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business, they are entitled to receive regular reports about what the business has done with their money. The hard core of these reports consists of three primary financial statements. They are called external financial statements because the information is released outside the business.

    The income statement reports the revenue, expenses, and profit or loss of the business for the period. Recording revenue and expenses is based on accrual-basis accounting methods.

    The chapter begins by explaining the key differences between cash flows and accrual-basis profit accounting. Then the format 24

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    I N T R O D U C I N G F I N A N C I A L S T A T E M E N T S
    and content of each of the three primary financial statements is illustrated and explained for a typical business.
    The external financial statements are oriented to the outside shareowners and lenders of the business who are not involved in managing the business. The development of the standards and conventions for presenting external financial statements has been guided by this basic orientation. For their decision-making and control functions, business managers need more useful internal profit reports, which I develop in the next chapter.
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    C H A P T E R 3
    Reporting Profit
    to Managers
    MManagers have to keep on top of the unending stream of changes in today’s business environment. Few factors remain constant very long. Managers need to quickly assess the profit and other financial impacts of these changes. Deciding on the best response to changes is never easy, but one thing is clear: Managers need all relevant information for their profit-making decision analysis.
    USING THE EXTERNAL INCOME STATEMENT FOR
    DECISION-MAKING ANALYSIS
    The external income statement (see Figure 2.2) is useful up to a point for decision-making analysis, but it does not present all the information about operating expenses that is needed by managers. To demonstrate this important point, consider the following situation. Suppose you have done extensive market research and you’re convinced that reducing sales prices across the board next year by just 5 percent would result in a 25 percent increase in sales volume across the board. In order to concentrate on this basic decision, assume zero cost inflation next year (don’t you wish!). Would this be a good move?
    Of course, your prediction of a 25 percent sales volume DANGER!
    increase is critical. This big jump in sales volume may or may not materialize. Such a large response to shaving sales prices implies that sales demand is very sensitive to sales 27

    F I N A N C I A L R E P O R T I N G
    prices. In other words, you face a very elastic demand curve, as economists say. Does the external income statement provide all the information needed to analyze this decision? No, not entirely. The external profit report (income statement) doesn’t include enough information about how operating expenses would react to the sales volume increase and the sales revenue increase.
    External Income Statement for New Example
    Figure 3.1 presents the external income statement for the most recent year for a new business example. This external profit performance report has been prepared according to generally accepted accounting principles (GAAP) regarding the format and disclosure standards for this key financial statement. Be warned, however, that every business is a little different when it comes to details in their income statements.
    Terminology differs somewhat from business to business. For instance, some companies prefer the term gross profit instead of gross margin in their external income statements (sales revenue minus cost-of-goods-sold expense). Many businesses report two or more classes of operating expenses below the gross margin line instead of just one amount for all selling and administrative expenses as shown in Figure 3.1. For instance, a business may disclose the amount of its research and development expense for the year as