Chapter 2 Basic Financial Statements PDF

Chapter 2 Basic Financial Statements Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education....

Chapter 2 Basic Financial Statements Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 2-1  Introduction to Financial Statements Investors and creditors are interested in the cash flows that they expect to receive in the future.  Creditors are interested in the ability of an enterprise to meet its payment obligations, which may include payment of interest.  Investors are interested in the market value of their stock holdings and any dividends they might receive. Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 2-2  Financial Statements  A financial statement is simply a declaration of what is believed to be true about an enterprise, communicated in terms of a monetary unit, such as the dollar.  When accountants prepare financial statements, they are describing in financial terms certain attributes of the enterprise that they believe fairly represent its financial activities. Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 2-3  Three Primary Financial Statements  Statement of financial position (often referred to as the balance sheet)  Income statement  Statement of cash flows Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 2-4  Financial Statements: Balance Sheet 1. Statement of Financial Position (Balance Sheet) a. Describes where the enterprise stands at a specific date. b. A snapshot of the business in financial or dollar terms that shows what the enterprise looks like at a specific date. Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 2-5  Financial Statements: Income Statement 2. Income Statement a. An activity statement that shows the revenues and expenses for a designated period of time. b. Revenues generate positive cash flows through transactions with customers. c. Expenses generate negative cash flows (outflows of cash) through business activities. Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 2-6  Financial Statements: Statement of Cash Flows 3. Statement of Cash Flows a. Details the company’s sources and uses of cash during an accounting period. b. Enables the financial statement user to better understand the change in the cash balance shown on the comparative balance sheet. Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 2-7  Statement of Financial Position Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 2-8  Features of the Balance Sheet 1. Heading a. Names of the business b. Name of the financial statement c. Date 2. Assets: Generally listed in order of expected liquidity beginning with cash. 3. Liabilities: Listed on the other side of the balance sheet before owners’ equity. 4. Equity: Divided into the categories of capital stock and retained earnings. Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 2-9  Business Entity Concept Business Entity An economic unit that engages in identifiable business activities. For accounting purposes, the activities of the entity are separate from the personal activities of its owners. Should only include items related to the operation of the business. Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 2-10  Assets Assets have three basic characteristics: 1. Economic resources 2. Owned by the business 3. Expected to benefit future operations* *In most cases, the benefit to future operations comes in the form of positive future cash flows. Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 2-11  The Cost Principle  Historical cost refers to the original amount the entity paid to acquire the asset.  Examples of assets reported at historical cost include merchandise inventory, land, buildings, and equipment.  Examples of assets reported at net realizable value, or fair value, include accounts receivable and investments. Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 2-12  The Going-Concern Assumption  The going-concern assumption indicates that we assume that a business will be a continuing enterprise which will operate for an indefinite period.  This assumption supports the principle of historical cost, as most long-term assets are not intended for resale but meant to assist the business in continuing its core operations. Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 2-13  The Objectivity Principle  Objective describes information that is factual, definite, and verifiable.  Objective information lacks subjectivity.  Objectivity is a primary reason for reporting long-term assets at historical cost as that value is verifiable. Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 2-14  The Stable-Dollar Assumption A limitation of measuring assets at historical cost is that the value of the monetary unit or dollar is not always stable.  Inflation is a term used to describe the situation where the value of the monetary unit decreases, meaning that it will purchase less than it did previously.  Deflation, on the other hand, is the opposite situation in which the value of the monetary unit increases, meaning that it will purchase more than it did previously. Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 2-15  Liabilities Liabilities:  Financial obligations or debts.  Represent negative future cash flows.  The person or organization to whom the debt is owed is called a creditor.  Usually listed on the balance sheet in the order in which they are expected to be repaid.  Represents claims against the borrower’s assets. Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 2-16  Owners’ Equity Owners’ Equity:  Represents the owners’ claims on the assets of the business.  Indicates a residual amount as creditors have legal priority over owners.  Entitles owners to the residual assets once creditors have been paid in full.  Always equal to total assets minus total liabilities. Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 2-17  Increases in Owners’ Equity The owners’ equity in a business comes from two primary sources: 1. Investments of cash or other assets by owners. 2. Earnings from profitable operation of the business. Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 2-18  Decreases in Owners’ Equity Decreases in owners’ equity also are caused in two ways: 1. Payments of cash or transfers of other assets to owners. 2. Losses from unprofitable operation of the business. Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 2-19  The Accounting Equation Assets = Liabilities + Owners’ Equity Example: Assets = Liabilities + Owners’ Equity $300,000 = $80,000 + $220,000 Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 2-20  The Effects of Business Transactions How does a statement of financial position come about? What has occurred in the past for it to exist at any point in time? The statement of financial position is a picture of the results of past business transactions that has been captured by the company’s information system and organized into a concise financial description of where the company stands at a point in time. The specific items and dollar amounts are the direct results of the transactions in which the company has engaged. Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 2-21  Illustration: Introduction To illustrate how a balance sheet comes about, and later to show how the income statement and statement of cash flows relate to the balance sheet, we use an example of a small auto repair business, Overnight Auto Service. Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 2-22  Overnight: Transaction 1 On January 20, Michael McBryan started Overnight Auto Service. He and his family invested $80,000 and received 8,000 shares of stock at $10 per share. Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 2-23  Overnight: Transaction 2 On January 21, Overnight purchased the land from the city for $52,000 cash. Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 2-24  Overnight: Transaction 3 On January 22, Overnight purchased an old garage for $36,000. Overnight paid $6,000 down in cash and issued a 90-day note payable for the remaining $30,000 owed. Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 2-25  Overnight: Transaction 4 On January 23, Overnight purchased tools and automotive repair equipment for $13,800 on account, due within 60 days. Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 2-26  Overnight: Transaction 5 Overnight realized that the company had purchased more tools and equipment than it needed. On January 24, Overnight sold some of the new tools to Ace Towing for $1,800, a price equal to Overnight’s cost. Ace agreed to pay the amount within 45 days. Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 2-27  Overnight: Transaction 6 On January 26, Ace Towing pays Overnight $600 as a partial settlement of its accounts receivable. Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 2-28  Overnight: Transaction 7 On January 27, Overnight made a partial payment of $6,800 on its account payable to Snappy Tools. Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 2-29  Overnight: Transaction 8 On January 31, Overnight recorded auto repair services provided for the last week of January of $2,200, received in cash. Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 2-30  Overnight: Transaction 9 On January 31, Overnight paid operating expenses of $1,400 in cash. Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 2-31 Overnight: Expanded Accounting Equation Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 2-32  Income Statement The income statement is a summarization of the company’s revenue and expense transactions for a period of time. Revenues  Increases in the company’s assets from its profit-directed activities.  Result in positive cash flows. Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 2-33  Income Statement (cont.) Expenses  Decreases in the company’s assets from its profit-directed activities.  Result in negative cash flows. Net income is the difference between revenues and expenses for a specified period of time. Net Income = Revenues − Expenses Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 2-34  Overnight’s Income Statement Investments by the owners and payments to the owners are not included on the Income Statement. Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 2-35  Statement of Cash Flows Classifies cash flows into three categories: 1. Operating activities: the cash effects of revenue and expense transactions that are included on the income statement. 2. Investing activities: the cash effects of purchasing and selling assets, such as land and buildings. 3. Financing activities: the cash effects of the owners investing in the company and creditors loaning money to the company and the repayment of either or both. Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 2-36  Overnight’s Statement of Cash Flows Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 2-37  Relationships Among Financial Statements Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 2-38  Financial Statement Articulation Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 2-39  Financial Reporting and Financial Statements Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 2-40  Forms of Business Organization 1. Sole Proprietorship a. An unincorporated business owned by one person. b. Often the owner also acts as the manager. c. Common for small retail stores, farms, service businesses, and professional practices in law, medicine, and accounting. d. Most common form of business organization in our economy. Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 2-41  Forms of Business: Partnership 2. Partnership a. An unincorporated business owned by two or more persons voluntarily acting as partners (co- owners). b. Widely used for small businesses as well as some large professional practices, including CPA firms and law firms. c. Owners of a partnership are personally responsible for all debts of the business. d. From an accounting standpoint, a partnership is viewed as a business entity separate from the personal affairs of its owners. Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 2-42  Forms of Business: Corporation 3. Corporations a. Recognized under the law as an entity separate from its owners. b. Owners of a corporation are not personally liable for the debts of the business. c. These owners can lose no more than the amounts they have invested in the business—a concept known as limited liability. Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 2-43  Corporations (cont.) d. Ownership of a corporation is divided into transferable shares of capital stock. e. Owners are called stockholders or shareholders. f. Stockholders are generally free to sell some or all of these shares to other investors at any time. g. Corporations are the dominant form of business organization in terms of the dollar volume of business activity. Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 2-44  Reporting Ownership Equity in the Statement of Financial Position Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 2-45  Liquidity and Profitability Liquidity is the ability of the business to pay its debts as they come due.  Critical to the survival of the business.  A business that is not liquid may be forced into bankruptcy by its creditors. Profitability refers to a company’s ability to generate net income from the business.  Profitable operations increase owner’s equity. Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 2-46  Short-Run vs. Long-Run  In the short-run, liquidity and profitability may be independent of each other.  Over the long term, liquidity and profitability go hand in hand.  A key indicator of a company’s short-term liquidity is the relationship between the company’s liquid assets and the liabilities requiring payment in the near future. Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 2-47  Adequate Disclosure  Adequate disclosure means that users of financial statements are informed of all information necessary for the proper interpretation of the statements.  Disclosures are made in the body of the financial statements and in the notes accompanying the statements.  It is common for the notes to the financial statements to be longer than the statements themselves. Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 2-48  Adequate Disclosure (cont.) Items that may require disclosure include but are not limited to:  Significant accounting policies  Subsequent events  Unsettled lawsuits  Contractual commitments  Assets pledged as collateral Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 2-49  Management’s Interest in Financial Statements  Creditors are more likely to extend credit if financial statements show a strong statement of financial position— that is, relatively little debt and large amounts of liquid assets.  Window dressing occurs when management takes measures to make the company appear as strong as possible in its financial statements. Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 2-50  End of Chapter 2 Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 2-51