Chapter

2
BASIC FINANCIAL STATEMENTS

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Learning Objective

To explain the nature and general purpose of financial statements.

LO1
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Introduction to Financial Statements

Balance Sheet Income Statement
Statement of Cash Flows

Three primary financial statements.

We will use a corporation to describe these statements.

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Introduction to Financial Statements

Balance Sheet
Income Statement
Statement of Cash Flows

Describes where the enterprise stands at a specific date.

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Introduction to Financial Statements

Balance Sheet
Income Statement
Statement of Cash Flows

Depicts the revenue and expenses for a designated period of time.

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Introduction to Financial Statements

Revenues result in positive cash flow.

Expenses result in negative cash flow.

Either in the past, present, or future.

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Introduction to Financial Statements

Balance Sheet
Income Statement
Statement of Cash Flows

Net income (or net loss) is simply the difference between revenues and expenses.

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Introduction to Financial Statements

Balance Sheet
Income Statement
Statement of Cash Flows

Depicts the ways cash has changed during a designated period of time.

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A Starting Point: Statement of Financial Position

Vagabond Travel Agency Balance Sheet December 31, 2007 Assets Liabilities & Owners' Equity Cash $ 22,500 Liabilities: Notes receivable 10,000 Notes payable $ 41,000 Accounts receivable 60,500 Accounts payable 36,000 Supplies 2,000 Salaries payable 3,000 Land 100,000 Total liabilities $ 80,000 Building 90,000 Owners' Equity: Office equipment 15,000 Capital stock 150,000 Retained earnings 70,000 Total $ 300,000 Total $ 300,000
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Learning Objective
To explain certain accounting principles that are important for an understanding of financial statements and how professional judgment by accountants may affect the application of those principles.

LO2
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The Concept of the Business Entity

Vagabond Travel Agency

A business entity is separate from the personal affairs of its owner.

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Assets
Vagabond Travel Agency Balance Sheet December 31, 2007 Assets Liabilities & Owners' Equity Cash $ 22,500 Liabilities: Notes receivable 10,000 Notes payable $ 41,000 Accounts receivable 60,500 Accounts payable 36,000 Supplies 2,000 Salaries payable 3,000 Land 100,000 Total liabilities $ 80,000 Building 90,000 Owners' Equity: Office equipment 15,000 Capital stock 150,000 Retained earnings 70,000 Total $ 300,000 Total $ 300,000

Assets are economic resources that are owned by the business and are expected to benefit future operations.

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Assets
Cost Principle
These accounting principles support Going-Concern cost as the basis Assumption for asset valuation.

Stable-Dollar Assumption

Objectivity Principle
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Accounting Principles

The cost principle tells us that accounting information is based upon actual cost incurred. We refer to this as historical cost. The going-concern assumption states that in the absence of information to the contrary, the business entity is assumed to continue operations into the foreseeable future.

The objectivity principle states that accounting information must be unbiased and based upon independent evidence.

The stable-dollar assumption tells us that we will only record accounting information that can be expressed in monetary units, usually dollars in the United States.

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Liabilities
Vagabond Travel Agency Balance Sheet December 31, 2007 Assets Liabilities & Owners' Equity Cash $ 22,500 Liabilities: Notes receivable 10,000 Notes payable $ 41,000 Accounts receivable 60,500 Accounts payable 36,000 Supplies 2,000 Salaries payable 3,000 Land 100,000 Total liabilities $ 80,000 Building 90,000 Owners' Equity: Office equipment 15,000 Capital stock 150,000 Retained earnings 70,000 Total $ 300,000 Total $ 300,000

Liabilities are debts that represent negative future cash flows for the enterprise.

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Owners Equity
Vagabond Travel Agency Balance Sheet December 31, 2007 Assets Liabilities & Owners' Equity Cash $ 22,500 Liabilities: Notes receivable 10,000 Notes payable $ 41,000 Accounts receivable 60,500 Accounts payable 36,000 Supplies 2,000 Salaries payable 3,000 Land 100,000 Total liabilities $ 80,000 Building 90,000 Owners' Equity: Office equipment 15,000 Capital stock 150,000 Retained earnings 70,000 Total $ 300,000 Total $ 300,000

Owners equity represents the owners claims on the assets of the business.

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Owners Equity

Changes in Owners Equity

Owners Investments Business Earnings Payments to Owners Business Losses

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Learning Objective
To demonstrate how certain business transactions affect the elements of the accounting equation: Assets = Liabilities + Owners Equity.

LO3
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The Accounting Equation

Travel Assets =Vagabond Liabilities + Agency Owners Equity Balance Sheet December 31, 2007 $300,000 = $80,000 + $220,000 Assets Liabilities & Owners' Equity Cash $ 22,500 Liabilities: Notes receivable 10,000 Notes payable $ 41,000 Accounts receivable 60,500 Accounts payable 36,000 Supplies 2,000 Salaries payable 3,000 Land 100,000 Total liabilities $ 80,000 Building 90,000 Owners' Equity Office equipment 15,000 Capital stock 150,000 Retained earnings 70,000 Total $ 300,000 Total $ 300,000
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Lets analyze some transactions for JJs Lawn Care Service.

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On May 1, Jill Jones and her family invested $8,000 in JJs Lawn Care Service and received 800 shares of stock.
JJ's Lawn Care Service Balance Sheet May 1, 2007 Assets Owners' Equity $ 8,000 Capital Stock $

Cash

8,000

Total
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8,000 Total

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On May 2, JJs purchased a riding lawn mower for $2,500 cash.

JJ's Lawn Care Service Balance Sheet May 2, 2007 Assets Owners' Equity Cash $ 5,500 Capital Stock $ Tools & Equipment 2,500

8,000

Total

8,000 Total

8,000

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On May 8, JJs purchased a $15,000 truck.

JJs paid $2,000 down in cash and issued a note payable for the remaining $13,000.
JJ's Lawn Care Service Balance Sheet May 8, 2007 Assets Liabilities and Owners' Equity Cash $ 3,500 Liabilities: Tools & Equipment 2,500 Notes Payable $ 13,000 Truck 15,000 Owners' Equity: Capital Stock 8,000

Total
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$ 21,000 Total

$ 21,000
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On May 11, JJs purchased some repair parts for $300 on account.
JJ's Lawn Care Service Balance Sheet May 11, 2007 Assets Liabilities and Owners' Equity Cash $ 3,500 Liabilities: Tools & Equipment 2,800 Notes Payable $ 13,000 Truck 15,000 Accounts Payable 300 Total Liabilities $ 13,300 Owners' Equity: Capital Stock 8,000 Total $ 21,300 Total $ 21,300

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Jill realized she had purchased more repair parts than needed. On May 18, JJs was able to sell half of the repair parts to ABC Lawns for $150, a price equal to JJs cost. JJs will receive the cash within 30 days.
JJ's Lawn Care Service Balance Sheet May 18, 2007 Assets Liabilities and Owners' Equity Cash $ 3,500 Liabilities: Accounts Receivable 150 Notes Payable $ 13,000 Tools & Equipment 2,650 Accounts Payable 300 Truck 15,000 Total Liabilities $ 13,300 Owners' Equity: Capital Stock 8,000 Total $ 21,300 Total $ 21,300

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On May 25, ABC Lawns pays JJs $75 as a partial settlement of its accounts receivable.
JJ's Lawn Care Service Balance Sheet May 25, 2007 Assets Liabilities and Owners' Equity Cash $ 3,575 Liabilities: Accounts Receivable 75 Notes Payable $ 13,000 Tools & Equipment 2,650 Accounts Payable 300 Truck 15,000 Total Liabilities $ 13,300 Owners' Equity: Capital Stock 8,000 Total $ 21,300 Total $ 21,300

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On May 28, JJs pays $150 of its accounts payable.

JJ's Lawn Care Service Balance Sheet May 28, 2007 Assets Liabilities and Owners' Equity Cash $ 3,425 Liabilities: Accounts Receivable 75 Notes Payable $ 13,000 Tools & Equipment 2,650 Accounts Payable 150 Truck 15,000 Total Liabilities 13,150 Owners' Equity: Capital Stock 8,000 Total $ 21,150 Total $ 21,150

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On May 29, JJs recorded lawn care services provided during May of $750. All clients were paid in cash.
JJ's Lawn Care Service Balance Sheet May 29, 2007 Assets Liabilities and Owners' Equity Cash $ 4,175 Liabilities: Accounts Receivable 75 Notes Payable $ 13,000 Tools & Equipment 2,650 Accounts Payable 150 Truck 15,000 Total Liabilities 13,150 Owners' Equity: Capital Stock 8,000 Retained Earnings 750 Total $ 21,900 Total $ 21,900

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Learning Objective
To explain how the statement of financial position, often referred to as the balance sheet, is an expansion of the basic accounting equation.

LO4
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On May 31, JJs purchased gasoline for the lawn mower and the truck for $50 cash.
JJ's Lawn Care Service Balance Sheet May 31, 2007 Assets Liabilities and Owners' Equity Cash $ 4,125 Liabilities: Accounts Receivable 75 Notes Payable $ 13,000 Tools & Equipment 2,650 Accounts Payable 150 Truck 15,000 Total Liabilities 13,150 Owners' Equity: Capital Stock 8,000 Retained Earnings 700 Total $ 21,850 Total $ 21,850

Now, lets review how JJs transactions affected the accounting equation. The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin

May 1 Balances May 2 Balances May 8 Balances May 11 Balances May 18 Balances May 25 Balances May 28 Balances May 29 Balances May 31 Balances

Cash $ 8,000 $ 8,000 (2,500) $ 5,500 (2,000) $ 3,500 $ 3,500 $ 3,500 75 $ 3,575 (150) $ 3,425 750 $ 4,175 (50) $ 4,125

Assets Accts. Tools & + Rec. + Equip. +

= Truck

Liabilities + Owners' Equity Notes Accts. Capital Retained = Payable + Pay. + Stock + Earnings $ 8,000 $ 8,000 $ 8,000

$ 2,500 $ 2,500 $ 2,500 300 $ 2,800 (150) $ 2,650 $ 2,650 $ 2,650 $ 2,650 $ 2,650 $ 15,000 $ 15,000 $ 15,000 $ 15,000 $ 15,000 $ 15,000 $ 15,000 $ 15,000 $ 13,000 $ 13,000 $ 13,000 $ 13,000 $ 13,000 $ 13,000 $ 13,000 $ 13,000 $ 300 $ 300 $ 300 $ 300 (150) $ 150 $ 150 $ 150

$ 8,000 $ 8,000 $ 8,000 $ 8,000 $ 8,000 $ 8,000 $ 8,000 $ $ 750 750 (50) 700

$ 150 $ 150 (75) $ 75 $ 75 $ 75 $ 75

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Lets prepare the Income Statement and Statement for JJs Care Assets of Cash Flows = Liabilities + Lawn Owners' Equity Accts. Tools & Notes Accts. Capital Retained Service for the month ending May 31, 2007. Cash + Rec. + Equip. + Truck = Payable + Pay. + Stock + Earnings
May 1 Balances May 2 Balances May 8 Balances May 11 Balances May 18 Balances May 25 Balances May 28 Balances May 29 Balances May 31 Balances $ 8,000 $ 8,000 (2,500) $ 5,500 (2,000) $ 3,500 $ 3,500 $ 3,500 75 $ 3,575 (150) $ 3,425 750 $ 4,175 (50) $ 4,125 $ 150 $ 150 (75) $ 75 $ 75 $ 75 $ 75

These transactions impact the $ 15,000 $ 13,000 $ 2,500 $ 15,000 $ 13,000 Statement of Cash 300 $ 300 Flows. $ 2,800 $ 15,000 $ 13,000 $ 300
$ 2,500 $ 2,500 (150) $ 2,650 $ 2,650 $ 2,650 $ 2,650 $ 2,650 $ 15,000 $ 15,000 $ 15,000 $ 13,000 $ 13,000 $ 13,000 $ 300 $ 300 (150) $ 150

$ 8,000 $ 8,000 $ 8,000 $ 8,000 $ 8,000 $ 8,000 $ 8,000 $ 8,000 $ 8,000 $ 8,000 $ $ 750 750 (50) 700

These transactions $ 15,000 $ 13,000 $ 150 impact the Income $ 15,000 $ 13,000 $ 150 Statement.

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Learning Objective
To explain how the income statement reports an enterprises financial performance for a period of time in terms of the relationship of revenues and expenses.

LO5
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JJ's Lawn Care Service Income Statement For the Month Ended May 31, 2007 Sales Revenue Operating Expense: Gasoline Expense Net Income $ 750 50 700

Investments by and payments to the owners are not included on the Income Statement.
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Learning Objective
To explain how the statement of cash flows presents the change in cash for a period of time in terms of the companys operating, investing, and financing activities.

LO6
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JJ's Lawn Care Service Statement of Cash Flows For the Month Ended May 31, 2007 Cash flows from operating activities: Cash received from revenue transactions $ 750 Cash paid for expenses (50) Net cash provided by operating activities $ 700 Cash flows from investing activities: Purchase of lawn mower $ (2,500) Purchase of truck (2,000) Collection for sale of repair parts 75 Payment for repair parts (150) Net cash used by investing activities (4,575) Cash flows from financing activities: Investment by owners 8,000 Increase in cash for month $ 4,125 Cash balance, May 1, 2007 Cash balance, May 31, 2007 $ 4,125
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JJ's Lawn Care Service Statement of Cash Flows For the Month Ended May 31, 2007 Cash flows from operating activities: Cash received from revenue transactions $ 750 Cash paid for expenses (50) Net cash provided by operating activities $ 700 Cash flows from investing activities: Operating activities include cash Purchase of lawn mower $ the (2,500) Purchase of truckof revenue and expense (2,000) effects Collection for sale of repair parts 75 transactions. Payment for repair parts (150) Net cash used by investing activities (4,575) Cash flows from financing activities: Investment by owners 8,000 Increase in cash for month $ 4,125 Cash balance, May 1, 2007 Cash balance, May 31, 2007 $ 4,125
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JJ's Lawn Care Service Statement of Cash Flows For the Month Ended May 31, 2007 Cash flows from operating activities: Cash received from revenue transactions $ 750 Cash paid for expenses (50) Net cash provided by operating activities $ 700 Cash flows from investing activities: Purchase of lawn mower $ (2,500) Purchase of truck (2,000) Collection for sale of repair parts 75 Payment for repair parts (150) Net cash used by investing activities (4,575) Cash flows from financing activities: Investing activities include the cash Investment by owners 8,000 Increase in cash for $ 4,125 effects ofmonth purchasing and selling Cash balance, May 1, 2007 assets. Cash balance, May 31, 2007 $ 4,125
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JJ's Lawn Care Service Statement of Cash Flows For the Month Ended May 31, 2007 Cash flows from operating activities: Cash received from revenue transactions $ 750 Cash paid for expenses (50) Net cash provided by operating activities $ 700 Cash flows from investing activities: Purchase of lawn mower $ (2,500) Financing cash Purchase of truck activities include the (2,000) Collection of repair parts with the owners 75 effects for ofsale transactions Payment for repair parts (150) and creditors. Net cash used by investing activities (4,575) Cash flows from financing activities: Investment by owners 8,000 Increase in cash for month $ 4,125 Cash balance, May 1, 2007 Cash balance, May 31, 2007 $ 4,125
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Now, lets prepare the Balance Sheet for JJs Lawn for May 31, 2007. Assets Care Service = Liabilities + Owners' Equity
May 1 Balances May 2 Balances May 8 Balances May 11 Balances May 18 Balances May 25 Balances May 28 Balances May 29 Balances May 31 Balances Cash $ 8,000 $ 8,000 (2,500) $ 5,500 (2,000) $ 3,500 $ 3,500 $ 3,500 75 $ 3,575 (150) $ 3,425 750 $ 4,175 (50) $ 4,125 $ 150 $ 150 (75) $ 75 $ 75 $ 75 $ 75 Accts. Tools & + Rec. + Equip. + Truck Notes Accts. Capital Retained = Payable + Pay. + Stock + Earnings $ 8,000 $ 8,000 $ 8,000 $ 15,000 $ 15,000 $ 15,000 $ 13,000 $ 13,000 $ 13,000 $ 300 $ 300 $ 8,000 $ 8,000 $ 8,000 $ 8,000 $ 8,000 $ 8,000 $ 8,000 $ $ 750 750 (50) 700

$ 2,500 $ 2,500 $ 2,500 300 $ 2,800 (150) $ 2,650

$ 15,000 $ 13,000 will $ 300 These balances on the $ 300 $ 2,650 appear $ 15,000 $ 13,000 (150) Balance Sheet. $ 2,650 $ 15,000 $ 13,000 $ 150 $ 2,650 $ 2,650 $ 15,000 $ 15,000 $ 13,000 $ 13,000 $ 150 $ 150

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JJ's Lawn Care Service Balance Sheet May 31, 2007 Assets Cash Accounts receivable Tools & equipment Truck Total assets $ 4,125 75 2,650 15,000 21,850 Liabilities Notes payable $ Accounts payable Owners' Equity Capital stock Retained earnings Total liabilities & equity $ 13,000 150 8,000 700 21,850

Assets = Liabilities + Owners Equity $21,850 =

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$13,150

$8,700
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Learning Objective
To explain the important relationships among the statement of financial position, income statement, and statement of cash flows, and how these statements relate to each other.

LO7
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Relationships Among Financial Statements

Date at beginning of period Balance Sheet

Time

Date at end of period Balance Sheet

Income Statement Statement of Cash Flows

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Financial Statement Articulation

JJ's Lawn Care Service Statement of Cash Flows For the Month Ended May 31, 2007 Cash flows from operating activities: Cash received from revenue transactions $ 750 Cash paid for expenses (50) Net cash provided by operating activities $ Cash flows from investing activities: Purchase of lawn mower $ (2,500) Purchase of truck (2,000) Collection for sale of repair parts 75 Payment for repair parts (150) Net cash used by investing activities Cash flows from financing activities: Investment by owners Increase in cash for month $ Cash balance, May 1, 2007 Cash balance, May 31, 2007 $

JJ's Lawn Care Service Income Statement For the Month Ended May 31, 2007
700

Sales Revenue Operating Expense: Gasoline Expense Net Income

750 50 700

(4,575) 8,000 4,125 4,125

JJ's Lawn Care Service Balance Sheet May 31, 2007 Assets Cash $ Accounts receivable Tools & equipment Truck Total assets $ Liabilities 4,125 Notes payable $ 75 Accounts payable 2,650 Owners' Equity 15,000 Capital stock Retained earnings 21,850 Total liabilities & equity $ 13,000 150 8,000 700 21,850

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Financial Reporting and Financial Statements

Financial statements are just one source of financial accounting information.
Balance Sheet Statement of Cash Flows

Income Statement

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Learning Objective
To explain common forms of business ownershipsole proprietorship, partnership, and corporationand demonstrate how they differ in terms of their presentation in the statement of financial position.

LO8
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Forms of Business Organization

Sole Proprietorships

Partnerships

Corporations

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Reporting Ownership Equity in the Statement of Financial Position

Sole Proprietorships

Owner's equity: Jill Jones, capital $ 8,000

Partnerships

Partners' equity Jill Jones, capital $ 4,000 Bill Jones, capital 4,000 Total partners' equity

$ 8,000

Corporations
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Owners' equity Capital stock $ 7,000 Retained earnings 1,000 Total stockholders' equity $ 8,000
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The Use of Financial Statements by External Parties

Two concerns:
Creditors

Liquidity
Profitability

Investors
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The Need for Adequate Disclosure

Balance Sheet
Income Statement
Statement of Cash Flows

Notes to the financial statements often provide facts necessary for the proper interpretation of the statements.
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Learning Objective
To discuss the importance of financial statements to a company and its investors and creditors and why management may take steps to improve the appearance of the company in its financial statements.

LO9
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Managements Interest in Financial Statements

Creditors are more likely to extend credit if financial statements show a strong statement of financial positionthat 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 it financial statements.
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End of Chapter 2

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