1. Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD Chapter 2 Financial Statements & Accounting Transactions

2. Financial Statements Financial Statements report on the financial performance of the organization In various courses on Corporate Finance, the inner most secrets of the most closed organization can be teased out through careful use of the financial statements Financial Statements are the primary means of financial communication. Producing the statements follows a definite cycle called the Accounting Cycle (Chapter 3) A complete set of financial statements usually consists of the Balance Sheet, Income Statement, Statement of Owner's Equity and Cash Flow Statement Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

3. Financial Statements Exhibit 2.1 Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

4. Income Statement Reports revenues earned against expenses incurred by a business over a period of time Net Income (Loss) = Revenues – Expenses Revenues are earned by providing products or services to customers as part of the business’s main operations Expenses are those costs incurred by the business (or the amount of assets used up) in the course of generating revenues Exhibit 2.2, shows how rent and salary expenses were incurred to generate consulting revenue Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

5. Statement of Owner’s Equity Owner’s Equity is always the difference between the total value of assets and the total value of liabilities It represents how much of the assets belong to the owner vs. how much belongs to creditors Owner’s invest in an organization when they transfer personal assets (cash, vehicles, homes as offices) into the organization Owner withdrawals occur when owners pull out assets (cash or other) reducing their equity The Statement of Owner’s Equity reports on changes in equity over a period of time Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

6. Balance Sheet Aka Statement of Financial Position Reports the financial position of the business at a point in time It describes financial position by listing the types and dollar amounts of assets, liabilities and equity The main sections of a Balance Sheet are the Assets, Liabilities and Equity sections, such that the equation assets - liabilities = equity is always maintained Exhibit 2.4 shows a sample Balance Sheet Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

7. Balance Sheet Assets are the properties and economic resources held by the business used to generate income –Assets provide some future benefit to the company –Liquid assets are those that are cash or readily convertible to cash (accounts receivable, inventory) –Fixed assets are tangible assets held for the service they provide, like buildings, land, furniture, patents (not sold to generate revenue) Current Assets are those assets that are generally cash or converted into cash within one accounting period (usually one year) Fixed Assets are those assets not convertible to cash in one accounting period, but are “consumed” over many periods in the course of business operation Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

8. Balance Sheet Liabilities are debts or obligations of a business They are the claims others have against the business It represents how much of the assets belong to the owner vs. how much belongs to creditors through –short term lending (credit cards), –debt instruments (bonds, debentures) or –long term credit (mortgages, loans) Current Liabilities are those liabilities expected to be met within one accounting period –Accounts payable is a current liability created by buying supplies on credit –Notes payable is the value of a written promise to make future payments Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

9. Balance Sheet Equity is the owner’s claim on the assets of the business Can also be considered as net assets, the amount of assets remaining after deducting liabilities Equity can be increased when owner’s bring more personal assets into the business Equity can also be increased through Retained Earnings, the amount of profits that are rolled back into the organization at the end of an accounting period increasing the value of owner’s equity Equity is decreased if there are losses in a period (-ve Retained Earnings) or if an owner makes a withdrawal Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

10. Cash Flow Statement Aka Statement of Changes in Financial Position Describes the sources and uses of cash over a period of time. Also reports the amount of cash on hand at the beginning and end of the period As you can see, cash is the most important asset, and thus gets its own report Managing cash flow is to be considered one of the most important responsibilities of owners and accountants as it is the oil that keeps the business engine running Exhibit 2.5 shows an example Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

11. Generally Accepted Accounting Principles These are the general rules under which accounting is carried out. The primary purpose of GAAP is to make financial statements relevant, reliable, consistent and comparable. GAAP imposes limits on the range of accounting practices that can be used to general financial statements Don’t let the words “Generally Accepted” fool you. These Principles are not just guidelines, but are akin to law, the departure from which will be seriously questioned. Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

12. Generally Accepted Accounting Principles Business Entity Principle –Each economic entity must have records kept separate from the owners Cost Principle –All transactions are recorded based on actual cash, or equivalent, amount received or paid Objectivity Principle –Financial Statement info is supported by objective, independent, unbiased and verifiable evidence. Keep expense receipts and invoices Going Concern Principle –The users of financial statements assume that the business is going to continue operations, unless otherwise informed Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

13. Generally Accepted Accounting Principles Monetary Unit Principle –Transactions are expressed in units of money as the common denominator –Transactions are not expressed in units of production (cars, or widgets) –The monetary unit is assumed to be stable and not adjusted for changes in currency value or inflation Revenue Recognition Principle –Revenue is recorded at the time it is earned regardless of whether the cash from the sale is received. –Equivalently, the expenses incurred to generate the revenue are recognized in the same accounting period as the revenues they generated. This is called the Matching Principle. Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

14. Revenue Recognition Principle Has been the source of concern in many of the recent scandals Because GAAP are “generally accepted” some firms have taken liberties with their interpretation Revenue can be recognized at –(retail) The time of sale –(project) as the project progresses, or at certain stages of the project –(rent/insurance) with the passage of time Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

15. The Accounting Equation Assets = Liabilities + Owner’s Equity Assets – Liabilities = Owner’s Equity Anytime one side of the equation changes, the other must change by the same amount, maintaining balance Double Entry Accounting is the means through which balance is maintained: For every transaction, there are entries in at least 2 accounts (Chapter 3) Lets examine the first month activities of Vertically Inclined Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

16. Finlay Financial Statements In Exhibit 2.11, note how the various statements work with each other to provide a complete summary of activities –The Net Income from the Income Statement is fed into the Statement of Owner’s Equity –The closing balance of Owner’s Equity is fed into the Capital line item of the Balance Sheet Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

17. Exercise Lets do Problem 2-5A, except instead of using the format of Exhibit 2.10, use the T-account format Good examples to try are –Problems 2-6A, 2-7A, 2-5B, 2-6B, 2-7B Chapter 3 Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD