© the mcgraw-hill companies, inc., 2005 mcgraw-hill/irwin 2-1 review: accounting and basic...

© The McGraw-Hill Companies, Inc., 2005McGraw-Hill/Irwin

2-1

Review: ACCOUNTING AND BASIC FINANCIAL STATEMENTS

Professor Chris Wimmer – Feb 24, 2008


2-2

Accounting

information

The accounting

process

Decision makers

Economic activities

Actions (decisions)

Accounting “links” decision

makers with economic

activities and with the results of

their decisions.


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Information Users

InvestorsCreditors ManagersOwnersCustomersEmployeesRegulators -SEC -IRS -EPA

Information Users

InvestorsCreditors ManagersOwnersCustomersEmployeesRegulators -SEC -IRS -EPA

Decisions Supported

Performance evaluationsStock investmentsTax strategiesLabor relationsResource allocationsLending decisionsBorrowing

Decisions Supported

Performance evaluationsStock investmentsTax strategiesLabor relationsResource allocationsLending decisionsBorrowing

Information SystemInformation System

Financial Information

ProvidedProfitability

Financial position

Cash flows

Financial Information

ProvidedProfitability

Financial position

Cash flows


2-4

Introduction to Financial StatementsIntroduction to Financial Statements

Three primary financial

statements.Income Statement

Balance Sheet

Statement of Cash FlowsWe will use a corporation

to describe these statements.


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Describes where the enterprise stands at a

specific date.

Income Statement

Balance Sheet

Statement of Cash Flows


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Depicts the revenue and

expenses for a designated

period of time.

Income Statement

Balance Sheet



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Revenues result in positive

cash flow.

Expenses result in negative

cash flow.

Either in the past, present, or future.


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Net income (or net loss) is simply the difference between

revenues and expenses.

Income Statement

Balance Sheet



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Depicts the ways cash has changed during

a designated period of time.

Income Statement

Balance Sheet



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Vagabond Travel AgencyBalance Sheet

December 31, 2005Assets Liabilities & Owners' Equity

Cash 22,500$ Liabilities:Notes receivable 10,000 Notes payable 41,000$ Accounts receivable 60,500 Accounts payable 36,000 Supplies 2,000 Salaries payable 3,000 Land 100,000 Total liabilities 80,000$ Building 90,000 Owners' Equity:Office equipment 15,000 Capital stock 150,000

Retained earnings 70,000 Total 300,000$ Total 300,000$

A Starting Point: Statement of Financial Position

A Starting Point: Statement of Financial Position


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The Concept of the Business EntityThe Concept of the Business Entity

Vagabond Travel

Agency

A business entity is

separate from the personal affairs of its

owner.


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AssetsAssets

Assets are economic resources

that are owned by the business and are expected to provide positive

future cash flows.


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LiabilitiesLiabilities

Liabilities are debts that

represent negative future cash flows

for the enterprise.


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Owners’ EquityOwners’ Equity

Owners’ equity represents the

owners’ claims to the assets of the

business.


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Owners’ EquityOwners’ Equity

Changes in Owners’ Equity

•Owners’ Investments

•Business Earnings

•Payments to Owners

•Business Losses


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Cash 22,500$ Liabilities:Notes receivable 10,000 Notes payable 41,000$ Accounts receivable 60,500 Accounts payable 36,000 Supplies 2,000 Salaries payable 3,000 Land 100,000 Total liabilities 80,000$ Building 90,000 Owners' EquityOffice equipment 15,000 Capital stock 150,000


The Accounting EquationThe Accounting Equation

Assets = Liabilities + Owners’ Equity

$300,000 = $80,000 + $220,000


$300,000 = $80,000 + $220,000


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The Need forFinancial Statements


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Financial Disclosure BenefitsFinancial Disclosure Benefits

Enhances decision-makingReduces riskReduces risk lowers cost


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Three Primary Financial Statements

Balance SheetIncome StatementStatement of Cash Flows


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The Balance Sheet


2-21

The Balance Sheet

Assets LiabilitiesCash $40,000 Accounts Payable $80,000Account Receivable 5,000 Notes Payable 20,000Inventories 90,000 Total Liabilities $100,000Land 10,000 Stockholders' EquityPlant and equip. 125,000 Capital Stock $145,000

Retained Earnings 25,000Total Stockholders' Equity 170,000

$270,000

Total Liabilites and Stockholders' Equity $270,000

The Quick CorporationBalance Sheet

December 31, 2004


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The Balance Sheet

Presents the financial position of a company at a particular point in time.

Assets LiabilitiesCash $40,000 Accounts Payable $80,000Account Receivable 5,000 Notes Payable 20,000Inventories 90,000 Total Liabilities $100,000Land 10,000 Stockholders' EquityPlant and equip. 125,000 Capital Stock $145,000

Retained Earnings 25,000Total Stockholders' Equity 170,000

$270,000

Total Liabilites and Stockholders' Equity $270,000

The Quick CorporationBalance Sheet

December 31, 2004• Three categories:– Assets– Liabilities– Owners’

Equity


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

Assets

likely to occur


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Assets

assets have implications for the future


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Assets

substance rules over legal form


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Assets


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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


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Liabilities


the obligation can involve either type of future event


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Liabilities


have already happened


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Liabilities



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Owners’ Equity

The residual interest in the assets of an entity that remains after deducting liabilities

Also known as net assetsCreditors legally have first claim to assetsThe owners’ equity of a corporation is referred to as

stockholders’ equity


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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


2-33Owners’ Equity: Two Primary Components

Paid-in CapitalThe value of assets contributed by investors in exchange for shares of stock

Retained EarningsThe cumulative earnings of the company not paid to owners as dividends


2-34

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 assetsCurrent liabilities are repaid usually within one

year


2-35

The Accounting Equation

The balance sheet is a detailed version of the accounting equation

ASSETS = LIABILITIES + STOCKHOLDERS’ EQUITYASSETS = LIABILITIES + STOCKHOLDERS’ EQUITY


2-36Balance Sheet Conceptsand 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.


2-37

The going concern assumption presumes that the business will continue for the foreseeable future

Balance Sheet Conceptsand Conventions


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The Income Statement


2-39


RevenuesFees Earned $541,000

ExpensesCost of goods sold $215,000Salary expense 85,000Rent expense 45,000Supplies expense 15,200Utilites expense 75,000Insurance expense 1,200Interest expense 3,000

Total expenses 439,400

Income before taxes 101,600Income taxes 40,640Net Income $60,960

The Quick CorporationIncome Statement

For the Year Ended December 31, 2004


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Describes a company’s financial performance for a specified period of time

RevenuesFees Earned $541,000

ExpensesCost of goods sold $215,000Salary expense 85,000Rent expense 45,000Supplies expense 15,200Utilites expense 75,000Insurance expense 1,200Interest expense 3,000

Total expenses 439,400

Income before taxes 101,600Income taxes 40,640Net Income $60,960

The Quick CorporationIncome Statement

For the Year Ended December 31, 2004

• Reports•Revenues•Expenses•Net Income


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Elements of the Income Statement

Revenue is the amount of assets created through the performance of business operationsRetailers generate revenue by selling goodsService businesses generate revenue by providing a

valuable service


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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



2-43

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



2-44Income Statement Conceptsand Conventions

Time PeriodThe life of a business is divided into time periods to

measure performance

Revenue recognition occurs whenThe goods have been delivered or the service has

been provided andCash has been collected or collection is reasonably

assured


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The Statement ofCash Flows


2-46

The Statement of Cash Flows

Cash flows from OperationsCash revenues $535,000Less cash expenses (485,000)Net cash provided by operating activities $50,000

Cash flows from Investing ActivitiesPurchase of land (30,000)Sale of equipment 10,000Net cash used by investing activities (20,000)

Cash flows from Financing ActivitiesIssuance of capital stock 10,000Issuance of dividends (15,000)Net cash used by financing activities (5,000)

Net increase in cash 25,000Cash Balance January 1, 2004 15,000Cash Balance December 31, 2004 $40,000

The Quick CorporationStatement of Cash Flows

For the Year Ended December 31, 2004Describes a company’s cash flows for a specified period of time


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Cash flows from OperationsCash revenues $535,000Less cash expenses (485,000)Net cash provided by operating activities $50,000

Cash flows from Investing ActivitiesPurchase of land (30,000)Sale of equipment 10,000Net cash used by investing activities (20,000)

Cash flows from Financing ActivitiesIssuance of capital stock 10,000Issuance of dividends (15,000)Net cash used by financing activities (5,000)

Net increase in cash 25,000Cash Balance January 1, 2004 15,000Cash Balance December 31, 2004 $40,000

The Quick CorporationStatement of Cash Flows

For the Year Ended December 31, 2004Classifies individual cash

flows according to three main activities: Operating activities Investing activities Financing activities

The Statement of Cash Flows


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Operating Activities

Inflows/Receipts:Selling productsProviding services

Outflows/Payments:InventoryWagesUtilitiesRentInterestTaxes, etc.

Producing and Selling Goods and ServicesDay-to-Day Activities


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Investing Activities

Inflows/Sale of:LandBuildingsEquipmentStocks of other

companies

Outflows/Purchase of:LandBuildingsEquipmentStocks of other companies

Buying and Selling Long-Term Assets


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Financing Activities

Inflows/Receipts:Sell stock sharesLoan proceeds

Outflows/Payments:Repay loansAcquire treasury stockPay cash dividends

Cash to/from Creditors and Investors


2-51

Cash Flow Process

Raw Cash Flow Data

Accounting Adjustments

Net Income

Undo Accounting Adjustments



2-52

Notes to theFinancial Statements


2-53

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


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The External Audit


2-55

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


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Other Conceptsand Conventions


2-57

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


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Comparability Information is more useful when it can be

compared to that of other companies or to that of the same company over time

ConsistencyFinancial statements should be prepared using the

same accounting methods consistently to be comparable



2-59

ConservatismWhen in doubt, recognize all losses but do not

anticipate gains

MaterialityAn item is material if misstatement of that item

could impact a decisionMateriality is largely a matter of professional

judgement



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ArticulationThe 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



2-61

$

Articulation

Accrual Adjustments

$Net Income- Dividends


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In Summary ...In Summary ...

Financial information reduces uncertainty for creditors and investors

The balance sheet reports assets, liabilities, and equityThe income statement reports revenues and expensesThe statement of cash flows reports changes in cashNotes to financial statements provide important detail and

supplemental explanationsAudits do not provide guarantees


2-63

Let’s analyze some

transactions for JJ’s Lawn Care

Service.


2-64

JJ's Lawn Care ServiceBalance Sheet

May 1, 2005Assets

Cash 8,000$ Capital Stock 8,000$

Total 8,000$ Total 8,000$

Owners' Equity

On May 1, 2005, Jill Jones and her family invested $8,000 in JJ’s Lawn Care Service and

received 800 shares of stock.


2-65


May 2, 2005Assets

Cash 5,500$ Capital Stock 8,000$ Tools & Equipment 2,500

Total 8,000$ Total 8,000$

Owners' Equity

On May 2, JJ’s purchased a riding lawn mower for $2,500 cash.


2-66

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.


May 8, 2005Assets

Cash 3,500$ Liabilities: Tools & Equipment 2,500 Notes Payable 13,000$ Truck 15,000 Owners' Equity:

Capital Stock 8,000

Total 21,000$ Total 21,000$

Liabilities and Owners' Equity


2-67

JJ's Lawn Care ServiceBalance SheetMay 11, 2005

AssetsCash 3,500$ Liabilities: Tools & Equipment 2,800 Notes Payable 13,000$ Truck 15,000 Accounts Payable 300

Total Liabilities 13,300$ Owners' Equity:Capital Stock 8,000

Total 21,300$ Total 21,300$


On May 11, JJ’s purchased some repair parts for $300 on account.


2-68


AssetsCash 3,500$ Liabilities: Accounts Receivable 150 Notes Payable 13,000$ Tools & Equipment 2,650 Accounts Payable 300 Truck 15,000 Total Liabilities 13,300$

Owners' Equity:Capital Stock 8,000

Total 21,300$ Total 21,300$


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.


2-69


AssetsCash 3,575$ Liabilities: Accounts Receivable 75 Notes Payable 13,000$ Tools & Equipment 2,650 Accounts Payable 300 Truck 15,000 Total Liabilities 13,300$


Total 21,300$ Total 21,300$


On May 25, ABC Lawns pays JJ’s $75 as a partial settlement of its accounts receivable.


2-70


AssetsCash 3,425$ Liabilities: Accounts Receivable 75 Notes Payable 13,000$ Tools & Equipment 2,650 Accounts Payable 150 Truck 15,000 Total Liabilities 13,150


Total 21,150$ Total 21,150$


On May 28, JJ’s pays $150 of its accounts payable.


2-71



Owners' Equity:Capital Stock 8,000 Retained Earnings 750

Total 21,900$ Total 21,900$


On May 29, JJ’s recorded lawn care services provided during May of $750. All clients paid in

cash.


2-72



Owners' Equity:Capital Stock 8,000 Retained Earnings 700

Total 21,850$ Total 21,850$


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.


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Assets = Liabilities +

Cash +Accts. Rec. +

Tools & Equip. + Truck =

Notes Payable +

Accts. Pay. +

Capital Stock +

Retained Earnings

May 1 8,000$ 8,000$ Balances 8,000$ 8,000$

May 2 (2,500) 2,500$ Balances 5,500$ 2,500$ 8,000$

May 8 (2,000) 15,000$ 13,000$ Balances 3,500$ 2,500$ 15,000$ 13,000$ 8,000$

May 11 300 300$ Balances 3,500$ 2,800$ 15,000$ 13,000$ 300$ 8,000$

May 18 150$ (150) Balances 3,500$ 150$ 2,650$ 15,000$ 13,000$ 300$ 8,000$

May 25 75 (75) Balances 3,575$ 75$ 2,650$ 15,000$ 13,000$ 300$ 8,000$

May 28 (150) (150) Balances 3,425$ 75$ 2,650$ 15,000$ 13,000$ 150$ 8,000$

May 29 750 750 Balances 4,175$ 75$ 2,650$ 15,000$ 13,000$ 150$ 8,000$ 750$

May 31 (50) (50) Balances 4,125$ 75$ 2,650$ 15,000$ 13,000$ 150$ 8,000$ 700$

Owners' Equity


2-74


Cash +Accts. Rec. +


Notes Payable +

Accts. Pay. +

Capital Stock +

Retained Earnings

May 1 8,000$ 8,000$ Balances 8,000$ 8,000$

May 2 (2,500) 2,500$ Balances 5,500$ 2,500$ 8,000$

May 8 (2,000) 15,000$ 13,000$ Balances 3,500$ 2,500$ 15,000$ 13,000$ 8,000$

May 11 300 300$ Balances 3,500$ 2,800$ 15,000$ 13,000$ 300$ 8,000$

May 18 150$ (150) Balances 3,500$ 150$ 2,650$ 15,000$ 13,000$ 300$ 8,000$

May 25 75 (75) Balances 3,575$ 75$ 2,650$ 15,000$ 13,000$ 300$ 8,000$

May 28 (150) (150) Balances 3,425$ 75$ 2,650$ 15,000$ 13,000$ 150$ 8,000$

May 29 750 750 Balances 4,175$ 75$ 2,650$ 15,000$ 13,000$ 150$ 8,000$ 750$

May 31 (50) (50) Balances 4,125$ 75$ 2,650$ 15,000$ 13,000$ 150$ 8,000$ 700$

Owners' Equity

These transactions impact the

Statement of Cash Flows.

These transactions impact the

Statement of Cash Flows.

These transactions impact the Income

Statement.

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, 2005.


2-75

JJ's Lawn Care ServiceIncome Statement

For the Month Ended May 31, 2005

Sales Revenue 750$ Operating Expense: Gasoline Expense 50 Net Income 700$

Investments by and payments to the owners are not included on the Income Statement.

Investments by and payments to the owners are not included on the Income Statement.


2-76JJ's Lawn Care ServiceStatement of Cash Flows

For the Month Ended May 31, 2005Cash flows from operating activities: Cash received from revenue transactions 750$ Cash paid for expenses (50) Net cash provided by operating activities 700$ Cash flows from investing activities: Purchase of lawn mower (2,500)$ Purchase of truck (2,000) Collection for sale of repair parts 75 Payment for repair parts (150) Net cash used by investing activities (4,575) Cash flows from financing activities: Investment by owners 8,000 Increase in cash for month 4,125$ Cash balance, May 1, 2005 - Cash balance, May 31, 2005 4,125$




Operating activities include the cash effects of revenue and expense

transactions.

Operating activities include the cash effects of revenue and expense

transactions.




Investing activities include the cash effects of purchasing and selling

assets.

Investing activities include the cash effects of purchasing and selling

assets.




Financing activities include the cash effects of transactions with the owners

and creditors.

Financing activities include the cash effects of transactions with the owners

and creditors.


2-80


Cash +Accts. Rec. +


Notes Payable +

Accts. Pay. +

Capital Stock +

Retained Earnings

May 1 8,000$ 8,000$ Balances 8,000$ 8,000$

May 2 (2,500) 2,500$ Balances 5,500$ 2,500$ 8,000$

May 8 (2,000) 15,000$ 13,000$ Balances 3,500$ 2,500$ 15,000$ 13,000$ 8,000$

May 11 300 300$ Balances 3,500$ 2,800$ 15,000$ 13,000$ 300$ 8,000$

May 18 150$ (150) Balances 3,500$ 150$ 2,650$ 15,000$ 13,000$ 300$ 8,000$

May 25 75 (75) Balances 3,575$ 75$ 2,650$ 15,000$ 13,000$ 300$ 8,000$

May 28 (150) (150) Balances 3,425$ 75$ 2,650$ 15,000$ 13,000$ 150$ 8,000$

May 29 750 750 Balances 4,175$ 75$ 2,650$ 15,000$ 13,000$ 150$ 8,000$ 750$

May 31 (50) (50) Balances 4,125$ 75$ 2,650$ 15,000$ 13,000$ 150$ 8,000$ 700$

Owners' Equity

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.

These balances will appear on the

Balance Sheet.


2-81

Cash 4,125$ Notes payable 13,000$ Accounts receivable 75 Accounts payable 150 Tools & equipment 2,650 Truck 15,000 Capital stock 8,000

Retained earnings 700 Total assets 21,850$ Total liabilities & equity 21,850$

Assets Liabilities

Owners' Equity



$21,850 = $13,150 + $8,700


$21,850 = $13,150 + $8,700


2-82

Relationships Among Financial Statements

Relationships Among Financial Statements

Date at beginning of period

Date at end of period

Balance Sheet

Balance Sheet

Time

Income Statement



2-83

Financial Statement ArticulationFinancial Statement Articulation

Cash 4,125$ Notes payable 13,000$ Accounts receivable 75 Accounts payable 150 Tools & equipment 2,650 Truck 15,000 Capital stock 8,000

Retained earnings 700 Total assets 21,850$ Total liabilities & equity 21,850$

Assets Liabilities

Owners' Equity


JJ's Lawn Care ServiceStatement of Cash Flows


JJ's Lawn Care ServiceIncome Statement

For the Month Ended May 31, 2005

Sales Revenue 750$ Operating Expense: Gasoline Expense 50 Net Income 700$


2-84

Financial Reporting and Financial Statements

Financial Reporting and Financial Statements


Balance Sheet

Income Statement

Other Information:•Industry•Competition•National economy

Financial statements are just one source of financial

accounting information.


2-85

Forms of Business OrganizationsForms of Business Organizations

Sole Proprietorship

Sole Proprietorship PartnershipPartnership CorporationCorporation


2-86

Reporting Ownership Equity in the Balance Sheet

Reporting Ownership Equity in the Balance Sheet

Owner's equity:

Jill Jones, capital 8,000$ Sole

Proprietorship

Sole Proprietorship

Partners' equity Jill Jones, capital 4,000$ Bill Jones, capital 4,000 Total partners' equity 8,000$

PartnershipPartnership

Owners' equity Capital stock 7,000$ Retained earnings 1,000 Total stockholders' equity 8,000$

CorporationCorporation


2-87

The Use of Financial Statements by External Parties

The Use of Financial Statements by External Parties

Creditors

Investors

Two concerns:

Liquidity

Profitability

Two concerns:

Liquidity

Profitability


2-88

The Need for Adequate DisclosureThe Need for Adequate Disclosure

Notes to the financial

statements often provide facts

necessary for the proper

interpretation of the statements.

Notes to the financial

statements often provide facts

necessary for the proper

interpretation of the statements.

Income Statement

Balance Sheet



2-89

Management’s Interest in Financial Statements

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.


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End of reviewEnd of review

© the mcgraw-hill companies, inc., 2005 mcgraw-hill/irwin 2-1 review: accounting and basic...

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