CHAPTER 2

Financial Statements:
An Overview
 Learning Objective 1
Understand the basic
elements and
formats of the three
primary financial
statements.
Balance Sheet
What are the Income
three basic Statement
financial
statements? Statement of
Cash Flows
 Primary Financial Statements
These financial statements answer basic
questions:
What is the company’s current financial status?
What were the company’s operating results for
the period?
How did the company obtain and use cash
during the period?
 The Balance Sheet

Summary of the financial

Assets: cash, accounts position of a company at
receivable, inventory, a particular date.
land, buildings,
equipment, and intangible
items.
• What are the resources
of the company?
Liabilities:Sometimes
accounts
payable,referred to as a
notes payable,
Statement
and mortgages of
payable. • What are the company’s
Financial existing obligations?
Owners’ Equity:
Position
net
assets after all obligations
have been satisfied. • What are the company’s
net assets?
What Is the Accounting Equation?

Assets = Liabilities + Owners’ Equity

Define double-entry
accounting
A system of recording
transactions in a way that
maintains the equality of the
accounting equation.
 Accounting Equation
Assets = Liabilities + Owners’ Equity

Resources Sources of Funding

Resources Creditors’ Owners’

= claims
+ claims
to use to
generate against against
revenues resources resources
 Sample Balance Sheet

Assets Liabilities
Cash $ 40 Accounts payable $ 50
Accounts receivable 100 Notes payable 150
Land 200 $200
Owners’ Equity
Total assets $340
Capital stock $100
Retained earnings 40
Must $140
Equal Total liabilities
and owners’ equity $340
 What Are Classified and
Comparative Balance Sheets?

They distinguish between

current and long-term assets.
current and long-term liabilities.
Listed in decreasing order of liquidity.
Comparative so financial statement users
can identify significant changes over
time. They have more than one year on
the Balance Sheet.
 Describe Three Balance Sheet
Limitations.
Assets recorded at
historical value.
Only recognizes
assets that can be
expressed in
monetary terms.
Owners’ equity is
usually less than
the company’s
market value.
 The Income Statement

Revenues Shows the results of a

Assets (cash or AR) company’s operations
created through over a period of time.
business operations
Expenses • What goods were sold or
Sometimes services performed that
Assets (cash or AP) provided revenue for the
consumed through
referred to company?
businessasoperations
a • What costs were incurred in
Net Income or (Net
Statement ofLoss) normal operations to
Earnings
Revenues - Expenses generate these revenues?
• What are the earnings or
company profit?
 Sample Income Statement
The Example Company
Income Statement
For the Years Ended December 31, 2003 and 2002
2003 2002
Revenues:
Sales $100 $ 85
Other revenue 30 15
Total revenues $130 $100
Expenses:
Cost of goods sold $ 62 $ 58
Operating & admin. 16 12
Income tax 20 18
Total expenses $ 98 $ 88
Net Income $ 32 $ 12
How Do You Calculate Earnings
Per Share?

Earnings per share (EPS):

Net Income (Net Loss)

# of Shares of Stock Outstanding

Tells the owner of a single share of

stock how much of the net income
for the year belongs to him or her.
 Statement of Retained Earnings

Beginning retained earnings An additional

financial statement
+ Net income that identifies
– Dividends paid changes in retained
earnings from one
= Ending retained earnings accounting period to
the next.

Net income results in: Dividends result in:

Increase in net assets Decrease in net assets
Increase in retained earnings Decrease in retained earnings
Increase in owners’ equity Decrease in owners’ equity
 Statement of Cash Flows
Statement of Cash Flows Reports the amount of cash
Cash inflows collected and paid out by a
Sell goods or services. company in operating,
Sell other assets or by investing, and financing
borrowing. activities.
Receive cash from
investments by owners.
Cash outflows How did the company
Pay operating receive cash?
expenses.
Expand operations, How did the company
repay loans. use its cash?
Pay owners a return on
investment.
 What Are The Three Primary
Types Of Activities On A
Statement Of Cash Flows?
Operating Activities: A company’s day-to-day activities.
Major operating cash inflow—cash receipts from
selling goods or from providing services.
Major operating cash outflow—payments to purchase
inventory and to pay operating expenses.
Investing Activities: Buying and selling long-term
assets.
Financing Activities: Cash is obtained from or repaid to
owners and creditors.
 Statement of Cash Flows
Operating Investing Financing
Activities Activities Activities

CASH
INFLOWS

CASH
OUTFLOWS

Operating Investing Financing

Activities Activities Activities
 Sample Statement of Cash Flows
The Example Company
Statement of Cash Flows
December 31, 2003

Cash Flows From Operating Activities:

Receipts 48
Payments (43) 5

Cash Flows From Investing Activities:

Receipts 0
Payments (4) (4)

Cash Flows Used By Financing Activities:

Receipts 10
Payments (6) 4

Net Cash Flow 5

 How the Financial Statements Tie
Together Is Called?

Articulation--the
relationship between an
operating statement (the
income statement or the
statement of cash flows)
and comparative balance
sheets.
 Financial Statement Articulation
Cash Flow Statement
Cash--Op. Act. $ 973,000
Cash--Inv. Act. (1,188,000)
Cash--Fin. Act. 245,000
Net increase $ 30,000
Beg. cash 80,000
End. cash $ 110,000 Balance
Balance Sheet 12/31/02 Sheet 12/31/03
Income Statement
Cash $ 80,000 Cash $ 110,000
Other 4,550,000 Revenues $12,443,000 Other 4,975,000
Total $4,630,000 Expenses 11,578,400 Total $5,085,000
Net income $ 864,600
Liabilities $2,970,000 Liabilities $2,860,400
Stmt of Retained Earnings
Cap. stock 900,000 Cap. stock 1,000,000
R/E 760,000 R/E 12/31/02 $ 760,000 R/E 1,224,600
Total $4,630,000 Net income 864,600 Total $5,085,000
Dividends (400,000)
R/E 12/31/03 $1,224,600
 Learning Objective 2

Recognize the need

for financial statement
notes and identify the
types of information
included in the notes.
 Notes to the Financial Statements
What are the four general types?
Summary of significant accounting policies:
assumptions, estimates, and judgments.
Additional information about the summary
totals.
Disclosure of important information that is
not recognized in the financial statements.
Supplementary information required by
the FASB or the SEC.
Notes are an acceptable way to convey
information to users when the information is
too uncertain or needs further explanation.
 Learning Objective 3

Describe the
purpose of an
audit report and
the incentives the
auditor has to
perform a good
audit.
 The Audit Report
CPA firms have economic incentives to
perform credible audits.
• Reputation
• Lawsuits

Owners and managers want the

most favorable results possible.
• Bank credit
• Bonuses
• Public stock price
 The Audit Report
 Issued by independent CPA firms.
 CPAs attest to conformity with GAAP.
 Financial
statements are
the responsibility
of the company’s
management and
not the CPA.
 Learning Objective 4

Use financial ratios to

identify a company’s
strengths and
weaknesses and to
forecast its future
performance.
 What Is the Debt Ratio and Its
Purpose?
Measure of leverage.
Varies from industry to industry, but should
be around 50%.

Total liabilities
Total assets
 What Is the Current Ratio and Its
Purpose?
Measure of liquidity.
Also called Working Capital Ratio.
Some successful companies have current
ratios less than 1.0.

Total current assets

Total current liabilities
 What Is Asset Turnover and Its
Purpose?
Measure of company efficiency.
The higher the asset turnover ratio, the more
efficient the company is using its assets
to generate sales.

Sales
Total assets
 What Is Return on Sales and Its
Purpose?
Measure of the amount of profit earned per
dollar of sales.
Evaluated within the appropriate industry.

Net income
Sales
 What Is Return on Equity and Its
Purpose?
Overall measure of performance--profit
earned per dollar of investment.
Typically between 15% and 25%.

Net income
Owners’ equity
What Is the Price-Earnings Ratio and Its
Purpose?
Measure of growth potential, earnings
stability, and management capabilities.
In the U.S., typically between 5 and 30.

Market price per share

Earnings per share
 Financial Ratios
Debt ratio Total liabilities
Total assets
Current ratio Current assets
Current liabilities
Sales
Asset turnover Total assets

Return on sales Net income

Sales
Return on equity Net income
Owners’ equity
Price-earnings ratio Market price per share
Earnings per share
 Learning Objective 5

Explain the
fundamental
concepts and
assumptions that
underlie financial
accounting.
 Accounting Model

The basic accounting assumptions,

concepts, principles, and procedures
that determine the manner of
recording, measuring, and reporting a
company’s transactions.
 What Are The Fundamental
Concepts and Assumptions?

Separate Entity Concept

Arm’s-Length Transactions
Cost Principle
Monetary Measurement Concept
Going Concern Assumption
 Describe the Separate Entity
Concept.
Entity--The organizational unit for which
accounting records are maintained.
Separate entity concept--The activities of
an entity are to be separate from those of its
individual owners.
Proprietorship
Partnership
Corporation
What Is An Arm’s-Length
Transaction?
The exchange of
goods or
services
between
independent and
rational parties,
each looking out
for their
company’s best
interests.
 What Is Meant By The Cost
Principle?
All transactions are recorded at
historical cost.

Historical cost is assumed to

represent the fair market value of
the item at the date of the
transaction because it reflects the
actual use of resources by
independent parties.
What Is The Monetary Measurement
Concept?
Accountants measure only those economic
activities that can be measured in monetary
terms.
Listed values may not be the same as actual
market values:
Inflation.
Measurement issues.
What Do We Mean By The Going
Concern Assumption?
An entity will have
a continuing
existence for the
foreseeable future.
“If You Always Do What You
Always Did, You Always Get
What You Always Got.”
W. Edward Deming

End Chapter 2