While we have emphasized the importance of financial statements to investors and creditors, the management of a business organization is vitally concerned with the financial position of the business and with its profitability and cash flows. Therefore, management is anxious to receive financial statements as frequently and as quickly as possible so that it may take action to improve areas of weak performance. Most large organizations provide managers with financial statements on at least a monthly basis. With modern technology, financial statements prepared on a weekly, daily, or even hourly basis are possible.
Managers have a special interest in the annual financial statements, because these state- ments are used by decision makers outside of the organization. For example, if creditors view the annual financial statements as strong, they will be more willing to extend credit to the business than if they regard the company’s financial statements as weak. Management is con- cerned with its ability to obtain the funds it needs to meet its objectives, so it is particularly interested in how investors and creditors react to the company’s financial statements.
Notes to the statements contain vital information
Discuss the importance of financial statements to a company and its investors and creditors and why management may take steps to improve the appearance of the company in its financial statements.
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The Use of Financial Statements by External Parties 59
A strong statement of financial position is one that shows relatively little debt and large amounts of liquid assets relative to the liabilities due in the near future. A strong income state- ment is one that shows large revenues relative to the expenses required to earn the revenues.
A strong statement of cash flows is one that not only shows a strong cash balance but also indicates that cash is being generated by operations. Demonstrating that these positive charac- teristics of the company are ongoing and can be seen in a series of financial statements is par- ticularly helpful in creating confidence in the company on the part of investors and creditors.
Because of the importance of the financial statements, management may take steps that are specifically intended to improve the company’s financial position and financial performance.
For example, cash purchases of assets may be delayed until the beginning of the next account- ing period so that large amounts of cash will be included in the statement of financial position and the statement of cash flows. On the other hand, if the company is in a particularly strong cash position, liabilities due in the near future may be paid early, replaced with longer-term liabilities, or even replaced by additional investments by owners to communicate that future negative cash flows will not be as great as they might otherwise appear.
These actions are sometimes called window dressing —measures taken by management to make the company appear as strong as possible in its financial statements. Users of financial statements should realize that, while the financial statements are fair representations of the financial position at the end of the period and financial performance during the period, they may not necessarily describe the typical financial situation of the business throughout the entire financial reporting period. In its annual financial statements, in particular, manage- ment tries to make the company appear as strong as is reasonably possible. As a result, many creditors regard more frequent financial statements (for example, quarterly or even monthly) as providing important additional information beyond that in the annual financial statements.
The more frequently financial statements are presented, the less able management is to window-dress and make a company look financially stronger than it actually is.
Ethics, Fraud & Corporate Governance
A major outgrowth from the business failures amid allega- tions of fraudulent financial reporting discussed in the last chapter was the passage of the Sarbanes-Oxley Act of 2002.
This Act was signed into law by President George W. Bush on July 30, 2002. The Sarbanes-Oxley Act (hereafter SOX or the Act) is generally viewed as the most far-reaching piece of securities legislation since the original Securities Acts were passed in the 1930s.
One of the major requirements of this legislation is for CEOs and CFOs to certify the accuracy of their com- pany’s financial statements. The CEOs and CFOs of all public companies must certify on an annual and quarterly basis that they (1) have reviewed their company’s finan- cial statements, (2) are not aware of any error or omission that would make the financial statements misleading, and (3) believe that the financial statements fairly present in all material respects the company’s financial condition (bal- ance sheet) and results of operations (income statement).
There is some evidence that this certification requirement is affecting corporate behavior. For example, a former CFO of HealthSouth (Weston Smith, shown to the right) contacted federal authorities about the massive (alleged) accounting
© Gary Tramontinal/Bloomberg via Getty Images
fraud at that company because he was not willing to certify that HealthSouth’s financial statements were materially accurate.
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Concluding Remarks
Throughout this text, we emphasize how accounting information is the basis for business decisions. In this chapter, you have been introduced to business transactions and how they are combined and presented in the form of three basic financial statements—the statement of financial position (balance sheet), the income statement, and the statement of cash flows.
These financial statements constitute some of the primary products of the accountant’s work, and they provide investors, creditors, and other parties with pertinent information that is use- ful for decision making.
As you continue your study of financial accounting, in Chapter 3 you will learn how busi- ness transactions are actually recorded, how they move through an accounting system, and how they eventually lead to the preparation of financial statements. The foundation you have received in Chapter 2 will be helpful to you as we move into a more sophisticated discussion of business transactions and how they impact a company’s financial position, results of opera- tions, and cash flows.
Concluding Remarks
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S U M M A R Y O F L E A R N I N G O B J E C T I V E S
END-OF-CHAPTER REVIEW
Explain the nature and general purpose of finan- cial statements. Financial statements are presenta- tions of information in financial terms about an enterprise that are believed to be fair and accurate. They describe certain attributes of the enterprise that are important for decision makers, particularly investors (owners) and creditors.
Explain certain accounting principles that are important for an understanding of financial state- ments and how professional judgment by accoun- tants may affect the application of those principles.
Accountants prepare financial statements by applying a set of standards or rules referred to as generally accepted accounting principles. Consistent application of these standards permits com- parisons between companies and between years of a single com- pany. Generally accepted accounting principles allow for significant latitude in how certain transactions should be accounted for, meaning that professional judgment is particularly important.
Demonstrate how certain business transactions affect the elements of the accounting equation:
Assets Liabilities Owners’ Equity. Business trans- actions result in changes in the three elements of the basic account- ing equation. A transaction that increases total assets must also increase total liabilities and owners’ equity. Similarly, a transaction that decreases total assets must simultaneously decrease total lia- bilities and owners’ equity. Some transactions increase one asset and reduce another. Regardless of the nature of the specific transac- tion, the accounting equation must stay in balance at all times.
Explain how the statement of financial position, often referred to as the balance sheet, is an expan- sion of the basic accounting equation. The statement of financial position, or balance sheet, presents in detail the ele- ments of the basic accounting equation. Various types of assets are listed and totaled. The enterprise’s liabilities are listed, totaled, and added to the owners’ equity. The balancing feature of this financial statement is one of its dominant characteristics because the state- ment is simply an expansion of the basic accounting equation.
Explain how the income statement reports an enterprise’s financial performance for a period of time in terms of the relationship of revenues and expenses. Revenues are created as the enterprise provides goods and services for its customers. Many expenses are required to be able to provide those goods and services. The difference between the revenues and expenses is net income or net loss.
Explain how the statement of cash flows presents the change in cash for a period of time in terms of the company’s operating, investing, and financing activities. Cash is one of the most important assets, and the state- ment of cash flows shows in detail how the enterprise’s cash balance
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changed between the beginning and end of the accounting period.
Operating activities relate to ongoing revenue and expense transac- tions. Investing activities relate to the purchase and sale of various types of assets (for example, land, buildings, and equipment). Financ- ing activities describe where the enterprise has received its debt and equity financing. The statement of cash flows combines informa- tion about all of these activities into a concise statement of changes in cash that reconciles the beginning and ending cash balances.
Explain how the statement of financial position (balance sheet), income statement, and state- ment of cash flows relate to each other. The three primary financial statements are based on the same underlying transactions. They are not alternatives to each other, but rather represent three different ways of looking at the financial activi- ties of the reporting enterprise. Because they are based on the same transactions, they “articulate” with each other.
Explain common forms of business ownership—sole proprietorship, partnership, and corporation—and demonstrate how they differ in terms of their pre- sentation in the statement of financial position. Owners’ equity is one of three major elements in the basic accounting equation.
Regardless of the form of organization, owners’ equity represents the interest of the owners in the assets of the reporting enterprise.
For a sole proprietorship, owner’s equity consists of the interest of a single owner. For a partnership, the ownership interests of all partners are added together to determine the total owners’ equity of the enterprise. For a corporation, which may have many owners, the total contribution to the enterprise represents its owners’ equity.
In all cases, the enterprise’s net income is added to owners’ equity.
Discuss the importance of financial statements to a company and its investors and creditors and why management may take steps to improve the appearance of the company in its financial statements.
Financial statements are particularly important for investors and creditors in their attempts to evaluate future cash flows from the enterprise to them. Management is interested in the enterprise looking as positive as possible in its financial statements and may take certain steps to improve the overall appearance of the enter- prise. A fine line, however, exists between the steps management can take and the steps that are unethical, or even illegal.
Key Terms Introduced or Emphasized in Chapter 2
accounting equation (p. 44) Assets are equal to the sum of liabilities plus owners’ equity.
articulation (p. 39) The close relationship that exists among the financial statements that are prepared on the basis of the same underlying transaction information.
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liabilities (p. 42) Debts or obligations of an entity that resulted from past transactions. They represent the claims of creditors on the enterprise’s assets.
liquidity (p. 57) Having the financial ability to pay debts as they become due.
negative cash flows (p. 39) A payment of cash that reduces the enterprise’s cash balance.
operating activities (p. 51) A category in the statement of cash flows that includes the cash effects of all revenues and expenses included in the income statement.
owners’ equity (p. 43) The excess of assets over liabilities. The amount of the owners’ investment in the business, plus profits from successful operations that have been retained in the business.
partnership (p. 56) An unincorporated form of business organization in which two or more persons voluntarily associate for purposes of carrying out business activities.
positive cash flows (p. 39) Increases in cash that add to the enterprise’s cash balance.
retained earnings (p. 57) The portion of stockholders’ equity that has accumulated as a result of profitable operations.
revenues (p. 49) Increases in the enterprise’s assets as a result of profit-oriented activities.
sole proprietorship (p. 55) An unincorporated business owned by a single individual.
stable-dollar assumption (p. 42) An assumption by accountants that the monetary unit used in the preparation of financial statements is stable over time or changes at a sufficiently slow rate that the resulting impact on financial statements does not distort the information.
statement of cash flows (p. 39) An activity statement that explains the enterprise’s change in cash in terms of its operating, investing, and financing activities.
statement of financial position (p. 38) Same as balance sheet.
stockholders (p. 56) Owners of capital stock in a corporation.
stockholders’ equity (p. 57) The owners’ equity of an enterprise organized as a corporation.
window dressing (p. 59) Measures taken by management specifically intended to make a business look as strong as possible in its balance sheet, income statement, and statement of cash flows.
assets (p. 40) Economic resources owned by an entity.
balance sheet (p. 38) The financial statement showing the financial position of an enterprise by summarizing its assets, liabilities, and owners’ equity at a point in time. Also called the statement of financial position.
business entity (p. 40) An economic unit that controls resources, incurs obligations, and engages in business activities.
capital stock (p. 57) Transferable units of ownership in a corporation.
corporation (p. 56) A business organized as a separate legal entity and chartered by a state, with ownership divided into transferable shares of capital stock.
cost principle (p. 41) The widely used principle of accounting for assets at their original cost to the current owner.
creditor (p. 42) A person or organization to whom debt is owed.
deflation (p. 42) A decline in the general price level, resulting in an increase in the purchasing power of the monetary unit.
disclosure (p. 58) The accounting principle of providing with financial statements any financial and other facts that are necessary for proper interpretation of those statements.
expenses (p. 49) Past, present, or future reductions in cash required to generate revenues.
financial statement (p. 38) A declaration of information believed to be true and communicated in monetary terms.
financing activities (p. 51) A category in the statement of cash flows that reflects the results of debt and equity financing transactions.
going-concern assumption (p. 41) An assumption by accountants that a business will operate in the foreseeable future unless specific evidence suggests that this is not a reasonable assumption.
income statement (p. 38) An activity statement that subtracts from the enterprise’s revenue those expenses required to generate the revenues, resulting in a net income or a net loss.
inflation (p. 42) An increase in the general price level, resulting in a decline in the purchasing power of the monetary unit.
investing activities (p. 51) A category in the statement of cash flows that reflects the results of purchases and sales of assets, such as land, buildings, and equipment.
Demonstration Problem
Account balances for Crystal Auto Wash at September 30, 2011, are shown below. The figure for retained earnings is not given, but it can be determined when all the available information is as- sembled in the form of a balance sheet.
Demonstration Problem
Accounts Payable . . . $14,000 Accounts Receivable . . . 800 Buildings . . . 52,000 Cash . . . 9,200 Capital Stock . . . 100,000 Retained Earnings . . . ?
Land . . . $68,000 Machinery & Equipment . . . 65,000 Notes Payable (due in
30 days) . . . 29,000 Salaries Payable . . . 3,000 Supplies . . . 400
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Self-Test Questions 63
Self-Test Questions
Self-T est Questions
Instructions
a. Prepare a balance sheet at September 30, 2011.
b. Does this balance sheet indicate that the company is in a strong financial position? Explain briefly.
c. How would an income statement and a statement of cash flows allow you to better respond to part b?
Solution to the Demonstration Problem a.
CRYSTAL AUTO WASH BALANCE SHEET SEPTEMBER 30, 2011
Assets Liabilities & Owners’ Equity Cash . . . $ 9,200 Liabilities:
Accounts Receivable . . . 800 Notes Payable . . . $ 29,000 Supplies . . . 400 Accounts Payable . . . 14,000 Land . . . 68,000 Salaries Payable . . . 3,000 Buildings . . . 52,000 Total liabilities . . . $ 46,000
Machinery & Owners’ equity:
Equipment . . . 65,000 Capital Stock. . . $100,000 *Retained Earnings . . . 49,400 Total . . . $195,400 Total . . . $195,400
*Computed as $195,400(total assets) $46,000 (total liabilities) $149,400 (owners’ equity); $149,400 $100,000 (capital stock) $49,400.
b. The balance sheet indicates that Crystal Auto Wash is in a weak financial position. The only liquid assets—cash and receivables—total only $10,000, but the company has $46,000 in liabilities due in the near future.
c. An income statement for Crystal Auto Wash would show the company’s revenues and expenses for the period (month, quarter, or year) ending on the date of the balance sheet, September 30, 2011. This information would be helpful in determining whether the company is successful in selling its auto wash services at an amount that exceeds its cost of providing those services, something the company must do to remain in business and be successful. The statement of cash flows for the same period as the income statement would show where the company’s cash came from and where it went in terms of its operating, investing, and financing activities. This information would be particularly helpful in assessing the strength of the company’s ability to satisfy its obligations as they come due in light of the relatively weak balance sheet.
The answers to these questions appear on page 82.
Note: In order to review as many chapter concepts as possible, some self-test questions include more than one correct answer. In these cases, you should indicate all of the correct answers.
1. A set of financial statements:
a. Is intended to assist users in evaluating the fi nancial position, profi tability, and future prospects of an entity.
b. Is intended to substitute for fi ling income tax returns to the Internal Revenue Service in determining the amount of income taxes owed by a business organization.
c. Includes notes disclosing information necessary for the proper interpretation of the statements.
d. Is intended to assist investors and creditors in making decisions involving the allocation of economic resources.
2. Which of the following statements is (are) not consistent with generally accepted accounting principles relating to asset valuation?
a. Most assets are originally recorded in accounting records at their cost to the business entity.
b. Subtracting total liabilities from total assets indicates what the owners’ equity in the business is worth under current market conditions.
c. Accountants assume that assets such as offi ce supplies, land, and buildings will be used in business operations rather than sold at current market prices.
d. Accountants prefer to base the valuation of assets on objective, verifi able evidence rather than upon apprais- als or personal opinions.
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