Review: ACCOUNTING AND BASIC FINANCIAL STATEMENTS

Review: ACCOUNTING AND BASIC FINANCIAL STATEMENTS
In chapter two we will discuss in detail the content and preparation of the three basic financial statements prepared by accountants. Professor Chris Wimmer – Feb 24, 2008 2

The accounting process The accounting process
Accounting “links” decision makers with economic activities ¾ and with the results of their decisions. Accounting “links” decision makers with economic activities ¾ and with the results of their decisions. Accounting information Accounting information Economic activities Economic activities Actions (decisions) Actions (decisions) Decision makers Decision makers

Financial Information Provided
Information System Information Users Investors Creditors Managers Owners Customers Employees Regulators SEC -IRS -EPA Financial Information Provided Profitability Financial position Cash flows Decisions Supported Performance evaluations Stock investments Tax strategies Labor relations Resource allocations Lending decisions Borrowing

Introduction to Financial Statements
Three primary financial statements. Income Statement Balance Sheet Statement of Cash Flows We will use a corporation to describe these statements. There are three fundamental financial statements used in accounting. The income statement shows our revenues and expenses. The balance sheet is a listing of all asset, liability, and equity account balances that do not appear on the income statement. The statement of cash flows shows where the company gets and spends its cash. In this chapter, we also will look at the financial statements of a corporation.

Income Statement Balance Sheet Statement of Cash Flows Describes where the enterprise stands at a specific date. The balance sheet describes the financial position of the company at a specific point in time. We may prepare a balance sheet monthly, quarterly, or annually depending on the needs of management and external users.

Income Statement Balance Sheet Statement of Cash Flows Depicts the revenue and expenses for a designated period of time. Net income is defined as the excess of revenues over expenses. Financial statements have a three-line title with the company name, the name of the statement, and the period covered by the report. The income statement lists revenues and expenses that were incurred over a period of time. Most companies prepare monthly income statements.

Revenues result in positive cash flow. Expenses result in negative cash flow. In the long-run, revenues will generate positive cash inflows to the company and expenses will result in negative cash flows to the company. Just remember, revenues and expenses that appear on the income statement may not always produce cash flows in the current accounting period. Either in the past, present, or future.

Income Statement Balance Sheet Statement of Cash Flows Net income (or net loss) is simply the difference between revenues and expenses. If expenses exceed revenues, we have a net loss rather than net income.

Income Statement Balance Sheet Statement of Cash Flows Depicts the ways cash has changed during a designated period of time. We will cover the statement of cash flows in detail in a later chapter. The statement of cash flows is divided into three major sections: (1) cash flows from operating activities; (2) cash flows from investing activities, and (3) cash flows from financing activities. The statement describes cash inflows and outflows over a period of time.

A Starting Point: Statement of Financial Position
The balance sheet is an inventory of assets, liabilities and equity at the end of the month. Our total assets are equal to three hundred thousand dollars. This includes cash of twenty-two thousand five hundred dollars, notes receivable of ten thousand dollars, supplies of two thousand dollars, and the balances in the remaining asset accounts. Liabilities include notes payable of forty-one thousand, accounts payable of thirty-six thousand and salaries payable of three thousand dollars. The accounts in the owners’ equity section of the balance sheet are capital stock of one hundred-fifty thousand dollars and retained earnings of seventy thousand dollars. Notice that the total assets are equal to the total liabilities plus owners’ equity.

The Concept of the Business Entity
A business entity is separate from the personal affairs of its owner. Vagabond Travel Agency The business entity principle tells us that we must separate the transactions of individual owners of a business from those of the business.

Assets Assets are economic resources that are owned by the business and are expected to provide positive future cash flows. Assets may be viewed as resources owned or controlled by an entity. They include such items as cash, accounts receivable (amounts owed to the company by customers), land, building and equipment, and supplies.

Liabilities Liabilities are debts that represent negative future cash flows for the enterprise. Liabilities represent the claims of creditors on the entity’s assets. Liabilities include accounts payable (amounts we owe to creditors for assets purchased on account), taxes payable, and wages payable (amounts we owe to our employees at the end of the accounting period).

Owners’ Equity Owners’ equity represents the owners’ claims to the assets of the business. The equities of an entity include investments by owners, withdrawals by those owners, and earnings retained by the business.

Changes in Owners’ Equity
Owners’ Investments Business Earnings Payments to Owners Business Losses Investments by owners and net income increase owners’ equity. Payments to owners and net losses decrease owners’ equity.

The Accounting Equation
Assets = Liabilities + Owners’ Equity $300,000 = $80, $220,000 The basic accounting equation states that assets are equal to liabilities plus equity of a company. The equation makes sense because in a general way it states that assets must be equal to the claims against those assets. There are two broad categories of claims against an asset. We may have claims by creditors, liabilities or, after all creditor claims are satisfied, the residual owners, stockholders, have a claim on those assets. 3

The Need for Financial Statements

Financial Disclosure Benefits
Enhances decision-making Reduces risk Reduces risk lowers cost

Three Primary Financial Statements
Balance Sheet Income Statement Statement of Cash Flows

The Balance Sheet

The Balance Sheet Three categories:
Presents the financial position of a company at a particular point in time. Three categories: Assets Liabilities Owners’ Equity

Assets Probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events. likely to occur

Assets Probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events. assets have implications for the future

Assets Probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events. substance rules over legal form

Assets Probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.

Liabilities Probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events. includes legal and implied commitments

Liabilities Probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events. the obligation can involve either type of future event

Liabilities Probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events. have already happened

Liabilities Probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.

Owners’ Equity The residual interest in the assets of an entity that remains after deducting liabilities Also known as net assets Creditors legally have first claim to assets The owners’ equity of a corporation is referred to as stockholders’ equity

Owners’ Equity Factors Impacting the Amount of Owners’ Equity
DECREASE Owners’ Equity INCREASE Owners’ Equity Owners Withdraw Assets Company Suffers a Loss Owners Invest Assets Company Generates a Profit

Owners’ Equity: Two Primary Components
Paid-in Capital The value of assets contributed by investors in exchange for shares of stock Retained Earnings The cumulative earnings of the company not paid to owners as dividends

The Balance Sheet Format
A classified balance sheet distinguishes between current and noncurrent categories for assets and liabilities Current assets are more liquid than other assets Current liabilities are repaid usually within one year

The Accounting Equation
The balance sheet is a detailed version of the accounting equation ASSETS = LIABILITIES + STOCKHOLDERS’ EQUITY

Balance Sheet Concepts and Conventions
The entity concept requires that the records of the business must be kept separate from the personal finances of the owner. Under the historical cost convention, assets and liabilities are recorded at their original costs and are not adjusted for changes in value.

Balance Sheet Concepts and Conventions
The going concern assumption presumes that the business will continue for the foreseeable future

The Income Statement

The Income Statement Reports Revenues Expenses Net Income
Describes a company’s financial performance for a specified period of time Reports Revenues Expenses Net Income

Elements of the Income Statement
Revenue is the amount of assets created through the performance of business operations Retailers generate revenue by selling goods Service businesses generate revenue by providing a valuable service

Expenses are the amount of assets consumed from the performance of business operations Gains and losses refer to money made or lost on activities outside the normal business operations Net income (loss) is the difference between revenues and expenses

Earnings per share represents how much income belongs to the owner of one share of stock

Income Statement Concepts and Conventions
Time Period The life of a business is divided into time periods to measure performance Revenue recognition occurs when The goods have been delivered or the service has been provided and Cash has been collected or collection is reasonably assured

The Statement of Cash Flows

Describes a company’s cash flows for a specified period of time

Classifies individual cash flows according to three main activities: Operating activities Investing activities Financing activities

Producing and Selling Goods and Services Day-to-Day Activities
Operating Activities Producing and Selling Goods and Services Day-to-Day Activities Inflows/Receipts: Selling products Providing services Outflows/Payments: Inventory Wages Utilities Rent Interest Taxes, etc.

Buying and Selling Long-Term Assets
Investing Activities Buying and Selling Long-Term Assets Inflows/Sale of: Land Buildings Equipment Stocks of other companies Outflows/Purchase of: Land Buildings Equipment Stocks of other companies

Cash to/from Creditors and Investors
Financing Activities Cash to/from Creditors and Investors Inflows/Receipts: Sell stock shares Loan proceeds Outflows/Payments: Repay loans Acquire treasury stock Pay cash dividends

Accounting Adjustments
Cash Flow Process Raw Cash Flow Data Accounting Adjustments Net Income Undo Accounting Adjustments Statement of Cash Flows

Notes to the Financial Statements

Four Types of Notes A summary of significant accounting policies
Additional information about the summary totals found in the statements Disclosure of important information not recognized in the statements Supplementary information required by the FASB or the SEC

The External Audit

The External Audit Provides an independent outside opinion from a CPA firm that The statements are prepared in accordance with GAAP The audit was conducted using generally accepted auditing standards Not a guarantee! The SEC requires all publicly traded companies to provide potential investors with audited financial statements

Other Concepts and Conventions

Relevance and reliability are the two primary qualities that make information useful Relevant information must be timely, useful for evaluating past decisions, and useful for evaluating future decisions Reliable information must be reliable, unbiased, and represent the economic conditions that it purports to represent

Comparability Information is more useful when it can be compared to that of other companies or to that of the same company over time Consistency Financial statements should be prepared using the same accounting methods consistently to be comparable

Conservatism When in doubt, recognize all losses but do not anticipate gains Materiality An item is material if misstatement of that item could impact a decision Materiality is largely a matter of professional judgement

Articulation The three primary financial statements are an integrated set of reports on a company’s financial health For example, net income (income statement) increases retained earnings (balance sheet) in order for net assets to equal stockholders’ equity

Articulation Accrual Adjustments $ $ Net Income - Dividends

In Summary ... Financial information reduces uncertainty for creditors and investors The balance sheet reports assets, liabilities, and equity The income statement reports revenues and expenses The statement of cash flows reports changes in cash Notes to financial statements provide important detail and supplemental explanations Audits do not provide guarantees

Let’s analyze some transactions for JJ’s Lawn Care Service.
Let’s look at how specific business transactions impact the basic financial statement we just discussed.

On May 1, 2005, Jill Jones and her family invested $8,000 in JJ’s Lawn Care Service and received 800 shares of stock. Part I On May first, Jill Jones and her family invested eight thousand dollars in JJ’s Lawn Care Service and received eight hundred shares of stock in return. Let’s see how the balance sheet would look immediately after this transaction. Part II You can see that the cash account of JJ’s Lawn Care increased by eight thousand dollars and the capital stock of the company also increased by eight thousand dollars. Notice that the basic accounting equation is in balance. Total assets are equal to total liabilities plus owners’ equity. 3

On May 2, JJ’s purchased a riding lawn mower for $2,500 cash.
Part I On the second of May, JJ’s Lawn Care purchased a riding lawn mower for twenty-five hundred dollars cash. Let’s see how the balance sheet looks now. Part II The cash account has been reduced by the twenty-five hundred dollars spent and the tools and equipment account has been increased by the same amount. We merely traded one asset, cash, for another, the riding lawn mower. Owner’s equity is not changed by the transaction and the basic accounting equation is still in balance. 3

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. Part I In our next transaction JJ’s Lawn Care purchases a truck for fifteen thousand dollars, paying two thousand dollars cash and signing a note payable for thirteen thousand dollars. Now, let’s update the balance sheet. Part II The cash account decreased by two thousand dollars and the truck account increased by fifteen thousand dollars. There was a net increase in the asset side of the equation of thirteen thousand dollars. The liability account, notes payable, increased by thirteen thousand dollars. Total assets are now equal to twenty-one thousand dollars. Total liabilities are equal to thirteen thousand dollars and owners’ equity is equal to eight thousand dollars. The accounting equation is still in balance. 3

On May 11, JJ’s purchased some repair parts for $300 on account.
Part I On May eleventh, JJ’s Lawn Care purchases repair parts for the riding lawn mower for three hundred dollars. The parts are purchased on account. JJ’s will pay the balance on the account at some point in the future. Let’s update the balance sheet. Part II The tools and equipment account increased by three hundred dollars and the liability account, accounts payable, increased by the same amount. Our balance sheet is getting progressively more complicated. 3

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. Part I On May eighteenth, JJ’s Lawn Care sells one-half of its repair parts at cost to ABC Lawns. ABC agrees to pay for the parts in thirty days. One-half of the cost of the parts is one hundred fifty dollars. Can you update the balance sheet? Try and do it before proceeding to the next slide. Part II The asset accounts, tools and equipment, decreased by one hundred fifty dollars and the asset account, accounts receivable, increased by the same amount. Once again, we have exchanged one asset, repair parts, for another asset, accounts receivable. How did you do with your update? 3

On May 25, ABC Lawns pays JJ’s $75 as a partial settlement of its accounts receivable.
On May twenty-fifth, ABC Lawns makes a partial payment on it account for seventy-five dollars cash. Let’s prepare the updated balance sheet on May twenty-fifth. Part II The cash account increases by seventy-five dollars and the accounts receivable decreases by the same amount. Notice that our total assets are still equal to total liabilities plus owners’ equity. 3

On May 28, JJ’s pays $150 of its accounts payable.
Part I On May twenty-eighth, JJ’s Lawn Care makes a partial payment on its accounts payable of one hundred fifty dollars. Its time to update the balance sheet. Part II The cash account decreases by one hundred-fifty dollars and accounts payable also decreases by one hundred fifty dollars. The total assets are now recorded at twenty-one thousand one hundred fifty dollars. Total liabilities plus owners’ equity is equal to the same amount. 3

On May 29, JJ’s recorded lawn care services provided during May of $750. All clients paid in cash.
Part I On May twenty ninth, JJ’s Lawn Care begins providing services to customers. On this date the company did work that totaled seven hundred fifty dollars. All of the customers paid cash for the services rendered. Give updating the balance sheet a try now. Be careful with this one. Part II The cash account increases by seven hundred fifty dollars and retained earnings increases by the same amount. The monies received represent earnings of the company that have been retained. The seven hundred fifty dollars represents revenue earned by the business. How did you do? 3

On May 31, JJ’s purchased gasoline for the lawn mower and the truck for $50 cash.
Part I In the final transaction for May, JJ’s Lawn Care purchased fifty dollars worth of gasoline for its riding mower and truck. Let’s make the final update to the balance sheet on May thirty first. Part II The cash account decreased by fifty dollars and so did the retained earnings of the company. JJ’s Lawn Care used fifty dollars of its earnings to pay for the gasoline. The fifty dollars spend is an expense of the business. Now, let’s review how JJ’s transactions affected the accounting equation. 3

On this slide we have placed all the transactions that impacted each account into the appropriate column so we can verify the balance in each account and get ready to prepare the financial statements for JJ’s Lawn Care. 3

These transactions impact the Statement of Cash Flows.
Let’s prepare the Income Statement and Statement of Cash Flows for JJ’s Lawn Care Service for the month ending May 31, 2005. These transactions impact the Statement of Cash Flows. Part I All of the transactions that impact the cash account will appear on the statement of cash flows. Part II The revenues and expenses that caused the change in retained earnings will appear on the income statement of the company. Part II Let’s begin by preparing the income statement and statement of cash flows for JJ’s Lawn Care for the period ended May 31, 2005. These transactions impact the Income Statement. 3

Part I As you can see JJ’s Lawn care has one revenue for services for seven hundred fifty dollars, and one expense for gasoline of fifty dollars. So the net income for the month of May is seven hundred dollars. Remember, net income is the excess of revenues over expenses incurred during the accounting period. Part II Investments by owners and payments to owners do not appear on the income statement. These amounts appear on the company’s balance sheet. Investments by and payments to the owners are not included on the Income Statement. 3

Here is the statement of cash flows for JJ’s Lawn Care for the month ended May 31, You can clearly see the three sections of the statement. 3

Operating activities include the cash effects of revenue and expense transactions.
Cash flows from operating activities include the seven hundred dollars in net income we calculated on the previous screen. 3

JJ’s had a cash outflow for investing activities
JJ’s had a cash outflow for investing activities. The company invested in the riding lawn mower, truck and repair parts; however, the company recovered some of the cost of repair parts by selling them to ABC Lawns. Investing activities include the cash effects of purchasing and selling assets. 3

Financing activities include the cash effects of transactions with the owners and creditors.
The only financing activity was the original investment by the owners of JJ’s Lawn Care. The cash inflows and outflows resulted in an increase in cash of four thousand one hundred and twenty-five dollars during the month. Because the cash account had a zero balance at the beginning of the month, the ending balance in the cash account is four thousand one hundred twenty-five dollars. Let’s finish by preparing the balance sheet for JJ’s Lawn Care. 3

These balances will appear on the Balance Sheet.
Now, let’s prepare the Balance Sheet for JJ’s Lawn Care Service for May 31, 2005. These balances will appear on the Balance Sheet. Here are the account balances we will use to prepare the balance sheet. 3

Assets = Liabilities + Owners’ Equity $21,850 = $13,150 + $8,700
Part I We list the asset accounts on the lefts of the balance sheet and the liabilities and owners’ equity accounts on the right. You can go back to the previous screen and see all the account balances that appear on the balance sheet. Part II As a final check we must make sure that the accounting equation is still in balance. The total assets of twenty-one thousand eight hundred fifty dollars is exactly equal to the total of the company’s liabilities plus its owners’ equity. Notice that the balance sheet lists all assets, liabilities and equities on a certain date. In our example, the date is May 31, 2005. Assets = Liabilities + Owners’ Equity $21,850 = $13, $8,700 3

Relationships Among Financial Statements
Date at beginning of period Date at end of period Time Balance Sheet Balance Sheet All the financial statements are interrelated. We can start with the balance sheet at the beginning of an accounting period, analyze the income and cash flows of the company and arrive at the ending balances that will appear on the balance sheet. Let’s see how this works in our example of JJ’s Lawn Care. Income Statement Statement of Cash Flows 3

Financial Statement Articulation
Part I Here is our balance sheet for JJ’s Lawn Care at the end of May. Part II Our net income impacts the retained earnings of the company. Part III The statement of cash flows not only provides us with the balance in the cash account, but also details information about the acquisition and disposition of assets and liabilities as well as changes in the owners’ equity balance. You can clearly see how all the financial statements articulate with each other. 3

Financial Reporting and Financial Statements
Statement of Cash Flows Balance Sheet Income Statement Other Information: Industry Competition National economy Financial statements are just one source of financial accounting information. Financial statements are only one source of information about the operations of a company. We can compare the financial statements of our company to those of other companies in the same industry, our major national or international competitors, and to the norms for the national economy. 3

Forms of Business Organizations
Sole Proprietorship Partnership Corporation There are three general forms of business operations. A proprietorship is a business owned by just one individual. A partnership is owned by two or more individuals. Some partnerships have several thousand partners. A corporation is owned by individuals who normally are not active in the day-to-day operations of that business. For example, you may become an owner of IBM by purchasing shares of stock on the New York Stock Exchange. While you are a part owner, you do not necessarily work for IBM nor are you active in the operations of the company.

Reporting Ownership Equity in the Balance Sheet
Sole Proprietorship Partnership Part I The owners’ equity section of the balance sheet will look different for each type of business entity. For a sole proprietorship, we will have a capital account for the owner. In addition, we will have a drawing account to record payments to the owner. Part II For a partnership we will have a separate capital account for each partner. We will track changes in each partner’s capital account over time. In addition, we will have a separate drawing account for payments made to each partner. Part II As we have seen, for a corporation we will show owners’ contributions in the capital stock account and accumulated earnings of the company in the retained earnings account. By looking at the equity section of a balance sheet we should be able to tell the form of business. Corporation

The Use of Financial Statements by External Parties
Two concerns: Liquidity Profitability Creditors Creditors and investors have two major concerns about the operations and financial position of any company. First, the company must be liquid, that is, it must be able to pay all bills when due. Second, the company must be profitable in the long-run. Unprofitable companies drain the cash position of the company and this causes concern on the part of creditors and investors. Investors

The Need for Adequate Disclosure
Income Statement Balance Sheet Statement of Cash Flows Notes to the financial statements often provide facts necessary for the proper interpretation of the statements. In addition to the basic financial statements, companies prepare notes to the financial statements. These notes are meant to provide the reader with additional insights into the operations and financial position of the company.

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. Part I Creditors and investors are more likely to be interested in financially strong companies. These companies usually have little or no debt and a significant amount of assets that can be converted into cash quickly. Part II When management engages in measures to make the company appear financially stronger than it really is, we refer to this as window dressing. Window dressing may be legal, but it often impugns the integrity of the management team. Window dressing occurs when management takes measures to make the company appear as strong as possible in it financial statements.

End of review We have covered a great deal of material in this chapter. We looked at recording business transactions and the preparation of basic financial statements. We will build on this chapter during the rest of the course. If you are feeling a little confused about the material presented, it is an excellent idea to go through this presentation again. 4

Review: ACCOUNTING AND BASIC FINANCIAL STATEMENTS

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