CHAPTER 2

Financial Statements:
An Overview
 Primary Financial Statements

These financial statements

answer basic questions:
What is the company’s current
financial status?
What were the company’s
operating results for the
period?
How did the company obtain
and use cash during the
period?
 Learning Objective 1

Understand the
basic elements,
uses, and
limitations of the Balance
Balance Sheet
Sheet
 The Balance Sheet

Assets: cash, accounts Summary of the financial

receivable, inventory, position of a company at
land, buildings, a particular date.
equipment, and
intangible items. • What are the resources
Sometimes
Liabilities: accounts of the company?
referred to as a
payable, notes
Statement
and of
payable, • What are the company’s
Financial
mortgages payable. existing obligations?
Position
Owners’ Equity: net
assets after all • What are the company’s
obligations have been
satisfied. net assets?
 What Is the Accounting
Equation?

Assets = Liabilities + Owners’ Equity

Define double-entry
accounting
A system of recording
transactions in a way that
maintains the equality of the
accounting equation.
 Accounting Equation

Assets = Liabilities + Owners’ Equity

Resources Sources of Financing

Resources Creditors’ Owners’

to use to
= claims
+ claims
generate against against
revenues resources resources
 Sample Balance Sheet
Assets Liabilities
Cash $ 40 Accounts payable $ 50
Accounts receivable 100 Notes payable 150
Land 200 $200
Owners’ Equity
Total assets $340
Capital stock $100
Retained earnings 40
Must $140
Equal Total liabilities
and owners’ equity $340
 What Are Classified and
Comparative Balance Sheets?

They distinguish between

current and long-term assets.
current and long-term liabilities.
Listed in decreasing order of liquidity.
Comparative so financial statement users
can identify significant changes over
time. They present more than one year’s
Balance Sheet.
 Describe Three Balance Sheet
Limitations.

Assets recorded at historical

value.
Only recognizes assets that
can be expressed in
monetary terms.
Owners’ equity is usually less
than the company’s market
value.
 Learning Objective 2

Understand the
elements and
uses of the
Income
Statement
 The Income Statement

Shows the results of a

company’s operations
Revenues over a period of time.
Assets (cash or AR)
created through • What goods were sold or
Sometimes
business operations services performed that
referred to
Expenses provided revenue for the
company?
Assets (cash
as a or AP)
consumed through • What costs were incurred in
Statement
business of
operations normal operations to
Earnings generate these revenues?
Net Income or (Net Loss)
• What are the earnings or
Revenues - Expenses company profit?
 Sample Income Statement
The Example Company
Income Statement
For the years ended 2006 and 2005
2006 2005
Revenues:
Sales $100 $ 85
Other revenue 30 15
Total revenues $130 $100
Expenses:
Cost of goods sold $ 62 $ 58
Operating & admin. 16 12
Income tax 20 18
Total expenses $ 98 $ 88
Net Income $ 32 $ 12
 How Do You Calculate
Earnings Per Share?

Earnings per share (EPS):

Net Income (Net Loss)

# of Shares of Stock Outstanding

Tells the owner of a single share

of stock how much of the net
income for the year belongs to
him or her.
 Statement of Retained Earnings

Beginning retained earnings An additional

financial statement
+ Net income that identifies
– Dividends paid changes in retained
earnings from one
= Ending retained earnings accounting period to
the next.

Net income results in: Dividends result in:

Increase in net assets Decrease in net assets
Increase in retained earnings Decrease in retained earnings
Increase in owners’ equity Decrease in owners’ equity
 Learning Objective 3

Understand the
categories and
uses of the
Statement of
Cash Flows and
see how the
financial
statements tie
together.
 Statement of Cash Flows
Reports the amount of cash
Statement of Cash Flows collected and paid out by a
Cash inflows company in operating,
Sell goods or services. investing, and financing
activities.
Sell other assets or by
borrowing.
Receive cash from How did the company
investments by owners. receive cash?
Cash outflows
Pay operating expenses. How did the company
Expand operations, repay
loans.
use its cash?
Pay owners a return on
investment.
 Name The Primary Activities
On A Statement Of Cash
Flows?
Operating Activities: A company’s day-to-day activities.
Major operating cash inflow—cash receipts from
selling goods or from providing services.
Major operating cash outflow—payments to purchase
inventory and to pay operating expenses.
Investing Activities: Buying and selling long-term
assets.
Financing Activities: Cash is obtained from or repaid to
owners and creditors.
 Statement of Cash Flows
Operating Investing Financing
Activities Activities Activities

CASH
INFLOWS

CASH
OUTFLOWS

Operating Investing Financing

Activities Activities Activities
 Sample Statement of Cash
Flows
The Example Company
Statement of Cash Flows
December 31, 2006
Cash Flows From Operating Activities:
Receipts 48
Payments (43) 5

Cash Flows From Investing Activities:

Receipts 0
Payments (4) (4)

Cash Flows Used By Financing Activities:

Receipts 10
Payments (6) 4

Net Cash Flow 5

 Financial Statements Tying
Together Is Called?

Articulation--the
relationship between an
operating statement (the
income statement or the
statement of cash flows)
and comparative balance
sheets.
 Financial Statement Articulation
Cash Flow Statement
Cash--Op. Act. $ 973,000
Cash--Inv. Act. (1,188,000)
Cash--Fin. Act. 245,000
Net increase $ 30,000
Beg. cash 80,000
End. cash $ 110,000 Balance
Balance Sheet 12/31/02 Sheet 12/31/03
Income Statement
Cash $ 80,000 Cash $ 110,000
Other 4,550,000 Revenues $12,443,000 Other 4,975,000
Total $4,630,000 Expenses 11,578,400 Total $5,085,000
Net income $ 864,600
Liabilities $2,970,000 Liabilities $2,860,400
Stmt of Retained Earnings
Cap. stock 900,000 Cap. stock 1,000,000
R/E 760,000 R/E 12/31/02 $ 760,000 R/E 1,224,600
Total $4,630,000 Net income 864,600 Total $5,085,000
Dividends (400,000)
R/E 12/31/03 $1,224,600
 Learning Objective 4

Recognize the need for

financial statement
notes and identify the
types of information
included in the notes.
 Notes to the Financial
Statements
What are the four general types?
Summary of significant accounting policies:
assumptions, estimates, and judgments.
Additional information about the summary totals.
Disclosure of important information that is not
recognized in the financial statements.
Supplementary information required by
the MASB.
Notes are an acceptable way to convey
information to users when the information is
too uncertain or needs further explanation.
 Learning Objective 5

Describe the
purpose of an
audit report and
the incentives the
auditor has to
perform a good
audit.
 The Audit Report
CPA firms have economic incentives
to perform credible audits.
• Reputation
• Lawsuits

Owners and managers want the

most favorable results possible.
• Bank credit
• Bonuses
• Public stock price
 The Audit Report

• Issued by independent CPA firms.

• CPAs attest to conformity with GAAP.

• Financial
statements are the
responsibility of
the company’s
management and
not the CPA.
 Learning Objective 6

Explain the
fundamental
concepts and
assumptions that
underlie financial
accounting.
 Accounting Model

The basic accounting assumptions,

concepts, principles, and procedures that
determine the manner of recording,
measuring, and reporting a company’s
transactions.
 What Are The Fundamental
Concepts and Assumptions?

Separate Entity Concept

Arm’s-Length Transactions

Cost Principle

Monetary Measurement Concept

Going Concern Assumption

 Describe the Separate Entity
Concept.
Entity--The organizational unit for which
accounting records are maintained.
Separate entity concept--The activities of
an entity are to be separate from those of
its individual owners.
Proprietorship
Partnership
Corporation
What Is An Arm’s-Length
Transaction?
The exchange of
goods or
services between
independent and
rational parties,
each looking out
for their
company’s best
interests.
 What Is Meant By The Cost
Principle?

All transactions are recorded at

historical cost.

Historical cost is assumed to

represent the fair market value of
the item at the date of the
transaction because it reflects the
actual use of resources by
independent parties.
 What Is The Monetary
Measurement Concept?
Accountants measure only those economic
activities that can be measured in monetary
terms.
Listed values may not be the same as actual
market values:
Inflation.
Measurement issues.
 What Do We Mean By The Going
Concern Assumption?

An entity will
have a continuing
existence for the
foreseeable
future.