Chapter 2
Financial Statements &
Accounting Transactions
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
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
Financial Statements
• Exhibit 2.1
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
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
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
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
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
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
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
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
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
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
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
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
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
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
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