MANAGEMENT DECISIONS
AND FINANCIAL
ACCOUNTING REPORTS
Baginski & Hassell
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.
Four Primary Financial Statements
• 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
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 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.
– 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
• 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
• Accruals: Revenues and expense
recognition preceding cash flows
• Deferrals: Cash flows preceding
revenue and expense recognition
• 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
(continuing down the page)
$XX
XX
XX
XX
XX
$XX
Liabilities
Current liabilities
$XX
Long-term liabilities
XX
XX
Owners’ Equity
Contributed capital
XX
Retained earnings
XX
Total liabilities & owners’ equity
(end)
XX
$XX
Balance Sheet Account Format
Assets
Liabilities
Owners’ equity
Total assets
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
–
–
–
–
–
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
(*) 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
• Preferred stock
• Common 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).
• Net realizable value (NRV): Amount
expected to be realized from the asset’s 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, “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 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
$XX
XX
$XX
$XX
Income Statement: Multiple Step Format
Sales
$XX
Cost of goods sold
XX
Gross profit (margin)
XX
Operating expenses
Selling expenses
General and administrative expenses
Operating income
(continuing down the page)
$XX
XX
XX
XX
(Continued)
Operating income
Financial revenues, (expenses), gains, and
(losses)
XX
Income before income taxes
XX
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 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
(*) “Ask ABNER:” Abnormal and Not Expected to Recur?
• 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.
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?
“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