CHAPTER 2

Financial Statements and

Accounting Concepts/Principles
 2-2

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

Financial
Statements
An entity’s financial statements are the
end product of a process that starts with
transactions between the entity and
other organizations and individuals.
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 2-3

Accounts

Transactions
Transactions are
are
Cash summarized
summarized inin
accounts.
accounts.
Accounts
Receivable
Accounts
Accounts areare further
further
Accounts summarized
summarized in in the
the
Payable financial
financial statements.
statements.

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 2-4

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

In addition to the financial statements, the annual report will

probably include several accompanying footnotes or
explanations of the accounting policies and detailed
information about many of the amounts and captions shown
on the financial statements.
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 2-5

Balance Sheet

Assets
Assetsrepresent
representthe
theamount
amountof ofresources
resources
owned
ownedby bythe
theentity.
entity. Liabilities
Liabilitiesare
are
amounts
amountsowedowedtoto
other
otherentities.
entities.

Equity
Equityis isthe
the
ownership
ownershipright rightofof
the
theowner(s)
owner(s)of ofthe
the
entity
entityin inthe
theassets
assets
that
thatremain
remainafterafter
deducting
deductingthe the
liabilities.
liabilities.
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 2-6

Balance Sheet
Current
Currentassets
assetsare
arethose
thoseassets
assetsthat
thatare
are Current
Currentliabilities
liabilities
likely
likelyto
tobe
beconverted
convertedinto
intocash
cashor
orused
usedtoto are
arethose
those
benefit
benefitthe
theentity
entitywithin
withinone
oneyear.
year. liabilities
liabilitiesthat
thatare
are
likely
likelytotobebepaid
paid
with
withcash
cashwithin
within
one
oneyear
yearof ofthe
the
balance
balancesheet
sheet
date.
date.

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 2-7

Balance Sheet

Assets
Assets = Liabilities
Liabilities + Equity
Equity

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 2-8

Balance Sheet
Account Definition
Cash Cash on hand and in the bank
Accounts receivable Amounts due from customers
Merchandise inventory Cost of merchandise acquired and not yet sold
Equipment Cost of equipment purchased and used in business
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 Amounts borrowed that will be repaid within one year of
the balance sheet date
Accounts payable Amounts due to suppliers
Other accrued liabililites Amounts owed to various creditors
Long-term debt Amounts borrowed from banks or other creditors that will
not be repaid within one year from the balance sheet date
Owners' equity Explained in more detail later in this chapter

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 2-9

Income Statement
The
The income
income statement
statement shows
shows the
the profit
profitfor
for the
theperiod
periodof
oftime
time
under
underconsideration.
consideration.
Revenues Main Street Store, Inc.
Revenuesresult
result Income Statement
from
fromthetheentity’s
entity’s For the Year Ended August 31, 2004
operating
operatingactivities
activities
(e.g.,
(e.g.,selling
selling Net sales $ 1,200,000
Cost of goods sold 850,000
merchandise).
merchandise). Gross profit $ 350,000
Selling, general, and admin. expenses 311,000
Costs Income from operations $ 39,000
Costsand
and Interest expense 9,000
expenses
expensesare are Income before taxes $ 30,000
incurred
incurredin in Income taxes 12,000
generating
generating Net income $ 18,000
revenues
revenuesand and Net income per share of common
operating
operatingthe the stock outstanding $ 1.80
entity.
entity.

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 2-10

Income Statement
The
The income
income statement
statement shows
shows the
the profit
profitfor
for the
theperiod
periodof
oftime
time
under
underconsideration.
consideration.
Main Street Store, Inc.
Gains
Gainsandandlosses
losses Income Statement
are For the Year Ended August 31, 2004
arealso
alsoreported
reportedon on
the
theincome
income Net sales $ 1,200,000
statement
statementand and Cost of goods sold 850,000
result
resultfrom
fromnon-
non- Gross profit $ 350,000
Selling, general, and admin. expenses 311,000
operating
operatingactivities,
activities, Income from operations $ 39,000
rather
ratherthan
thanfrom
fromthe
the Interest expense 9,000
day-to-day
day-to-day Income before taxes $ 30,000
operating Income taxes 12,000
operatingactivities
activities Net income $ 18,000
that
thatgenerate
generate
revenues
revenuesand and Net income per share of common
expenses.
expenses. stock outstanding $ 1.80

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 2-11

Income Statement
Captions Explanation
Net sales Amount of sales of merchandise to customers, less the
amount of customer returns of merchandise
Cost of goods sold Represents the total cost of merchandise removed from
inventory and delivered to customers as a result of sales
Gross profit 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
Selling, general, and Represent the operating expenses of the entity
administrative expenses
Income from operations Represents one of the most important measures of the
firm's activities
Interest expense Represents the cost of using borrowed funds
Income taxes 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
Net income per share of A significant item in evaluating the market value of a share
common stock of common stock; Often referred to as "earnings per
outstanding
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 2-12

Statement of Changes
in Owners’ Equity
Main Street Store, Inc.
Statement of Changes in Owners' Equity
For the Year Ended August 31, 2004

Paid-In Capital:
Beginning balance $ -
Common stock, par value $10; 50,000 shares
authorized, 10,000 shares issued and
outstanding 100,000
Additional paid-in capital 90,000
Balance, August 31, 2004 $ 190,000
Retained Earnings:
Beginning balance $ -
Net income for the year 18,000
Less: Cash dividends of $.50 per share (5,000)
Balance, August 31, 2004 $ 13,000
Total owners' equity $ 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.
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 2-13

Statement of Changes
in Owners’ Equity
Captions Explanation
Paid-in capital Represents the total amount invested in the entity by the
owners
Common stock Reflects the number of shares authorized by the
corporation's charter, the number of shares issued to
stockholders, and the number of shares that are still held
by the stockholders
Additional paid-in capital Difference between the total amount invested by the
owners and the par value or stated value of the stock
Retained earnings Represents the cumulative net income of the entity that
has been retained for use in the business
Dividends Are distributions of earnings to the owners

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 2-14

Statement of Cash Flows

M a in S tre e t S tore , Inc.
S ta te m e nt of Ca sh Flow s
For the Ye a r Ende d August 31, 2004

Ca sh Flow s from Ope ra ting Activitie s: The purpose of this

Ne t incom e
Add (de duct) ite m s not a ffe cting ca sh:
$ 18,000
financial statement
De pre cia tion e x pe nse 4,000
Incre a se in a ccounts re ce iva ble (80,000) is to identify the
Incre a se in m e rcha ndise inve ntory (170,000)
Incre a se in curre nt lia bilitie s
Ne t ca sh use d by ope ra ting a ctivitie s
67,000
(161,000)
sources and uses
Ca sh Flow s from Inve sting Activitie s:
Ca sh pa id for e quipm e nt $ (40,000)
of cash during the
Ca sh Flow s from Fina ncing Activitie s:
Ca sh re ce ive d from issue of long-te rm de bt 50,000
year.
Ca sh re ce ive d from sa le of com m on stock 190,000
P a ym e nt of ca sh divide nd on com m on stock (5,000)
Ne t ca sh provide d by fina ncing a ctivitie s $ 235,000
Ne t incre a se in ca sh for the ye a r $ 34,000

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 2-15

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 Deducted because it reflects sales revenues, included in

receivable net income, but not yet received in cash
Increase in merchandise Deducted because cash was spent to acquire the
inventory increase in inventory
Increase in current Added because cash has not yet been paid for the
liabilities 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

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 2-16

Time-Line Model
8/31/03 8/31/04

Balance Fiscal 2004 Balance

Sheet Sheet
Income Statement for the Year
A = L + OE A = L + OE
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
Financining Activities
+ Beginning Cash Balance
Ending Cash Balance
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 2-17

Financial Statement
Relationships

Balance Sheet Income Statement

Ow ners' Net
Assets = Liabilities + Equity income = Revenues - Expenses

The arrow indicates that net income

affects retained earnings, which is a
component of owners’ equity.

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 2-18

Financial Statement
Relationships
If assets equal $300,000 and liabilities equal $125,000,
what is owners’ equity?
Balance Sheet
Owners'
Assets = Liabilities + Equity
300,000 = 125,000 + ?

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 2-19

Financial Statement
Relationships
If assets equal $300,000 and liabilities equal $125,000,
what is owners’ equity?
Balance Sheet
Owners'
Assets = Liabilities + Equity
300,000 = 125,000 + 175,000

Owners’ equity equals $175,000

($300,000 - $125,000).

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 2-20

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

What is owners’ equity at the end of the year?

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 2-21

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

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.
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Concepts/Principles
Accounting Entity
Every economic entity can be
separately identified and
accounted for.
Unit of Measurement
Only transactions denominated
in dollars are recorded in the
accounting records.
McGraw-Hill/Irwin
2-22
Now Future
Going Concern Concept
The presumption that the entity
will continue to operate in the
future—it’s not being liquidated.
Cost Principle
Transactions are recorded at
their original cost to the entity as
measured in dollars.
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Concepts/Principles
Objectivity
The accountants’ desire to have a
given transaction recorded in the
same way in all situations.
Matching Concept
All expenses incurred to generate
that period’s revenues be
deducted from revenues earned.
McGraw-Hill/Irwin
2-23
Accounting Period
The period of time selected for
reporting results of operations
and changes in financial position.
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.
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Concepts/Principles
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
2-24
Full Disclosure
Circumstances and events that
make a difference to financial
statement users should be
disclosed.
Conservatism
When in doubt, make judgments
and estimates that result in lower
profits and asset valuations.
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 2-25

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.

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 2-26

Limitations of Financial Statements

The balance sheet does

not report market values
or replacement cost of
the assets.

Many estimates are

used, such as warranty
costs, depreciation, and
pension expense.

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 2-27

The Corporation’s Annual Report

The annual report is

distributed to
shareholders (and others).
It contains the financial
statements, together with
the report of the external
auditor’s examination of
the financial statements.
It may also contain
Management’s Discussion
and Analysis (MD&A).

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 2-28

End of Chapter 2

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