2-1

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 Accounting
What the Numbers Mean
CHAPTER 2: Financial Statements and
Accounting Concepts/Principles

Marshall, McManus, and Viele

12th Edition

2-2
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 Learning Objectives
After studying this chapter, you should understand and be able to:
LO 2-1: Explain what transactions are.
LO 2-2: Identify and explain the kind of information reported in each financial statement
and describe how financial statements are related to each other.
LO 2-3: Explain the meaning and usefulness of the accounting equation.
LO 2-4: Explain the meaning of each of the captions on the financial statements illustrated
in this chapter.
LO 2-5: Identify and explain the broad, generally accepted concepts and principles that
apply to the accounting process.
LO 2-6: Discuss why investors must carefully consider cash flow information in
conjunction with accrual accounting results.
LO 2-7: Identify and explain several limitations of financial statements.
LO 2-8: Describe what a corporation’s annual report is and why it is issued.

2-3
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 Financial Statements

Transactions are economic

interchanges between entities that are
accounted for and reflected in financial
statements.

Learning Objective 2-1: Explain what transactions are. 2-4

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 Financial Statements

Learning Objective 2-1: Explain what transactions are. 2-5

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 Accounts
Transactions
Transactions are
are
summarized
summarized in
in accounts.
accounts.

An
An account
account isis aa record
record in
in which
which
transactions
transactions affecting
affecting individual
individual assets,
assets,
liabilities,
liabilities, stockholders’
stockholders’equity,
equity, revenues,
revenues,
and
and expenses
expenses are are recorded.
recorded.

Accounts
Accounts are
are further
further
summarized
summarized in
in the
the financial
financial
statements.
statements.
Learning Objective 2-1: Explain what transactions are. 2-6
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 Financial Statements
Financial Statements
Required Disclosure that Satisfy
Requirement
Financial position at the
Balance Sheet
end of the period
Earnings for the period Income Statement
Cash flows during the
Statement of Cash Flows
period
Investments by and
Statement of Changes in
distributions to owners
Stockholders' Equity
during the period

In addition to the financial statements, the annual report will

probably include several accompanying notes that include
explanations of the accounting policies used and detailed
information about many of the amounts and captions shown
on the financial statements.
Learning Objective 2-2: Identify and explain the kind of information reported in each financial statement and describe how financial statements
are related to each other. 2-7
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 Balance Sheet—Elements
Assets
Assetsrepresent
representthe
theamount
amountof ofresources
resources
owned Liabilities
Liabilitiesare
ownedby bythe
theentity.
entity. are
amounts
amountsowedowed
to
toother
otherentities.
entities.

Stockholders’
Stockholders’
equity
equityisisthethe
ownership
ownershipright rightofof
the
thestockholder(s)
stockholder(s)
ofofthe
theentity
entityininthe
the
assets
assetsthat thatremain
remain
after
afterdeducting
deductingthe the
liabilities.
liabilities.

Learning Objective 2-3: Explain the meaning and usefulness of the accounting equation. 2-8
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 Balance Sheet
Presents the balances in an entity's accounts at a given point in time

Assets = Liabilities + Equity

Learning Objective 2-3: Explain the meaning and usefulness of the accounting equation. 2-9
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 Balance Sheet
Accounts receivable Amounts due from customers
Merchandise inventory Cost of merchandise acquired but not yet sold
Equipment Cost of equipment purchased and used in business
Accumulated Portion of the cost of equipment that is estimated to have
depreciation been used up in the process of operating the business
Depreciation Process of spreading the cost of an asset over its useful life
to the entity
Short-term debt Amounts borrowed that will be repaid within one year of the
balance sheet date
Accounts payable Amounts due to suppliers
Other accrued liabilities Amounts owed to various creditors
Long-term debt Amounts borrowed from banks or other creditors that will
not be repaid within one year from the balance sheet date
Stockholders' equity Residual claim of owners, computed as "assets minus
liabilities"

Learning Objective 2-3: Explain the meaning and usefulness of the accounting equation. 2 - 10
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 Balance Sheet
Current assets are those assets that are likely to be
converted into cash or used to benefit the entity within
one year.

Plant and
equipment
includes long-
term assets
that will benefit
the entity over
several years.

Learning Objective 2-3: Explain the meaning and usefulness of the accounting equation. 2 - 11
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 Balance Sheet
Long-term debts are those debts that will not be repaid
within one year of the balance sheet date.

Current
liabilities
are those
liabilities
that are
to be paid
within
one year.

Learning Objective 2-3: Explain the meaning and usefulness of the accounting equation. 2 - 12
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 Income Statement
The
Theincome
incomestatement
statement shows
showsthe
thenet
netincome
income(or
(ornet
net
loss)
loss) for
forthe
theperiod
periodof
oftime
timeunder
underconsideration.
consideration.
Revenues
Revenuesresult
resultfrom
fromthe
theentity’s
entity’s Expenses
operating Expensesare
areincurred
incurrediningenerating
generating
operatingactivities
activities(e.g.,
(e.g.,selling
selling revenues
revenuesand
andoperating
operatingthe
theentity.
entity.
merchandise).
merchandise).

Notice that the

statement starts
with net sales and
that the various
expenses are
subtracted to arrive
at net income.

Learning Objective 2-4: Explain the meaning of each of the captions on the financial statements illustrated in this
chapter. 2 - 13
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 Income Statement
Earnings per share of common
Income taxes are shown after stock outstanding is reported as
a separate item at the bottom of
all the other income statement the income statement because of
items have been reported. its significance in evaluating the
market value of a share of
common stock.

Learning Objective 2-4: Explain the meaning of each of the captions on the financial statements illustrated in this
chapter. 2 - 14
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 Income Statement
Captions Explanation
Net sales Amount of sales of merchandise to customers, less the
amount of customer returns of merchandise
Cost of goods sold Represents the total cost of merchandise removed from
inventory and delivered to customers as a result of sales
Gross profit Difference between net sales and cost of goods sold and
represents the seller's maximum amount of "cushion" from
which all other expenses of the business must be
deducted before it is possible to have net income
Selling, general, and Represents the operating expenses of the entity
administrative expenses

Income from operations Represents one of the most important measures of the
firm's activities
Interest expense Represents the cost of using borrowed funds
Income taxes Shown after all of the other income statement items have
been reported, because income taxes are a function of the
firm's income before taxes
Earnings per share of A significant item in evaluating the market value of a share
common stock of common stock; often referred to as EPS
outstanding
Learning Objective 2-4: Explain the meaning of each of the captions on the financial statements illustrated in this
chapter. 2 - 15
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 Statement of Changes
in Stockholders' Equity
MAIN STREET STORE, INC.
Statement of Changes in Stockholders’ Equity
For the Year Ended August 31, 2020
Paid-In Capital:
Beginning balance $ –0–
Common stock, par value, $10; 50,000 shares authorized,
10,000 shares issued and outstanding 100,000
Additional paid-in capital 90,000
Balance, August 31, 2020 $190,000
Retained Earnings:
Beginning balance $ –0–
Net income for the year 18,000
Less: Cash dividends of $.50 per share (5,000)
Balance, August 31, 2020 $ 13,000
Total stockholders’ equity $203,000

This financial statement shows the details of stockholders' equity and

explains the changes that occurred in the components of stockholders'
equity during the year.
Learning Objective 2-4: Explain the meaning of each of the captions on the financial statements illustrated in this
chapter. 2 - 16
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 Statement of Changes
in Stockholders' Equity
Captions Explanation
Paid-in capital Represents the total amount invested in the entity by
the owners
Common stock Reflects the number of shares authorized by the
corporation's charter, the number of shares issued to
stockholders, and the number of shares still held by
the stockholders
Additional paid-in Difference between the total amount invested by the
capital stockholders and the par value or stated value of the
Retained earnings stock
Represents the cumulative net income of the entity
that has been retained for use in the business
Dividends Distributions of earnings to the stockholders

Learning Objective 2-4: Explain the meaning of each of the captions on the financial statements illustrated in this
chapter. 2 - 17
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 Statement of Cash Flows
The purpose of this financial statement is to identify the
sources and uses of cash during the year.
MAIN STREET STORE, INC.
Statement of Cash Flows
For the Year Ended August 31, 2020
Cash Flows from Operating Activities:
Net income $ 18,000
Add (deduct) items not affecting cash:
Depreciation expense 4,000
Increase in accounts receivable (80,000)
Increase in merchandise inventory (170,000)
Increase in current liabilities 67,000
Net cash used by operating activities $(161,000)
Cash Flows from Investing Activities:
Cash paid for equipment $ (40,000)
Cash Flows from Financing Activities:
Cash received from issue of long-term debt $ 50,000
Cash received from sale of common stock 190,000
Payment of cash dividend on common stock (5,000)
Net cash provided by financing activities $ 235,000
Net increase in cash for the year $ 34,000
Learning Objective 2-4: Explain the meaning of each of the captions on the financial statements illustrated in this
chapter. 2 - 18
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 Statement of Cash Flows
Captions Explanation
Cash flows from Shown first; net income is the starting point for this
operating activities measure of cash flow
Depreciation expense Added back to net income because it is subtracted to
arrive at net income, but does not require the use of cash
Increase in accounts Deducted because it reflects sales revenues included in
receivable net income, but not yet received in cash
Increase in Deducted because cash was spent to acquire the
merchandise inventory increase in inventory
Increase in current Added because cash has not yet been paid for the
liabilities products and services that have been received during the
current fiscal period
Cash flows from Show the cash sources and uses related to long-lived
investing activities assets
Cash flows from Show the cash sources and uses related to transactions
financing activities with creditors and stockholders
Learning Objective 2-4: Explain the meaning of each of the captions on the financial statements illustrated in this
chapter. 2 - 19
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 Time-Line Model

Learning Objective 2-4: Explain the meaning of each of the captions on the financial statements illustrated in this
chapter. 2 - 20
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 Financial Statement Relationships

The arrow indicates that net income

affects retained earnings, which is a
component of stockholders' equity.

Learning Objective 2-4: Explain the meaning of each of the captions on the financial statements illustrated in this
chapter. 2 - 21
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 Financial Statement Relationships

Learning Objective 2-4: Explain the meaning of each of the captions on the financial statements illustrated in this
chapter. 2 - 22
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 Financial Statement Relationships

If assets equal $320,000 and liabilities equal $117,000,

what is stockholders' equity?

Balance Sheet
Stockholders'
Assets = Liabilities + Equity
320,000 = 117,000 + ?

Learning Objective 2-4: Explain the meaning of each of the captions on the financial statements illustrated in this
chapter. 2 - 23
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 Financial Statement Relationships

If assets equal $320,000 and liabilities equal $117,000,

what is stockholders' equity?
Balance Sheet
Stockholders'
Assets = Liabilities + Equity
320,000 = 117,000 + 203,000

Stockholders' equity equals $203,000.

($320,000 - $117,000)
Learning Objective 2-4: Explain the meaning of each of the captions on the financial statements illustrated in this
chapter. 2 - 24
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 Financial Statement Relationships
Now, suppose that total assets increase by $10,000 during
the year and total liabilities decrease by $3,000 during the
year.

Balance Sheet
Stockholders'
Assets = Liabilities + Equity
320,000 117,000 203,000
10,000 (3,000) ?
330,000 114,000 ?

What is stockholders' equity at the end of the year?

Learning Objective 2-4: Explain the meaning of each of the captions on the financial statements illustrated in this
chapter. 2 - 25
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 Financial Statement Relationships
Stockholders' equity must have increased by $13,000.
Since stockholders' equity was $203,000 at the beginning
of the year, it must be $216,000 at the end of the year.

Balance Sheet
Stockholders'
Assets = Liabilities + Equity
320,000 117,000 203,000
10,000 (3,000) 13,000
330,000 114,000 216,000

Learning Objective 2-4: Explain the meaning of each of the captions on the financial statements illustrated in this
chapter. 2 - 26
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 Accounting Concepts and
Principles

Learning Objective 2-5: Identify and explain the broad, generally accepted concepts and principles that apply to the accounting
process. 2 - 27
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 Concepts/Principles Related to the
Entire Model
Accounting equation
Assets = Liabilities + Stockholders’
equity

Accounting Entity Going Concern Concept

Every economic entity can be The presumption that the entity will
separately identified and accounted continue to operate in the future—
for. that it is not being liquidated.

Learning Objective 2-5: Identify and explain the broad, generally accepted concepts and principles that apply to the accounting
process. 2 - 28
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 Concepts/Principles Related to
Transactions
Unit of Measurement
Only transactions denominated in
dollars (currency) are recorded in the
accounting records.

Cost Principle Objectivity

Transactions are recorded at their The accountant’s desire to have a given
original cost to the entity as transaction recorded in the same way
measured in dollars. in all situations

Learning Objective 2-5: Identify and explain the broad, generally accepted concepts and principles that apply to the accounting
process. 2 - 29
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 Concepts/Principles Related to Bookkeeping
Procedures and the Accounting Process
Accounting Period Matching revenue and expense
The period of time selected for
All expenses incurred to generate
reporting results of operations and
that period’s revenues are to be
changes in financial position
deducted from the revenues earned.

Revenue is recognized at the

Accrual Accounting
time of sale.
Recognize revenue at the point of
When the title to the product being sale and recognize expenses when
sold passes from the seller to the incurred, even though the cash
buyer or when the services involved in receipt or payment may occur at
the transaction have been performed another time.
Learning Objective 2-5: Identify and explain the broad, generally accepted concepts and principles that apply to the accounting
process. 2 - 30
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 Concepts/Principles Related to
Financial Statements

Consistency Full Disclosure

Provides meaningful trend Circumstances and events that make a
comparisons over several years difference to financial statement users
should be disclosed.

Materiality Conservatism
The benefit of increased accuracy When in doubt, make judgments and
should outweigh the cost of estimates that result in lower profits
achieving the increased accuracy. and asset valuations.

Learning Objective 2-5: Identify and explain the broad, generally accepted concepts and principles that apply to the accounting
process. 2 - 31
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 Accrual Accounting Vs. Cash Flows
Revenue Recognition -Timing Is the Key
Accrual accounting Cash flow
recognizes: recognizes:

Revenue Revenue
when revenue is earned, when payment is received
at the point of sale of for services rendered
services or products or products sold

Expenses Expenses
when they are incurred when they are paid
Learning Objective 2-6: Describe why investors must carefully consider cash flow information in conjunction with accrual accounting
results. 2 - 32
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 Limitations of Financial
Statements
Financial statements
report only quantitative
Qualitative
economic economic data.
variables are
usually subjective
They do not reflect
in value and qualitative economic
cannot be variables, such as the
quantified in
terms of dollars
value of the
and cents that can management team or the
be verified. employees’ morale.

How do the terms “quantitative” and “qualitative” differ?

Learning Objective 2-7: Identify and explain several limitations of financial statements. 2 - 33
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 Limitations of Financial
Statements
Cost Concept Matching Concept
Assets are usually valued Estimates are
at the cost of the asset acceptable, provided
when acquired. there is a basis for them.

The balance sheet does Many estimates are

not report market values used, such as warranty
or replacement costs of costs, depreciation, and
the assets. pension expense.
Learning Objective 2-7: Identify and explain several limitations of financial statements. 2 - 34
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 The Corporation’s Annual Report

The annual report is

distributed to
shareholders (and others).
It contains the financial
statements, together with
the report of the external
auditor’s examination of
the financial statements.

Learning Objective 2-8: Describe what a corporation’s annual report is and why it is issued. 2 - 35
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 End of Chapter 2

2 - 36
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