Chapter 2

Chapter 2 Basic Concepts of Financial Accounting

The Need for Financial Statements

Financial Disclosure Benefits • Enhances decision-making • Reduces risk • Reduces risk lowers cost

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Three Primary Financial Statements • Balance Sheet • Income Statement • Statement of Cash Flows

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The Balance Sheet

The Balance Sheet

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The Balance Sheet Presents the financial position of a company at a particular point in time. • Three categories: – Assets – Liabilities – Owners’ Equity

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

likely to occur Financial Accounting, 6e Stice/Stice/Diamond, 2001 © Thomson

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

assets have implications for the future Financial Accounting, 6e Stice/Stice/Diamond, 2001 © Thomson

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

substance rules over legal form Financial Accounting, 6e Stice/Stice/Diamond, 2001 © Thomson

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

Financial Accounting, 6e Stice/Stice/Diamond, 2001 © Thomson

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 Financial Accounting, 6e Stice/Stice/Diamond, 2001 © Thomson

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. the obligation can involve either type of future event Financial Accounting, 6e Stice/Stice/Diamond, 2001 © Thomson

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. have already happened Financial Accounting, 6e Stice/Stice/Diamond, 2001 © Thomson

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.

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Owners’ Equity The residual interest in the assets of an entity that remains after deducting liabilities – Also known as net assets – Creditors legally have first claim to assets – The owners’ equity of a corporation is referred to as stockholders’ equity Financial Accounting, 6e Stice/Stice/Diamond, 2001 © Thomson

Owners’ Equity Factors Impacting the Amount of Owners’ Equity DECREASE Owners’ Equity

INCREASE Owners’ Equity

Owners Withdraw Assets

Owners Invest Assets

Company Suffers a Loss

Company Generates a Profit

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Owners’ Equity: Two Primary Components Paid-in Capital The value of assets contributed by investors in exchange for shares of stock

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

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Owners’ Equity: Two Additional Components Treasury Stock – Repurchased shares of the company’s stock

Accumulated Other Comprehensive Income – Increases and decreases to equity due to

• changes in the market prices of investments • changes in exchange rates Financial Accounting, 6e Stice/Stice/Diamond, 2001 © Thomson

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 assets – Current liabilities are repaid usually within one year Financial Accounting, 6e Stice/Stice/Diamond, 2001 © Thomson

The Accounting Equation The balance sheet is a detailed version of the accounting equation

ASSETS = LIABILITIES + STOCKHOLDERS’ EQUITY

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Balance Sheet Concepts and 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. Financial Accounting, 6e Stice/Stice/Diamond, 2001 © Thomson

Balance Sheet Concepts and Conventions • The going concern assumption presumes that the business will continue for the foreseeable future • The balance sheet shows two views of the same thing: the resources of the firm. • The left side of the balance sheet shows the composition of a firm’s resources (cash, inventory, and so on). • The right side shows the amount of resources supplied by creditors and the amount supplied by owners. Financial Accounting, 6e Stice/Stice/Diamond, 2001 © Thomson

Basic accounting equation to analyze transactions • The financial accounting process consists of analyzing a transaction’s effect on the elements of the equation: • The equation balances for each transaction and for the summation of all transactions. Financial Accounting, 6e Stice/Stice/Diamond, 2001 © Thomson

The Income Statement

The Income Statement

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The Income Statement Describes a company’s financial performance for a specified period of time • Reports • Revenues • Expenses • Net Income Financial Accounting, 6e Stice/Stice/Diamond, 2001 © Thomson

Elements of the Income Statement • Revenue is the amount of assets created through the performance of business operations – Retailers generate revenue by selling goods – Service businesses generate revenue by providing a valuable service Financial Accounting, 6e Stice/Stice/Diamond, 2001 © Thomson

Elements of the Income Statement • 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 Financial Accounting, 6e Stice/Stice/Diamond, 2001 © Thomson

Elements of the Income Statement • Earnings per share represents how much income belongs to the owner of one share of stock

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Income Statement Concepts and Conventions • Time Period – The life of a business is divided into time periods to measure performance

• Revenue recognition occurs when – The goods have been delivered or the service has been provided and – Cash has been collected or collection is reasonably assured Financial Accounting, 6e Stice/Stice/Diamond, 2001 © Thomson

Preparing Balance Sheet and Income Statement • Balance sheets are prepared by cumulating the effect of all transactions on the elements of the basic accounting equation. • Income statements summarize all revenue and expense transactions that took place during a period of time. • The difference between revenues and expenses is net income. Financial Accounting, 6e Stice/Stice/Diamond, 2001 © Thomson

Relationship between Balance Sheet and Income Statement • Revenue and expense transactions affect owners’ equity. Therefore, the income statement summarizes the impact these transactions have on the balance sheet item owners’ equity.

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Accrual basis vs. Cash basis of accounting • The accrual basis recognizes revenues when they are earned, that is, when the goods are delivered or the service is rendered. • The cash basis recognizes revenues when cash is received from the customer. Financial Accounting, 6e Stice/Stice/Diamond, 2001 © Thomson

Accrual basis vs. Cash basis of accounting (cont’d) • The accrual basis recognizes expenses when resources are consumed. • The cash basis recognizes expenses when cash is paid. • The accrual basis provides a better measure of performance. GAAP requires use of the accrual basis. Financial Accounting, 6e Stice/Stice/Diamond, 2001 © Thomson

Sole proprietorships vs. Corporations • The primary difference in Balance Sheets of these two types of businesses involves owners’ equity. • In sole proprietorships, only one component of owners’ equity is used; it is referred to as capital, and it reflects the owners’ interests that arise from both direct contributions and profitable operations. Financial Accounting, 6e Stice/Stice/Diamond, 2001 © Thomson

Sole proprietorships vs. Corporations (cont’d) • Corporations use two components: invested capital, which reflects owners’ direct contributions, and retained earnings, which show the owners’ interest that arose from profits.

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