2-1

CHAPTER 2

Financial Statements and Accounting Concepts/Principles

McGraw-Hill/Irwin

2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

2-2

What Should You Learn in Chapter 2?

1. What transactions are. 2. The kind of information reported in each financial statement and how financial statements are related to each other. 3. The meaning and usefulness of the accounting equation. 4. The meaning of each of the captions on the financial statements illustrated in this chapter.

2-3

What Should You Learn in Chapter 2?

5. The broad, generally accepted concepts and principles that apply to the accounting process. 6. Why investors must carefully consider cash flow information in conjunction with accrual accounting results. 7. Several limitations of financial statements 8. What a corporations annual report is and why it is issued.

2-4

Understanding Financial Statement Relationships Exercise Number 3

This information represents selected data from the December 31, 2009, balance sheet and income statement for the year then ended.

Total assets, 31/12/2009 ... $155,000 Total liabilities, 31/12/2009 ..... 75,000 Paid-in capital, 31/12/2009 .. 45,000 Retained earnings, 31/12/2009 ? Net income for 2009 .... 25,500 Dividends declared and paid during 2009 ... 16,500 Retained earnings, 1/1/2009 .... ?

2-5

Understanding Financial Statement Relationships Exercise Number 3

This information represents selected data from the December 31, 2009, balance sheet and income statement for the year then ended.

Total assets, 31/12/2009 ... $155,000 Total liabilities, 31/12/2009 ..... 75,000 Paid-in capital, 31/12/2009 .. 45,000 Retained earnings, 31/12/2009 35,000 Net income for 2009 .... 25,500 Dividends declared and paid during 2009 ... 16,500 Retained earnings, 1/1/2009 .... 26,000

2-6

Understanding Financial Statement Relationships Exercise Number 4

This information represents selected data from the December 31, 2009, balance sheet and income statement for the year then ended.

Total assets, 31/12/2009 ... $420,000 Total liabilities, 31/12/2009 ..... 215,000 Paid-in capital, 31/12/2009 .. 75,000 Retained earnings, 31/12/2009 ? Net income for 2009 .... ? Dividends declared and paid during 2009 ... 50,000 Retained earnings, 1/1/2009 .... 78,000

2-7

Understanding Financial Statement Relationships Exercise Number 4

This information represents selected data from the December 31, 2009, balance sheet and income statement for the year then ended.

Total assets, 31/12/2009 ... $420,000 Total liabilities, 31/12/2009 ..... 215,000 Paid-in capital, 31/12/2009 .. 75,000 Retained earnings, 31/12/2009 130,000 Net income for 2009 .... 102,000 Dividends declared and paid during 2009 ... 50,000 Retained earnings, 1/1/2009 .... 78,000

2-8

LO4

Balance Sheet
Account Definition Cash on hand and in the bank Amounts due from customers Cost of merchandise acquired and not yet sold Cost of equipment purchased and used in business

Cash Accounts receivable Merchandise inventory Equipment

Accumulated depreciation Portion of the cost of equipment that is estimated to have been used up in the process of operating the business Short-term debt Accounts payable Other accrued liabilities Long-term debt Owners' equity Amounts borrowed that will be repaid within one year of the balance sheet date Amounts due to suppliers Amounts owed to various creditors Amounts borrowed from banks or other creditors that will not be repaid within one year from the balance sheet date Residual claim of owners, computed as "assets minus liabilities"

2-9

LO4

Income Statement
Explanation Amount of sales of merchandise to customers, less the amount of customer returns of merchandise Represents the total cost of merchandise removed from inventory and delivered to customers as a result of sales Difference between net sales and cost of goods sold; Represents the seller's maximum amount of "cushion" from which all other expenses of the business must be deducted before it is possible to have net income Represents the operating expenses of the entity Represents one of the most important measures of the firm's activities Represents the cost of using borrowed funds Shown after all of the other income statement items have been reported because income taxes are a function of the firm's income before taxes A significant item in evaluating the market value of a share of common stock; Often referred to as "earnings per share" or EPS

Captions Net sales Cost of goods sold Gross profit

Selling, general, and administrative expenses Income from operations Interest expense Income taxes

Net income per share of common stock outstanding

2-10

LO4

Statement of Changes in Owners Equity

Captions Paid-in capital Common stock Explanation Represents the total amount invested in the entity by the owners Reflects the number of shares authorized by the corporation's charter, the number of shares issued to stockholders, and the number of shares still held by the stockholders Difference between the total amount invested by the owners and the par value or stated value of the stock Represents the cumulative net income of the entity that has been retained for use in the business Distributions of earnings to the owners

Additional paid-in capital Retained earnings Dividends

2-11

LO4

Statement of Cash Flows

Captions Explanation Cash flows from operating Shown first; Net income is the starting point for this activities measure of cash generation Depreciation expense Added back to net income because it is subtracted to arrive at net income, but does not require the use of cash Increase in accounts receivable Increase in merchandise inventory Increase in current liabilities Deducted because it reflects sales revenues, included in net income, but not yet received in cash Deducted because cash was spent to acquire the increase in inventory Added because cash has not yet been paid for the products and services that have been received during the current fiscal period Cash flows from investing Shows the cash sources and uses related to long-lived activities assets Cash flows from financing Shows the cash sources and uses related to transactions activities with creditors and stockholders

2-12

LO5

Concepts/Principles

Now

Future

Accounting Entity Every economic entity can be separately identified and accounted for.

Going Concern Concept The presumption that the entity will continue to operate in the futureits not being liquidated.

Unit of Measurement Only transactions denominated in a currency (lei, euro, dollars ) are recorded in the accounting records.

Cost Principle Transactions are recorded at their original cost to the entity as measured in the currency.

2-13

LO5

Concepts/Principles

Objectivity The accountants desire to have a given transaction recorded in the same way in all situations.

Accounting Period The period of time selected for reporting results of operations and changes in financial position.

Matching Concept All expenses incurred to generate that periods revenues be deducted from revenues earned.

Accrual Accounting Recognize revenue at the point of sale and recognize expenses when incurred, even though the cash receipt or payment occurs at another time.

2-14

LO5

Concepts/Principles
Full Disclosure Circumstances and events that make a difference to financial statement users should be disclosed.

Consistency Provides meaningful trend comparisons over several years.

Materiality The increased benefit of increased accuracy should out weigh the cost of achieving the increased accuracy.

Conservatism When in doubt, make judgments and estimates that result in lower profits and asset valuations.

2-15

LO6

Accrual Accounting Vs. Cash Flows

Revenue Recognition -Timing is the Key
Accrual Accounting Recognizes: Cash Flow Recognizes:

Revenue
when revenue is earned, at the point of sale of services or products.

Revenue
when payment is received for services rendered or products sold.

Expenses
when they are incurred.

Expenses
when they are paid.

2-16

LO7

Limitations of Financial Statements

Financial statements report only quantitative economic data. They do not reflect qualitative economic variables, such as the value of the management team or the employees morale. How do the terms quantitative and qualitative differ???

2-17

LO7

Limitations of Financial Statements

The balance sheet does not report market values or replacement cost of the assets.

Historical Cost Concept - Assets are usually valued at the cost of the asset when acquired.

Matching Concept Estimates are acceptable provided there is a basis for them.

Many estimates are used, such as warranty costs, depreciation, and pension expense.

2-18

LO8

The Corporations Annual Report

The annual report is distributed to shareholders (and others). It contains the financial statements, together with the report of the external auditors examination of the financial statements.

It also contains Managements Discussion and Analysis (MD&A).