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Chapter 2: Financial Statements and the Accounting Process

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  • 1. Chapter 2: Financial Statements and the Accounting Process
  • 2. Financial Accounting GAAP (Generally Accepted Accounting Principles) The Accounting Information System Financial Statements Parties involved in Standard Setting Conceptual framework Qualitative Characteristics or Fundamental Concepts Recognition and Measurement Concepts Assumptions Principles Constraints Objectives
  • 3. Financial Accounting GAAP (Generally Accepted Accounting Principles) The Accounting Information System Financial Statements Transaction Analysis Financial Statements Parties involved in Standard Setting Conceptual framework Qualitative Characteristics or Fundamental Concepts Recognition and Measurement Concepts Assumptions Principles Constraints Objectives
  • 4. Today’s class objectives Transaction Analysis Financial Statements Statement of Stockholders’ Equity Balance Sheet Statement of Cash Flows Income Statement Assets Liabilities Equity Statement of Retained Earnings Contributed Capital Retained Earnings Stock Net Income Dividends Point in Time Period of Time
  • 5. The Balance Sheet (B/S)
    • Based on the relationship:
    • Assets = Sources of Assets
    • Assets = Claims to Assets
    • Assets = Liabilities + Equity
    • The Balance Sheet (or Accounting) Equation:
    • Assets = Liabilities + Stockholders’ Equity
    • A = L + SE
    Point in Time
  • 6. The B/S: Assets
    • Assets are
      • probable future economic benefits
      • obtained or controlled by an entity
      • result of past transactions or events.
    • On B/S, classified in order of liquidity: current and non-current.
    • Current assets are expected to be converted to cash, sold, or used up within the next accounting period (usually defined as a year).
  • 7. The B/S: Assets
    • Current assets (CA)
      • Cash
      • Short-term marketable securities
      • Accounts receivable
      • Inventory
      • Prepaid expenses
    • Property, plant, and equipment (PP&E)
    • Long-term investments
    • Intangible assets
      • Patents
      • Goodwill
  • 8. The B/S: Liabilities
    • Liabilities are claims by creditors against the assets of a company.
    • The creditors have a priority claim (before the owners) to the assets in liquidation.
    • Liabilities are classified in terms of due dates: current liabilities and non-current liabilities.
    • Current liabilities will require the use of current assets or the creation of other current liabilities at maturity.
  • 9. The B/S: Liabilities
    • Current liabilities (CL)
      • Accounts payable
      • Wages payable
      • Interest payable
      • Short-term notes payable
      • Unearned revenues
      • Other payables
    • Long-term liabilities (LTL)
      • Bonds payable
      • Mortgage payable
      • Long-term notes payable
  • 10. The B/S: Equity
    • Equity represents the claims of the owners against the assets of a company.
    • Corporations have a different form of ownership than proprietorships (individual owner), but the concept is the same.
    • Most of the applications in this course will be for corporations, but some of the early material deals with proprietorships.
  • 11. The B/S: Equity for Single Owner (Proprietorship)
    • Owner’s equity account consists of:
      • contributions by owner
      • withdrawals by owner
      • earnings of the proprietorship
    • Ex: John Smith, Capital $150,000
  • 12. The B/S: Equity for Corporation
    • Stockholders’ equity (SE) consists of:
      • Contributed capital (CC)
        • Common Stock
        • Preferred Stock (see Chapter 9)
        • Additional paid in capital (see Chapter 9)
      • Retained earnings (RE)
        • Net income
        • Dividends
    • SE = CC + RE
  • 13. The B/S: Equity for Corporation Ex: Stockholders’ equity
    • Common stock (5,000 shares
    • at $2 par value) $ 10,000
    • Paid-in capital in excess of par $ 90,000
    • Total paid-in capital $100,000
    • Retained Earnings $ 50,000
    • Total Stockholders’ equity $150,000
  • 14. Ex. 2-14
    • Indicate: CA, PE, OA, CL, LTL, SE
    • ___ Cash
    • ___ Common Stock
    • ___ Notes Payable
    • ___ Prepaid Insurance
    • ___ Accounts Receivable
    • ___ Machinery
    • ___ Investments
    • ___ Patents
    CA SE CL/LTL CA/OA CA PE OA OA
  • 15. Ex. 2-14 - continued
    • Indicate: CA, PE, OA, CL, LTL, SE
    • ___ Taxes Payable
    • ___ Inventory
    • ___ Wages Payable
    • ___ Accounts Payable
    • ___ Marketable Securities
    • ___ Land
    • ___ Goodwill
    • ___ Interest Payable
    CL CA CL CL CA/OA PE OA CL
  • 16. Balance Sheet - Transactions
    • The balance sheet is affected by every transaction that an entity encounters.
    • Each transaction has counter balancing entries that keep total assets equal to total liabilities and owners’ equity, i.e., the balance sheet equation and the balance sheet must always be balanced.
  • 17. Balance Sheet - Transactions
    • A balance sheet could be prepared after every transaction, but this practice would be awkward and unnecessary.
    • Therefore, balance sheets are usually prepared monthly or on some other periodic schedule.
  • 18. Balance Sheet - Transactions
    • Transactions are recorded in accounts, which are summary records of the changes in particular assets, liabilities, or owners’ equity.
    • The account balance is the total of all entries to the account.
    • For each transaction, the accountant determines:
      • Which specific accounts are affected
      • Whether the account balances are increased or decreased
      • The amount of the change in each account
  • 19. Analyzing the impact of transactions on the company’s Balance Sheet – Smile Inc.
    • 1/5/06 Gil invests $60,000 to begin his comic book store business (“Smile Inc”), and Smile Inc. issues common stock.
    • 1/7/06 Smile Inc. purchases a small store, paying $50,000 in cash.
    • 1/10/06 Smile Inc. acquires furniture for $4,000 on account (payable/due within 14 days).
    • 1/11/06 Smile Inc. purchases a computer system, costing $2,000 on account (payable/due within 30 days).
    • 1/15/06 Smile Inc. applies and receives a loan in the amount of $10,000 from Best Bank.
    • 1/20/06 Smile Inc. purchases comic books (Inventory) for $8,000 ($1,000 cash and the rest on account due within 30 days).
    • 1/22/06 Gil buys some furniture for his apartment for $1,500 using his credit card.
    • 1/24/06 Smile Inc. returns some inventory (which was purchased for $500) for full credit.
    • 1/24/06 Smile Inc. pays for the furniture bought in transaction 3.
    • Required: 1. Record the transactions using the Balance Sheet Equation
    • 2. Prepare a Balance Sheet for 1/31/2006
    Point in Time
  • 20. Smile Inc.
    • Stockholders’ Assets = Liabilities + Equity
    • =
    • (1) =
    • (2) =
    • (3) =
    • (4) =
    • (5) =
    • (6) =
    • (7) =
    • (8) =
    • (9) ______ ______ ______ ______ = _______ ________ ________
    • Tot
    Cash Inventory Furniture & Computers Store Accounts Payable Loan (note Payable) Common Stock +60,000 +60,000 -50,000 +50,000 +4,000 +4,000 +2,000 +2,000 +10,000 +10,000 -1,000 +8,000 +7,000 No Transaction -500 -500 -4,000 -4,000 15,000 7,500 6,000 50,000 8,500 10,000 60,000 Point in Time: 1/31/2006
  • 21. Smile Inc.
    • Balance Sheet
    • Jan / 31 / 2006
    • Assets: Liabilities:
    • Cash 15,000 A / P 8,500
    • Inventory 7,500 Loan (N/P) 10,000
    • PP&E-Furniture 6,000 18,500
    • PP&E-Store 50,000 SE 60,000
    • 78,500 78,500
    Point in Time
  • 22. The Statement of Stockholders’ Equity
    • Equity represents the claims of the owners against the assets of a company.
    • Equity is the excess of assets over liabilities of a company (“Net Assets”)
  • 23. The Statement of Owner’s Equity
    • Beginning owner’s equity ( OE Begin )
    • Plus: Investments by owners ( I )
    • Plus: Net income ( NI )
    • Less: Withdrawals by owners ( W )
    • Ending owner’s equity ( OE End )
    • OE Begin + I + NI - W = OE End
    Period of Time
  • 24. The Statement of Stockholders’ Equity
    • Beginning stockholders’ equity ( SE Begin )
    • Plus: Issue of stock ( I )
    • Plus: Net income ( NI )
    • Less: Dividends paid to stockholders ( Div )
    • Ending stockholders’ equity ( SE End )
    • SE Begin + I + NI - Div = SE End
    Period of Time
  • 25. The Statement of Retained Earnings
    • Beginning retained earnings balance ( RE Begin )
    • Plus: Net income ( NI )
    • Less: Dividends ( Div )
    • Ending retained earnings balance ( RE End )
    • RE Begin + NI - Div = RE End
    • Note that the Statement of Retained Earnings is a subset of the Statement of Stockholders’ Equity .
    Period of Time
  • 26. Ex. 2-17 (20X1, 20X2, and 20X3)
    • Use the following formulas to solve for the missing items:
    • A = L + SE
    • SE Begin + Issue + NI - D = SE End
  • 27. Ex. 2-17 (20X1, in 000s)
    • (a ) SE, 1/1/X1
    • A = L + SE
    • 100 = 60 + SE
    • 40 = SE
    • (b ) SE, 12/31/X1
    • SE Begin + Issue + NI - D = SE End
    • 40 + 18 + 20 - 20 = SE End
    • 58 = SE End
  • 28. Ex. 2-17 (20X2, in 000s)
    • (c) Liabilities, 1/1/X2
    • A = L + SE
    • 120 = L + 58
    • 62 = L
    • (d) SE, 1/1/X2 = SE,12/31/X1
    • = $ 58
    • (e) SE, 12/31/X2 = SE, 1/1/X3 = $75,000
  • 29. Ex. 2-17 (20X3, in 000s)
    • (f) Assets, 1/1/X3
    • A = L + SE
    • A = 72 + 75
    • 147 = 72 + 75
    • (g) Income or (loss)
    • 57 – 75 + 17 = (1)
  • 30. The Statement of Stockholders’ Equity Start of Period Beginning balance of SE Statement of Retained Earnings Beginning balance of Contributed Capital Beginning balance of Retained Earnings End of Period PERIOD Ending balance of SE Ending balance of Retained Earnings Ending balance of Contributed Capital + Net Income - Dividends + Issue of Stock
  • 31. Today’s class objectives Transaction Analysis Financial Statements Statement of Stockholders’ Equity Balance Sheet Statement of Cash Flows Income Statement Assets Liabilities Equity Statement of Retained Earnings Contributed Capital Retained Earnings Stock Net Income Dividends Operating Losses Gains Revenues Expenses Investing Financing Point in Time Period of Time
  • 32. The Income Statement
    • Revenues (Rev.)
      • inflow of assets or settlement of liabilities
      • from delivery of goods or services
      • related to a company’s central operations.
    • Expenses (Exp.)
      • outflow or consumption of assets or incurrence of liabilities
      • from delivery of goods or services
      • related to a company’s central operations.
    Period of Time
  • 33. The Income Statement
    • Gains
      • inflow of net assets
      • from activities that are peripheral operations.
    • Losses
      • outflow of net assets
      • from activities that are peripheral operations.
    • Note that some items that fall into this category still have the title “revenue” or “expense”. Examples include interest revenue and interest expense.
  • 34. The Income Statement: Revenues - Expenses = Net Income
    • Revenue examples
      • Sales
      • Fees earned
      • Other revenues and gains
    • Expense examples
      • Cost of goods sold
      • Wage expense
      • Rent expense
      • Selling expense
      • Depreciation expense
      • Other expenses and losses
  • 35. The Statement of Cash Flows
    • Cash flows from operating activities:
      • Usually cash flows related to income statement items (e.g., cash inflows from sales, cash outflows from interest payments).
    • Cash flow from investing activities:
      • Usually cash flows related to non-current assets (e.g., cash outflow from purchase of equipment).
    • Cash flow from financing activities:
      • Usually cash flows related to equity items or non-current liabilities (e.g., sale of stock, issuance of bonds).
    Period of Time
  • 36. Relationships Among the Financial Statements Statement of Cash Flows Income Statement Statement of O.E. or Statement of R.E. or Statement of S.E. Ending Balance Sheet Assets (Cash) = Liabilities + Equity Beginning Balance Sheet Assets (Cash) = Liabilities + Equity
  • 37. The Statement of Stockholders’ Equity Start of Period Beginning balance of SE Beginning balance of Contributed Capital Beginning balance of Retained Earnings End of Period PERIOD Ending balance of SE Ending balance of Retained Earnings Ending balance of Contributed Capital + Net Income - Dividends + Issue of Stock + Revenues - Expenses
  • 38.
    • Solution:
    • Issue of stocks?
    • A = 50 – 50 = 0
    • Net Income?
    • Net Income = Rev. - Exp
    • B = NI = 150 – 100 = 50
    • RE beg ?
    • RE beg + NI – Div = RE end
    • C + 50 – 30 = 110
    • C = 90
    E Total Liabilities – End 95 Total Liabilities – Beg 250 Total Assets – End D Total Assets – Beg 50 Cont. Capital – End 50 Cont. Capital – Beg 110 RE – End C RE – Beg B Net Income A Issue of stocks 30 Dividend 100 Expenses $150 Revenues
  • 39.
    • Solution:
    • Asset – beginning?
    • A = L + SE
    • A = L + (Cont. Capital + RE)
    • D = 95 + (50 + 90) = 235
    • Liabilities – ending?
    • 250 = E + (50 + 110)
    • E = 90
    E Total Liabilities – End 95 Total Liabilities – Beg 250 Total Assets – End D Total Assets – Beg 50 Cont. Capital – End 50 Cont. Capital – Beg 110 RE – End C=90 RE – Beg B=50 Net Income A=0 Issue of stocks 30 Dividend 100 Expenses $150 Revenues
  • 40. Transaction Analysis
    • The foundation of financial accounting.
    • Based on the balance sheet/accounting equation:
    • Assets = Liabilities + Equity
    • Every economic transaction affects at least two items in the accounting equation.
    • Illustration: Ex. 2-44.
  • 41. Ex. 2-44 Worksheet
    • Cash + Parts + A/R = A/P + C/S + RE
    • 9/3 =
    • 9/9 =
    • 9/12 =
    • 9/18 =
    • 9/20 =
    • 9/26 =
    • 9/29 _____ _____ _____ = _____ _____ _____
    Tot . 12,350 + 3,850 + 1,350 = 4,000 + 15,000 + (1,450) 15,000 15,000 5,000 5,000 (2,500) (2,500) exp. 2,200 2,200 rev. (1,150) (1,150) exp. 850 (850) (1,000) (1,000) Point in Time
  • 42. Ex. 2-44 Financial Statements
    • Income Statement - Month of September
    • Revenues $ ________
    • Expenses ________
    • Net Income (loss) $ ________
    • Statement of Retained Earnings - September
    • RE (beginning) $________
    • Net Income (loss) ________
    • Dividends ________
    • RE (ending) $________
    2,200 (3,650) (1,450) -0- (1,450) -0- (1,450) Period of Time
  • 43. Ex. 2-44 Financial Statements
    • Balance Sheet - at September 30
    • Assets
    • Cash $ ________
    • Parts ________
    • A/R ________
    • Total $ ________
    • Liab. and S.E.
    • A/P $ ________
    • CS ________
    • RE (ending) ________
    • Total $ ________
    12,350 3,850 1,350 17,550 4,000 15,000 (1,450) 17,550 Point in Time
  • 44. Ex. 2-44 Financial Statements
    • Statement of Cash Flows - for September
    • Cash flow from operating activities:
    • Cash collected from customers $ ________
    • Cash paid to suppliers ________
    • Cash paid for rent ________
    • Cash flow from financing activities:
    • Cash from issue of stock $ ________
    • Net increase in cash $ ________
    850 (1,000) (2,500) 15,000 12,350 Period of Time Total (2,650)
  • 45. Ex. 2-45 Worksheet
    • Nov. Cash + A/R + Supp = N/P + U.Rev + C/S + RE
    • Bal. 7,500 2,000 = 2,200 300 3,000 4,000
    • 2 =
    • 7 =
    • 11 =
    • 17 =
    • 30 _____ _____ _____ = _____ _____ _____ _____
    Tot . 7,400 + 150 + 1,500 = 2,200 + 100 + 3,000 + 3,750 100 100 rev. 150 150 rev. (200) (200) exp. (200) 200 rev. (500) (500) exp. Point in Time
  • 46. Ex. 2-45 Financial Statements
    • Income Statement - Month of November, 2001
    • Revenues $ ________
    • Expenses ________
    • Net Income (loss) $ ________
    • Statement of Retained Earnings - November
    • RE (beginning) $________
    • Net Income (loss) ________
    • Dividends ________
    • RE (ending) $________
    450 (700) (250) 4,000 (250) -0- 3,750 Period of Time
  • 47. Ex. 2-45 Financial Statements
    • Balance Sheet - at November 30, 2001
    • Assets
    • Cash $ ________
    • A/R ________
    • Supplies ________
    • Total $ ________
    • Liab. and S.E.
    • N/P $ ________
    • Unearned Fees ________
    • C/S ________
    • RE (ending) ________
    • Total $ ________
    7,400 150 1,500 9,050 2,200 100 3,750 9,050 3,000 Point in Time
  • 48. Ex. 2-45 Financial Statements
    • Statement of Cash Flows - for November, 2001
    • Cash flow from operating activities:
    • Cash collected from customers $ ________
    • Cash paid to employees ________
    • Cash paid for supplies ________
    • Net decrease in cash $ ________
    • Beginning cash balance $ ________
    • Ending cash balance $ ________
    100 (200) -- (100) 7,500 7,400 Period of Time
  • 49. Accrual Basis and Cash Basis
    • The most common ways of measuring income are the accrual basis and the cash basis .
    • Accrual basis - recognizes the impact of transactions for the time periods when revenues and expenses occur even if no cash changes hands
    • Cash basis - recognizes the impact of transactions only when cash is received or disbursed
  • 50. Accrual Basis and Cash Basis
    • Under the accrual basis:
    • Revenues are recorded when earned.
      • For example, a sale on account is recorded as revenue when the transaction takes place even though the seller receives no cash at that moment.
    • Expenses are recorded when incurred.
      • For example, a purchase on account is recorded as an expense when the transaction takes place even though the buyer disburses no cash at that moment.
  • 51. Accrual Basis and Cash Basis
    • Under the cash basis:
    • Revenues are recorded when a sale is made for cash at the time when the cash changes hands.
    • Expenses are recorded when a purchase is made for cash at the time when the cash changes hands.
  • 52. Accrual Basis and Cash Basis
    • The accrual basis is the current standard for the measurement of income.
    • Presents a more complete summary of what happened during the year
    • Recognizes revenues when they are earned and expenses when they are incurred
    • Matches costs to revenues
  • 53. Accrual Basis
    • Revenue Recognition has two parts. Both must occur for revenues to be recognized:
    • Earned : Delivery has occurred or services have been rendered.
    • Realization: Cash collection is reasonably assured.
    • Matching is the recording of expenses in the same time period as the related revenues are recognized. There are two types of expenses:
    • Product costs , which are naturally linked with revenues (e.g., cost of goods sold).
    • Period costs , which are expenses that are incurred over a particular time period.
  • 54. Ex. 2-38 Adjustments to Financial statements Tax Payable +500 Wages Payable +2,400 Rental Payable +240 Unearned Rev. -600 Interest Receivable +75 RE (Tax Expense) -500 RE (Wages Exp.) -2,400 RE (Interest Rev.) +75 RE (Rental Exp.) -240 RE (Rent Revenue) +300 RE (Insurance Exp.) +320 RE (Rent Revenue) +600 Rent Receivable +300 No Entry Prepaid Insurance +320 = h. = g. = f. = e. = d. = c. = b. = a. + Stockholders’ equity Liabilities = Assets
  • 55. 2-32 – Cash Flow Calculation
    • Assets = Liabilities+ Stockholders’ Equity
    • Credit Sales =
    • Collections =
    • Salaries Expenses =
    • Payments to Employees _______ = ________
    • AR beg + Revenues – Collections = AR end
    • Payables beg + Expenses – Payments = Payables end
    Cash Accounts Receivable Wages Payable Retained Earnings + Beg. Bal. Beg. Bal. + Net Income (Revenues–IS) - + + - Net Income (Expenses–IS) - - End. Bal. End. Bal.
  • 56. 2-32 – Cash Flow Calculation
    • AR beg + Revenues – Collections = AR end
    • 3 + 11 - X = 2
    • X = 12
    • Payables beg + Expenses – Payments = Payables end
    • 2 + 6 - Y = 3
    • Y = 5
  • 57. Template Company Income Statement For the Period Ended December 31, 20XX
    • Revenues
    • Service revenues +$
    • Sales revenues +$
    • Total revenues +$
    • Cost of revenues/goods sold - $
    • Gross profit =$
    • Operating expenses
    • Sales and marketing - $
    • General and administrative - $
    • Total operating expenses - $
    • Income from operations =$
    • Other income, gains and losses +/-$
    • Income from operations before income taxes =$
    • Provision for income tax (tax expense) - $
    • Net income =$
  • 58. Template Company Balance Sheet December 31, 20XX
    • ASSETS
    • Current Assets
    • Cash
    • Accounts Receivable (net)
    • Inventory
    • Short Term Investments
    • Prepaid Expenses
    • Total Current Assets
    • Long Term Investments
    • Property, Plant and Equipment
    • Land, Buildings, Improvements
    • Equipment, Furniture, Vehicle
    • (Less Accumulated Depreciation)
    • Total PPE (net)
    • TOTAL ASSETS
    • LIABILITIES
    • Current Liabilities Accounts Payable Wages Payable
    • Notes Payable
    • Unearned Revenues
    • Total Current Liabilities
    • Long-Term Liabilities Long-Term Loans Long-Term Notes
    • Mortgage
    • Total Long-Term Liabilities
    • TOTAL LIABILITIES
    • EQUITY
    • Contributed Capital
    • Preferred/Common stock
    • Additional Paid in Capital
    • Retained Earnings
    • TOTAL EQUITY
    • LIABILITIES AND EQUITY

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