communicate their financial information via the annual reports to shareholders. n The content of an annual report includes: 1. A letter to shareholders from the CEO (i.e., IBM 2008 Annual Report, p1-9). 2. Management’s Discussion and Analysis (MD&A) (i.e., IBM 2008 Annual Report, p18-57).

Overview of Financial Statements6 Annual Financial Reports (contd.) 3. Report of Management ( i.e., on the effectiveness of Internal control; required by Sarbanes-Oxley Act of 2002). (IBM 2008 Annual Report, p58) 4. Report of Independent Registered Public Accounting Firm. (i.e., IBM 2008 Annual Report, p59) 5. Audited Consolidated Financial statements and Notes. (i.e., IBM 2008 Annual Report60-119)

Overview of Financial Statements7 The Four Financial Statements 1. Consolidated Income Statement 2. Consolidated Statement of Retained Earnings 3. Consolidated Balance Sheet 4. Consolidated Statement of Cash Flows

Overview of Financial Statements8 The Content of Four Financial Statements n The Income Statement (Statement of Earnings): reports the operating results of a firm for a period of time. n Accounts reported include revenue, expenses, gains, losses, the net income and the earnings per share.

Overview of Financial Statements9 The Content of Four Financial Statements (Contd.) n The Statement of Retained Earnings: reports the earnings not distributed to shareholders. n Accounts reported include beginning balance of retained earnings, current year’s net income, dividends distributed for the reporting period and the ending balance of retained earnings.

Overview of Financial Statements10 The Content of Four Financial Statements (contd.) n The Balance Sheet Statement (Statement of Financial Position) : reports the financial position of a firm on a particular date. n Accounts reported include assets, liabilities and stockholders’ equity.

Overview of Financial Statements11 The Content of Four Financial Statements (contd.) n The Statement of Cash Flows: reports cash flows from three business activities and the net increase (or decrease) of the cash during the year. n Business activities affect cash flows: operating, investing and financing.

The Financial Statements12 Exhibit 1-1 (from Financial Accounting by Harrison and Horngren) For the fiscal years ended (In thousands) 2/2/2006 1/27/ Net sales$1,031,548 $992, Cost of sales588, , Gross profit443, ,841 4.Selling, general, and admin. exps.392, ,516 5.Charges from sale of subsidiary1,882 3, Income from operations49,165 59, Other income (expense): 8.Interest expense(2,771)(1,769) 9.Interest income Other4,278 1, Total other income (expense), net1,760 (162) 12. Income before income taxes50,925 59, Income tax provision20,370 23, Net income$ 30,555 $ 36,096 LANDS’ END, INC. & SUBSIDIARIES Consolidated Statement of Earnings 12

The Financial Statements13 Exhibit 1-2 (from Financial Accounting by Harrison and Horngren) For the fiscal years ended (In thousands)2/2/2006 1/27/2005 Retained Earnings 1. Beginning balance$229,554 $193, Net income30,555 36, Cash dividends paid Issuance of treasury stock--- (2) 5. Ending balance$260,109 $229,554 LANDS’ END, INC. & SUBSIDIARIES Consolidated Statement of Retained Earnings 13

The Financial Statements14 Exhibit 1- 3 (from Financial Accounting by Harrison and Horngren) (In thousands) 2/2/2006 1/27/2005 ASSETS Current assets: 1.Cash$17,176 $5, Receivables8,046 4,459 3.Inventory164, ,652 4.Prepaid advertising and other exp.32,033 19, Total current assets222, ,168 Property, plant & equip., at cost: 6.Land and buildings72,248 69,798 7.Fixtures and equipment83,880 74,745 8.Leasehold improvements2,912 1, Total property, plant & equipment159, , Less accum. depr. & amortization60,055 49, Property, plant, & equipment, net98,985 96, Intangibles, net2,423 2, Total assets$323,497 $297,612 LANDS’ END, INC. & SUBSIDIARIES Consolidated Balance Sheet 14

The Financial Statements15 Exhibit 1- 3 (contd.) LIABILITIES AND SHAREHOLDERS’ INVESTMENT Current liabilities: 14.Interest payable$ 9,319 $7, Accounts payable62,380 52, Salary payable4,555 5, Accrued liabilities23,751 25, Accrued profit sharing1,483 1, Income taxes payable 13,256 9, Current maturities of long-term debt Total current liabilities114, , Deferred income taxes7,212 5, Long-term liabilities Shareholders’ investment: 24.Com. stock, 40,221 shares issued26,567 26, Retained earnings260, , Other(85,484) (66,645) 27. Total shareholders’ investment201, , Total liabilities & shareholders’ inv.$323,497 $297,612 15

The Financial Statements16 Exhibit 1- 4 (from Financial Accounting by Harrison and Horngren) 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, Cash received from interest Cash paid to suppliers & employees(967,075)(926,714) 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 activities41,39234,461 Cash flows from investing activities: 7.Cash paid for capital additions and businesses acquired(13,904)(32,102) 8.Proceeds from divestiture1, Net cash flows used for investing activities(12,239)(32,102) LANDS’ END, INC. & SUBSIDIARIES Consolidated Statement of Cash Flows 16

The Financial Statements17 Exhibit 1-4 (contd.) Cash flows form financing activities: 10.Proceeds from short-term and long-term debt1,780 $7, Payment of long-term debt(40)(40) 12.Purchases of treasury stock(20,001)(27,979) 13.Issuance of treasury stock858 1, Cash dividends paid Net cash flows used for financing activities (17,403)(18,502) 16. Net increase (decrease) in cash11,750 (16,143) 17. Beginning cash5,426 21, Ending cash$ 17,176 $ 5,426 17

The Financial Statements18 Exhibit 1-5 (from Financial Accounting by Harrison and Horngren) Net income ……………………………..$ 30,555 Income Statement -- Fiscal Year 2006 (Details given in Exhibit 1-8)  Beginning retained earnings …………..$229,554 Net income ………………………………30,555 Cash dividends ………………………….--- Ending retained earnings ………………$260,109 Statement of Retained Earnings -- Fiscal Year

The Financial Statements19 Exhibit 1- 5 (contd.)  Beginning retained earnings ……………...$229,554 Net income ………………………………….30,555 Cash dividends ……………………………..--- Ending retained earnings ………………….$260,109 Statement of Retained Earnings -- Fiscal Year 2006 ASSETS Cash ……………………………………...$ 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 Balance Sheet Statement - Fiscal Year

The Financial Statements20 Exhibit 1- 5 (contd.)  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 Balance Sheet Statement -- 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 Statement of Cash Flows - Fiscal Year

The Financial Statements21 Definitions of Assets, Liabilities and Equity (all are presented on a balance sheet statement) n Assets: the economic resources of a business that are expected to be of benefit to the business entity in the future. n Examples: cash, office supplies, inventories, accounts receivable, buildings, equipment, etc.)

The Financial Statements22 Definitions of Assets, Liabilities and Equity (contd.) n Liabilities: claims to assets; legal obligations required future payments of assets or services as a result of a business entity’s past transactions. n Examples: accounts payable, bonds payable… n Equity: residual claims to a business entity from stockholders.

The Financial Statements23 Definitions of Revenues and Expenses n Revenues: increase or inflow of assets; will eventually increase stockholders’ equity (i.e., sales revenue) n Expenses: decrease or outflow of assets; will eventually decrease stockholders’ equity. n Gains: increase in assets from incidental transactions not related to the major operation. n Losses: decrease in assets from incidental transactions.

The Financial Statements24 The Accounting Equation and the Computation of Accounting Net Income n Assets = Liabilities + Stockholders’ Equity Balance Sheet AssetsLiabilities Equity n Net Income = Revenues - Expenses + Gains - Losses

The Financial Statements25 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.

The Financial Statements26 External Users and Usage of Financial Statements 26

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 27

Overview of Financial Statements28 4. The Financial Reporting Reform n 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. n 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.

Overview of Financial Statements29 Key Provisions of Sarbanes and Oxley Act n Creating the Public Company Accounting Oversight Board: establish auditing standards. n Increasing Corporate Executive Accountability. n Prohibition of Non-Audit Services. n Evaluation of Internal Control.

The Financial Statements30 5. Types of Business 1. Proprietorships 2. Partnerships 3. Corporations

The Financial Statements31 Types of Business (contd.)

The Financial Statements32 Corporations n A business entity formed under a state law. n 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.

The Financial Statements33 Corporations (contd.) n The ownership of a corporation is divided by shares. n To be an owner of a corporation, an individual just need to buy shares from stock markets. n Owners of a corporation have limited liability. The most an owner can lose is what he (she) invested.

The Financial Statements34 Corporations (contd.) n The stockholders elect “board of directors” who sets business policies for the corporation. n 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).

The Financial Statements35 Corporations (contd.) n The board also appoints vice presidents who are in charge of different areas (i.e., marketing, accounting, finance...).

The Financial Statements36 6. The Authorities prescribing the Accounting Standards n Financial Statements (F/S) are prepared based on generally accepted accounting principles (GAAP). n The authorities prescribe the accounting standards include:

The Financial Statements37 The Authorities prescribing the Accounting Standards (contd.) u the Financial Accounting Standards Board (FASB, a private agency), u the Securities and Exchange Commission (SEC, a public agency).

The Financial Statements38 A Historical Perspective of Authorities prescribing the Accounting Standards

Environment and Theoretical Structure of Financial Accounting39 The Need for International Accounting Standards n 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. n In response to this problem, International Accounting Standards Committee (IASC) was founded in 1973 to develop a single set of global accounting standards.

Environment and Theoretical Structure of Financial Accounting40 The History of International Accounting Standard Setting (cont.) n 41 International Accounting Standards (IAS) were issued by IASC. n IASC created International Accounting Standards Board (IASB) in April, 2001 to be in charge of prescribing the standards. n IASB endorsed 41 IAS and named its pronouncement as International Financial Reporting Standards (IFRS).

Environment and Theoretical Structure of Financial Accounting41 Convergence of the U.S. Accounting Standards and the International Accounting Standards n 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. n The FASB is working closely with the IASB on the convergence of accounting standards.

Environment and Theoretical Structure of Financial Accounting42 Short-Term International Convergence (source: FASB Project Updates) n The FASB started a short term joint project with the IASB to eliminate narrow differences between US GAAP and IFRS in October n Both IASB and FASB acknowledged that convergence of IFRS and U.S. GAAP is a primary objective of both Boards.

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

The SEC’s Roadmap Toward Global Accounting Standards (Source: Intermediate Accounting by Kieso, Weygandt and Warfield) The Financial Statements44

Environment and Theoretical Structure of Financial Accounting45 Current Compliances n 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. n Foreign issuers filing reports with the SEC can use U.S. GAAP, the international standards or the GAAP of its home country. n If foreign firms chose to use the standards of its home country, they must file reports with reconciliation to U.S. GAAP.

The Financial Statements46 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