CHAPTER 2 Financial Statements and Accounting Concepts/Principles

PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 2-2 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

PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 2-3 Accounting Transactions Transactions are economic interchanges between entities that are accounted for and reflected in financial statements. Borrow cash from the bank

PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 2-4 Financial Statements Transactions Procedures for sorting, classifying, and presenting (bookkeeping) Selection of alternative methods of reflecting the effects of certain transactions (accounting) FINANCIAL STATEMENTS

PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 2-5 Financial Statements Accounts are further summarised in the financial statements. Cash Accounts Receivable Accounts Payable Transactions are summarised in accounts. ACCOUNTS

PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 2-6 Financial Statements

PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 2-7 Balance Sheet The balance lists an organisations ASSETS, LIABILITIES and OWNERS’ EQUITY at a point in time. It is a snapshot of its financial position. It is sometimes called STATEMENT OF FINANCIAL POSITION.

PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 2-8 Balance Sheet Two sections shown side by side, with total of each side the same.

PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 2-9 Balance Sheet Assets represent the amount of resources owned by the entity.

PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 2-10 Balance Sheet Liabilities are amounts owed to other entities.

PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 2-11 Balance Sheet Equity is the ownership right of the owner(s) of the entity in the assets that remain after deducting the liabilities.

PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 2-12 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.

PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 2-13 Balance Sheet Explanation of balance sheet accounts:

PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 2-14 Balance Sheet Explanation of balance sheet accounts:

PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 2-15 The Accounting Equation A=L+OE ACCOUNTING EQUATION

PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 2-16 The Accounting Equation ACCOUNTING EQUATION A=L+OE Sometimes re-arranged as: OE=A-L Consistent with everyday meaning of EQUITY NET ASSETS

PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 2-17 Income Statement 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

PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 2-18 Income Statement Revenues result from the entity’s operating activities (e.g. selling inventory).

PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 2-19 Income Statement Costs and expenses are incurred in generating revenues and operating the entity.

PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 2-20 Income Statement Explanation of income statement accounts:

PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 2-21 Income Statement Explanation of income statement accounts:

PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 2-22 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

PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 2-23 Statement of Changes in Owners’ Equity Total amount invested by the owners

PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 2-24 Statement of Changes in Owners’ Equity Link between the balance sheet and the income statement

PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 2-25 Statement of Changes in Owners’ Equity Explanation of accounts:

PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 2-26 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.

PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 2-27 Statement of Cash Flows Cash consequences of the income statement

PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 2-28 Statement of Cash Flows Cash used to purchase, or cash received from sale of, long term assets.

PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 2-29 Statement of Cash Flows Amounts raised from issue of long-term borrowings or shares, or dividends paid

PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 2-30 Statement of Cash Flows Explanation of headings:

PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 2-31 Time-line Model Balance Sheet 1/7/05 Balance Sheet 30/6/06 Financial Year 2006 A = L + OE Income Statement for the Year Statement of Changes in Owners’ Equity

PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 2-32 Time-line Model Balance Sheet 1/7/05 Balance Sheet 30/6/06 Financial Year 2006 A = L + OE Cash Flow Statement

PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 2-33 Financial Statement Relationships The arrow indicates that net profit affects retained earnings, which is a component of owners’ equity. Horizontal model The key to using this model is to keep the balance sheet in balance.

PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 2-34 Concepts/Principles Broad concepts and principles that have been generally agreed upon over time Related to entire model Related to financial statements Related to transactions Related to the accounting process

PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 2-35 Concepts/Principles Accounting Entity Every economic entity can be separately identified and accounted for. Now Future Going Concern Concept The presumption that the entity will continue to operate in the future—it’s not being liquidated. Related to entire model

PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 2-36 Concepts/Principles Objectivity The accountant’s desire to have a given transaction recorded in the same way in all situations. Related to transactions Unit of Measurement Only transactions denominated in dollars are recorded in the accounting records. Cost Principle Transactions are recorded at their original cost to the entity as measured in dollars.

PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 2-37 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.

PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 2-38 Relevance Financial information should assist users to make informed decisions. Full Disclosure Circumstances and events that make a difference to financial statement users should be disclosed. Materiality The increased benefit of increased accuracy should out weigh the cost of achieving the increased accuracy. Concepts/Principles Comparability Consistent use of accounting treatments, with changes and effects of changes disclosed Related to financial statements

PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 2-39 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’s morale.

PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 2-40 Limitations of Financial Statements The balance sheet does not report market values or replacement cost of the assets. Many estimates are used, such as warranty costs, depreciation and doubtful debts expense.

PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 2-41 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.

PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 2-42 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.