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1. Chapter 2: Basic Financial StatementsChapter 2: Basic Financial Statements
2. Learning Objective Learning objective number 1 is to explain the nature and general purpose of financial statements.
Learning objective number 1 is to explain the nature and general purpose of financial statements.
3. Introduction to Financial Statements Three primary financial statements. There are three fundamental financial statements used in accounting.
The income statement shows revenues and expenses.
The balance sheet is a listing of all asset, liability, and equity account balances that do not appear on the income statement.
The statement of cash flows shows how the company receives and spends its cash.
This chapter will look at the financial statements of a corporation.
There are three fundamental financial statements used in accounting.
The income statement shows revenues and expenses.
The balance sheet is a listing of all asset, liability, and equity account balances that do not appear on the income statement.
The statement of cash flows shows how the company receives and spends its cash.
4. Introduction to Financial Statements The balance sheet describes the financial position of a company at a specific point in time. A balance sheet may be prepared monthly, quarterly, or annually depending on the needs of management and external users. The balance sheet is sometimes referred to as the statement of financial position. The balance sheet describes the financial position of a company at a specific point in time. A balance sheet may be prepared monthly, quarterly, or annually depending on the needs of management and external users. The balance sheet is sometimes referred to as the statement of financial position.
5. Introduction to Financial Statements Net income is defined as the excess of revenues over expenses. Financial statements begin with a three-line title comprised of the company name, the name of the statement, and the period covered by the report. The income statement lists revenues and expenses that were incurred over a period of time. Most companies prepare monthly income statements. Net income is defined as the excess of revenues over expenses. Financial statements begin with a three-line title comprised of the company name, the name of the statement, and the period covered by the report. The income statement lists revenues and expenses that were incurred over a period of time. Most companies prepare monthly income statements.
6. Introduction to Financial Statements In the long-run, revenues will generate positive cash inflows to the company and expenses will result in negative cash flows to the company. Just remember, revenues and expenses that appear on the income statement may not always produce cash flows in the current accounting period.In the long-run, revenues will generate positive cash inflows to the company and expenses will result in negative cash flows to the company. Just remember, revenues and expenses that appear on the income statement may not always produce cash flows in the current accounting period.
7. Introduction to Financial Statements If expenses exceed revenues, the result is a net loss rather than net income.If expenses exceed revenues, the result is a net loss rather than net income.
8. Introduction to Financial Statements The statement of cash flows will be covered in detail in a later chapter. The statement of cash flows is divided into three major sections: (1) cash flows from operating activities; (2) cash flows from investing activities, and (3) cash flows from financing activities. The statement describes cash inflows and outflows over a period of time. The statement of cash flows will be covered in detail in a later chapter. The statement of cash flows is divided into three major sections: (1) cash flows from operating activities; (2) cash flows from investing activities, and (3) cash flows from financing activities. The statement describes cash inflows and outflows over a period of time.
9. A Starting Point: Statement of Financial Position The balance sheet is an inventory of assets, liabilities, and equity at the end of the month. Our total assets are equal to three hundred thousand dollars. This includes cash of twenty-two thousand five hundred dollars, notes receivable of ten thousand dollars, supplies of two thousand dollars, and the balances in the remaining asset accounts.
Liabilities include notes payable of forty-one thousand, accounts payable of thirty-six thousand and salaries payable of three thousand dollars. The accounts in the owners equity section of the balance sheet are capital stock of one hundred-fifty thousand dollars and retained earnings of seventy thousand dollars.
Notice that the total assets are equal to the total liabilities plus owners equity. The balance sheet is an inventory of assets, liabilities, and equity at the end of the month. Our total assets are equal to three hundred thousand dollars. This includes cash of twenty-two thousand five hundred dollars, notes receivable of ten thousand dollars, supplies of two thousand dollars, and the balances in the remaining asset accounts.
Liabilities include notes payable of forty-one thousand, accounts payable of thirty-six thousand and salaries payable of three thousand dollars. The accounts in the owners equity section of the balance sheet are capital stock of one hundred-fifty thousand dollars and retained earnings of seventy thousand dollars.
Notice that the total assets are equal to the total liabilities plus owners equity.
10. Learning Objective Learning objective number 2 is to explain certain accounting principles that are important for an understanding of financial statements and how professional judgment by accountants may affect the application of those principles.
Learning objective number 2 is to explain certain accounting principles that are important for an understanding of financial statements and how professional judgment by accountants may affect the application of those principles.
11. The Concept of the Business Entity The business entity principle states that the transactions of individual owners of a business and those of the business must be separate.
The business entity principle states that the transactions of individual owners of a business and those of the business must be separate.
12. Assets Assets are resources owned or controlled by an entity. They include such items as cash, accounts receivable (amounts owed to the company by customers), land, building and equipment, and supplies.Assets are resources owned or controlled by an entity. They include such items as cash, accounts receivable (amounts owed to the company by customers), land, building and equipment, and supplies.
13. Assets The cost principle tells us that accounting information is based upon actual cost incurred. We refer to this as historical cost.
The going-concern assumption states that in the absence of information to the contrary, the business entity is assumed to continue operations into the foreseeable future.
The objectivity principle states that accounting information must be unbiased and based upon independent evidence.
The stable-dollar assumption tells us that we will only record accounting information that can be expressed in monetary units, usually dollars in the United States.
The cost principle tells us that accounting information is based upon actual cost incurred. We refer to this as historical cost.
14. Liabilities Liabilities represent the claims of creditors on an entitys assets. Liabilities include accounts payable (amounts owed to creditors for assets purchased on account), taxes payable, and wages payable (amounts owed to our employees at the end of the accounting period).Liabilities represent the claims of creditors on an entitys assets. Liabilities include accounts payable (amounts owed to creditors for assets purchased on account), taxes payable, and wages payable (amounts owed to our employees at the end of the accounting period).
15. Owners Equity The equities of an entity include investments by owners, withdrawals by owners, and earnings retained by the business. The equities of an entity include investments by owners, withdrawals by owners, and earnings retained by the business.
16. Owners Equity Investments by owners and net income increase owners equity. Payments to owners and net losses decrease owners equity.Investments by owners and net income increase owners equity. Payments to owners and net losses decrease owners equity.
17. Learning Objective Learning objective number 3 is to demonstrate how certain business transactions affect the elements of the accounting equation: Assets = Liabilities + Owners Equity.
Learning objective number 3 is to demonstrate how certain business transactions affect the elements of the accounting equation: Assets = Liabilities + Owners Equity.
18. The Accounting Equation The basic accounting equation states that assets are equal to liabilities plus equity of a company. The equation makes sense because it states that assets must be equal to the claims against those assets.
There are two broad categories of claims against an asset: Claims by creditors (called liabilities), or after all creditor claims are satisfied, the residual owners (the stockholders) have a claim on those assets.
The basic accounting equation states that assets are equal to liabilities plus equity of a company. The equation makes sense because it states that assets must be equal to the claims against those assets.
There are two broad categories of claims against an asset: Claims by creditors (called liabilities), or after all creditor claims are satisfied, the residual owners (the stockholders) have a claim on those assets.
19. Lets look at how specific business transactions impact the basic financial statement.Lets look at how specific business transactions impact the basic financial statement.
20. Part I On May 1st, Jill Jones and her family invested $8,000 in JJs Lawn Care Service and received 800 shares of stock in return. Lets see how the balance sheet would look immediately after this transaction.
Part II
The cash account of JJs Lawn Care increased by eight thousand dollars and the capital stock of the company also increased by eight thousand dollars. Notice that the basic accounting equation is in balance. Total assets are equal to total liabilities plus owners equity.Part IOn May 1st, Jill Jones and her family invested $8,000 in JJs Lawn Care Service and received 800 shares of stock in return. Lets see how the balance sheet would look immediately after this transaction.
Part II
The cash account of JJs Lawn Care increased by eight thousand dollars and the capital stock of the company also increased by eight thousand dollars. Notice that the basic accounting equation is in balance. Total assets are equal to total liabilities plus owners equity.
21. Part I
On the 2nd of May, JJs Lawn Care purchased a riding lawn mower for $2,500 cash. Lets see how the balance sheet looks now. Part II The cash account has been reduced by the $2,500 spent and the tools and equipment account has been increased by the same amount. One asset, cash, was merely traded for another, the riding lawn mower. Owners equity is not changed by the transaction and the basic accounting equation is still in balance.Part I
On the 2nd of May, JJs Lawn Care purchased a riding lawn mower for $2,500 cash. Lets see how the balance sheet looks now.
22. Part I
In the next transaction JJs Lawn Care purchases a truck for $15,000, paying $2,000 cash and signing a note payable for $13,000. Lets update the balance sheet. Part II The cash account decreased by $2,000 and the truck account increased by $15,000. There was a net increase in the asset side of the equation of $13,000. The liability account, notes payable, increased by $13,000. Total assets are now equal to $21,000. Total liabilities are equal to $13,000 and owners equity is equal to $8,000. The accounting equation is still in balance.Part I
In the next transaction JJs Lawn Care purchases a truck for $15,000, paying $2,000 cash and signing a note payable for $13,000. Lets update the balance sheet.
23. Part I On May 11th, JJs Lawn Care purchases repair parts for the riding lawn mower for $300. The parts are purchased on account. JJs will pay the balance on the account at some point in the future. Lets update the balance sheet. Part II
The tools and equipment account increased by $300 and the liability account, accounts payable, increased by the same amount. The balance sheet is getting progressively more complicated.Part IOn May 11th, JJs Lawn Care purchases repair parts for the riding lawn mower for $300. The parts are purchased on account. JJs will pay the balance on the account at some point in the future. Lets update the balance sheet.
24. Part I
On May 18th, JJs Lawn Care sells one-half of its repair parts at cost to ABC Lawns. ABC agrees to pay for the parts in thirty days. One-half of the cost of the parts is $150. Can you update the balance sheet? Try before proceeding to the next slide.
Part II The asset account, Tools and Equipment, decreased by $150 and the asset account, accounts receivable, increased by the same amount. Once again, one asset, repair parts, has been exchanged for another asset, accounts receivable. How did you do? Part I
On May 18th, JJs Lawn Care sells one-half of its repair parts at cost to ABC Lawns. ABC agrees to pay for the parts in thirty days. One-half of the cost of the parts is $150. Can you update the balance sheet? Try before proceeding to the next slide.
Part IIThe asset account, Tools and Equipment, decreased by $150 and the asset account, accounts receivable, increased by the same amount. Once again, one asset, repair parts, has been exchanged for another asset, accounts receivable. How did you do?
25. Part I
On May 25th, ABC Lawns makes a partial payment on account for $75 cash. Lets prepare the updated balance sheet on May 25th. Part II The cash account increases by $75 and accounts receivable decreases by the same amount. Notice that total assets are still equal to total liabilities plus owners equity.Part I
On May 25th, ABC Lawns makes a partial payment on account for $75 cash. Lets prepare the updated balance sheet on May 25th.
26. Part I On May 28th, JJs Lawn Care makes a partial payment on its accounts payable of $150. Its time to update the balance sheet. Part II The cash account decreases by $150 and accounts payable also decreases by $150. The total assets are now recorded at $21,150. Total liabilities plus owners equity is equal to the same amount.Part IOn May 28th, JJs Lawn Care makes a partial payment on its accounts payable of $150. Its time to update the balance sheet.
27. Part I
On May 29th, JJs Lawn Care begins providing services to customers. On this date the company did work that totaled $750. All of the customers paid cash for the services rendered. Try updating the balance sheet before moving to the next slide. Be careful with this one.
Part II The cash account increases by $750 and retained earnings increases by the same amount. The monies received represent earnings of the company that have been retained. The $750 represents revenue earned by the business. How did you do?Part I
On May 29th, JJs Lawn Care begins providing services to customers. On this date the company did work that totaled $750. All of the customers paid cash for the services rendered. Try updating the balance sheet before moving to the next slide. Be careful with this one.
Part IIThe cash account increases by $750 and retained earnings increases by the same amount. The monies received represent earnings of the company that have been retained. The $750 represents revenue earned by the business. How did you do?
28. Learning Objective Learning objective number 4 is to explain how the statement of financial position, often referred to as the balance sheet, is an expansion of the basic accounting equation.
Learning objective number 4 is to explain how the statement of financial position, often referred to as the balance sheet, is an expansion of the basic accounting equation.
29. Part I
In the final transaction for May, JJs Lawn Care purchased $50 worth of gasoline for its riding mower and truck. Lets make the final update to the balance sheet on May 31st. Part II The cash account decreased by $50 and so did the retained earnings of the company. JJs Lawn Care used $50 of its earnings to pay for the gasoline. The $50 spent is an expense of the business.Part I
In the final transaction for May, JJs Lawn Care purchased $50 worth of gasoline for its riding mower and truck. Lets make the final update to the balance sheet on May 31st.
30. All of these transactions have been placed on this slide, in the appropriate columns for the accounts theyve impacted. Lets verify the balance in each account and get ready to prepare the financial statements for JJs Lawn Care.All of these transactions have been placed on this slide, in the appropriate columns for the accounts theyve impacted. Lets verify the balance in each account and get ready to prepare the financial statements for JJs Lawn Care.
31. Part I All of the transactions that impacted the cash account will appear on the statement of cash flows. Part II The revenues and expenses that caused the change in retained earnings will appear on the income statement of the company. Part II Lets begin by preparing the income statement and statement of cash flows for JJs Lawn Care for the period ended May 31, 2007. Part IAll of the transactions that impacted the cash account will appear on the statement of cash flows.
32. Learning Objective Learning objective number 5 is to explain how the income statement reports an enterprises financial performance for a period of time in terms of the relationship of revenues and expenses.
Learning objective number 5 is to explain how the income statement reports an enterprises financial performance for a period of time in terms of the relationship of revenues and expenses.
33. Part I JJs Lawn care has one revenue for services for $750, and one expense for gasoline of $50. So the net income for the month of May is $700. Remember, net income is the excess of revenues over expenses incurred during the accounting period. Part II Investments by owners and payments to owners do not appear on the income statement. These amounts appear on the companys balance sheet.Part IJJs Lawn care has one revenue for services for $750, and one expense for gasoline of $50. So the net income for the month of May is $700. Remember, net income is the excess of revenues over expenses incurred during the accounting period.
34. Learning Objective Learning objective number 6 is to explain how the statement of cash flows presents the change in cash for a period of time in terms of the companys operating, investing, and financing activities.
Learning objective number 6 is to explain how the statement of cash flows presents the change in cash for a period of time in terms of the companys operating, investing, and financing activities.
35. Here is the statement of cash flows for JJs Lawn Care for the month ended May 31, 2007. Notice the three sections of the statement. Here is the statement of cash flows for JJs Lawn Care for the month ended May 31, 2007. Notice the three sections of the statement.
36. Cash flows from operating activities include the $700 in net income calculated on the previous screen.Cash flows from operating activities include the $700 in net income calculated on the previous screen.
37. JJs had a cash outflow for investing activities. The company invested in the riding lawn mower, truck, and repair parts; however, the company recovered some of the cost of repair parts by selling them to ABC Lawns.JJs had a cash outflow for investing activities. The company invested in the riding lawn mower, truck, and repair parts; however, the company recovered some of the cost of repair parts by selling them to ABC Lawns.
38. The only financing activity was the original investment by the owners of JJs Lawn Care. The cash inflows and outflows resulted in an increase in cash of $4,125 during the month. Because the cash account had a zero balance at the beginning of the month, the ending balance in the cash account is $4,125. Lets finish by preparing the balance sheet for JJs Lawn Care.
The only financing activity was the original investment by the owners of JJs Lawn Care.
39. Here are the account balances to use when preparing the balance sheet.Here are the account balances to use when preparing the balance sheet.
40. Part I
Asset accounts are listed on the left side of the balance sheet and the liabilities and owners equity accounts on the right. Feel free to go back to the previous screen and see all the account balances that appear on the balance sheet. Part II As a final check, make sure that the accounting equation is still in balance. The total assets of $21,850 is exactly equal to the total of the companys liabilities plus owners equity. Notice that the balance sheet lists all assets, liabilities, and equities on a certain date. In this example, the date is May 31, 2007.Part I
Asset accounts are listed on the left side of the balance sheet and the liabilities and owners equity accounts on the right.
41. Learning Objective Learning objective number 7 is to explain the important relationships among the statement of financial position, income statement, and statement of cash flows, and how these statements relate to each other.
Learning objective number 7 is to explain the important relationships among the statement of financial position, income statement, and statement of cash flows, and how these statements relate to each other.
42. Relationships Among Financial Statements All the financial statements are interrelated. We can start with the balance sheet at the beginning of an accounting period, analyze the income and cash flows of the company, and arrive at the ending balances that will appear on the balance sheet. Lets see how this works in the JJs Lawn Care example. All the financial statements are interrelated. We can start with the balance sheet at the beginning of an accounting period, analyze the income and cash flows of the company, and arrive at the ending balances that will appear on the balance sheet.
43. Financial Statement Articulation Part I
This is the balance sheet for JJs Lawn Care at the end of May.
Part II Net income impacts the retained earnings of the company. Part III
The statement of cash flows not only provides the balance in the cash account, but also details information about the acquisition and disposition of assets and liabilities as well as changes in the owners equity balance. Its clear to see how all the financial statements articulate with each other.Part I
This is the balance sheet for JJs Lawn Care at the end of May.
Part IINet income impacts the retained earnings of the company.
44. Financial Reporting and Financial Statements Financial statements are only one source of information about the operations of a company. The financial statements of a company can be compared to those of other companies in the same industry, major national or international competitors, and to the norms for the national economy.Financial statements are only one source of information about the operations of a company. The financial statements of a company can be compared to those of other companies in the same industry, major national or international competitors, and to the norms for the national economy.
45. Learning Objective Learning objective number 8 is to explain common forms of business ownershipsole proprietorship, partnership, and corporationand demonstrate how they differ in terms of their presentation in the statement of financial position.
Learning objective number 8 is to explain common forms of business ownershipsole proprietorship, partnership, and corporationand demonstrate how they differ in terms of their presentation in the statement of financial position.
46. Forms of Business Organization There are three general forms of business operations.
A proprietorship is a business owned by just one individual.
A partnership is owned by two or more individuals. Some partnerships have several thousand partners.
A corporation is owned by individuals who normally are not active in the day-to-day operations of that business. For example, you may become an owner of IBM by purchasing shares of stock on the New York Stock Exchange. While you are a part owner, you do not necessarily work for IBM nor are you active in the operations of the company.There are three general forms of business operations.
A proprietorship is a business owned by just one individual.
A partnership is owned by two or more individuals. Some partnerships have several thousand partners.
A corporation is owned by individuals who normally are not active in the day-to-day operations of that business. For example, you may become an owner of IBM by purchasing shares of stock on the New York Stock Exchange. While you are a part owner, you do not necessarily work for IBM nor are you active in the operations of the company.
47. Reporting Ownership Equity in the Statement of Financial Position Part I
The owners equity section of the balance sheet will look different for each type of business entity. For a sole proprietorship, there will be a capital account for the owner, and a drawing account to record payments to the owner.
Part II For a partnership, each partner has a separate account, where changes are tracked over time. Theres also a separate drawing account for payments made to each partner.
Part II To review, a corporation will show owners contributions in the capital stock account and accumulated earnings of the company in the retained earnings account.
You should be able to tell the form of business by looking at the equity section of a balance sheet. Part I
The owners equity section of the balance sheet will look different for each type of business entity. For a sole proprietorship, there will be a capital account for the owner, and a drawing account to record payments to the owner.
48. The Use of Financial Statements by External Parties Creditors and investors have two major concerns about the operations and financial position of any company.
First, the company must be liquid, that is, it must be able to pay all bills when due.
Second, the company must be profitable in the long-run. Unprofitable companies drain the cash position of the company, causing concern on the part of creditors and investors.Creditors and investors have two major concerns about the operations and financial position of any company.
First, the company must be liquid, that is, it must be able to pay all bills when due.
Second, the company must be profitable in the long-run. Unprofitable companies drain the cash position of the company, causing concern on the part of creditors and investors.
49. The Need for Adequate Disclosure In addition to the basic financial statements, companies prepare notes to the financial statements. These notes are meant to provide the reader with additional insights into the operations and financial position of the company.In addition to the basic financial statements, companies prepare notes to the financial statements. These notes are meant to provide the reader with additional insights into the operations and financial position of the company.
50. Learning Objective Learning objective number 9 is to 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. Learning objective number 9 is to 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.
51. Managements Interest in Financial Statements Part I
Creditors and investors are more likely to be interested in financially strong companies. These companies usually have little or no debt and a significant amount of assets that can be converted into cash quickly. Part II When management engages in measures to make the company appear financially stronger than it really is, this is referred to as window dressing. Window dressing may be legal, but it often impugns the integrity of the management team.Part I
Creditors and investors are more likely to be interested in financially strong companies. These companies usually have little or no debt and a significant amount of assets that can be converted into cash quickly.
52. End of Chapter 2 End of chapter 2.End of chapter 2.
