Über die Autorin bzw. den Autor

Bonita K. Kramer, Ph.D., is a professor ofaccounting in the College of Business at Montana StateUniversity in Bozeman. She is a Certified Public Accountant, Certified Management Accountant, and Certified Internal Auditor. Christie Wilson Johnson is a CPA and an associate professor of accounting at Montana State University in Bozeman.

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FINANCIAL STATEMENTS DEMYSTIFIED

The McGraw-Hill Companies, Inc.

Contents

Chapter One

Why Are Financial Statements Necessary?

Financial statements are the output of the accounting process, a formal way of communicating financial information that can be used by a variety of parties in making decisions about a business. For example, understanding financial statements can help you decide whether you want to invest in, lend money to, or grant credit to a company. The owners of an existing business use information derived from financial statements in planning and evaluating business activities. Union officials may use financial statements in their negotiations with management on behalf of the employees. The results reported in financial statements may help a company determine the size of bonuses paid to top management. In short, financial statements are a critical source of information for most business decisions.

In this book, we assume that you know nothing about the accounting process or the different types of financial statements that result from that process. However, even if you already know something about accounting or financial statements, you may find this book useful in providing a more complete view of financial statements, their interrelationships, and the accounting concepts that underlie their preparation.

What will you learn if you read this book? Our purpose is to assist you in understanding financial statements by acquainting you with accounting and financial statement terminology, the underlying concepts on which financial statements are based, and the form and content of those statements and their interrelationships. You will develop skills in reading financial statements, including the accompanying footnotes, and understanding the related auditor's report. Once we have covered those topics, you will be able to develop skills in identifying fraudulently misstated financial statements, a topic covered in the final chapter.

Objectives of Financial Reporting

Before we introduce you to the four basic financial statements, you should understand the overall purpose of summarizing accounting information in formal financial statements. The accounting profession has identified the objectives of financial reporting as follows:

• To provide information that is useful in making investment and credit decisions

• To provide information that is useful in assessing cash flow prospects

• To provide information about the resources of a business, claims to those resources, and changes in them

Note that "to provide information" is the focus of these objectives. In other words, the information provided by financial statements can be useful in answering the following types of questions:

• Is the business profitable?

• Do the operating activities of the business generate sufficient cash flows?

• Has the business grown? Was the growth achieved through its own profits, additional investments by its owners, or borrowing?

• Does the business generate sufficient cash flows to repay amounts borrowed? To return profits to its owner or owners?

• Does the business generate sufficient cash flows to pay its current obligations?

• Is the business likely to continue to be able to pay its obligations as they become due over the long run?

• What are the amounts and types of the resources of the business? What are the amounts and types of claims against those resources?

Many of the answers to these questions can be found directly in the financial statements and indirectly through the relationships between certain items in the financial statements and other information disclosed in the notes to those statements. The answers to these questions can help you decide whether to purchase a business or invest in another business by becoming a partner or stockholder or perhaps help you decide whether to continue to operate or sell your existing business. You may decide whether to lend money or extend credit to a business or determine why it will be difficult or easy for you to get a business loan or establish credit. Financial statement information can help you determine the likelihood of being repaid if you lend money or extend credit or gauge the likelihood of receiving an adequate return on your investment in your own business or investments in others. As you progress through this book, it should become clear that the more you learn about financial statements and the concepts on which they are based, the more understandable and useful they become.

The Four Basic Financial Statements

At this point, we want to introduce you very briefly to the four basic financial statements: (1) the balance sheet, (2) the income statement, (3) the statement of changes in owner's equity, and (4) the statement of cash flows. Later chapters will discuss each type of statement and the underlying concepts in more detail.

THE BALANCE SHEET

The balance sheet presents the assets, liabilities, and residual equity of the owner or owners of a business. It is a snapshot of the business, showing its financial position at a specific point in time. In fact, the balance sheet sometimes is referred to as the statement of financial position.

Assets are the economic resources of the business. They may be tangible—something you can see and touch—or they may represent rights the business possesses. Examples of assets include cash, accounts receivable, inventories of goods to be sold to customers, supplies, prepaid expenses, land, buildings, equipment, investments, and natural resources.

Liabilities are obligations of the business, or creditor claims against the assets of the business. Examples of liabilities include accounts payable to suppliers, customer deposits for goods or services to be provided, salaries or wages payable, taxes payable, rent payable, mortgage notes payable, and interest payable.

Equity is the excess of the assets over the liabilities, or the owners' claims against the assets in the business. Sometimes the terms net assets and net worth are used to describe the owner's residual interest. Depending on the form in which the business is organized, this residual interest may be called owner's equity (for a sole proprietorship: a one-owner business), owners' equity (for a partnership in which there is more than one owner), or stockholders' equity (for a corporation) (see Figure 1.1).

The balance sheet is based on a basic formula that is called the balance sheet equation or sometimes the accounting equation (Figure 1.2):

This formula always must hold true; in other words, assets always equal liabilities plus owner's equity. It is probably apparent now how the balance sheet gets its name: It always must be in balance!

A simple balance sheet for a corporation appears in Figure 1.3. Each financial statement includes a heading indicating the name of the business, the type of statement, and the date or period of time pertaining to the statement. Assume the business was formed on January 1, 20x1, with assets, liabilities, and owner's equity, as shown in Figure 1.3.

The assets of this business consist of cash and supplies, which are economic resources of the business. The liabilities consist of a single note payable, which is an...