1. BASIC FINANCIAL STATEMENTS
Chapter 2
BASIC FINANCIAL STATEMENTS
Chapter 2: Basic Financial Statements 2

2. Introduction to Financial Statements
Three primary financial statements.
Income Statement
Balance Sheet
Statement of Cash Flows
We will use a corporation to describe these statements.
There are three fundamental financial statements used in accounting.
The income statement shows revenues and expenses.
The balance sheet is a listing of all asset, liability, and equity account balances that do not appear on the income statement.
The statement of cash flows shows how the company receives and spends its cash.
This chapter will look at the financial statements of a corporation.

3. Introduction to Financial Statements
Income Statement
Balance Sheet
Statement of Cash Flows
Describes where the enterprise stands at a specific date.
The balance sheet describes the financial position of a company at a specific point in time. A balance sheet may be prepared monthly, quarterly, or annually depending on the needs of management and external users. The balance sheet is sometimes referred to as the statement of financial position.

4. Introduction to Financial Statements
Income Statement
Balance Sheet
Statement of Cash Flows
Depicts the revenue and expenses for a designated period of time.
Net income is defined as the excess of revenues over expenses. Financial statements begin with a three-line title comprised of the company name, the name of the statement, and the period covered by the report. The income statement lists revenues and expenses that were incurred over a period of time. Most companies prepare monthly income statements.

5. Introduction to Financial Statements
Revenues result in positive cash flow.
Expenses result in negative cash flow.
In the long-run, revenues will generate positive cash inflows to the company and expenses will result in negative cash flows to the company. Just remember, revenues and expenses that appear on the income statement may not always produce cash flows in the current accounting period.
Either in the past, present, or future.

6. Introduction to Financial Statements
Income Statement
Balance Sheet
Statement of Cash Flows
Net income (or net loss) is simply the difference between revenues and expenses.
If expenses exceed revenues, the result is a net loss rather than net income.

7. Introduction to Financial Statements
Income Statement
Balance Sheet
Statement of Cash Flows
Depicts the ways cash has changed during a designated period of time.
The statement of cash flows will be covered in detail in a later chapter. The statement of cash flows is divided into three major sections: (1) cash flows from operating activities; (2) cash flows from investing activities, and (3) cash flows from financing activities. The statement describes cash inflows and outflows over a period of time.

8. A Starting Point: Statement of Financial Position
The balance sheet is an inventory of assets, liabilities, and equity at the end of the month. Our total assets are equal to three hundred thousand dollars. This includes cash of twenty-two thousand five hundred dollars, notes receivable of ten thousand dollars, supplies of two thousand dollars, and the balances in the remaining asset accounts.
Liabilities include notes payable of forty-one thousand, accounts payable of thirty-six thousand and salaries payable of three thousand dollars. The accounts in the owners’ equity section of the balance sheet are capital stock of one hundred-fifty thousand dollars and retained earnings of seventy thousand dollars.
Notice that the total assets are equal to the total liabilities plus owners’ equity.

9. The Concept of the Business Entity
A business entity is separate from the personal affairs of its owner.
Vagabond Travel Agency
The business entity principle states that the transactions of individual owners of a business and those of the business must be separate.

10. Assets
Assets are economic resources that are owned by the business and are expected to benefit future operations.
Assets are resources owned or controlled by an entity. They include such items as cash, accounts receivable (amounts owed to the company by customers), land, building and equipment, and supplies.

11. Assets Cost Principle Stable-Dollar Going-Concern Assumption
These accounting principles support cost as the basis for asset valuation.
Stable-Dollar
Assumption
Going-Concern
Assumption
The cost principle tells us that accounting information is based upon actual cost incurred. We refer to this as historical cost.
The going-concern assumption states that in the absence of information to the contrary, the business entity is assumed to continue operations into the foreseeable future.
The objectivity principle states that accounting information must be unbiased and based upon independent evidence.
The stable-dollar assumption tells us that we will only record accounting information that can be expressed in monetary units, usually dollars in the United States.
Objectivity
Principle

12. Liabilities
Liabilities are debts that represent negative future cash flows for the enterprise.
Liabilities represent the claims of creditors on an entity’s assets. Liabilities include accounts payable (amounts owed to creditors for assets purchased on account), taxes payable, and wages payable (amounts owed to our employees at the end of the accounting period).

13. Owners’ Equity
Owners’ equity represents the owners’ claims on the assets of the business.
The equities of an entity include investments by owners, withdrawals by owners, and earnings retained by the business.

14. Changes in Owners’ Equity
Owners’ Investments
Business Earnings
Payments to Owners
Business Losses
Investments by owners and net income increase owners’ equity. Payments to owners and net losses decrease owners’ equity.

15. The Accounting Equation
Assets = Liabilities + Owners’ Equity
$300,000 = $80, $220,000
The basic accounting equation states that assets are equal to liabilities plus equity of a company. The equation makes sense because it states that assets must be equal to the claims against those assets.
There are two broad categories of claims against an asset: Claims by creditors (called liabilities), or after all creditor claims are satisfied, the residual owners (the stockholders) have a claim on those assets. 3

16. Let’s analyze some transactions for JJ’s Lawn Care Service.
Let’s look at how specific business transactions impact the basic financial statement.

17. On May 1, Jill Jones and her family invested $8,000 in JJ’s Lawn Care Service and received 800 shares of stock.
Part I On May 1st, Jill Jones and her family invested $8,000 in JJ’s Lawn Care Service and received 800 shares of stock in return. Let’s see how the balance sheet would look immediately after this transaction.
Part II
The cash account of JJ’s Lawn Care increased by eight thousand dollars and the capital stock of the company also increased by eight thousand dollars. Notice that the basic accounting equation is in balance. Total assets are equal to total liabilities plus owners’ equity. 3

18. On May 2, JJ’s purchased a riding lawn mower for $2,500 cash.
Part I
On the 2nd of May, JJ’s Lawn Care purchased a riding lawn mower for $2,500 cash. Let’s see how the balance sheet looks now. Part II The cash account has been reduced by the $2,500 spent and the tools and equipment account has been increased by the same amount. One asset, cash, was merely traded for another, the riding lawn mower. Owners’ equity is not changed by the transaction and the basic accounting equation is still in balance. 3

19. 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.
Part I
In the next transaction JJ’s Lawn Care purchases a truck for $15,000, paying $2,000 cash and signing a note payable for $13,000. Let’s update the balance sheet. Part II The cash account decreased by $2,000 and the truck account increased by $15,000. There was a net increase in the asset side of the equation of $13,000. The liability account, notes payable, increased by $13, Total assets are now equal to $21,000. Total liabilities are equal to $13,000 and owners’ equity is equal to $8,000. The accounting equation is still in balance. 3

20. On May 11, JJ’s purchased some repair parts for $300 on account.
Part I On May 11th, JJ’s Lawn Care purchases repair parts for the riding lawn mower for $300. The parts are purchased on account. JJ’s will pay the balance on the account at some point in the future. Let’s update the balance sheet. Part II
The tools and equipment account increased by $300 and the liability account, accounts payable, increased by the same amount. The balance sheet is getting progressively more complicated. 3

21. 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.
Part I
On May 18th, JJ’s Lawn Care sells one-half of its repair parts at cost to ABC Lawns. ABC agrees to pay for the parts in thirty days. One-half of the cost of the parts is $150. Can you update the balance sheet? Try before proceeding to the next slide.
Part II The asset account, Tools and Equipment, decreased by $150 and the asset account, accounts receivable, increased by the same amount. Once again, one asset, repair parts, has been exchanged for another asset, accounts receivable. How did you do? 3

22. On May 25, ABC Lawns pays JJ’s $75 as a partial settlement of its accounts receivable.
On May 25th, ABC Lawns makes a partial payment on account for $75 cash. Let’s prepare the updated balance sheet on May 25th. Part II The cash account increases by $75 and accounts receivable decreases by the same amount. Notice that total assets are still equal to total liabilities plus owners’ equity. 3

23. On May 28, JJ’s pays $150 of its accounts payable.
Part I On May 28th, JJ’s Lawn Care makes a partial payment on its accounts payable of $150. Its time to update the balance sheet. Part II The cash account decreases by $150 and accounts payable also decreases by $150. The total assets are now recorded at $21,150. Total liabilities plus owners’ equity is equal to the same amount. 3

24. On May 29, JJ’s recorded lawn care services provided during May of $750. All clients were paid in cash.
Part I
On May 29th, JJ’s Lawn Care begins providing services to customers. On this date the company did work that totaled $750. All of the customers paid cash for the services rendered. Try updating the balance sheet before moving to the next slide. Be careful with this one.
Part II The cash account increases by $750 and retained earnings increases by the same amount. The monies received represent earnings of the company that have been retained. The $750 represents revenue earned by the business. How did you do? 3

25. On May 31, JJ’s purchased gasoline for the lawn mower and the truck for $50 cash.
Part I
In the final transaction for May, JJ’s Lawn Care purchased $50 worth of gasoline for its riding mower and truck. Let’s make the final update to the balance sheet on May 31st. Part II The cash account decreased by $50 and so did the retained earnings of the company. JJ’s Lawn Care used $50 of its earnings to pay for the gasoline. The $50 spent is an expense of the business.
Now, let’s review how JJ’s transactions affected the accounting equation. 3

26. All of these transactions have been placed on this slide, in the appropriate columns for the accounts they’ve impacted. Let’s verify the balance in each account and get ready to prepare the financial statements for JJ’s Lawn Care. 3

27. These transactions impact the Statement of Cash Flows.
Let’s prepare the Income Statement and Statement of Cash Flows for JJ’s Lawn Care Service for the month ending May 31, 2007.
These transactions impact the Statement of Cash Flows.
Part I All of the transactions that impacted the cash account will appear on the statement of cash flows. Part II The revenues and expenses that caused the change in retained earnings will appear on the income statement of the company. Part II Let’s begin by preparing the income statement and statement of cash flows for JJ’s Lawn Care for the period ended May 31, 2007.
These transactions impact the Income Statement. 3

28. Part I JJ’s Lawn care has one revenue for services for $750, and one expense for gasoline of $50. So the net income for the month of May is $700. Remember, net income is the excess of revenues over expenses incurred during the accounting period. Part II Investments by owners and payments to owners do not appear on the income statement. These amounts appear on the company’s balance sheet.
Investments by and payments to the owners are not included on the Income Statement. 3

29. Here is the statement of cash flows for JJ’s Lawn Care for the month ended May 31, Notice the three sections of the statement. 3

30. Operating activities include the cash effects of revenue and expense transactions.
Cash flows from operating activities include the $700 in net income calculated on the previous screen. 3

31. JJ’s had a cash outflow for investing activities
JJ’s had a cash outflow for investing activities. The company invested in the riding lawn mower, truck, and repair parts; however, the company recovered some of the cost of repair parts by selling them to ABC Lawns.
Investing activities include the cash effects of purchasing and selling assets. 3

32. Financing activities include the cash effects of transactions with the owners and creditors.
The only financing activity was the original investment by the owners of JJ’s Lawn Care. The cash inflows and outflows resulted in an increase in cash of $4,125 during the month. Because the cash account had a zero balance at the beginning of the month, the ending balance in the cash account is $4,125. Let’s finish by preparing the balance sheet for JJ’s Lawn Care. 3

33. These balances will appear on the Balance Sheet.
Now, let’s prepare the Balance Sheet for JJ’s Lawn Care Service for May 31, 2007.
These balances will appear on the Balance Sheet.
Here are the account balances to use when preparing the balance sheet. 3

34. Assets = Liabilities + Owners’ Equity $21,850 = $13,150 + $8,700
Part I
Asset accounts are listed on the left side of the balance sheet and the liabilities and owners’ equity accounts on the right. Feel free to go back to the previous screen and see all the account balances that appear on the balance sheet. Part II As a final check, make sure that the accounting equation is still in balance. The total assets of $21,850 is exactly equal to the total of the company’s liabilities plus owners’ equity. Notice that the balance sheet lists all assets, liabilities, and equities on a certain date. In this example, the date is May 31, 2007.
Assets = Liabilities + Owners’ Equity
$21,850 = $13, $8,700 3

35. Relationships Among Financial Statements
Date at beginning of period
Date at end of period
Time
Balance Sheet
Balance Sheet
All the financial statements are interrelated. We can start with the balance sheet at the beginning of an accounting period, analyze the income and cash flows of the company, and arrive at the ending balances that will appear on the balance sheet. Let’s see how this works in the JJ’s Lawn Care example.
Income Statement
Statement of Cash Flows 3

36. Financial Statement Articulation
Part I
This is the balance sheet for JJ’s Lawn Care at the end of May.
Part II Net income impacts the retained earnings of the company. Part III
The statement of cash flows not only provides the balance in the cash account, but also details information about the acquisition and disposition of assets and liabilities as well as changes in the owners’ equity balance. It’s clear to see how all the financial statements articulate with each other. 3

37. Financial Reporting and Financial Statements
Financial statements are just one source of financial accounting information.
Statement of Cash Flows
Balance Sheet
Income Statement
Other Information:
Industry
Competitors
National economy
Financial statements are only one source of information about the operations of a company. The financial statements of a company can be compared to those of other companies in the same industry, major national or international competitors, and to the norms for the national economy. 3

38. Forms of Business Organization
Sole Proprietorships
Partnerships
Corporations
There are three general forms of business operations.
A proprietorship is a business owned by just one individual.
A partnership is owned by two or more individuals. Some partnerships have several thousand partners.
A corporation is owned by individuals who normally are not active in the day-to-day operations of that business. For example, you may become an owner of IBM by purchasing shares of stock on the New York Stock Exchange. While you are a part owner, you do not necessarily work for IBM nor are you active in the operations of the company.

39. Reporting Ownership Equity in the Statement of Financial Position
Sole Proprietorships
Partnerships
Part I
The owners’ equity section of the balance sheet will look different for each type of business entity. For a sole proprietorship, there will be a capital account for the owner, and a drawing account to record payments to the owner.
Part II For a partnership, each partner has a separate account, where changes are tracked over time. There’s also a separate drawing account for payments made to each partner.
Part II To review, a corporation will show owners’ contributions in the capital stock account and accumulated earnings of the company in the retained earnings account.
You should be able to tell the form of business by looking at the equity section of a balance sheet.
Corporations

40. The Use of Financial Statements by External Parties
Two concerns:
Liquidity
Profitability
Creditors
Creditors and investors have two major concerns about the operations and financial position of any company.
First, the company must be liquid, that is, it must be able to pay all bills when due.
Second, the company must be profitable in the long-run. Unprofitable companies drain the cash position of the company, causing concern on the part of creditors and investors.
Investors

41. The Need for Adequate Disclosure
Income Statement
Balance Sheet
Statement of Cash Flows
Notes to the financial statements often provide facts necessary for the proper interpretation of the statements.
In addition to the basic financial statements, companies prepare notes to the financial statements. These notes are meant to provide the reader with additional insights into the operations and financial position of the company.

42. Management’s Interest in Financial Statements
Creditors are more likely to extend credit if financial statements show a strong statement of financial position—that is, relatively little debt and large amounts of liquid assets.
Part I
Creditors and investors are more likely to be interested in financially strong companies. These companies usually have little or no debt and a significant amount of assets that can be converted into cash quickly. Part II When management engages in measures to make the company appear financially stronger than it really is, this is referred to as window dressing. Window dressing may be legal, but it often impugns the integrity of the management team.
Window dressing occurs when management takes measures to make the company appear as strong as possible in it financial statements.