CHAPTER 2 Financial Statements and Accounting Concepts/Principles

CHAPTER 2

Financial Statements and Accounting Concepts/Principles

PowerPoint Slides t/a Accounting: What the Numbers MeanMarshall, McCartney, van Rhyn, McManus, VieleSlides prepared by Sandra Chapple Copyright 2005 McGraw-Hill Australia Pty Ltd

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Overview

• Accounting transactions

• Financial statements

• The accounting equation

• Time line for financial statements

• Generally accepted concepts and principles

• Limitations of financial statements

• Company annual report


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Accounting Transactions

Transactions are economic interchanges between entities that are accounted for and reflected in financial

statements.

Borrow cash

from the bank


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Financial Statements

Transactions

• Procedures for sorting, classifying,

and presenting (bookkeeping)

• Selection of alternative methods of

reflecting the effects of certain

transactions (accounting)

FINANCIAL

STATEMENTS


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Accounts are further summarised in the

financial statements.

Accounts are further summarised in the

financial statements.

Cash

Accounts Receivable

Accounts Payable

Transactions are summarised in

accounts.

Transactions are summarised in

accounts.

ACCOUNTS


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Required DisclosureFinancial Statement that

Satisfies RequirementFinancial position at the end of the period

Balance Sheet

Result for the period Income Statement Cash flows during the period

Statement of Cash Flows

Investments by and distributions to owners during the period

Statement of Changes in Owners' Equity


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Balance SheetThe balance lists an organisations ASSETS,

LIABILITIES and OWNERS’ EQUITY at a point in time.

It is a snapshot of its financial position.

It is sometimes called STATEMENT OF FINANCIAL POSITION.


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Balance Sheet

Two sections shown side by side, with total of each side the same.


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Balance Sheet

Assets represent the amount of

resources owned by the entity.

Assets represent the amount of

resources owned by the entity.


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Balance Sheet

Liabilities are amounts owed

to other entities.

Liabilities are amounts owed

to other entities.


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Balance Sheet

Equity is the ownership right

of the owner(s) of the entity in the

assets that remain after

deducting the liabilities.

Equity is the ownership right

of the owner(s) of the entity in the

assets that remain after

deducting the liabilities.


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Balance Sheet

Current assets are those assets that are likely to be converted into cash or used to benefit the entity within one year.

Current assets are those assets that are likely to be converted into cash or used to benefit the entity within one year.

Current liabilities are those liabilities that are likely to be paid with cash within one year of the balance

sheet date.

Current liabilities are those liabilities that are likely to be paid with cash within one year of the balance

sheet date.


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Balance Sheet

Account ExplanationCash

Cash on hand and in the bankAccounts receivable

Amounts due from customersInventory

Cost of inventory acquired and not yet soldEquipment Cost of equipment purchased and used in

businessAccumulated depreciation Portion of the cost of equipment that is

estimated to have been used up in the process of operating the business

Explanation of balance sheet accounts:


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Balance Sheet

Account ExplanationShort-term borrowings Amounts borrowed that will be repaid within

one year of the balance sheet dateAccounts payable Amounts due to suppliersOther accrued liabililites Amounts owed to various creditorsLong-term borrowings Amounts borrowed from banks or other

creditors that will not be repaid within one year from the balance sheet date

Owners' equity Explained in more detail later in this presentation

Explanation of balance sheet accounts:


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The Accounting Equation

A = L + OEACCOUNTING

EQUATION


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The Accounting Equation

ACCOUNTING EQUATION

A = L +OESometimes re-arranged as:

OE

= A - LConsistent with everyday

meaning of EQUITY

NET ASSETS


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Income Statement

The income statement shows the profit or loss for the period of time under consideration.

It is sometimes called:

• Statement of financial performance

• Statement of earnings

• Profit and loss statement

• Statement of operations


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Income Statement

Net sales 1,200,000$ Cost of goods sold 850,000 Gross profit 350,000$ Selling, general, and admin. expenses 311,000 Profit from operations 39,000$ Interest expense 9,000 Profit before taxes 30,000$ Income taxes 12,000 Net profit 18,000$

Net profit per ordinary share 1.80$

Main Street Store, Inc.Income Statement

For the Year Ended 30 June 2006

Revenues result from the entity’s

operating activities (e.g. selling inventory).

Revenues result from the entity’s

operating activities (e.g. selling inventory).


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Income Statement

Net sales 1,200,000$ Cost of goods sold 850,000 Gross profit 350,000$ Selling, general, and admin. expenses 311,000 Profit from operations 39,000$ Interest expense 9,000 Profit before taxes 30,000$ Income taxes 12,000 Net profit 18,000$

Net profit per ordinary share 1.80$

Main Street Store, Inc.Income Statement

For the Year Ended 30 June 2006

Costs and expenses are

incurred in generating

revenues and operating the

entity.

Costs and expenses are

incurred in generating

revenues and operating the

entity.


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Income Statement

Net sales Amount of sales of merchandise to customers, less the amount of customer returns of merchandise

Cost of goods sold Represents the total cost of merchandise removed from inventory and delivered to customers as a result of sales

Gross profit Difference between net sales and cost of goods sold; Represents the seller's maximum amount of "cushion" from which all other expenses of the business must be met before it is possible to have net profit

Explanation of income statement accounts:


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Income Statement

Account ExplanationSelling, general, and administrative expenses

Represent the operating expenses of the entity

Profit from operations Represents one of the most important measures of the firm's activities

Interest expense Represents the cost of using borrowed fundsIncome taxes Shown after all of the other income statement

items have been reported because income taxes are a function of the firm's income before taxes

Net profit per share of ordinary share in issue

A significant item in evaluating the market value of an ordinary share; Often referred to as "earnings per share" or EPS

Explanation of income statement accounts:


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Statement of Changesin Owners’ Equity

This financial statement shows the detail of owners’ equity and explains

the changes that occurred in the components of owners’ equity during

the year.

It is sometimes called:

• Statement of changes in share capital

• Statement of changes in retained earnings


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Statement of Changes in Owners’ Equity

Contributed Capital:Beginning balance -$

Ordinary Shares10,000 shares issued 190,000

Balance,30 June 2006 190,000$

Retained Earnings:Beginning balance -$

Net profit for the year 18,000

Less: Cash dividends of $.50 per share (5,000)

Balance, June 30 2006 13,000$ Total owners' equity 203,000$

Main Street Store, Inc.Statement of Changes in Owners' Equity

For the Year Ended June 30 2006

Total amount invested by the owners

Total amount invested by the owners


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Contributed Capital:Beginning balance -$

Ordinary Shares10,000 shares issued 190,000

Balance,30 June 2006 190,000$

Retained Earnings:Beginning balance -$

Net profit for the year 18,000

Less: Cash dividends of $.50 per share (5,000)

Balance, June 30 2006 13,000$ Total owners' equity 203,000$

Main Street Store, Inc.Statement of Changes in Owners' Equity


Link between the balance

sheet and the income

statement

Link between the balance

sheet and the income

statement


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Statement of Changesin Owners’ Equity

Account ExplanationContributed capital Represents the total amount invested in the

entity by the ownersRetained earnings Represents the cumulative net profit of the

entity that has been retained for use in the business

Dividends Are distributions of earnings to the owners

Explanation of accounts:


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The purpose of this financial statement is to identify the sources and uses of cash during

the year.

This is done by reporting the changes in all other balance sheet items.

Cash flow data is important as it is highly reliable and is less subject to manipulation

than accrual accounting.


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Cash Flows from Operating Activities:Cash Received from operations 1,120,000$ Cash paid to suppliers (985,000) Other expenses paid (287,000) Interest paid (9,000) Taxes paid - Net cash used by operating activities (161,000)

Cash Flows from Investing Activities:Cash paid for equipment (40,000)$

Cash Flows from Financing Activities:Cash received from issue of long-term borrowings 50,000 Proceeds from issue of ordinary shares 190,000 Dividend paid on ordinary shares (5,000) Net cash provided by financing activities 235,000$

Net increase in cash for the year 34,000$

Cash balance at beginning of year -$ Cash balance at end of year 34,000$

Main Street Store, Inc.Statement of Cash Flows


Cash consequences of the income

statement

Cash consequences of the income

statement


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Cash used to purchase, or

cash received from sale of,

long term assets.

Cash used to purchase, or

cash received from sale of,

long term assets.


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Amounts raised from issue of

long-term borrowings or

shares, or dividends paid

Amounts raised from issue of

long-term borrowings or

shares, or dividends paid


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Headings ExplanationCash flows from operating activities

Shown first. Includes:

- Cash received from customers

- Cash paid to suppliers - Other expenses paid ( excludes depreciation and accruals - non cash)

Cash flows from investing activities

Shows the cash sources and uses related to long-lived assets

Cash flows from financing activities

Shows the cash sources and uses related to long term borrowings and shareholders

Net increase in cash Net change in cash resulting from all activities - Corresponds to difference between opening and closing cash

Statement of Cash FlowsExplanation of headings:


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Time-line Model

Balance Sheet

1/7/05

Balance Sheet

30/6/06Financial Year 2006

A = L + OE A = L + OEIncome Statement for the Year


Beginning BalancesPaid-in Capital ChangesRetained Earnings Changes:+ Net Profit- DividendsEnding Balances

Revenue- Expenses

Net Profit


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Time-line Model

Balance Sheet

1/7/05

Balance Sheet

30/6/06Financial Year 2006

A = L + OE A = L + OE

Cash Flow Statement

Cash Provided (Used) by:Operating Activities

Investing ActivitiesFinancing Activities

+ Beginning Cash BalanceEnding Cash Balance


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Financial Statement Relationships

Assets = Liabilities + Owners'

Equity Net

profit = Revenues - Expenses

Balance Sheet Income Statement

The arrow indicates that net profit affects retained earnings, which is a component of owners’ equity.

Horizontal modelHorizontal model

The key to using this model is to keep the balance sheet in balance.


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Concepts/Principles

Broad concepts and principles that have

been generally agreed upon over time

Related to entire model

Related to financial

statements

Related to transactions

Related to the

accounting process


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Concepts/Principles

Accounting EntityEvery economic entity can be

separately identified and accounted for.

Now Future

Going Concern ConceptThe presumption that the entity will continue to operate in the

future—it’s not being liquidated.

Related to entire model


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Concepts/Principles

ObjectivityThe accountant’s desire to have a given transaction recorded in the

same way in all situations.

Related to transactions

Unit of MeasurementOnly transactions

denominated in dollars are recorded in the

accounting records.

Cost PrincipleTransactions are recorded at

their original cost to the entity as measured in dollars.


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Concepts/Principles

Related to the

accounting process

Matching ConceptAll expenses incurred to

generate that period’s revenues be deducted from

revenues earned.

Accounting PeriodThe period of time selected

for reporting results of operations and changes in

financial position.

Accrual AccountingRecognise revenue at the point of

sale and recognise expenses when incurred, even though the

cash receipt or payment occurs at another time.


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Relevance

Financial information should assist users to make informed decisions.

Full DisclosureCircumstances and events that make a difference to financial

statement users should be disclosed.

MaterialityThe increased benefit of

increased accuracy should out weigh the cost of achieving the

increased accuracy.

Concepts/PrinciplesComparability

Consistent use of accounting treatments, with changes and effects of changes disclosed

Related to financial

statements


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Limitations of Financial Statements

Financial statements report only quantitative

economic data.

They do not reflect qualitative economic variables, such as the

value of the management team or the

employee’s morale.


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The balance sheet does not report market values or replacement cost of

the assets.

Many estimates are used, such as warranty costs, depreciation and doubtful debts expense.


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Financial statements are not adjusted to show the

impact of inflation.

Financial statements do not reflect opportunity

cost, i.e. income foregone when an

income earning opportunity is foregone.


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The Company’s Annual Report

The annual report is distributed to shareholders

(and others).

It contains the financial statements and notes,

together with the report of the external auditor’s

examination of the financial statements.

It may also contain highlights for the year, including net

revenue, earnings per share and return on average

shareholders equity, as well as an historical summary of some financial data for the

last five years.

Documents

CHAPTER 2 Financial Statements and Accounting Concepts/Principles