1. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-1 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 2-1 CHAPTER 2 Financial Statements and Accounting Concepts/Principles McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

2. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-2 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 2-2 Borrow cash from the bank Transactions are economic interchanges between entities that are accounted for and reflected in financial statements. L O 1 Financial Statements

3. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-3 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 2-3 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. Transactions Procedures for sorting, classifying, and presenting (bookkeeping) Selection of alternative methods of reflecting the effects of certain transactions (accounting) Financial Statements L O 1

4. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-4 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 2-4 Accounts Account balances are then used in the preparation of financial statements. Cash Accounts Receivable Accounts Payable Transactions are summarized in accounts. L O 1 Accounts are used to organize like-kind transactions.

5. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-5 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 2-5 Financial Statements In addition to the financial statements, the annual report will probably include several accompanying notes or explanations of the accounting policies used and detailed information about many of the amounts and captions shown in the financial statements. L O 2

6. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-6 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 2-6 Balance Sheet-Elements L O 2 Liabilities are amounts owed to other entities. Assets represent the amount of resources owned by the entity. Equity is the ownership right of the owner(s) of the entity in the assets that remain after deducting the liabilities.

7. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-7 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 2-7 Balance Sheet L O 2 Current assets are those assets that are likely to be converted into cash or used to benefit the entity within one year. Current Liabilities are those liabilities that are to be paid within one year.

8. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-8 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 2-8 Balance Sheet LiabilitiesEquityAssets =+ L O 2

9. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-9 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 2-9 Income Statement The income statement shows the profit (or loss) for the period of time under consideration. L O 2 Revenues result from the entity’s operating activities (e.g., selling merchandise). Costs and expenses are incurred in generating revenues and operating the entity. Costs and expenses are incurred in generating revenues and operating the entity.

10. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-10 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 2-10 Income Statement Gains and losses are also reported on the income statement and result from non- operating activities, rather than from the day-to-day operating activities that generate revenues and expenses. The income statement shows the profit (or loss) for the period of time under consideration. L O 2

11. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-11 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 2-11 Statement of Changes in Owners’ Equity This financial statement shows the detail of owners’ equity and explains the changes that occurred in the components of owners’ equity during the year. L O 2

12. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-12 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 2-12 Statement of Cash Flows The purpose of this financial statement is to identify the sources and uses of cash during the year. L O 2

13. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-13 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 2-13 Time-Line Model Balance Sheet 8/31/08 Balance Sheet 8/31/09 Fiscal 2009 A = L + OE Income Statement for the Year Statement of Changes in Owners’ Equity Statement of Cash Flows L O 3

14. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-14 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 2-14 Financial Statement Relationships and the Accounting Equation The arrow indicates that net income affects retained earnings, which is a component of owners’ equity. L O 3

15. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-15 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 2-15 Financial Statement Relationships and the Accounting Equation If assets equal $300,000 and liabilities equal $125,000, what is owners’ equity? L O 3

16. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-16 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 2-16 Financial Statement Relationships and the Accounting Equation If assets equal $300,000 and liabilities equal $125,000, what is owners’ equity? Owners’ equity equals $175,000 ($300,000 - $125,000) L O 3

17. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-17 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 2-17 Financial Statement Relationships and the Accounting Equation Now, suppose that total assets increase $12,000 during the year and total liabilities decrease $3,000 during the year. What is owners’ equity at the end of the year? L O 3

18. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-18 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 2-18 Financial Statement Relationships and the Accounting Equation Now, suppose that total assets increase $12,000 during the year and total liabilities decrease $3,000 during the year. 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. L O 3

19. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-19 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 2-19 Balance Sheet L O 4

20. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-20 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 2-20 Income Statement L O 4

21. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-21 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 2-21 Statement of Changes in Owners’ Equity L O 4

22. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-22 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 2-22 Statement of Cash Flows L O 4

23. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-23 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 2-23 Concepts/Principles Accounting Entity Every economic entity can be separately identified and accounted for. Unit of Measurement Only transactions denominated in dollars (currency) are recorded in the accounting records. Now Future Going Concern Concept The presumption that the entity will continue to operate in the future—it’s not being liquidated. Cost Principle Transactions are recorded at their original cost to the entity as measured in dollars. L O 5

24. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-24 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 2-24 Concepts/Principles Matching Concept All expenses incurred to generate that period’s revenues be deducted from revenues earned. Accounting Period The period of time selected for reporting results of operations and changes in financial position. Objectivity The accountants’ desire to have a given transaction recorded in the same way in all situations. 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. L O 5

25. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-25 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 2-25 Concepts/Principles Full Disclosure Circumstances and events that make a difference to financial statement users should be disclosed. 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. Conservatism When in doubt, make judgments and estimates that result in lower profits and asset valuations. L O 5

26. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-26 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 2-26 Accrual Accounting Vs. Cash Flows L O 6 Revenue Recognition -Timing is the Key Cash Flow Recognizes: Accrual Accounting Recognizes: Revenue when payment is received for services rendered or products sold. Revenue when payment is received for services rendered or products sold. Revenue when revenue is earned, at the point of sale of services or products. Revenue when revenue is earned, at the point of sale of services or products. Expenses when they are paid. Expenses when they are paid. Expenses when they are incurred. Expenses when they are incurred.

27. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-27 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 2-27 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. L O 7 How do the terms “quantitative” and “qualitative” differ???

28. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-28 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 2-28 Limitations of Financial Statements L O 7 Matching Concept - Estimates are acceptable provided there is a basis for them. Historical Cost Concept-Assets are usually valued at the cost of the Asset when acquired. 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.

29. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-29 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 2-29 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 also contains Management’s Discussion and Analysis (MD&A). L O 8

30. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-30 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 2-30 End of Chapter 2