1. © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Accounting: What The Numbers Mean
Tenth Edition
Marshall, McManus, and Viele

2. Financial Statements and Accounting Concepts/Principles
Chapter 2
Financial Statements and Accounting Concepts/Principles
Chapter 2: Financial Statements and Accounting Concepts/Principles
PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA

3. Financial Statements Transactions Procedures for sorting, classifying,
LO 1
Transactions
Procedures for sorting, classifying,
and presenting (bookkeeping)
Selection of alternative methods of
reflecting the effects of certain
transactions (accounting)
Financial Statements
Recording transactions, the economic interchanges between an entity and other organizations and/or individuals, requires both bookkeeping and accounting functions. The flow begins with the bookkeeping function, procedures for sorting, classifying, and presenting the transactions, and continues with an accounting function of selecting among alternative methods of reflecting the effects of those transactions. The entity's financial statements are the end product of these processes.
An entity’s financial statements are the end product of a process that starts with transactions between the entity and other organizations and individuals.
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4. Accounts Transactions are summarized in accounts.
LO 1
Transactions are summarized in accounts.
Cash
Accounts are used to organize like-kind transactions.
Accounts Receivable
Transactions are summarized in accounts.
Accounts are used to organize like-kind transactions, just like file folders are used to organize information stored in a file cabinet.
Account balances are then used in the preparation of financial statements.
Accounts Payable
Account balances are then used in the preparation of financial statements.
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5. Financial Statements
LO 2
Learning Objective 2: Identify and explain the kind of information reported in each financial statement and describe how financial statements are related to each other.
The four financial statements include: 1) the balance sheet that presents the financial position of an entity at the end of an accounting period; 2) the income statement that reports the earnings of an entity for the accounting period; 3) the statement of cash flows that shows the cash inflows and outflows during the period; and 4) the statement of changes in stockholders' equity that reports the investments and distributions to owners during the period. These financial statements are contained in an annual report that will probably include several notes or explanations of the accounting policies used and detailed information about the amounts and captions shown in the financial statements.
In addition to the financial statements, the annual report will probably include several accompanying notes or explanations of the accounting policies used and detailed information about many of the amounts and captions shown in the financial statements.
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6. Balance Sheet—Elements
LO 3
Assets represent the amount of resources owned by the entity.
Liabilities are amounts owed to other entities.
Equity is the ownership right of the owner(s) of the entity in the assets that remain after deducting the liabilities.
Learning Objective 3: Explain the meaning and usefulness of the accounting equation.
The balance sheet is a listing of an organization's assets, liabilities, and equity at a point in time. Assets represent the amount of resources owned by an entity, the probable future economic benefits obtained or controlled by the entity as a result of past transactions or events. Liabilities are those amounts owed to other entities, the probable future sacrifices of the entity's economic benefits arising from present obligations to transfer assets or provide services to other entities in the future as a result of past transactions or events. Stockholders' equity is the stockholders' ownership in the assets of an entity that remain after deducting the liabilities. Stockholders' equity is often referred to as net assets. Assets minus liabilities equal stockholders' equity.
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7. = + Balance Sheet Liabilities Equity Assets LO 3
Assets = Liabilities + Stockholders' Equity. The balance sheet equation must balance. Total assets include current and long-lived assets. Total liabilities include both current and long-term liabilities. Total liabilities combined with stockholders' equity must equal total assets.
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8. Balance Sheet
LO 4
Current assets are those assets that are likely to be converted into cash or used to benefit the entity within one year.
Plant and equipment includes long-term assets that will benefit the entity over several years.
Learning Objective 4: Explain the meaning of each of the captions on the financial statements illustrated in this chapter.
Current assets are those assets that are likely to be converted into cash or used to benefit the entity within one year. Current assets include cash, accounts receivable, and merchandise inventory.
Plant and equipment includes long-term assets that will benefit the entity over several years. Accumulated depreciation represents the portion of the cost of the equipment that is estimated to have been used up in the process of operating the business. Depreciation in accounting is the process of spreading the cost of an asset over its useful life to the entity—it is not an attempt to recognize the economic loss in value of an asset because of its age or use.
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9. Balance Sheet
LO 4
Long-term liabilities are those liabilities that will not be repaid within one year of the balance sheet date.
Current liabilities are those
liabilities that are to be paid within one year.
Current liabilities represent amounts borrowed that will be repaid within one year of the balance sheet date. Current liabilities include short-term debt, accounts payable, and other accrued liabilities.
Long-term liabilities are those liabilities that will not be repaid within one year of the balance sheet date.
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10. are incurred in generating revenues and operating the entity.
Income Statement
LO 4
The income statement shows the profit (or loss) for the period of time under consideration.
Revenues result from the entity’s operating activities (e.g., selling merchandise).
Costs and expenses
are incurred in generating revenues and operating the entity.
The income statement shows the profit for the period of time under consideration. The income statement may be called the statement of earnings, profit and loss statement, or statement of operations. The income statement reports the revenues that result from the entity's operating activities and deducts the costs and expenses incurred in generating the revenues to arrive at net income, which represents the profit or loss for the period. The income statement also reports the earnings per share of common stock - net income divided by the average number of the company's shares of common stock outstanding.
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11. Income Statement
LO 4
The income statement shows the profit (or loss) for the period of time under consideration.
Gains and losses are also reported on the income statement and result from non-operating activities, rather than from the day-to-day operating activities that generate revenues and expenses.
The income statement also reports gains and losses for the period under consideration. Gains and losses result from the non-operating activities of the entity rather than the day-to-day operating activities that generate revenues and expenses.
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12. Statement of Changes in Stockholders' Equity
LO 4
The statement of changes in stockholders' equity reports the details of stockholders' equity and explains the changes that occurred in paid-in capital and retained earnings during the year. Paid-in capital includes common stock at par value and additional paid-in capital. Retained earnings include the net income or loss reported by the entity since its inception less any dividends that have been distributed to owners. This statement provides the details of the balances reported in the stockholders' equity section of the balance sheet.
This financial statement shows the detail of stockholders' equity and explains the changes that occurred in the components of stockholders' equity during the year.
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13. Statement of Cash Flows
The purpose of this financial statement is to identify the sources and uses of cash during the year.
The statement of cash flows details the inflows and outflows of cash during a period of time, which is typically one year. The inflows and outflows of cash are separated into three distinct categories: 1) operating activities; 2) investing activities; and 3) financing activities.
Cash flows from operating activities consist of inflows and outflows of cash required to operate the business on a day-to-day basis. Inflows result from selling products or services. Outflows result from paying expenses required to generate revenue such as wages, rent, utilities, etc.
Cash flows from investing activities result from the organization using cash to purchase long-term assets such as equipment, building factories, or purchasing land. The long- term assets are acquired with the intention of increasing revenue. Inflows typically result from the sale of long-term operational assets.
Cash flows from financing activities typically include the borrowing or repayment of monies. Cash inflows from financing activities may come from investments from stockholders or the borrowing of funds from bondholders or a financial institution such as a bank. Outflows from financing activities may result from the repayment of previously borrowed funds or the payment of cash dividends.
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14. Time-Line Model
LO 4
The beginning balance sheet reports the assets, liabilities, and stockholders' equity account balances as the accounting period begins. The income statement reports the revenue earned and expenses incurred during the year. The net income is calculated and reported in the changes in stockholders' equity and the net income is added to the beginning balance in retained earnings. Dividends are deducted at this time as well. The ending balance in stockholders' equity is reported on the end-of-year balance sheet. In addition, the statement of cash flows shows the increase or decrease in the cash account, which is combined with the beginning balance, then the calculated balance is reported in the asset account, cash, in the ending balance sheet.
Earning revenue always increases Stockholders' Equity.
Incurring expenses will always decrease Stockholders' Equity. Expenses are necessary in order to generate revenue.
Dividends will also decrease Stockholders' Equity, however, they are never treated as an expense. Expenses are defined as costs associated with generating revenue.
Dividends are never considered an expense because they reflect a distribution of profits from the organization to the investors. The payment of dividends to investors has no correlation to the generation of revenue. This is a golden rule of accounting discussed in the conceptual framework that should never be ignored.
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15. Financial Statement Relationships
LO 4
This exhibit illustrates the financial statement relationships. Take a few minutes to review these relationships. As you study this, note that net income for the year was an increase in retained earnings and is one of the reasons retained earnings changed during the year.
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16. Balance Sheet
LO 4
The balance sheet presents the balances in an entity's accounts at a given point in time. The current asset accounts on the balance sheet include cash, accounts receivable, and merchandise inventory. Non-current asset accounts on the balance sheet include equipment and the contra-account to equipment, accumulated depreciation. The liabilities on the balance sheet include current and long-term liabilities. The current liabilities on a balance sheet include short-term debt, accounts payable, and other accrued liabilities; long-term liabilities include long-term debt. Stockholders' equity accounts on the balance sheet report the residual claims of the owners to the assets, which is also represented as assets minus liabilities.
The balance sheet is one of the four reports that are typically generated by an accounting information system. The balance sheet reports the ending balances of all assets, liabilities, and stockholders' equity at a specific point in time. At a minimum, an organization will produce a balance sheet at the end of its accounting year. However, some organizations will report these results at other intervals throughout the year - typically quarterly. Internally, an organization may decide to produce this report monthly depending on its information requirements.
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17. Income Statement
LO 4
The income statement captions include net sales (sales minus returns), cost of goods sold (the cost of merchandise removed from inventory and sold to customers), and gross profit (net sales minus cost of goods sold). Selling, general, and administrative expenses (also known as operating expenses) are deducted from gross profit to arrive at income from operations (an important measure of the firm's activities). Interest expense (the cost of borrowing funds) and income tax expense (which is calculated after all other items have been reported) are deducted from income from operations to arrive at net income. Net income per share of common stock outstanding (which is net income earned divided by the average number of shares of the entity's common stock outstanding) is often referred to as earnings per share or EPS.
The income statement captures revenue and related expenses in generating revenue. It typically measures profit or loss over a period of time not to exceed one year. Some organizations will generate this statement monthly or quarterly to assess how the organization is performing and/or meeting its objectives.
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18. Statement of Changes in Stockholders' Equity
LO 4
The statement of changes in stockholders' equity reports paid-in capital, the total amount stockholdrs have invested in the entity, which includes common stock, the number of shares of authorized, issued, and outstanding (outstanding means the shares still held by the stockholders). The retained earnings account reports the cumulative net income of the entity that has been retained for use in the business minus the dividends, which are distributions of earnings to stockholders. This statement reflects the changes that have occurred over a period of time with stockholders' equity. Each shareholder is considered an “owner” of the organization and therefore has the most interest in this financial statement.
The statement of changes in stockholders' equity is considered a supplemental statement to the balance sheet. The balance sheet reports the equity section at a “point in time,” while the statement of changes in stockholders' equity details the changes that occurred throughout the accounting period affecting this portion of the balance sheet.
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19. Statement of Cash Flows
The statement of cash flows includes three captions (referred to as activities). The first caption, cash flows from operating activities, begins with net income from the income statement, then 1) adds back depreciation expense because it is subtracted to arrive at net income but does not require the use of cash, 2) deducts an increase in accounts receivable because it reflects sales revenues that are included in net income but not yet received in cash, 3) deducts an increase in merchandise inventory because cash was spent to acquire the increase in inventory, and 4) adds an increase in current liabilities because cash has not yet been paid for the products and services that have been received during the current fiscal period. The caption, cash flows from investing activities, shows the cash sources and uses related to long-lived assets. The caption, cash flows from financing activities, shows the cash sources and uses related to transactions with creditors and stockholders.
The statement of cash flows is another supplementary statement. As an asset, the ending cash balance is reported on the balance sheet. This statement recaps the sources of cash and how cash was used throughout a period of time - typically one year. One key number to watch on this statement is whether the cash flows from operating activities are generating positive or negative results. Over time an organization should have a positive cash inflow from operating activities. If an organization consistently generates a negative cash inflow from operating activities, it is an indicator of trouble. Cash is mandatory to continue operations. When cash flow from operating activities is consistently negative, it translates to financing activities. Consistent borrowing to fund day-to-day operations will ultimately cause an organization to go bankrupt.
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20. Accounting Concepts and Principles
LO 5
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.
Unit of Measurement
Only transactions denominated in dollars (currency) are recorded in the accounting records.
Cost Principle
Transactions are recorded at their original cost to the entity as measured in dollars.
Learning Objective 5: Identify and explain the broad, generally accepted concepts and principles that apply to the accounting process.
Broad concepts and principles of accounting that have become generally accepted for financial accounting and reporting purposes include: 1) the accounting entity concept, a term that refers to an entity for which financial statements are prepared-every economic entity can be separately identified and accounted for; 2) going concern concept, a presumption that the entity will continue to operate in the future-it is not being liquidated; 3) unit of measurement principle, a requirement that only transactions denominated in dollars are recorded in the accounting records; and 4) the cost principle, which requires transactions to be recorded at their original cost to the entity as measured in dollars.
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21. Accounting Concepts and Principles
LO 5
Objectivity
The accountants’ desire to have a given transaction recorded in the same way in all situations.
Accounting Period
The period of time selected for reporting results of operations and changes in financial position.
Matching Concept
All expenses incurred to generate that period’s revenues be deducted from revenues earned.
Accrual Accounting
Recognize revenue at the point of sale and recognize expenses when incurred, even though the cash receipt or payment may occur at another time.
Other concepts and principles include: 1) objectivity, a concept that refers to the accountants' desire to have a given transaction recorded in the same way in all situations; 2) accounting period, a concept that relates to the period of time selected for reporting results of operations and changes in financial position; 3) matching concept, a concept that requires all expenses incurred to generate an accounting period's revenues be deducted from revenues earned in that accounting period; and 4) accrual accounting, a concept that recognizes revenue at the point of sale and recognizes expenses as they are incurred even though the cash receipt or payment may occur at another time or in another accounting period.
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22. Accounting Concepts and Principles
LO 5
Consistency
Provides meaningful trend comparisons over several years.
Full Disclosure
Circumstances and events that make a difference to financial statement users should be disclosed.
Materiality
The benefit of increased accuracy should outweigh the cost of achieving the increased accuracy.
Conservatism
When in doubt, make judgments and estimates that result in lower profits and asset valuations.
Other concepts and principles include: 1) consistency, which assures meaningful trend comparisons over several years. Consistency is the concept that makes it inappropriate to change from one generally accepted alternative method of accounting for a transaction to another method without explicitly describing the change in methods and its effect on the financial statements in the notes to the financial statements; 2) full disclosure, which requires that circumstances and events that make a difference to financial statement users should be disclosed; 3) materiality (cost-benefit relationship), which means that the benefit of increased accuracy should outweigh the cost of achieving the increased accuracy; and 4) conservatism, a principle that requires accountants, when in doubt, to make judgments and estimates that result in lower profits and asset valuations.
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23. Accrual Accounting Vs. Cash Flows
Revenue Recognition -Timing is the Key
Accrual accounting
recognizes:
Cash flow
recognizes:
Revenue
when revenue is earned,
at the point of sale of
services or products.
Revenue
when payment is received
for services rendered
or products sold.
Learning Objective 6: Describe why investors must carefully consider cash flow information in conjunction with accrual accounting results.
Differences between Accrual Accounting and Cash Flow – “The Matching Concept”
The rules of accrual accounting state:
Revenue is recognized at the point in time that a service or product is delivered to another entity. In other words, an “economic exchange” of value between two entities.
2) The exchange of cash is not required to recognize revenue. If the product or service has been delivered to the customer, revenue must be recognized.
3) Expenses are recognized at the point in time incurred. Cash does not need to be disbursed in order for an expense to be recognized. For example, your electric bill for the month of May is not received from the electric company until June and will be paid in June. The cost of the electricity for May is directly related to revenue for that month and needs to be reflected as an expense for the month of May.
4) The matching principle of accounting dictates that all expenses related to generating revenue for a given accounting period be matched to the same accounting period regardless of when cash changes hands.
Cash flow recognizes revenue when payment is received for services rendered or products sold and recognizes expenses when they are paid.
Expenses
when they are incurred.
Expenses
when they are paid.
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24. The Corporation’s Annual Report
LO 8
The annual report is distributed to shareholders (and others).
It contains the financial statements, together with the report of the external auditor’s examination of the financial statements.
It also contains Management’s Discussion and Analysis (MD&A).
Learning Objective 8: Describe what a corporation’s annual report is and why it is issued.
A corporation distributes an annual report to its shareholders. The annual report contains the financial statements, together with the report of the external auditor's examination of the financial statements. It also contains Management's Discussion and Analysis (MD&A).
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25. End of Chapter 2
End of Chapter 2.
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