© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 2-1 BASIC FINANCIAL STATEMENTS Chapter 2

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 2-2 Learning Objective LO1 To explain the nature and general purpose of financial statements.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 2-3 Income Statement Balance Sheet Statement of Cash Flows Introduction to Financial Statements Three primary financial statements. We will use a corporation to describe these statements.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 2-4 Introduction to Financial Statements Describes where the enterprise stands at a specific date. Income Statement Balance Sheet Statement of Cash Flows

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 2-5 Introduction to Financial Statements Depicts the revenue and expenses for a designated period of time. Income Statement Balance Sheet Statement of Cash Flows

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 2-6 Introduction to Financial Statements Revenues result in positive cash flow. Expenses result in negative cash flow. Either in the past, present, or future.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 2-7 Introduction to Financial Statements Net income (or net loss) is simply the difference between revenues and expenses. Income Statement Balance Sheet Statement of Cash Flows

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 2-8 Introduction to Financial Statements Depicts the ways cash has changed during a designated period of time. Income Statement Balance Sheet Statement of Cash Flows

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 2-9 A Starting Point: Statement of Financial Position

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 2-10 Learning Objective LO2 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.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 2-11 The Concept of the Business Entity Vagabond Travel Agency A business entity is separate from the personal affairs of its owner.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 2-12 Assets Assets are economic resources that are owned by the business and are expected to benefit future operations.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 2-13 Assets Cost Principle Going-ConcernAssumptionGoing-ConcernAssumption ObjectivityPrincipleObjectivityPrinciple Stable-DollarAssumptionStable-DollarAssumption These accounting principles support cost as the basis for asset valuation.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 2-14 Liabilities Liabilities are debts that represent negative future cash flows for the enterprise.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 2-15 Owners’ Equity Owners’ equity represents the owners’ claims on the assets of the business.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 2-16 Owners’ Equity Changes in Owners’ Equity Owners’ Investments Business Earnings Payments to Owners Business Losses

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 2-17 Learning Objective LO3 To demonstrate how certain business transactions affect the elements of the accounting equation: Assets = Liabilities + Owners’ Equity.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 2-18 The Accounting Equation Assets = Liabilities + Owners’ Equity $300,000 = $80,000 + $220,000 Assets = Liabilities + Owners’ Equity $300,000 = $80,000 + $220,000

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 2-19 Let’s analyze some transactions for JJ’s Lawn Care Service.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 2-20 On May 1, Jill Jones and her family invested $8,000 in JJ’s Lawn Care Service and received 800 shares of stock.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 2-21 On May 2, JJ’s purchased a riding lawn mower for $2,500 cash.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 2-22 On May 8, JJ’s purchased a $15,000 truck. JJ’s paid $2,000 down in cash and issued a note payable for the remaining $13,000.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 2-23 On May 11, JJ’s purchased some repair parts for $300 on account.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 2-24 Jill realized she had purchased more repair parts than needed. On May 18, JJ’s was able to sell half of the repair parts to ABC Lawns for $150, a price equal to JJ’s cost. JJ’s will receive the cash within 30 days.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 2-25 On May 25, ABC Lawns pays JJ’s $75 as a partial settlement of its accounts receivable.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 2-26 On May 28, JJ’s pays $150 of its accounts payable.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 2-27 On May 29, JJ’s recorded lawn care services provided during May of $750. All clients were paid in cash.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 2-28 Learning Objective LO4 To explain how the statement of financial position, often referred to as the balance sheet, is an expansion of the basic accounting equation.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 2-29 Now, let’s review how JJ’s transactions affected the accounting equation. On May 31, JJ’s purchased gasoline for the lawn mower and the truck for $50 cash.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 2-30

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 2-31 These transactions impact the Statement of Cash Flows. These transactions impact the Income Statement. Let’s prepare the Income Statement and Statement of Cash Flows for JJ’s Lawn Care Service for the month ending May 31, 2007.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 2-32 Learning Objective LO5 To explain how the income statement reports an enterprise’s financial performance for a period of time in terms of the relationship of revenues and expenses.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 2-33 Investments by and payments to the owners are not included on the Income Statement.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 2-34 Learning Objective LO6 To explain how the statement of cash flows presents the change in cash for a period of time in terms of the company’s operating, investing, and financing activities.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 2-35

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 2-36 Operating activities include the cash effects of revenue and expense transactions.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 2-37 Investing activities include the cash effects of purchasing and selling assets.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 2-38 Financing activities include the cash effects of transactions with the owners and creditors.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 2-39 Now, let’s prepare the Balance Sheet for JJ’s Lawn Care Service for May 31, These balances will appear on the Balance Sheet.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 2-40 Assets = Liabilities + Owners’ Equity $21,850 = $13,150 + $8,700 Assets = Liabilities + Owners’ Equity $21,850 = $13,150 + $8,700

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 2-41 Learning Objective LO7 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.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 2-42 Relationships Among Financial Statements Date at beginning of period Date at end of period Balance Sheet Time Income Statement Statement of Cash Flows

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 2-43 Financial Statement Articulation

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 2-44 Statement of Cash Flows Balance Sheet Income Statement Other Information: Industry Competitors National economy Financial Reporting and Financial Statements Financial statements are just one source of financial accounting information.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 2-45 Learning Objective LO8 To explain common forms of business ownership—sole proprietorship, partnership, and corporation—and demonstrate how they differ in terms of their presentation in the statement of financial position.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 2-46 Forms of Business Organization Sole Proprietorships Partnerships Corporations

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 2-47 Reporting Ownership Equity in the Statement of Financial Position Sole Proprietorships Partnerships Corporations

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 2-48 The Use of Financial Statements by External Parties Creditors Investors Two concerns: Liquidity Profitability Two concerns: Liquidity Profitability

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 2-49 The Need for Adequate Disclosure Notes to the financial statements often provide facts necessary for the proper interpretation of the statements. Income Statement Balance Sheet Statement of Cash Flows

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 2-50 Learning Objective LO9 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.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 2-51 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 it financial statements.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 2-52 End of Chapter 2