Financial Statements and Accounting Concepts/Principles CHAPTER 2 Financial Statements and Accounting Concepts/Principles Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola

Overview Accounting transactions Financial statements The accounting equation Time line for financial statements Generally accepted concepts and principles Limitations of financial statements Company annual report Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola

Accounting Transactions Transactions are economic exchanges between entities that are accounted for and reflected in financial statements. Trans + action = between parties Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola

Financial Statements Transactions FINANCIAL STATEMENTS Procedures for sorting, classifying, and presenting (bookkeeping). Selection of alternative methods of reflecting the effects of certain transactions (accounting). FINANCIAL STATEMENTS Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola

Financial Statements ACCOUNTS Transactions are summarised in accounts. Accounts are further summarised in the financial statements. Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola

Financial Statements Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola

Balance Sheet It is a snapshot of its financial position. The balance sheet lists an organization's ASSETS, LIABILITIES and OWNERS’ EQUITY at a point in time. It is a snapshot of its financial position. It used to be called the STATEMENT OF FINANCIAL POSITION. Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola

Balance Sheet Two sections shown side by side, with total of each side the same. A= L + OE Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola

Two sections shown side by side, with total of each side the same. Balance Sheet Two sections shown side by side, with total of each side the same. Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola

Assets represent the amount of resources owned by the entity. Balance Sheet Assets represent the amount of resources owned by the entity. Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola

Liabilities are amounts owed to other entities. Balance Sheet Liabilities are amounts owed to other entities. Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola

Balance Sheet Equity is the right of the owner(s) of the entity in the assets that remain after deducting the liabilities (known as net assets) or residual amount. Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola

Balance Sheet Current assets are those assets that are likely to be converted into cash or used to benefit the entity within one year. Current liabilities are those liabilities that are likely to be paid with cash within one year of the balance sheet date. Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola

Balance Sheet Explanation of balance sheet accounts: Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola

Balance Sheet Explanation of balance sheet accounts: Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola

The Accounting Equation = L + OE Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola

The Accounting Equation = L + OE Sometimes re-arranged as: OE = A - L NET ASSETS Consistent with everyday meaning of EQUITY as residual interest Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola

Income Statement It is sometimes called: The income statement shows the profit or loss for the period of time under consideration. It is sometimes called: Statement of financial performance Statement of earnings Profit and loss statement Statement of operations Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola

Income Statement Revenues result from the entity’s operating activities (e.g. selling inventory). Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola 3

Income Statement Costs and expenses are incurred in generating revenues and operating the entity. Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola 3

Income Statement Explanation of income statement accounts: 3 Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola 3

Income Statement Explanation of income statement accounts: 3 Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola 3

ROA and ROE ratios A ratio is a relationship. The Return on Assets (ROA) measures the return on investment on assets that management had available during the year = Operating Profit Average Assets Return on Equity (ROE) measures the net return the owners receive on their ownership in the company. = Profit - interest and tax Average Owners’ Equity Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola

Statement of Changes in Owners’ Equity This financial statement shows the detail of owners’ equity and explains the changes that occurred in the components of owners’ equity during the year. It is sometimes called: Statement of changes in share capital Statement of changes in retained earnings Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola

Statement of Changes in Owners’ Equity Total amount invested by the owners Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola 6

Statement of Changes in Owners’ Equity Link between the balance sheet and the income statement Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola 6

Statement of Changes in Owners’ Equity Explanation of accounts: Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola 6

Statement of Cash Flows The purpose of this financial statement is to identify the sources and uses of cash during the year. This is done by reporting the changes in all other balance sheet items. Cash flow data is important as it is highly reliable and is less subject to manipulation than accrual accounting. Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola

Statement of Cash Flows Cash consequences of the income statement Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola 6

Statement of Cash Flows Cash used to purchase, or cash received from sale of, long term assets. Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola 6

Statement of Cash Flows Amounts raised from issue of long-term borrowings or shares, or dividends paid Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola 6

Statement of Cash Flows Explanation of headings: Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola 6

Income Statement for the Year Statement of Changes in Owners’ Equity Time-line Model Financial Year 2007 1/7/06 30/6/07 Balance Sheet Balance Sheet A = L + OE A = L + OE Income Statement for the Year Statement of Changes in Owners’ Equity Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola 6

Time-line Model Financial Year 2007 1/7/06 30/6/07 Balance Sheet A = L + OE A = L + OE Cash Flow Statement Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola 6

Financial Statement Relationships Horizontal Model The arrow indicates that net profit affects retained earnings, which is a component of owners’ equity. The key to using this model is to keep the balance sheet in balance. Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola 6

Concepts/Principles Related to entire model Related to transactions Broad concepts and principles (practices) that have been generally agreed upon over time Related to the accounting process Related to financial statements Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola

Concepts/Principles Related to entire model Accounting Entity; Every economic entity can be separately identified and accounted for. Not the same as legal entity. Going Concern Concept; The presumption that the entity will continue to operate in the future—it is not being liquidated. Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola

Concepts/Principles Related to transactions Unit of Measurement; Only transactions denominated in $A dollars are recorded in the accounting records. Objectivity; The accountant’s desire to have a given transaction recorded in the same way in all situations. Cost Principle; Transactions are recorded at their original cost to the entity as measured in dollars. Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola

Concepts/Principles Related to the accounting process Matching Concept; All expenses incurred to generate that period’s revenues be deducted from revenues earned. Accounting Period; The period of time selected for reporting results of operations and changes in financial position. Accrual Accounting; Recognise revenue at the point of sale and recognise expenses when incurred, even though the cash receipt or payment occurs at another time. Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola

Concepts/Principles Related to financial statements Relevance; Financial information should assist users to make informed decisions. Comparability; Consistent use of accounting treatments, with changes and effects of changes disclosed Materiality; The increased benefit of increased accuracy should out weigh the cost of achieving the increased accuracy. Full Disclosure; Circumstances and events that make a difference to financial statement users should be disclosed. Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola

Concepts/Principles Related to financial statements Understandability; Information must be presented in such a way that it is comprehensible to users Prudence; Conservatism should guide accounting choices and judgments. Timeliness; Information should be provided within the decision time frame to assist in economic decision making. Reliability; Financial information should be free from error or bias. Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola

Limitations of Financial Statements Financial statements report only quantitative economic data. They do not reflect qualitative economic variables, such as the value of the management team or the employee morale. Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola

Limitations of Financial Statements The balance sheet does not generally report market values or the replacement costs of the assets. Many estimates are used, such as warranty costs, depreciation and doubtful debts expense. Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola

Limitations of Financial Statements Financial statements are not adjusted to show the impact of inflation. Financial statements do not reflect opportunity cost, i.e. income foregone when an income earning opportunity is foregone. Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola

The Company’s Annual Report The annual report is distributed to shareholders (and others). It contains the financial statements and notes, together with the report of the external auditor’s examination of the financial statements. It may also contain highlights for the year, including net revenue, earnings per share and return on average shareholders equity, as well as an historical summary of some financial data for the last five years. Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola