CHAPTER 2

FINANCIAL STATEMENTS AND ACCOUNTING CONCEPTS/PRINCIPLES

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Learning Objectives
1. What are generally accepted accounting principle? 2. What kind of information is reported on each financial statement and how are the financial statements related? 3. What are transactions? What is the meaning and usefulness of the accounting equation? 4. What are meanings of the captions in the financial statements?
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Learning Objectives
5. Why is cash flow important? 6. What are the limitations of financial statements? 7. What is an annual report and why is it issued? 8. What are some of the business practices related to organizations?
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Learning Objective 1

What kind of information is reported on each financial statement and how are the financial statements related?

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Financial Statements

Result of a process that begins with an economic event

The event becomes a recorded transaction The transaction becomes part of a firms financial statements

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The Financial Statements

Balance Sheet financial position at the end of the period Income Statement earnings for the period Statement of Changes in Owners Equity investments by and distributions to owners during the period Statement of Cash Flows cash flows for the period
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Process
Procedures for sorting, classifying, and presenting (bookkeeping) Selection of alternative methods of reflecting the effects of certain transactions (accounting)

Transactions

Financial statements

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Learning Objective 2

What are transactions? What is the meaning and usefulness of the accounting equation?

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Transactions
Economic interchanges between entities
Examples are: A sale A purchase Receipts of cash by borrower Payment of cash by lender
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Balance Sheet
Financial position at the end of a period A snapshot at a point in time Also called Statement of Financial Position Contains three parts:
Assets Liabilities Owners Equity

Assets = Liabilities + Owners Equity

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Learning Objective 3

What are the meanings of the captions in the financial statements?

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Assets

Probable future economic benefits Resources owned Can be classified as current or longterm

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Examples of Assets
Cash cash on hand or in banks

Accounts Receivable amounts due from customers

Merchandise Inventory merchandise acquired but not yet sold Equipment assets used in the business Less: Accumulated Depreciation cost of equipment estimated to have been used up

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Liabilities

Probable future sacrifices of economic benefits

Obligations Can be classified as current or long-term

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Examples of Liabilities

Accounts Payable - amounts owed to suppliers of merchandise inventory

Long-term Debt amounts borrowed but will not be repaid within one year

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Income Statement
Summary of the earnings for a period Consists of: Revenues Expenses Covers a period of time Also called Statement of Earnings, or Profit and Loss Statement, or Statement of Operations
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Income Statement Sections

Revenues - operating activities for the period - often reported as Net Sales Expenses - Costs incurred in generating revenues

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Examples of Expenses

Cost of Goods Sold total cost of inventory delivered to customers as a result of sales Selling, General, and Administrative Expenses operating expenses of an entity Interest Expense cost of using borrowed funds Income Taxes
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More Income Statement Sections

Gross Profit difference between sales and cost of goods sold Income From Operations an important measure of a firms activities Income Before Taxes income from operations less interest expense
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More Income Statement Sections

Net Income income remaining after all expenses have been deducted
Net Income Per Share of Common Stock Outstanding used in measuring the market value of a share of common stock

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Statement of Changes in Owners Equity

Also called Statement of Changes in Capital Stock, or Statement of Changes in Retained Earnings
Explains the changes that occurred in the components of owners equity during the year

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Owners Equity
Paid-In Capital Common Stock - at par value Additional Paid-In Capital difference between total amount invested by the owners and the par or stated value of the stock Retained Earnings cumulative net income retained in the business Dividends distribution of earnings to owners
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Learning Objective 5

Why is cash flow important?

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Statement of Cash Flows

Sources and uses of cash Covers a period of time Includes: Operating Activities Investing Activities Financing Activities

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Cash Flows from Operating Activities

Start with Net Income

Add back Depreciation Expense

Deduct (add) increases (decreases) in current assets Deduct (add) decreases (increases) in current liabilities
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Cash Flows from Investing Activities

Cash used to purchase long-lived assets Cash received from sales of long-lived assets
Other changes in cash investments

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Cash Flows from Financing Activities

Cash raised from the sale of long-term debt and common stock Cash paid to reduce long-term debt and stock outstanding

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Financial Statement Relationships

All financial statements are related
Net Income from the Income Statement affects Retained Earnings on the Balance Sheet The Income Statement and the Balance Sheet affect the Statement of Cash Flows
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Learning Objective 4
What are generally accepted accounting principles?

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Concepts and Principles

Accounting Entity entity for which financial statements are being prepared can be a proprietorship, partnership, corporation, or group of corporations

Going Concern presumption that the entity will continue to operate in the future
Unit of Measurement in the United States, the dollar is the measurement unit for all transactions
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Concepts and Principles

Cost Principle transactions are recorded at their original cost as measured in dollars Objectivity a given transaction should be recorded in the same way in all situations Accounting Period the period of time selected for recording results Matching expenses are matched with the revenues that produced them
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Concepts and Principles

Accrual Accounting revenue recognized at the time of sale and expenses recognized when incurred Consistency maintaining the method of accounting for a particular type of transaction Full Disclosure all necessary information is presented in the financial statements and notes so investors will not be misled
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Concepts and Principles

Materiality absolute exactness is not necessary as long as not misleading Conservatism make judgments and estimates that result in lower profits and asset valuations rather than higher profits and higher asset valuations

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Learning Objective 6
What are the limitations of financial statements?

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Limitations of Financial Statements

Financial statements do not reflect qualitative economic variables

Balance sheet does not reflect current values

Estimates are used in many areas of accounting
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More Limitations of Financial Statements

Two firms may use different accounting methods, making comparisons difficult

Inflation is not included in accounting procedures

Financial statements do not reflect opportunity costs

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Learning Objective 7
What is an annual report and why is it issued?

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Annual Report
Distributed to shareholders Contains: Financial statements External auditors report Footnotes and explanatory comments Letters from the CEO and president
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Learning Objective 8
What are some of the business practices related to organizations?

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Business Practices
Organizing a business Sole proprietorship Partnership Corporation

Fiscal Year annual reporting period

Par value arbitrary value assigned to stock; no relationship to value Parent and subsidiary corporations parent owns at least a majority of the stock of another corporation
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