Chapter

2 BASIC FINANCIAL
STATEMENTS

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 Financial
Financial Statements
Statements Preparation
Preparation
Process
Process

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 Introduction
Introduction to
to Financial
Financial Statements
Statements
A primary source of financial information is a company’s
financial statements.
 Companies prepare interim financial statements and
annual financial statements.
 Interim financial statements: Financial statements prepared
for periods of time shorter than one year (for example, for three
months or one month) 2000
 Annual financial statement: are for a year

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 Introduction
Introduction to
to Financial
Financial Statements
Statements
 Investors and creditors are particularly interested in
cash flows that they expect to receive in the future.
 Creditors, who have made loan or sold merchandise on
credit are interested in the payment of interest.
 Investors are interested in the market value of their
stock holdings, as well as dividends that the enterprise
will pay while they own the stock.
How investors & creditors will assess/analyze that the
enterprise will be able to make future cash payments?

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 Introduction
Introduction to
to Financial
Financial Statements
Statements
A financial statement is simply a declaration of what is believed to
be true about an enterprise, communicated in terms of a
monetary unit, such as the dollar .
Three primary financial statements.

Balance Sheet

Income Statement We will use a corporation

to describe these
Statement of Cash Flows statements.

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 Introduction
Introduction to
to Financial
Financial Statements
Statements
Balance Sheet
Describes
where the
Income Statement enterprise
stands at a
Statement of Cash Flows
specific date.

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 Introduction
Introduction to
to Financial
Financial Statements
Statements
Balance Sheet

Income Statement
Depicts the
revenue and
Statement of Cash Flows expenses for a
designated
period of time.

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 Introduction
Introduction to
to Financial
Financial Statements
Statements

Revenues Expenses
result in result in
positive negative
cash flow. cash flow.

Either in the past, present, or future.

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 Cash
Cash Flow
Flow
Meaning: the movement of money in and out of a
business.
Cash received signifies inflows
Cash spent signifies outflows
For example: A company sells a product of $100.
Immediate positive cash flow: If the customer pay cash
at the time of transaction (Cash Transaction)
Expected future cash flows: If the customer make the
payment in future (Credit Transaction)

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 Introduction
Introduction to
to Financial
Financial Statements
Statements
Balance Sheet

Income Statement
Net income (or
net loss) is
Statement of Cash Flows simply the
difference
between
revenues and
expenses.

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 Introduction
Introduction to
to Financial
Financial Statements
Statements
Balance Sheet

Income Statement

Statement of Cash Flows

Depicts the
ways cash has
changed during
a designated
period of time.

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 GAAP
GAAP 1:
1: The
The Concept
Concept of
of the
the
Business
Business Entity
Entity
A business entity is
an economic unit
that engages in
identifiable business
activities.
Vagabond
A business entity is
Travel
separate from the
Agency
personal activities of
its owner.

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 A
A Starting
Starting Point:
Point: Statement
Statement of
of
Financial
Financial Position
Position
Vagabond Travel Agency
Balance Sheet
December 31, 2011
Assets 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

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 Assets
Assets
Vagabond Travel Agency
Balance Sheet
December 31, 2002
Assets Liabilities & Owners' Equity
Cash Assets are
$ 22,500 Liabilities:
Notes receivable 10,000 economic resources
Notes payable $ 41,000
Accounts receivable 60,500 Accounts payable 36,000
Supplies 2,000 that are owned by
Salaries payable 3,000
Land
Building
100,000
the business and
Total liabilities
90,000 Owners' Equity:
$ 80,000

Office equipment 15,000 are expected to

Capital stock 150,000
Retained earnings 70,000
Total
provide positive
$ 300,000 Total $ 300,000
future cash flows.
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 Assets
Assets
 Expected positive future cash flows
1. When an asset is converted into cash i.e. notes
receivable & accounts receivable
2. Asset is used in operating the business to
create other assets i.e. plant, machinery, building
or land used to manufacture a product for sale
 Account Receivables: The balance of a money due to
a firm for goods/services delivered or used but not yet
paid for by the customers
 or amount to be collected in near future due to sale of
goods & services “on credit”

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 Assets
Assets
 Account receivables are short term expected to be
collected within 30 or 60 days, informal and involve
usually no interest
 Notes receivable are long term, legal contract and
usually has an interest
 Physical and tangible assets : Land, Building,
Machinery, Plant,
 Intangible assets: having no physical existence but
used in business operations & are non current.
1. Patent: an exclusive right granted by the federal
government for manufacture, use, and sale of a
particular product (invention) for 20 years

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 Assets
Assets
2. Brand name or trademark: A name, symbol, or design
that identifies a product or group of products e.g.
Cococola, Nike, Addidas, Puma
3. Goodwill are variety of favorable attributes of any
company e.g. company’s reputation, quality, management,
loyal employees, advertising image
4. Franchise: a right granted by a company or a
governmental unit to conduct a certain type of business
e.g. McDonalds
5. Copyright: An exclusive right granted by the federal
government to protect the production and sale of literary
or artistic materials for the life of the creator plus 70 years.

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 Assets
Assets
The most basic and at the same time most controversial
problems in accounting is determining the correct dollar
amount for the various assets of a business.

Cost Principle

These accounting
Stable-Dollar principles support Going-Concern
Assumption cost as the basis Assumption
for asset valuation.
Objectivity
Principle
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 The
The Cost
Cost Principle
Principle
Assets should be recorded at cost, rather than at
their current value/ market value
Thus, assets are shown in the balance sheet at their
historical cost (the original cost of the asset on
which it is bought)
Cost of tract of land $100,000 purchased in year
2012. 10 years later in year 2021 market value is
$250,000
What value of land will be recorded in B.S?

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 Going-concern
Going-concern Assumption
Assumption
Why don’t accountants change the recorded values
of assets with changing market prices?
Assets like land and buildings are acquired for use
not for resale
As these properties are not intended for sale their
market value is of less concern
And, business is a continuing enterprise or a going-
concern and will continue to trade for the
foreseeable future.

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 Objectivity
Objectivity Principle
Principle
Another reason for using cost rather than current
market value for assets is the need for definite,
factual basis for valuation
Objective is a term used to describe asset
valuations that are factual and verifiable by
independent experts e.g. CPA who perform an audit
of the business
Estimated market values for assets are not factual
and objective and are largely a matter of judgment,
opinion or biasness.
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 The
The Stable
Stable Dollar
Dollar Assumption
Assumption
The stable dollar assumption, is where accountants
assume that dollar is a stable unit of measurement and
it will remain constant across fiscal periods. The
inflation rate is assumed to be zero.
A limitation of measuring assets at historical cost is
that the monetary unit or dollar is not always stable
Cost principle and stable dollar assumption work well
in periods of stable prices and less satisfactory in
period of inflation
FASB required that financial data adjusted for inflation
but later concluded that it was not cost effective
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 Liabilities
Liabilities
Vagabond Travel Agency
Balance Sheet
December 31, 2002
Assets Liabilities & Owners' Equity
CashLiabilities are $ 22,500 Liabilities:
Notes receivable 10,000 Notes payable $ 41,000
debts that
Accounts receivable 60,500 Accounts payable 36,000
represent negative
Supplies
Land
2,000
100,000
Salaries payable
Total liabilities
3,000
$ 80,000
future cash flows
Building 90,000 Owners' Equity:
Office equipment 15,000 Capital stock 150,000
for the enterprise. Retained earnings 70,000
Total $ 300,000 Total $ 300,000

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 Liabilities
Liabilities
The person/organization to whom the debt is owed is
called a creditor
Liabilities are listed in order when they are expected to
be repaid (short term liability=expected to repaid within
1 Year)
Accounts payable: Purchasing merchandise, supplies and
services “on account” or “on credit”. Accounts payable
involve no written promises and interest payment
Note payable is a written promise to repay the amount
owed by a particular date & usually call for interest as
well

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 Liabilities
Liabilities
Liabilities that are similar may be combined
together
For example: interest, taxes payable may be
combined together and termed as “accrued
expenses”
Accrued means certain expenses have been
delayed or deferred
Creditor’s claim take legal priority over that of
owner
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 Owners’
Owners’ Equity
Equity
Vagabond Travel Agency
Balance Sheet
December 31, 2002
Assets Liabilities & Owners' Equity
CashOwners’ equity $ 22,500 Liabilities:
Notes receivable 10,000 Notes payable $ 41,000
represents the
Accounts receivable 60,500 Accounts payable 36,000
owner’s claim to
Supplies
Land
2,000
100,000
Salaries payable
Total liabilities
3,000
$ 80,000
the assets of the
Building 90,000 Owners' Equity:
Office equipment 15,000 Capital stock 150,000
business. Retained earnings 70,000
Total $ 300,000 Total $ 300,000

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 Owners’
Owners’ Equity
Equity
Changes in Owners’
Equity

•Owners’ •Payments
Investments to Owners
•Business •Business
Earnings Losses

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 Owner’s
Owner’s Equity
Equity
As the creditor’s claim has a priority over those
of the owner, owner’s equity is a residual
amount or residual claim (secondary to the
claim of creditors)
Therefore, owner’s equity is always equal to
total assets minus total liabilities

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 The
The Accounting
Accounting Equation
Equation
Assets
Assets ==Vagabond
Liabilities ++ Agency
Travel
Liabilities Owners’
Owners’ Equity
Equity
Balance Sheet
December 31, 2002
$300,000
Assets=
$300,000 = $80,000
$80,000 +Liabilities
+ $220,000
$220,000
& 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

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 The
The Accounting
Accounting Equation
Equation
Why do total assets equal the total liabilities
and owner’s equity?
The two sides of the balance sheet are two
views of the same business
The listing of assets shows us what things
business own
The listing of liabilities & O.E tells us who
supplied these resources to the business and
how much each group supplied?

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 Let’s analyze
some
transactions for
JJ’s Lawn Care
Service.

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 On May 1, 2003, Jill Jones and her family
invested $8,000 in JJ’s Lawn Care Service and
received 800 shares of stock.
JJ's Lawn Care Service
Balance Sheet
May 1, 2003
Assets Owners' Equity
Cash $ 8,000 Capital Stock $ 8,000

Total $ 8,000 Total $ 8,000

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 On May 2, JJ’s purchased a riding lawn
mower for $2,500 cash.
JJ's Lawn Care Service
Balance Sheet
May 2, 2003
Assets Owners' Equity
Cash $ 5,500 Capital Stock $ 8,000
Tools & Equipment 2,500

Total $ 8,000 Total $ 8,000

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 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.
JJ's Lawn Care Service
Balance Sheet
May 8, 2003
Assets Liabilities and Owners' Equity
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

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 On May 11, JJ’s purchased some repair
parts for $300 on account.
JJ's Lawn Care Service
Balance Sheet
May 11, 2003
Assets Liabilities and Owners' Equity
Cash $ 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

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 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.

JJ's Lawn Care Service

Balance Sheet
May 18, 2003
Assets Liabilities and Owners' Equity
Cash $ 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

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

JJ's Lawn Care Service

Balance Sheet
May 25, 2003
Assets Liabilities and Owners' Equity
Cash $ 3,575 Liabilities:
Accounts Receivable 75 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

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 On May 28, JJ’s pays $150 of its accounts
payable.
JJ's Lawn Care Service
Balance Sheet
May 28, 2003
Assets Liabilities and Owners' Equity
Cash $ 3,425 Liabilities:
Accounts Receivable 75 Notes Payable $ 13,000
Tools & Equipment 2,650 Accounts Payable 150
Truck 15,000 Total Liabilities 13,150
Owners' Equity:
Capital Stock 8,000

Total $ 21,150 Total $ 21,150

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 On May 29, JJ’s recorded lawn care services
provided during May of $750. All clients paid in
cash.
JJ's Lawn Care Service
Balance Sheet
May 29, 2003
Assets Liabilities and Owners' Equity
Cash $ 4,175 Liabilities:
Accounts Receivable 75 Notes Payable $ 13,000
Tools & Equipment 2,650 Accounts Payable 150
Truck 15,000 Total Liabilities 13,150
Owners' Equity:
Capital Stock 8,000
Retained Earnings 750
Total $ 21,900 Total $ 21,900

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 On May 31, JJ’s purchased gasoline for the
lawn mower and the truck for $50 cash.
JJ's Lawn Care Service
Balance Sheet
May 31, 2003
Assets Liabilities and Owners' Equity
Cash $ 4,125 Liabilities:
Accounts Receivable 75 Notes Payable $ 13,000
Tools & Equipment 2,650 Accounts Payable 150
Truck 15,000 Total Liabilities 13,150
Owners' Equity:
Capital Stock 8,000
Retained Earnings 700
Total $ 21,850 Total $ 21,850
Now, let’s review how JJ’s transactions
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affected the accounting©equation.
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 Assets = Liabilities + Owners' Equity
Accts. Tools & Notes Accts. Capital Retained
Cash + Rec. + Equip. + Truck = Payable + Pay. + Stock + 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

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 Let’s prepare the Income Statement and Statement
of Cash Flows for JJ’s Lawn Care Service for the
month ending May 31, 2003.
Assets = Liabilities + Owners' Equity
Accts. Tools & Notes Accts. Capital Retained
Cash + Rec. + Equip. + Truck = Payable + Pay. + Stock + Earnings
May 1 $ 8,000
These
These transactions
transactions $ 8,000
Balances $ 8,000 impact
impact the
the $ 8,000
May 2 (2,500) $ 2,500
Balances $ 5,500 $ 2,500Statement
Statement of of Cash
Cash $ 8,000
May 8 (2,000) $ 15,000 $ 13,000
Balances $ 3,500 $ 2,500
Flows.
Flows.
$ 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) These
These transactions
transactions (150)
Balances
May 29
$ 3,425
750
$ 75 $ 2,650
impact
$ 15,000
the Income
$ 13,000
impact the Income
$ 150
$ 8,000
750
Balances $ 4,175 $ 75 $ 2,650 Statement.
Statement.
$ 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
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 JJ's Lawn Care Service
Income Statement
For the Month Ended May 31, 2003

Sales Revenue $ 750

Operating Expense:
Gasoline Expense 50
Net Income $ 700

Investments
Investments by by and
and payments
payments to to the
the owners
owners
are
are not
not included
included on
on the
the Income
Income Statement.
Statement.
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 JJ's Lawn Care Service
Statement of Cash Flows
For the Month Ended May 31, 2003
Cash 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, 2003 -
Cash balance, May 31, 2003 $ 4,125

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 Income
Income Statement
Statement
Representation of company’s revenue &
expense transaction
Revenue & expense are important source of
cash flows for the business
Revenue: increases in the company’s assets
from its profit directed activities that result in
positive cash flows
Expense: decreases in the company’s assets
from its profit directed activities resulting in
negative cash flows
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 JJ's Lawn Care Service
Statement of Cash Flows
For the Month Ended May 31, 2003
Cash 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:
Operating
of lawn activities
Operating
Purchase activities include
mower include$ the
the cash
(2,500)cash
effects
Purchase of truckof revenue and expense
effects of revenue and (2,000)
expense
Collection for sale of repair parts 75
transactions.
transactions.
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, 2003 -
Cash balance, May 31, 2003 $ 4,125

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 JJ's Lawn Care Service
Statement of Cash Flows
For the Month Ended May 31, 2003
Cash 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:
Investing
Investing
Investment activities
activities include
by owners include the
the cash
cash 8,000
effects
Increase
effects of
in cash for
of purchasing
month
purchasing and
and selling
selling$ 4,125
Cash balance, May 1, 2003 -
Cash balance, May 31, 2003 assets.
assets. $ 4,125

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 JJ's Lawn Care Service
Statement of Cash Flows
For the Month Ended May 31, 2003
Cash 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)
Financing
Financing
Purchase
activities include
of truck activities include (2,000)
the
the cash
cash
effects
effectsfor
Collection of transactions
ofsale of repair parts with
transactions with the
the owner’s
owner’s
75
Payment for repair parts (150)
investment
investment and
and creditors’
creditors’
Net cash used by investing activities
loaning
loaning &
&
(4,575)
repayment
Cash flows from financing of
repayment of either
either or
activities: or both
both ..
Investment by owners 8,000
Increase in cash for month $ 4,125
Cash balance, May 1, 2003 -
Cash balance, May 31, 2003 $ 4,125

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 Relationships
Relationships Among
Among Financial
Financial
Statements
Statements

Beginning End of
of period Time period

Balance Balance
Sheet Sheet

Income Statement
Statement of Cash Flows
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 Relationships
Relationships Among
Among Financial
Financial
Statements
Statements
The three statements present three different “view” of a
company
How these F.S. relate to the period of time they cover?
B.S. is prepared at the beginning or ending points in
time, that gives a static look in terms of financial terms
where a company stands
I.S. and Statement of cash flow, covers the intervening
period of time between the two B.S.
Explaining the changes that occurred during the period

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 Forms
Forms of
of Business
Business Organizations
Organizations

Sole
Sole Partnership
Partnership Corporation
Corporation
Proprietorship
Proprietorship

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 Reporting
Reporting Ownership
Ownership Equity
Equity in
in the
the
Balance
Balance Sheet
Sheet
Sole
Sole Ow ner's equity:
Proprietorship
Proprietorship Jill Jones, capital $ 8,000

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

Owners' equity
Capital stock $ 7,000
Corporation
Corporation Retained earnings 1,000
Total stockholders' equity $ 8,000
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 The
The Use
Use of
of Financial
Financial Statements
Statements by
by
Outsiders
Outsiders

Two
Two concerns:
concerns:
Creditors Solvency
Solvency
Profitability
Profitability

Investors
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 The
The Need
Need for
for Adequate
Adequate Disclosure
Disclosure
Balance Sheet Notes
Notes to
to the
the
Income Statement
financial
financial
statements
statements often
often
Statement of Cash Flows
provide
provide facts
facts
necessary
necessary forfor the
the
proper
proper
interpretation
interpretation of of
the
the statements.
statements.

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 The
The Need
Need for
for Adequate
Adequate Disclosure
Disclosure
A company should disclose any financial facts that a
reasonably informed person would consider necessary
for the proper interpretation of F.S.
They may appear either in the body or in notes
accompanying statements.
Subsequent events ( events that occur after the date of
F.S.) or situations like lawsuits against the company,
due dates of major liabilities, assets pledged as
collateral to secure loan, amounts receivable from
officer or any insider

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 End
End of
of Chapter
Chapter 22

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 20