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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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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.

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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.

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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

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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.

Financial Statements

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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.

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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.

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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.

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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.

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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

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

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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.

1.80

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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.
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

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Indentify Accounts by Category and Financial Statement(s) Exercise

Category
Asset Liability Owners Equity Revenue Expense Gain A L OE R E G

Financial Statement
Balance Sheet Income Statement BS

IS

Loss

LS

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Exercise Items
Financial Financial Statement Caption Category Statement

Cash Accounts payable Common Stock Depreciation Expense Net Sales Accumulated Depreciation Long-Term Debt Net Income Merchandise Inventory Accounts Receivable Retained Earnings

A L OE E R A L OE A A OE

BS BS BS IS IS BS BS IS BS BS BS

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Exercise Items
Financial Financial Statement Caption Category Statement

Equipment Gain on sale of land Cost of goods sold Short term debt Selling expenses Additional paid-in capital Dividends Payable Loss on sale of building Dividends Paid Interest income Short-term investments

A G E L E OE L LS OE R A

BS IS IS BS IS BS BS IS Neither! IS BS

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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.

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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.

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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

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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.

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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 ?

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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)

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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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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.

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Understanding Financial Statement Relationships Exercise Number 1

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 ... ? Total liabilities, 31/12/2009 ..... $ 80,000 Paid-in capital, 31/12/2009 .. 55,000 Retained earnings, 31/12/2009 . ? Net income for 2009 . 68,000 Dividends declared and paid during 2009 12,000 Retained earnings, 1/1/2009 ..... 50,000

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Understanding Financial Statement Relationships Exercise Number 1

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 ... Total liabilities, 31/12/2009 ..... Paid-in capital, 31/12/2009 .. Retained earnings, 31/12/2009 . Net income for 2009 . Dividends declared and paid during 2009 Retained earnings, 1/1/2009 .....

241,000 $ 80,000 55,000 106,000 68,000 12,000 50,000

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Understanding Financial Statement Relationships Exercise Number 2

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 .. $ 435,000 Total liabilities, 31/12/2009 ........ ? Paid-in capital, 31/12/2009 . 59,000 Retained earnings, 31/12/2009 186,000 Net income for 2009 110,000 Dividends declared and paid during 2009 ... ? Retained earnings, 1/1/2009 ........ 124,000

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Understanding Financial Statement Relationships Exercise Number 2

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 .. $ 435,000 Total liabilities, 31/12/2009 ........ 190,000 Paid-in capital, 31/12/2009 . 59,000 Retained earnings, 31/12/2009 186,000 Net income for 2009 110,000 Dividends declared and paid during 2009 ... 48,000 Retained earnings, 1/1/2009 ........ 124,000