CHAPTER 2 (WILLIAMS)
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BASIC FINANCIAL STATEMENTS
Introduction to Financial Statements
Financial Statements – a declaration of what is believed
to be true about an enterprise, communicated in terms
of a monetary unit
Corporation is a unique form of organization that allows
many owners to combine their resources into a business
enterprise that is larger than would be possible based
on the financial resources of a single or a small number
of owners
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Balance Sheet (Statement of Financial Position)
–describes where the enterprise stands at a
specific date; it is sometimes described as a
snapshot of the business in financial or dollar
terms
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Income
Statement
(Statement
Comprehensive Income) – an activity statement
that shows the revenues and expenses for a
designated period of time
● Net Income (or Net Loss) is simply the
difference between all of an enterprise’s
revenues and expenses for a designated
period of time
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of
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Assets – are economic resources that are owned
by a business and are expected to benefit future
operations
● Cost Principle – historical cost; the
original amount the business entity paid
to acquire the asset
● Net Realizable Value – an amount that
approximates the cash that is expected
to be received when the receivable is
collected
● Going-concern Assumption – business is
a continuing enterprise; infinite lifetime
● Objectivity Principle – to describe asset
valuations that are factual and can be
verified by independent experts
● Stable Dollar Assumption – a limitation
of measuring assets at historical cost is
that the value of the monetary unit or
dollar is not always stable
Liabilities – creditor’s claims; are financial
obligations or debts
● Accrued is an accounting term
communicating that the payment of
certain expenses has been delayed or
deferred
Owner’s Equity – the owners’ claims on the
assets of the business; is a residual amount
Statement of Cash Flows - shows the ways cash
The Accounting Equation
changed during a designated period—the cash
received from revenues and other transactions
as well as the cash paid for certain expenses and
other acquisitions during the period
Total for assets always equals the total of liabilities plus
owners’ equity because they represent two views of the
same business
A Starting Point: Statement of Financial Position
Articulation – how financial satements relates to each
other
1. Balance Sheet (Statement of Financial Position)
- to demonstrate where the company stands, in
financial terms, at a specific point in time
● Entity Principle – GAAP require that f/s
describe the affairs of a specific
economic entity
● Business Entity – is regarded as separate
from the personal activities of its
owners
2. Income
Statement
(Statement
of
Comprehensive Income) – is a summarization of
the company’s revenue and expense
transactions for a period of time
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Revenues – are increases in the company’s
assets from its profit-directed activities; positive
cash flow
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Expenses – are decreases in the company’s
assets from its
negative cash flow
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profit-directed
activities;
Net Income – the difference between the
revenues and expenses for a specified period of
time
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Net Loss – having expenses greater than
revenues
3. Statement of Cash Flows – important
consideration in investors’ and creditors’
assessments of cash flows
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Profitability – profitable operations increase the value of
the owners’ equity in the business
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Operating Activities – are the cash effects of
revenue and expense transactions that are
included in the income statement
Investing Activities – are the cash effects of
purchasing and selling assets
Financing Activities – are the cash effects of the
owners investing in the company and creditors
loaning money to the company and the
repayment of either or both
● Noncash investing and financing
transactions – transactions that did not
affect cash; disclose
Forms of Business Organizations
1. Sole Proprietorship – an unincorporated
business owned by one person; the owner is
personally liable for the debts of the business
2. Partnership - an unincorporated business
owned by two or more persons voluntarily
acting as partners (co-owners)
3. Corporations - is recognized under the law as an
entity separate from its owners; not personally
liable for the debts of the business
● Limited Liability – these owners can lose
no more than the amounts they have
invested in the business
● Stockholders/ Shareholders – the
owners; ownership of a corporation is
divided into transferable shares of
capital stock
● Capital Stock – the amount that the
stockholders originally invested in the
business in exchange for shares of the
company’s stock
● Retained Earnings – represents the
increase in owners’ equity that has
accumulated over the years as a result
of profitable operations
The Use of Financial Statements by External Parties
Liquidity – the ability of the business to pay its debts as
they come due
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In studying financial statements, users should
always read the accompanying notes and the
auditors’ report
In the short run, liquidity and profitability may
be independent of each other
Over a longer term, however, liquidity and
profitability go hand in hand
The Need for Adequate Disclosure
Adequate Disclosure – means that users of financial
statements are informed of all information necessary for
the proper interpretation of the statement
Management’s Interest in Financial Statements
Managers have a special interest in the annual financial
statements, because these statements are used by
decision makers outside of the organization
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A strong statement of financial position is one
that shows relatively little debt and large
amounts of liquid assets relative to the liabilities
due in the near future
A strong income statement is one that shows
large revenues relative to the expenses required
to earn the revenues
A strong statement of cash flows is one that not
only shows a strong cash balance but also
indicates that cash is being generated by
operations
Window dressing – measures taken by management to
make the company appear as strong as possible in its
financial statements
Major requirements of Sarbanes-Oxley Act of 2002
(SOX) is for CEOs and CFOs to certify the accuracy of
their company’s financial statements. The CEOs and
CFOs of all public companies must certify on an annual
and quarterly basis that they (1) have reviewed their
company’s financial statements, (2) are not aware of any
error or omission that would make the financial
statements misleading, and (3) believe that the financial
statements fairly present in all material respects the
company’s financial condition (balance sheet) and
results of operations (income statement)
CHAPTER 2 (WARREN)
ANALYZING TRANSACTIONS
Using Accounts to Record Transaction
Accounting systems are designed to show the increases
and decreases in each accounting equation element as a
separate record – account
Normal Balances – is either a debit or credit depending
on whether increases in the account are recorded as
debits or credits
●
An account, in its simplest form, has three parts
1. A title, which is the name of the accounting
equation element recorded in the account
2. A space for recording increases in the amount of
the element
3. A space for recording decreases in the amount
of the element
T account – the left side of the account is called the
debit side, and the right side is called the credit side; are
often used in business to explain transactions
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is a simple way to illustrate the effects of
transactions on accounts and financial
statements
Balance Account – the excess of the debits of an asset
account over its credits; vice versa
CHART OF ACCOUNTS
Journal – serves as a record of when transactions
occurred and were recorded
Journalizing – the process of recording a transaction in
the journal
Journal Entry – the entry in the journal
Posting Journal Entries to Account
A transaction is first recorded in a journal. Periodically,
the journal entries are transferred to the accounts in the
ledger
Posting – the process of transferring the debits and
credits from the journal entries to the accounts
●
Ledger – a group of accounts for a business entity
Chart of Accounts – a list of the accounts in the ledger
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should meet the needs of a company’s
managers and other users of its financial
statements
Assets – are resources owned by the business entity
Liabilities – are debts owed to outsiders (creditors);
creditor’s claim on asset
Owner’s Equity – is the owner’s right to the assets of the
business after all liabilities have been paid
Revenues – are increases in owner’s equity as a result of
selling services or products to customers
Expenses – result from using up assets or consuming
services in the process of generating revenues
DOUBLE – ENTRY ACCOUNTING SYSTEM
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is based on the accounting equation and
requires: (1) every business transaction to be
recorded in at least two accounts, (2) the total
debits recorded for each transaction to be equal
to the total credits recorded
When an account normally having a debit
balance has a credit balance, or vice versa, an
error may have occurred or an unusual situation
may exist
The debits and credits for each journal entry are
posted to the accounts in the order in which
they occur in the journal
Trial Balance – one way to detect errors; it verifies the
equality of double-entry accounting
Errors:
1. Transposition – occurs when the order of the
digits is copied incorrectly
2. Slide – the entire number is copied incorrectly
one or more spaces to the right or the left
● The trial balance does not provide complete
proof of the accuracy of the ledger. It indicates
only that the debits and the credits are equal
Errors Not Affecting the Trial Balance
If the error has already been journalized and posted to
the ledger, a correcting journal entry is normally
prepared
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Comparing the two sets of T accounts shows
that the incorrect debit to Supplies may be
corrected by debiting Office Equipment for
$12,500 and crediting Supplies for $12,500
Office Equipment
xxx
Supplies
xxx
Financial Analysis and Interpretation: Horizontal Analysis
Horizontal Analysis – the amount of each item on a
current financial statement is compared with the same
item on an earlier statement
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the increase or decrease in the amount of the
item is computed, together with the percent of
increase or decrease
CHAPTER 2 (WILD)
ANALYZING AND RECORDING TRANSACTIONS
Source Documents – identify and describe transactions
and events entering the accounting process; provide
objective and reliable evidence about transactions and
events and their amounts
Example: sales invoice, checks, purchase order
The Account and Its Analysis
Account – is a record of increases and decreases in a
specific asset, liability, equity, revenue, or expense item
General ledger/ ledger – is a record containing all
accounts used by a company; often in electronic form
Assets – are resources owned or controlled by a
company, and those resources have expected future
benefits
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ANALYZING AND PROCESSING TRANSACTIONS
Ledger and Chart of Accounts
General ledger/ledger – the collection of all accounts
and their balances for an information system; book of
final entry
Chart of Accounts – is a list of all ledger accounts and
includes an identification number assigned to each
account
Account Number – provide a three-digit code that is
useful in recordkeeping
Debits and Credits
T-account – represents a ledger account and is a tool
used to understand the effects of one or more
transactions
Account Balance – the difference between total debits
and total credits for an account, including any beginning
balance
Double-Entry Accounting
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Liabilities – are claims (by creditors) against assets,
which means they are obligations to transfer assets or
provide products or services to others
●
Creditors - are individuals and organizations that
have rights to receive payments from a
company
Owner’s Equity (net assets) – the owner’s claim on a
company’s assets; is the owner’s residual interest in the
assets of a business after deducting liabilities
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Owner’s Investment – it increases both assets
and equity; the increase to equity is recorded in
an account titled Owner, Capital
Owner’s Withdrawals – is a contra equity
account because it reduces the normal balance
of equity; withdrawals (sole), dividends
(partnership and corporation)
Revenues – always increase equity; the inflow of
net assets from providing products and services
to customers
Expenses – always decrease equity; the outflow
of net assets in helping generate revenues
demands the accounting equation remain in
balance and thus requires that for each
transaction: (1) At least two accounts are
involved, with at least one debit and one credit,
(2) The total amount debited must equal the
total amount credited
Journalizing and Posting Transactions
Journal – gives a complete record of each transaction in
one place; it also shows debits and credits for each
transaction – book of original entry
Journalizing – the process of recording transactions in a
journal
Posting – the process of transferring journal entry
information to the ledger
4 Usual Steps in Processing Transactions
1.
2.
3.
4.
Identify transactions and source documents
Analyze transactions using accounting equation
Record journal entry
Post entry to ledger
Journalizing Transactions
General Journal – it can be used to record any
transaction and includes the following information
about each transaction: (1) date of transaction, (2) titles
of affected accounts, (3) dollar amount of each debit
and credit, and (4) explanation of the transaction
When a transaction is first recorded, the posting
reference (PR) column is left blank (in a manual system).
Later, when posting entries to the ledger, the
identification numbers of the individual ledger accounts
are entered in the PR column
Abnormal balance – refers to a balance on the side
where decreases are recorded
A zero balance for an account is usually shown by
writing zeros or a dash in the Balance column to avoid
confusion between a zero balance and one omitted in
error
TRIAL BALANCE
Trial Balance – is a list of accounts and their balances at
a point in time; is not a financial statement but a
mechanism for checking equality of debits and credits in
the ledger
Preparing a Trial Balance
1. List each account title and its amount (from
ledger) in the trial balance. If an account has a
zero balance, list it with a zero in its normal
balance column (or omit it entirely)
2. Compute the total of debit balances and the
total of credit balances
3. Verify (prove) total debit balances equal total
credit balances
Using a Trial Balance to Prepare Financial Statements
Accounting/ Fiscal Year – the one-year reporting period;
ending on a date other than December 31
Calendar-year - Businesses whose accounting year
begins on January 1 and ends on December 31
Financial Statements
Income Statement – reports the revenues earned less
the expenses incurred by a business over a period of
time
Statement of Owner’s Equity – reports information
about how equity changes over the reporting period
Balance Sheet - reports the financial position of a
company at a point in time, usually at the end of a
month, quarter, or year
DEBT RATIO
An important business objective is gathering
information to help assess a company’s risk of failing to
pay its debts. Companies finance their assets with either
liabilities or equity
A company that finances a relatively large portion of its
assets with liabilities is said to have a high degree of
financial leverage
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Higher financial leverage involves greater risk
because liabilities must be repaid and often
require regular interest payments (equity
financing does not)
The risk that a company might not be able to
meet such required payments is higher if it has
more liabilities (is more highly leveraged)
Debt Ratio – one way to assess the risk associated with
a company’s use of liabilities
Debt Ratio = Total (Current) Liabilities/ Total (Current)
Assets