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CHAPTER 2

Financial Statements and Accounting Concepts/Principles

McGraw-Hill/Irwin

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

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LO1

Financial Statements
Transactions are economic interchanges between entities that are accounted for and reflected in financial statements.

Borrow cash

from the bank

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

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LO1

Financial Statements
Transactions
Procedures for sorting, classifying, and presenting (bookkeeping) Selection of alternative methods of reflecting the effects of certain transactions (accounting)

An entitys financial statements are the end product of a process that starts with transactions between the entity and other organizations and individuals.
McGraw-Hill/Irwin

Financial Statements

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

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LO1

Accounts
Transactions are summarized in accounts.
Cash

Accounts Receivable
Accounts Payable

Accounts are used to organize like-kind transactions. Account balances are then used in the preparation of financial statements.

McGraw-Hill/Irwin

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

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LO2

Financial Statements
Required Disclosure Financial position at the end of the period Earnings for the period Cash flows during the period Investments by and distributions to owners during the period Financial Statement that Satisfies Requirement Balance Sheet Income Statement Statement of Cash Flows Statement of Changes in Owners' Equity

In addition to the financial statements, the annual report will probably include several accompanying notes or explanations of the accounting policies used and detailed information about many of the amounts and captions shown in the financial statements.
McGraw-Hill/Irwin 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

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LO2

Balance Sheet-Elements
Liabilities are amounts owed to other entities.

Assets represent the amount of resources owned by the entity.

Main Street Store, Inc. Balance Sheet August 31, 2009
Assets Current Assets Cash Accounts receivable Merchandise inventory Total current assets Plant and Equipment Equipment Less: Accumulated depreciation Total assets $ 34,000 80,000 170,000 284,000 40,000 Liabilities and Owners' Equity Current Liabilities Short-term debt $ 20,000 Accounts payable 35,000 Other accrued liabilities 12,000 Total current liabilities $ 67,000 Long-term debt 50,000 Total liabilities 117,000 203,000 $ 320,000

(4,000) Owners' equity $ 320,000 Total liabilities and owners' equity

Equity is the ownership right of the owner(s) of the entity in the assets that remain after deducting the liabilities.

McGraw-Hill/Irwin

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

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LO2

Balance Sheet

Current assets are those assets that are likely to be converted into cash or used to benefit the entity within one year.
Main Street Store, Inc. Balance Sheet August 31, 2009 Liabilities and Owners' Equity Current Liabilities $ 34,000 Short-term debt $ 20,000 80,000 Accounts payable 35,000 170,000 Other accrued liabilities 12,000 $ 284,000 Total current liabilities $ 67,000 Long-term debt 50,000 40,000 Total liabilities 117,000 (4,000) Owners' equity 203,000 $ 320,000 Total liabilities and owners' equity $ 320,000

Assets Current Assets Cash Accounts receivable Merchandise inventory Total current assets Plant and Equipment Equipment Less: Accumulated depreciation Total assets

Current Liabilities are those liabilities that are to be paid within one year.

McGraw-Hill/Irwin

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

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LO2

Balance Sheet

Assets

=
Assets

Liabilities
Main Street Store, Inc. Balance Sheet August 31, 2009

Equity

Current Assets Cash Accounts receivable Merchandise inventory Total current assets Plant and Equipment Equipment Less: Accumulated depreciation Total assets
McGraw-Hill/Irwin

34,000 80,000 170,000 284,000 40,000 (4,000)

Liabilities and Owners' Equity Current Liabilities Short-term debt $ 20,000 Accounts payable 35,000 Other accrued liabilities 12,000 Total current liabilities $ 67,000 Long-term debt 50,000 Total liabilities 117,000 Owners' equity Total liabilities and owners' equity 203,000 $ 320,000

320,000

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

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LO2

Income Statement

The income statement shows the profit (or loss) for the period of time under consideration.
Revenues result from the entitys operating activities (e.g., selling merchandise).
Main Street Store, Inc. Income Statement For the Year Ended August 31, 2009 Net sales Cost of goods sold Gross profit Selling, general, and admin. expenses Income from operations Interest expense Income before taxes Income taxes Net income Earnings per share of common stock outstanding $ $ $ $ $ 1,200,000 850,000 350,000 311,000 39,000 9,000 30,000 12,000 18,000

Costs and expenses are incurred in generating revenues and operating the entity.
McGraw-Hill/Irwin

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

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LO2

Income Statement

The income statement shows the profit (or loss) for the period of time under consideration.
Gains and losses are also reported on the income statement and result from nonoperating activities, rather than from the day-to-day operating activities that generate revenues and expenses.
McGraw-Hill/Irwin

Main Street Store, Inc. Income Statement For the Year Ended August 31, 2009 Net sales Cost of goods sold Gross profit Selling, general, and admin. expenses Income from operations Interest expense Income before taxes Income taxes Net income Earnings per share of common stock outstanding $ $ $ $ $ 1,200,000 850,000 350,000 311,000 39,000 9,000 30,000 12,000 18,000

1.80

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

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LO2

Statement of Changes in Owners Equity

Main Street Store, Inc. Statement of Changes in Owners' Equity For the Year Ended August 31, 2009 Paid-In Capital: Beginning balance Common stock, par value $10; 50,000 shares authorized, 10,000 shares issued and outstanding Additional paid-in capital Balance, August 31, 2009 Retained Earnings: Beginning balance Net income for the year Less: Cash dividends of $.50 per share Balance, August 31, 2009 Total owners' equity $ -

$ $

100,000 90,000 190,000 18,000 (5,000) 13,000 203,000

$ $

This financial statement shows the detail of owners equity and explains the changes that occurred in the components of owners equity during the year.
McGraw-Hill/Irwin 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

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LO2

Statement of Cash Flows

Main Street Store, Inc.

Statement of Cash Flows

For the Year Ended August 31, 2009 Cash Flows from Operating Activities: Net income Add (deduct) items not affecting cash: Depreciation expense Increase in accounts receivable Increase in merchandise inventory Increase in current liabilities Net cash used by operating activities Cash Flows from Investing Activities: Cash paid for equipment Cash Flows from Financing Activities: Cash received from issue of long-term debt Cash received from sale of common stock Payment of cash dividend on common stock Net cash provided by financing activities Net increase in cash for the year $ $ 50,000 190,000 (5,000) 235,000 34,000 $ (40,000) 4,000 (80,000) (170,000) 67,000 (161,000) $ 18,000

The purpose of this financial statement is to identify the sources and uses of cash during the year.

McGraw-Hill/Irwin

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

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LO3

Time-Line Model
8/31/09 Fiscal 2009 Balance Sheet A = L + OE

8/31/08 Balance Sheet A = L + OE

Income Statement for the Year

Revenue - Expenses Net Income

Statement of Changes in Owners Equity

Beginning Balances Paid-in Capital Changes Retained Earnings Changes: + Net Income - Dividends Ending Balances

Statement of Cash Flows

Cash Provided (Used) by: Operating Activities Investing Activities Financing Activities + Beginning Cash Balance Ending Cash Balance

McGraw-Hill/Irwin

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

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LO3

Financial Statement Relationships and the Accounting Equation

Balance Sheet Assets = Liabilities + Owners' Equity Net income =

Income Statement Revenues Expenses

The arrow indicates that net income affects retained earnings, which is a component of owners equity.

McGraw-Hill/Irwin

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

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LO3

Financial Statement Relationships and the Accounting Equation

If assets equal $300,000 and liabilities equal $125,000, what is owners equity?

Balance Sheet Assets 300,000 = = Liabilities 125,000 + + Owners' Equity ?

McGraw-Hill/Irwin

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

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LO3

Financial Statement Relationships and the Accounting Equation

If assets equal $300,000 and liabilities equal $125,000, what is owners equity?

Balance Sheet Assets 300,000 = = Liabilities 125,000 + + Owners' Equity 175,000

Owners equity equals $175,000

($300,000 - $125,000)

McGraw-Hill/Irwin

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

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LO3

Financial Statement Relationships and the Accounting Equation

Now, suppose that total assets increase $12,000 during the year and total liabilities decrease $3,000 during the year.
Balance Sheet Assets = 300,000 12,000 312,000 Liabilities + 125,000 (3,000) 122,000 Owners' Equity 175,000 ? ?

What is owners equity at the end of the year?

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

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LO3

Financial Statement Relationships and the Accounting Equation

Now, suppose that total assets increase $12,000 during the year and total liabilities decrease $3,000 during the year.
Balance Sheet Assets = 300,000 12,000 312,000 Liabilities + 125,000 (3,000) 122,000 Owners' Equity 175,000 15,000 190,000

Owners equity must have increased by $15,000. Since owners equity was $175,000 at the beginning of the year, it must be $190,000 at the end of the year.
McGraw-Hill/Irwin 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

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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"

McGraw-Hill/Irwin

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

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

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

McGraw-Hill/Irwin

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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

McGraw-Hill/Irwin

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

1-22 2-22

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

McGraw-Hill/Irwin

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

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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 dollars (currency) are recorded in the accounting records.
McGraw-Hill/Irwin

Cost Principle Transactions are recorded at their original cost to the entity as measured in dollars.
2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

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

McGraw-Hill/Irwin

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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.
McGraw-Hill/Irwin

Conservatism When in doubt, make judgments and estimates that result in lower profits and asset valuations.
2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

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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.
McGraw-Hill/Irwin

Expenses
when they are paid.
2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

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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???
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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.

McGraw-Hill/Irwin

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

1-29 2-29

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).

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End of Chapter 2

McGraw-Hill/Irwin

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