Lecture Accounting: What the numbers mean (5/e) - Chapter 2: Financial statements and accounting concepts/principles

After reading this chapter, you should be able to answer the following questions: What are generally accepted accounting principle? What kind of information is reported on each financial statement and how are the financial statements related? What are transactions? What is the meaning and usefulness of the accounting equation? What are meanings of the captions in the financial statements?...

CHAPTER 2

FINANCIAL STATEMENTS AND

ACCOUNTING CONCEPTS/PRINCIPLES

Learning Objectives

1 What are generally accepted

accounting principle?

2 What kind of information is reported

on each financial statement and

how are the financial statements

related?

3 What are transactions? What is the

meaning and usefulness of the

accounting equation?

Learning Objectives

5 Why is cash flow important?

6 What are the limitations of financial

statements?

7 What is an annual report and why

is it issued?

8 What are some of the business

practices related to organizations?

Learning Objective 1

reported on each financial statement and how are the financial statements

related?

• The transaction becomes part of a

firm’s financial statements

The Financial Statements

• Balance Sheet – financial position at the

end of the period

• Income Statement – earnings for the

period

• Statement of Changes in Owners’ Equity

– investments by and distributions to

owners during the period

• Statement of Cash Flows – cash flows

Procedures for sorting,  classifying, and 

presenting   ( bookkeeping)

Selection of alternative  methods of reflecting the  effects of certain 

transactions   ( accounting)

Financial  statements

Process

Learning Objective 2

is the meaning and usefulness

of the accounting equation?

Balance Sheet

• Financial position at the end of a period -

A snapshot at a point in time

• Also called Statement of Financial

Learning Objective 3

the captions in the financial statements?

Examples of Assets

• Accounts Receivable – amounts due from

customers

• Merchandise Inventory – merchandise

acquired but not yet sold

• Equipment – assets used in the business

• Less: Accumulated Depreciation – cost of

equipment estimated to have been used up

Examples of Liabilities

• Accounts Payable - amounts owed to

suppliers of merchandise inventory

• Long-term Debt – amounts borrowed

but will not be repaid within one year

• Covers a period of time

• Also called Statement of Earnings,

or Profit and Loss Statement, or

Income Statement Sections

• Revenues - operating activities for the

period - often reported as Net Sales

• Expenses - Costs incurred in

generating revenues

Examples of Expenses

• Cost of Goods Sold – total cost of

inventory delivered to customers as a

result of sales

• Selling, General, and Administrative

Expenses – operating expenses of an

entity

• Interest Expense – cost of using

borrowed funds

More Income Statement Sections

• Gross Profit – difference between sales

and cost of goods sold

• Income From Operations – an important

measure of a firm’s activities

• Income Before Taxes – income

from operations less interest

expense

More Income Statement Sections

• Net Income – income remaining after all expenses have been deducted

• Net Income Per Share of Common Stock Outstanding – used in measuring the

market value of a share of common stock

Statement of Changes in

Owners’ Equity

• Also called Statement of Changes in

Capital Stock, or Statement of Changes

in Retained Earnings

• Explains the changes that occurred in

the components of owners’ equity

during the year

Owners’ Equity

• Paid-In Capital

– Common Stock - at par value

– Additional Paid-In Capital – difference

between total amount invested by the

owners and the par or stated value of the

stock

• Retained Earnings – cumulative net income

retained in the business

– Dividends – distribution of earnings to

owners

Learning Objective 5

Statement of Cash Flows

• Sources and uses of cash

• Covers a period of time

• Includes:

– Operating Activities

– Investing Activities

– Financing Activities

Cash Flows from Operating

Activities

• Start with Net Income

• Add back Depreciation Expense

• Deduct (add) increases (decreases) in current assets

• Deduct (add) decreases (increases) in

Cash Flows from Investing

Cash Flows from Financing

Activities

• Cash raised from the sale of long-term

debt and common stock

• Cash paid to reduce long-term debt and stock outstanding

Financial Statement

Relationships

• All financial statements are related

• Net Income from the Income Statement affects Retained Earnings on the

Balance Sheet

• The Income Statement and the

Balance Sheet affect the

Learning Objective 4

accounting principles?

Concepts and Principles

• Accounting Entity – entity for which financial

statements are being prepared – can be a

proprietorship, partnership, corporation, or

group of corporations

• Going Concern – presumption that the

entity will continue to operate in the future

• Unit of Measurement – in the United States,

the dollar is the measurement unit for all

transactions

Concepts and Principles

• Cost Principle – transactions are recorded

at their original cost as measured in dollars

• Objectivity – a given transaction should be

recorded in the same way in all situations

• Accounting Period – the period of time

selected for recording results

• Matching – expenses are matched with the

revenues that produced them

Concepts and Principles

• Accrual Accounting – revenue recognized

at the time of sale and expenses

recognized when incurred

• Consistency – maintaining the method of

accounting for a particular type of

transaction

• Full Disclosure – all necessary information

is presented in the financial statements and

notes so investors will not be misled

Concepts and Principles

• Materiality – absolute exactness is not

necessary as long as not misleading

• Conservatism – make judgments

and estimates that result in lower

profits and asset valuations rather

than higher profits and higher asset

valuations

Learning Objective 6

financial statements?

Limitations of Financial

Statements

• Financial statements do not reflect

qualitative economic variables

• Balance sheet does not reflect current

values

• Estimates are used in many

areas of accounting

More Limitations of Financial

Learning Objective 7

why is it issued?

Annual Report

• Distributed to shareholders

• Contains:

– Financial statements

– External auditor’s report

– Footnotes and explanatory comments

– Letters from the CEO and president

Learning Objective 8

practices related to organizations?

• Fiscal Year – annual reporting period

• Par value – arbitrary value assigned to stock;

no relationship to value

• Parent and subsidiary corporations – parent

owns at least a majority of the stock of