Chapter 2: financial and accounting

LEARNING OBJECTIVES• Understand the basic elements, uses, and limitations of the financial statements FS: balance sheet, income statement, and the statement of cash flows.. • Recogniz

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LEARNING OBJECTIVES

• Understand the basic elements, uses, and

limitations of the financial statements (FS):

balance sheet, income statement, and the

statement of cash flows.

• Recognize the need for financial statement

notes and identify the types of information

included in the notes.

• Describe the purpose of an audit report and the

incentives the auditor has to perform a good audit.

Three basic questions

• (1) What is the company’s current financial status?

• (2) What were the company’s operating

results for the period?

• (3) How did the company obtain and use cash during the period?

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Primary Financial Statements

• The Balance Sheet

(Statement of Financial Position)

• Income Statement

(Statement of Earnings)

against resources

$200 Owners’ Equity

Paid-in Capital $100 Retained earnings 40Sample Balance Sheet

Classified and Comparative

Balance Sheets

• Classified balance sheet

– Distinguishes between current and long-term assets and liabilities.

– Listed in decreasing order of liquidity.

• Comparative balance sheet

– Presents two years of balance sheet

information.

– Helps users identify significant changes.

Limitations of the Balance

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Given the limitations of B/S,

should we need it?

• Would you invest in a business if you don’t know which assets it has?

• Would you lend the money to a business if you don’t know how much they have

borrowed?

The Income Statement

Revenues

Increase in a company’s resources from the sale

Net Income or (Net Loss)

Revenues - Expenses

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Other Items on the Income

Statement

• Earnings per share

Net Income (Net Loss)

# of Shares of Stock Outstanding

– The amount of earnings related to each share

of stock

• Gains (losses)

Statement of Retained

Earnings

• Shows the change in retained earnings

over the period of time

Beginning retained earnings

+ Net income – Dividends Ending retained earnings

• The total amount invested by the owners through the retention of profits

Statement of Cash Flows

• Reports categorized cash inflows and outflows

Operating Activities Day-to-day activities

Investing Activities Buying and selling long-term assets

Financing Activities Cash obtained or repaid

to owners or creditors

What are the differences

among the statements?

What are the interrelationships among

the FSs (articulation)?

Revenues $12,443,000 Expenses 11,578,400 Net income $ 864,600

Income 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

Cash Flow Statement

R/E 12/31/08 $ 760,000

Net income 864,600

Dividends (400,000) R/E 12/31/09 $ 1,224,600

Stmt of Retained

Earnings

Cash $ 110,000

Other 4,975,000 Total $5,085,000

Liabilities $2,860,400 Cap stock 1,000,000 R/E 1,224,600

Total $5,085,000

Balance Sheet 12/31/09

Practice 2-47/p.66

• Can we put all financial information in the financial statements?

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Notes to Financial Statements

1 Summary of significant accounting policies.

– assumptions, estimates, and judgments

– more than one acceptable method of accounting

2 Additional information about the summary totals found

in the financial statements.

– additional detail

3 Disclosure of important information that is not

recognized in the financial statements.

– too uncertain to be recognized (i.e guarantee)

4 Supplementary information required by the Financial

Accounting Standards Board (FASB) or the Securities

Note to Wal-Mart’s FS

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• Who control the preparation of the

financial statements?

• Who use them?

• Do the managements have any incentive

to bias the reported financial statement

numbers?

External Audits

Audit Report

– Issued by an independent CPA firm – Verifies financial statements have been prepared according to GAAP.

External Auditor vs Management

Owners and managers want the

most favorable results possible.

• Bank credit

• Bonuses

• Public stock price

CPA firms have economic incentives to perform credible

• Going Concern Assumption

– will continue to exist for the foreseeable future

 record assets at what they are worth to a

company in normal use, rather than what they would sell for in a liquidation sale

• Monetary Measurement Concept

– Record only the economic activities that can be

measured in monetary terms – The listed values may not be the same as the

actual market values.

What Are the Fundamental Concepts and Assumptions?

• Arm’s-Length Transactions

– Business dealings between independent, rational

parties who are looking out for their own interests.

– Would you trust the profit generated from the

transactions between a parent company and its children?

• Historical Cost Principle

– More objective

What Are the Fundamental Concepts and Assumptions?

Case (2-64)

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End of chapter