2-1
Chapter
2
BASIC FINANCIAL
STATEMENTS
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2008
2-2
Introduction to Financial Statements
Balance Sheet
Income Statement
Statement of Cash Flows
McGraw-Hill/Irwin
Three primary
financial
statements.
We will use a corporation
to describe these
statements.
© The McGraw-Hill Companies, Inc., 2008
2-3
Introduction to Financial Statements
Balance Sheet
Income Statement
Statement of Cash Flows
McGraw-Hill/Irwin
Describes
where the
enterprise
stands at a
specific date.
© The McGraw-Hill Companies, Inc., 2008
2-4
Introduction to Financial Statements
Balance Sheet
Income Statement
Statement of Cash Flows
McGraw-Hill/Irwin
Depicts the
revenue and
expenses for a
designated
period of time.
© The McGraw-Hill Companies, Inc., 2008
2-5
Introduction to Financial Statements
Revenues
result in
positive
cash flow.
Expenses
result in
negative
cash flow.
Either in the past, present, or future.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2008
2-6
Introduction to Financial Statements
Balance Sheet
Income Statement
Statement of Cash Flows
McGraw-Hill/Irwin
Net income (or
net loss) is
simply the
difference
between
revenues and
expenses.
© The McGraw-Hill Companies, Inc., 2008
2-7
Introduction to Financial Statements
Balance Sheet
Income Statement
Statement of Cash Flows
McGraw-Hill/Irwin
Depicts the
ways cash has
changed during
a designated
period of time.
© The McGraw-Hill Companies, Inc., 2008
A Starting Point: Statement of
Financial Position
2-8
Vagabond Travel Agency
Balance Sheet
December 31, 2007
Assets
Liabilities & Owners' Equity
Cash
$ 22,500 Liabilities:
Notes receivable
10,000
Notes payable
$ 41,000
Accounts receivable
60,500
Accounts payable
36,000
Supplies
2,000
Salaries payable
3,000
Land
100,000
Total liabilities
$ 80,000
Building
90,000 Owners' Equity:
Office equipment
15,000
Capital stock
150,000
Retained earnings
70,000
Total
$ 300,000 Total
$ 300,000
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2008
2-9
The Concept of the Business Entity
Vagabond
Travel
Agency
McGraw-Hill/Irwin
A business
entity is
separate from
the personal
affairs of its
owner.
© The McGraw-Hill Companies, Inc., 2008
2-10
Assets
Vagabond Travel Agency
Balance Sheet
December 31, 2007
Assets
Liabilities & Owners' Equity
Cash
$ 22,500 Liabilities:
Notes receivable
10,000
Notes payable
$ 41,000
Accounts receivable
60,500
Accounts payable
36,000
Supplies
2,000
Salaries payable
3,000
Land
100,000
Total liabilities
$ 80,000
Building
90,000 Owners' Equity:
Office equipment
15,000
Capital stock
150,000
Retained earnings
70,000
Total
$ 300,000 Total
$ 300,000
Assets are
economic resources
that are owned by
the business and
are expected to
benefit future
operations.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2008
2-11
Assets
Cost Principle
Stable-Dollar
Assumption
These accounting
principles support Going-Concern
cost as the basis
Assumption
for asset valuation.
Objectivity
Principle
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2008
2-12
Liabilities
Vagabond Travel Agency
Balance Sheet
December 31, 2007
Assets
Liabilities & Owners' Equity
Cash
$ 22,500 Liabilities:
Notes receivable
10,000
Notes payable
$ 41,000
Accounts receivable
60,500
Accounts payable
36,000
Supplies
2,000
Salaries payable
3,000
Land
100,000
Total liabilities
$ 80,000
Building
90,000 Owners' Equity:
Office equipment
15,000
Capital stock
150,000
Retained earnings
70,000
Total
$ 300,000 Total
$ 300,000
Liabilities are
debts that
represent negative
future cash flows
for the enterprise.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2008
2-13
Owners’ Equity
Vagabond Travel Agency
Balance Sheet
December 31, 2007
Assets
Liabilities & Owners' Equity
Cash
$ 22,500 Liabilities:
Notes receivable
10,000
Notes payable
$ 41,000
Accounts receivable
60,500
Accounts payable
36,000
Supplies
2,000
Salaries payable
3,000
Land
100,000
Total liabilities
$ 80,000
Building
90,000 Owners' Equity:
Office equipment
15,000
Capital stock
150,000
Retained earnings
70,000
Total
$ 300,000 Total
$ 300,000
Owners’ equity
represents the
owners’ claims on
the assets of the
business.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2008
2-14
Owners’ Equity
Changes in Owners’
Equity
•Owners’
Investments
•Payments
to Owners
•Business
Earnings
•Business
Losses
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2008
2-15
The Accounting Equation
Travel
Assets =Vagabond
Liabilities
+ Agency
Owners’ Equity
Balance Sheet
December 31, 2007
$300,000
= $80,000 +Liabilities
$220,000
Assets
& Owners' Equity
Cash
$ 22,500 Liabilities:
Notes receivable
10,000
Notes payable
$ 41,000
Accounts receivable
60,500
Accounts payable
36,000
Supplies
2,000
Salaries payable
3,000
Land
100,000
Total liabilities
$ 80,000
Building
90,000 Owners' Equity
Office equipment
15,000
Capital stock
150,000
Retained earnings
70,000
Total
$ 300,000 Total
$ 300,000
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2008
2-16
Let’s analyze
some
transactions for
JJ’s Lawn Care
Service.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2008
2-17
On May 1, Jill Jones and her family invested
$8,000 in JJ’s Lawn Care Service and received
800 shares of stock.
Cash
Total
McGraw-Hill/Irwin
JJ's Lawn Care Service
Balance Sheet
May 1, 2007
Assets
Owners' Equity
$ 8,000 Capital Stock
$
$
8,000 Total
$
8,000
8,000
© The McGraw-Hill Companies, Inc., 2008
2-18
On May 2, JJ’s purchased a riding lawn
mower for $2,500 cash.
JJ's Lawn Care Service
Balance Sheet
May 2, 2007
Assets
Owners' Equity
Cash
$ 5,500 Capital Stock
$
Tools & Equipment
2,500
Total
McGraw-Hill/Irwin
$
8,000 Total
$
8,000
8,000
© The McGraw-Hill Companies, Inc., 2008
2-19
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.
JJ's Lawn Care Service
Balance Sheet
May 8, 2007
Assets
Liabilities and Owners' Equity
Cash
$ 3,500 Liabilities:
Tools & Equipment
2,500 Notes Payable
$ 13,000
Truck
15,000 Owners' Equity:
Capital Stock
8,000
Total
McGraw-Hill/Irwin
$ 21,000 Total
$ 21,000
© The McGraw-Hill Companies, Inc., 2008
2-20
On May 11, JJ’s purchased some repair
parts for $300 on account.
JJ's Lawn Care Service
Balance Sheet
May 11, 2007
Assets
Liabilities and Owners' Equity
Cash
$ 3,500 Liabilities:
Tools & Equipment
2,800 Notes Payable
$ 13,000
Truck
15,000 Accounts Payable
300
Total Liabilities
$ 13,300
Owners' Equity:
Capital Stock
8,000
Total
McGraw-Hill/Irwin
$ 21,300 Total
$ 21,300
© The McGraw-Hill Companies, Inc., 2008
2-21
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.
JJ's Lawn Care Service
Balance Sheet
May 18, 2007
Assets
Liabilities and Owners' Equity
Cash
$ 3,500 Liabilities:
Accounts Receivable
150 Notes Payable
$ 13,000
Tools & Equipment
2,650 Accounts Payable
300
Truck
15,000
Total Liabilities
$ 13,300
Owners' Equity:
Capital Stock
8,000
Total
McGraw-Hill/Irwin
$ 21,300 Total
$ 21,300
© The McGraw-Hill Companies, Inc., 2008
2-22
On May 25, ABC Lawns pays JJ’s $75 as a partial
settlement of its accounts receivable.
JJ's Lawn Care Service
Balance Sheet
May 25, 2007
Assets
Liabilities and Owners' Equity
Cash
$ 3,575 Liabilities:
Accounts Receivable
75 Notes Payable
$ 13,000
Tools & Equipment
2,650 Accounts Payable
300
Truck
15,000
Total Liabilities
$ 13,300
Owners' Equity:
Capital Stock
8,000
Total
McGraw-Hill/Irwin
$ 21,300 Total
$ 21,300
© The McGraw-Hill Companies, Inc., 2008
2-23
On May 28, JJ’s pays $150 of its accounts
payable.
JJ's Lawn Care Service
Balance Sheet
May 28, 2007
Assets
Liabilities and Owners' Equity
Cash
$ 3,425 Liabilities:
Accounts Receivable
75 Notes Payable
$ 13,000
Tools & Equipment
2,650 Accounts Payable
150
Truck
15,000
Total Liabilities
13,150
Owners' Equity:
Capital Stock
8,000
Total
McGraw-Hill/Irwin
$ 21,150 Total
$ 21,150
© The McGraw-Hill Companies, Inc., 2008
2-24
On May 29, JJ’s recorded lawn care services
provided during May of $750. All clients were
paid in cash.
JJ's Lawn Care Service
Balance Sheet
May 29, 2007
Assets
Liabilities and Owners' Equity
Cash
$ 4,175 Liabilities:
Accounts Receivable
75 Notes Payable
$ 13,000
Tools & Equipment
2,650 Accounts Payable
150
Truck
15,000
Total Liabilities
13,150
Owners' Equity:
Capital Stock
8,000
Retained Earnings
750
Total
$ 21,900 Total
$ 21,900
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2008
2-25
On May 31, JJ’s purchased gasoline for the
lawn mower and the truck for $50 cash.
JJ's Lawn Care Service
Balance Sheet
May 31, 2007
Assets
Liabilities and Owners' Equity
Cash
$ 4,125 Liabilities:
Accounts Receivable
75 Notes Payable
$ 13,000
Tools & Equipment
2,650 Accounts Payable
150
Truck
15,000
Total Liabilities
13,150
Owners' Equity:
Capital Stock
8,000
Retained Earnings
700
Total
$ 21,850 Total
$ 21,850
Now, let’s review how JJ’s transactions
affected the accounting equation.
© The McGraw-Hill Companies, Inc., 2008
McGraw-Hill/Irwin
2-26
May 1
Balances
May 2
Balances
May 8
Balances
May 11
Balances
May 18
Balances
May 25
Balances
May 28
Balances
May 29
Balances
May 31
Balances
Cash
$ 8,000
$ 8,000
(2,500)
$ 5,500
(2,000)
$ 3,500
Assets
Accts.
Tools &
+ Rec. + Equip. +
McGraw-Hill/Irwin
Truck
Liabilities
+
Owners' Equity
Notes
Accts.
Capital
Retained
= Payable + Pay. + Stock + Earnings
$ 8,000
$ 8,000
$ 2,500
$ 2,500
$ 3,500
$ 3,500
75
$ 3,575
(150)
$ 3,425
750
$ 4,175
(50)
$ 4,125
=
$ 150
$ 150
(75)
$ 75
$ 75
$ 2,500
300
$ 2,800
(150)
$ 2,650
$ 8,000
$ 15,000
$ 15,000
$ 13,000
$ 13,000
$ 8,000
$ 15,000
$ 13,000
$ 300
$ 300
$ 15,000
$ 13,000
$ 300
$ 8,000
$ 2,650
$ 15,000
$ 13,000
$ 8,000
$ 2,650
$ 15,000
$ 13,000
$ 300
(150)
$ 150
$ 8,000
$ 8,000
$ 75
$ 2,650
$ 15,000
$ 13,000
$ 150
$ 8,000
$
$ 75
$ 2,650
$ 15,000
$ 13,000
$ 150
$ 8,000
$
750
750
(50)
700
© The McGraw-Hill Companies, Inc., 2008
2-27
Let’s prepare the Income Statement and
Statement
for JJ’s+ Lawn
Assets of Cash Flows
=
Liabilities
Owners'Care
Equity
Accts.
Tools &
Notes
Accts.
Capital
Retained
Service
for
the
month
ending
May
31,
2007.
Cash + Rec. + Equip. + Truck = Payable + Pay. + Stock + Earnings
May 1
Balances
May 2
Balances
May 8
Balances
May 11
Balances
May 18
Balances
May 25
Balances
May 28
Balances
May 29
Balances
May 31
Balances
$ 8,000
$ 8,000
(2,500)
$ 5,500
(2,000)
$ 3,500
These transactions
impact
the
$ 15,000
$ 13,000
$ 2,500Statement
$ 15,000
$ 13,000
of Cash
300
$ 300
Flows.
$ 2,800
$ 15,000
$ 13,000
$ 300
$ 2,500
$ 2,500
$ 3,500
$ 3,500
75
$ 3,575
(150)
$ 3,425
750
$ 4,175
(50)
$ 4,125
McGraw-Hill/Irwin
$ 8,000
$ 8,000
$ 8,000
$ 8,000
$ 8,000
$ 150
$ 150
(75)
$ 75
(150)
$ 2,650
$ 15,000
$ 13,000
$ 300
$ 8,000
$ 2,650
$ 15,000
$ 13,000
$ 8,000
$ 75
$ 2,650
$ 15,000
$ 13,000
$ 300
(150)
$ 150
$ 75
$ 2,650
$ 75
$ 2,650
These transactions
$ 15,000
$ 13,000
$ 150
impact the Income
$ 15,000
$ 13,000
$ 150
Statement.
$ 8,000
$ 8,000
$
$ 8,000
$
750
750
(50)
700
© The McGraw-Hill Companies, Inc., 2008
2-28
JJ's Lawn Care Service
Income Statement
For the Month Ended May 31, 2007
Sales Revenue
Operating Expense:
Gasoline Expense
Net Income
$
750
$
50
700
Investments by and payments to the owners
are not included on the Income Statement.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2008
2-29
JJ's Lawn Care Service
Statement of Cash Flows
For the Month Ended May 31, 2007
Cash flows from operating activities:
Cash received from revenue transactions $
750
Cash paid for expenses
(50)
Net cash provided by operating activities
$
700
Cash flows from investing activities:
Purchase of lawn mower
$ (2,500)
Purchase of truck
(2,000)
Collection for sale of repair parts
75
Payment for repair parts
(150)
Net cash used by investing activities
(4,575)
Cash flows from financing activities:
Investment by owners
8,000
Increase in cash for month
$ 4,125
Cash balance, May 1, 2007
Cash balance, May 31, 2007
$ 4,125
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2008
2-30
JJ's Lawn Care Service
Statement of Cash Flows
For the Month Ended May 31, 2007
Cash flows from operating activities:
Cash received from revenue transactions $
750
Cash paid for expenses
(50)
Net cash provided by operating activities
$
700
Cash flows from investing activities:
Operating
activities include$ the
cash
Purchase
of lawn mower
(2,500)
Purchase
of truckof revenue and expense
(2,000)
effects
Collection for sale of repair parts
75
transactions.
Payment for repair parts
(150)
Net cash used by investing activities
(4,575)
Cash flows from financing activities:
Investment by owners
8,000
Increase in cash for month
$ 4,125
Cash balance, May 1, 2007
Cash balance, May 31, 2007
$ 4,125
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2008
2-31
JJ's Lawn Care Service
Statement of Cash Flows
For the Month Ended May 31, 2007
Cash flows from operating activities:
Cash received from revenue transactions $
750
Cash paid for expenses
(50)
Net cash provided by operating activities
$
700
Cash flows from investing activities:
Purchase of lawn mower
$ (2,500)
Purchase of truck
(2,000)
Collection for sale of repair parts
75
Payment for repair parts
(150)
Net cash used by investing activities
(4,575)
Cash flows from financing activities:
Investing
activities include the cash8,000
Investment
by owners
Increase
in cash for
$ 4,125
effects
ofmonth
purchasing and selling
Cash balance, May 1, 2007
assets.
Cash balance, May 31, 2007
$ 4,125
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2008
2-32
JJ's Lawn Care Service
Statement of Cash Flows
For the Month Ended May 31, 2007
Cash flows from operating activities:
Cash received from revenue transactions $
750
Cash paid for expenses
(50)
Net cash provided by operating activities
$
700
Cash flows from investing activities:
Purchase of lawn mower
$ (2,500)
Financing
cash
Purchase
of truck activities include the
(2,000)
Collection
of repair parts with the owners
75
effects for
ofsale
transactions
Payment for repair parts
(150)
and creditors.
Net cash used by investing activities
(4,575)
Cash flows from financing activities:
Investment by owners
8,000
Increase in cash for month
$ 4,125
Cash balance, May 1, 2007
Cash balance, May 31, 2007
$ 4,125
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2008
2-33
Now, let’s prepare the Balance Sheet for JJ’s
Lawn
for
May 31,
2007.
Assets Care Service
=
Liabilities
+
Owners' Equity
May 1
Balances
May 2
Balances
May 8
Balances
May 11
Balances
May 18
Balances
May 25
Balances
May 28
Balances
May 29
Balances
May 31
Balances
Cash
$ 8,000
$ 8,000
(2,500)
$ 5,500
(2,000)
$ 3,500
Accts.
Tools &
+ Rec. + Equip. +
$ 2,500
$ 2,500
$ 3,500
$ 3,500
75
$ 3,575
(150)
$ 3,425
750
$ 4,175
(50)
$ 4,125
McGraw-Hill/Irwin
Truck
Notes
Accts.
Capital
Retained
= Payable + Pay. + Stock + Earnings
$ 8,000
$ 8,000
$ 150
$ 150
(75)
$ 75
$ 75
$ 2,500
300
$ 2,800
(150)
$ 2,650
$ 8,000
$ 15,000
$ 15,000
$ 15,000
$ 13,000
$ 13,000
$ 13,000
$ 8,000
$ 300
$ 300
$ 15,000
$ 13,000 will
$ 300
These
balances
on
the $ 300
$ 2,650 appear
$ 15,000
$ 13,000
(150)
Balance
Sheet.
$ 2,650
$ 15,000
$ 13,000
$ 150
$ 8,000
$ 8,000
$ 8,000
$ 8,000
$ 75
$ 2,650
$ 15,000
$ 13,000
$ 150
$ 8,000
$
$ 75
$ 2,650
$ 15,000
$ 13,000
$ 150
$ 8,000
$
750
750
(50)
700
© The McGraw-Hill Companies, Inc., 2008
2-34
JJ's Lawn Care Service
Balance Sheet
May 31, 2007
Assets
Cash
Accounts receivable
Tools & equipment
Truck
$
Total assets
$
4,125
75
2,650
15,000
21,850
Liabilities
Notes payable
$
Accounts payable
Owners' Equity
Capital stock
Retained earnings
Total liabilities & equity $
13,000
150
8,000
700
21,850
Assets = Liabilities + Owners’ Equity
$21,850 =
McGraw-Hill/Irwin
$13,150
+
$8,700
© The McGraw-Hill Companies, Inc., 2008
Relationships Among Financial
Statements
Date at
beginning
of period
2-35
Date at
end of
period
Time
Balance
Sheet
Balance
Sheet
Income Statement
Statement of Cash Flows
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2008
2-36
Financial Statement Articulation
JJ's Lawn Care Service
Statement of Cash Flows
For the Month Ended May 31, 2007
Cash flows from operating activities:
Cash received from revenue transactions $
750
Cash paid for expenses
(50)
Net cash provided by operating activities
$
Cash flows from investing activities:
Purchase of lawn mower
$
(2,500)
Purchase of truck
(2,000)
Collection for sale of repair parts
75
Payment for repair parts
(150)
Net cash used by investing activities
Cash flows from financing activities:
Investment by owners
Increase in cash for month
$
Cash balance, May 1, 2007
Cash balance, May 31, 2007
$
JJ's Lawn Care Service
Income Statement
For the Month Ended May 31, 2007
700
Sales Revenue
Operating Expense:
Gasoline Expense
Net Income
750
$
50
700
(4,575)
8,000
4,125
4,125
JJ's Lawn Care Service
Balance Sheet
May 31, 2007
Assets
Cash
$
Accounts receivable
Tools & equipment
Truck
Total assets
McGraw-Hill/Irwin
$
$
Liabilities
4,125 Notes payable
$
75 Accounts payable
2,650
Owners' Equity
15,000 Capital stock
Retained earnings
21,850 Total liabilities & equity $
13,000
150
8,000
700
21,850
© The McGraw-Hill Companies, Inc., 2008
Financial Reporting and Financial
Statements
Financial statements are
just one source of
financial accounting
information.
2-37
Income
Statement
Balance
Sheet
Statement
of Cash
Flows
Other Information:
•Industry
•Competitors
•National economy
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2008
2-38
Forms of Business Organization
Sole
Proprietorships
McGraw-Hill/Irwin
Partnerships
Corporations
© The McGraw-Hill Companies, Inc., 2008
Reporting Ownership Equity in the
Statement of Financial Position
Sole
Proprietorships
2-39
Ow ner's equity:
Jill Jones, capital
$
8,000
Partnerships
Partners' equity
Jill Jones, capital $ 4,000
Bill Jones, capital
4,000
Total partners' equity
$ 8,000
Corporations
Owners' equity
Capital stock
$ 7,000
Retained earnings
1,000
Total stockholders' equity $ 8,000
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2008
The Use of Financial Statements by
External Parties
2-40
Two concerns:
Creditors
Liquidity
Profitability
Investors
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2008
2-41
The Need for Adequate Disclosure
Balance Sheet
Income Statement
Statement of Cash Flows
McGraw-Hill/Irwin
Notes to the
financial
statements often
provide facts
necessary for the
proper
interpretation of
the statements.
© The McGraw-Hill Companies, Inc., 2008
Management’s Interest in Financial
Statements
2-42
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.
Window dressing occurs when management takes
measures to make the company appear as strong
as possible in it financial statements.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2008