Accounting Principles

CHAPTER 2 Financial Statements and Accounting Concepts/Principles

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Financial Statements Transactions •Procedures for sorting, classifying, and presenting (bookkeeping) •Selection of alternative methods of reflecting the effects of certain transactions (accounting)

Financial Statements An entity’s financial statements are the end product of a process that starts with transactions between the entity and other organizations and individuals. McGraw-Hill/Irwin

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Accounts

Cash

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

Accounts Receivable Accounts Payable

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Accounts Accounts are are further further summarized summarized in in the the financial financial statements. statements.

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Financial Statements Required Disclosure Financial position at the end of the period Earnings for the period Cash flows during the period Investments by and distributions to owners during the period

Financial Statement that Satisfies Requirement Balance Sheet Income Statement Statement of Cash Flows Statement of Changes in Owners' Equity

In addition to the financial statements, the annual report will probably include several accompanying footnotes or explanations of the accounting policies and detailed information about many of the amounts and captions shown on the financial statements. McGraw-Hill/Irwin

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Balance Sheet Assets Assetsrepresent representthe theamount amountof ofresources resources owned ownedby bythe theentity. entity.

Liabilities Liabilitiesare are amounts amountsowed owedto to other otherentities. entities.

Equity Equityis isthe the ownership ownershipright rightof of the theowner(s) owner(s)of ofthe the entity entityin inthe theassets assets that thatremain remainafter after deducting deductingthe the liabilities. liabilities. McGraw-Hill/Irwin

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Balance Sheet Current Currentassets assetsare arethose thoseassets assetsthat thatare are likely likelyto tobe beconverted convertedinto intocash cashor orused usedto to benefit benefitthe theentity entitywithin withinone oneyear. year.

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Current Currentliabilities liabilities are arethose those liabilities liabilitiesthat thatare are likely likelyto tobe bepaid paid with withcash cashwithin within one oneyear yearof ofthe the balance balancesheet sheet date. date.

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Balance Sheet

Assets Assets

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=

Liabilities Liabilities

+

Equity Equity

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Balance Sheet Account

Definition Cash Cash on hand and in the bank Accounts receivable Amounts due from customers Merchandise inventory Cost of merchandise acquired and not yet sold Equipment Cost of equipment purchased and used in business Accumulated depreciation Portion of the cost of equipment that is estimated to have been used up in the process of operating the business 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 liabililites 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 Owners' equity Explained in more detail later in this chapter

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Income Statement The The income income statement statement shows shows the the profit profitfor for the theperiod periodof oftime time under underconsideration. consideration. Revenues Revenuesresult result from fromthe theentity’s entity’s operating operatingactivities activities (e.g., (e.g.,selling selling merchandise). merchandise). Costs Costsand and expenses expensesare are incurred incurredin in generating generating revenues revenuesand and operating operatingthe the entity. entity. McGraw-Hill/Irwin

Main Street Store, Inc. Income Statement For the Year Ended August 31, 2004 Net sales Cost of goods sold Gross profit Selling, general, and admin. expenses Income from operations Interest expense Income before taxes Income taxes Net income Net income per share of common stock outstanding

$

$

1,200,000 850,000 350,000 311,000 39,000 9,000 30,000 12,000 18,000

$

1.80

$ $ $

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Income Statement The The income income statement statement shows shows the the profit profitfor for the theperiod periodof oftime time under underconsideration. consideration. Gains Gainsand andlosses losses are arealso alsoreported reportedon on the theincome income statement statementand and result resultfrom fromnonnonoperating operatingactivities, activities, rather ratherthan thanfrom fromthe the day-to-day day-to-day operating operatingactivities activities that thatgenerate generate revenues revenuesand and expenses. expenses. McGraw-Hill/Irwin

Main Street Store, Inc. Income Statement For the Year Ended August 31, 2004 Net sales Cost of goods sold Gross profit Selling, general, and admin. expenses Income from operations Interest expense Income before taxes Income taxes Net income Net income per share of common stock outstanding

$

$

1,200,000 850,000 350,000 311,000 39,000 9,000 30,000 12,000 18,000

$

1.80

$ $ $

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Income Statement Captions Net sales Cost of goods sold Gross profit

Selling, general, and administrative expenses Income from operations Interest expense Income taxes

Net income per share of common stock McGraw-Hill/Irwin outstanding

Explanation Amount of sales of merchandise to customers, less the amount of customer returns of merchandise Represents the total cost of merchandise removed from inventory and delivered to customers as a result of sales Difference between net sales and cost of goods sold; 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 Represent the operating expenses of the entity Represents one of the most important measures of the firm's activities Represents the cost of using borrowed funds 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 A significant item in evaluating the market value of a share of common stock; Often referred to as "earnings per share" or EPS © 2004 The McGraw-Hill Companies, Inc., All Rights

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Statement of Changes in Owners’ Equity Main Street Store, Inc. Statement of Changes in Owners' Equity For the Year Ended August 31, 2004 Paid-In Capital: Beginning balance Common stock, par value $10; 50,000 shares authorized, 10,000 shares issued and outstanding Additional paid-in capital Balance, August 31, 2004 Retained Earnings: Beginning balance Net income for the year Less: Cash dividends of $.50 per share Balance, August 31, 2004 Total owners' equity

$

$ $

$ $

-

100,000 90,000 190,000 18,000 (5,000) 13,000 203,000

This financial statement shows the detail of owners’ equity and explains the changes that occurred in the components of owners’ equity during the year. McGraw-Hill/Irwin

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Statement of Changes in Owners’ Equity Captions Paid-in capital Common stock

Additional paid-in capital Retained earnings Dividends

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Explanation Represents the total amount invested in the entity by the owners Reflects the number of shares authorized by the corporation's charter, the number of shares issued to stockholders, and the number of shares that are still held by the stockholders Difference between the total amount invested by the owners and the par value or stated value of the stock Represents the cumulative net income of the entity that has been retained for use in the business Are distributions of earnings to the owners

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Statement of Cash Flows M a in S tre e t S tore , Inc. S ta te m e nt of Ca sh Flow s For the Ye a r Ende d August 31, 2004 Ca sh Flow s from Ope ra ting Activitie s: Ne t incom e Add (de duct) ite m s not a ffe cting ca sh: De pre cia tion e x pe nse Incre a se in a ccounts re ce iva ble Incre a se in m e rcha ndise inve ntory Incre a se in curre nt lia bilitie s Ne t ca sh use d by ope ra ting a ctivitie s Ca sh Flow s from Inve sting Activitie s: Ca sh pa id for e quipm e nt Ca sh Flow s from Fina ncing Activitie s: Ca sh re ce ive d from issue of long-te rm de bt Ca sh re ce ive d from sa le of com m on stock P a ym e nt of ca sh divide nd on com m on stock Ne t ca sh provide d by fina ncing a ctivitie s Ne t incre a se in ca sh for the ye a r

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$

18,000 4,000 (80,000) (170,000) 67,000 (161,000)

$ (40,000) 50,000 190,000 (5,000) $ 235,000 $ 34,000

The purpose of this financial statement is to identify the sources and uses of cash during the year.

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Statement of Cash Flows Captions Explanation Cash flows from operating Shown first; Net income is the starting point for this activities measure of cash generation 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 receivable Increase in merchandise inventory Increase in current liabilities

Deducted because it reflects sales revenues, included in net income, but not yet received in cash Deducted because cash was spent to acquire the increase in inventory Added because cash has not yet been paid for the products and services that have been received during the current fiscal period Cash flows from investing Shows the cash sources and uses related to long-lived activities assets Cash flows from financing Shows the cash sources and uses related to transactions activities with creditors and stockholders

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Time-Line Model 8/31/03 Balance Sheet A = L + OE

8/31/04 Fiscal 2004 Income Statement for the Year Revenue - Expenses Net Income

Balance Sheet A = L + OE

Statement of Changes in Owners’ Equity Beginning Balances Paid-in Capital Changes Retained Earnings Changes: + Net Income - Dividends Ending Balances

Statement of Cash Flows

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Cash Provided (Used) by: Operating Activities Investing Activities Financining Activities + Beginning Cash Balance Ending Cash Balance © 2004 The McGraw-Hill Companies, Inc., All Rights

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Financial Statement Relationships Balance Sheet Assets

=

Liabilities +

Income Statement Ow ners' Equity

Net income

=

Revenues

-

Expenses

The arrow indicates that net income affects retained earnings, which is a component of owners’ equity.

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Financial Statement Relationships If assets equal $300,000 and liabilities equal $125,000, what is owners’ equity?

Balance Sheet Assets 300,000

McGraw-Hill/Irwin

= =

Liabilities 125,000

+ +

Owners' Equity ?

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Financial Statement Relationships If assets equal $300,000 and liabilities equal $125,000, what is owners’ equity?

Balance Sheet Assets 300,000

= =

Liabilities 125,000

+ +

Owners' Equity 175,000

Owners’ equity equals $175,000 ($300,000 - $125,000).

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Financial Statement Relationships Now, suppose that total assets increase $12,000 during the year and total liabilities decrease $3,000 during the year. Balance Sheet Assets = 300,000 12,000 312,000

Liabilities + 125,000 (3,000) 122,000

Owners' Equity 175,000 ? ?

What is owners’ equity at the end of the year?

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Financial Statement Relationships Now, suppose that total assets increase $12,000 during the year and total liabilities decrease $3,000 during the year. Balance Sheet Assets = 300,000 12,000 312,000

Liabilities + 125,000 (3,000) 122,000

Owners' Equity 175,000 15,000 190,000

Owners’ equity must have increased by $15,000. Since owners’ equity was $175,000 at the beginning of the year, it must be $190,000 at the end of the year. McGraw-Hill/Irwin

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Concepts/Principles

Now

Future

Accounting Entity Every economic entity can be separately identified and accounted for.

Going Concern Concept The presumption that the entity will continue to operate in the future—it’s not being liquidated.

Unit of Measurement Only transactions denominated in dollars are recorded in the accounting records.

Cost Principle Transactions are recorded at their original cost to the entity as measured in dollars.

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Concepts/Principles

Objectivity The accountants’ desire to have a given transaction recorded in the same way in all situations.

Accounting Period The period of time selected for reporting results of operations and changes in financial position.

Matching Concept All expenses incurred to generate that period’s revenues be deducted from revenues earned.

Accrual Accounting Recognize revenue at the point of sale and recognize expenses when incurred, even though the cash receipt or payment occurs at another time.

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Concepts/Principles

Consistency Provides meaningful trend comparisons over several years.

Materiality The increased benefit of increased accuracy should out weigh the cost of achieving the increased accuracy.

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Full Disclosure Circumstances and events that make a difference to financial statement users should be disclosed.

Conservatism When in doubt, make judgments and estimates that result in lower profits and asset valuations. © 2004 The McGraw-Hill Companies, Inc., All Rights

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Limitations of Financial Statements Financial statements report only quantitative economic data. They do not reflect qualitative economic variables, such as the value of the management team or the employees’ morale.

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Limitations of Financial Statements The balance sheet does not report market values or replacement cost of the assets. Many estimates are used, such as warranty costs, depreciation, and pension expense.

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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. It may also contain Management’s Discussion and Analysis (MD&A). McGraw-Hill/Irwin

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End of Chapter 2

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