BUSI3111 Ch2

Chapter 2
Basic Financial
Statements
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2-1
Introduction to Financial Statements
Investors and creditors are interested in the cash
flows that they expect to receive in the future.
 Creditors are interested in the ability of an
enterprise to meet its payment obligations, which
may include payment of interest.
 Investors are interested in the market value of their
stock holdings and any dividends they might
receive.
2-2
Financial Statements
 A financial statement is simply a declaration of
what is believed to be true about an enterprise,
communicated in terms of a monetary unit,
such as the dollar.
 When accountants prepare financial statements,
they are describing in financial terms certain
attributes of the enterprise that they believe
fairly represent its financial activities.
2-3
Three Primary Financial Statements
 Statement of financial position (often referred
to as the balance sheet)
 Income statement
 Statement of cash flows
2-4
Financial Statements: Balance Sheet
1. Statement of Financial Position (Balance
Sheet)
a. Describes where the enterprise stands at a
specific date.
b. A snapshot of the business in financial or
dollar terms that shows what the enterprise
looks like at a specific date.
2-5
Financial Statements: Income Statement
2. Income Statement
a. An activity statement that shows the
revenues and expenses for a designated
period of time.
b. Revenues generate positive cash flows
through transactions with customers.
c. Expenses generate negative cash flows
(outflows of cash) through business
activities.
2-6
Financial Statements: Statement of
Cash Flows
3. Statement of Cash Flows
a. Details the company’s sources and uses of
cash during an accounting period.
b. Enables the financial statement user to
better understand the change in the cash
balance shown on the comparative balance
sheet.
2-7
Statement of Financial Position
2-8
Features of the Balance Sheet
1. Heading
a. Names of the business
b. Name of the financial statement
c. Date
2. Assets: Generally listed in order of expected
liquidity beginning with cash.
3. Liabilities: Listed on the other side of the
balance sheet before owners’ equity.
4. Equity: Divided into the categories of capital
stock and retained earnings.
2-9
Business Entity Concept
Business Entity
• An economic unit that engages in identifiable
business activities.
• For accounting purposes, the activities of the
entity are separate from the personal activities
of its owners.
• Should only include items related to the
operation of the business.
2-10
Assets
Assets have three basic characteristics:
1. Economic resources
2. Owned by the business
3. Expected to benefit future operations*
*In most cases, the benefit to future operations

comes in the form of positive future cash flows.
2-11
The Cost Principle
 Historical cost refers to the original amount the
entity paid to acquire the asset.
 Examples of assets reported at historical cost
include merchandise inventory, land, buildings,
and equipment.
 Examples of assets reported at net realizable
value, or fair value, include accounts receivable
and investments.
2-12
The Going-Concern Assumption
 The going-concern assumption indicates that
we assume that a business will be a continuing
enterprise which will operate for an indefinite
period.
 This assumption supports the principle of
historical cost, as most long-term assets are not
intended for resale but meant to assist the
business in continuing its core operations.
2-13
The Objectivity Principle
 Objective describes information that is factual,
definite, and verifiable.
 Objective information lacks subjectivity.
 Objectivity is a primary reason for reporting
long-term assets at historical cost as that value
is verifiable.
2-14
The Stable-Dollar Assumption
A limitation of measuring assets at historical cost
is that the value of the monetary unit or dollar is
not always stable.
 Inflation is a term used to describe the situation
where the value of the monetary unit decreases,
meaning that it will purchase less than it did
previously.
 Deflation, on the other hand, is the opposite
situation in which the value of the monetary
unit increases, meaning that it will purchase
more than it did previously.
2-15
Liabilities
Liabilities:
 Financial obligations or debts.
 Represent negative future cash flows.
 The person or organization to whom the debt
is owed is called a creditor.
 Usually listed on the balance sheet in the order
in which they are expected to be repaid.
 Represents claims against the borrower’s assets.
2-16
Owners’ Equity
Owners’ Equity:
 Represents the owners’ claims on the assets of
the business.
 Indicates a residual amount as creditors have
legal priority over owners.
 Entitles owners to the residual assets once
creditors have been paid in full.
 Always equal to total assets minus total
liabilities.
2-17
Increases in Owners’ Equity
The owners’ equity in a business comes from two
primary sources:
1. Investments of cash or other assets by
owners.
2. Earnings from profitable operation of the
business.
2-18
Decreases in Owners’ Equity
Decreases in owners’ equity also are caused in
two ways:
1. Payments of cash or transfers of other assets
to owners.
2. Losses from unprofitable operation of the
business.
2-19
The Accounting Equation
Assets = Liabilities + Owners’ Equity
Example:
Assets = Liabilities + Owners’ Equity
$300,000 = $80,000 + $220,000
2-20
The Effects of Business Transactions
How does a statement of financial position come
about? What has occurred in the past for it to exist at
any point in time?
• The statement of financial position is a picture of
the results of past business transactions that has
been captured by the company’s information
system and organized into a concise financial
description of where the company stands at a point
in time.
• The specific items and dollar amounts are the
direct results of the transactions in which the
company has engaged.
2-21
Illustration: Introduction
To illustrate how a balance sheet comes about,
and later to show how the income statement
and statement of cash flows relate to the
balance sheet, we use an example of a small auto
repair business, Overnight Auto Service.
2-22
Overnight: Transaction 1
On January 20, Michael McBryan started Overnight
Auto Service. He and his family invested $80,000
and received 8,000 shares of stock at $10 per
share.
2-23
On January 21, Overnight purchased the land from
the city for $52,000 cash.
2-24
On January 22, Overnight purchased an old garage
for $36,000. Overnight paid $6,000 down in cash and
issued a 90-day note payable for the remaining
$30,000 owed.
2-25
On January 23, Overnight purchased tools and
automotive repair equipment for $13,800 on
account, due within 60 days.
2-26
Overnight realized that the company had purchased more tools
and equipment than it needed.
On January 24, Overnight sold some of the new tools to Ace
Towing for $1,800, a price equal to Overnight’s cost. Ace
agreed to pay the amount within 45 days.
2-27
On January 26, Ace Towing pays Overnight $600 as

a partial settlement of its accounts receivable.
2-28
On January 27, Overnight made a partial payment

of $6,800 on its account payable to Snappy Tools.
2-29
On January 31, Overnight recorded auto repair
services provided for the last week of January of
$2,200, received in cash.
2-30
On January 31, Overnight paid operating expenses

of $1,400 in cash.
2-31
Overnight: Expanded Accounting
Equation
2-32
Income Statement
The income statement is a summarization of the
company’s revenue and expense transactions for a
period of time.
Revenues
 Increases in the company’s assets from its
profit-directed activities.
 Result in positive cash flows.
2-33
Income Statement (cont.)
Expenses
 Decreases in the company’s assets from its
profit-directed activities.
 Result in negative cash flows.
Net income is the difference between revenues

and expenses for a specified period of time.
Net Income = Revenues − Expenses
2-34
Overnight’s Income Statement
Investments by the owners and payments to

the owners are not included on the
Income Statement.
2-35
Statement of Cash Flows
Classifies cash flows into three categories:
1. Operating activities: the cash effects of
revenue and expense transactions that are
included on the income statement.
2. Investing activities: the cash effects of
purchasing and selling assets, such as land and
buildings.
3. Financing activities: the cash effects of the
owners investing in the company and
creditors loaning money to the company and
the repayment of either or both.
2-36
Overnight’s Statement of Cash Flows
2-37
Relationships Among Financial
Statements
2-38
Financial Statement Articulation
2-39
Financial Reporting and Financial
Statements
2-40
Forms of Business Organization
1. Sole Proprietorship
a. An unincorporated business owned by one
person.
b. Often the owner also acts as the manager.
c. Common for small retail stores, farms,
service businesses, and professional
practices in law, medicine, and accounting.
d. Most common form of business organization
in our economy.
2-41
Forms of Business: Partnership
2. Partnership
a. An unincorporated business owned by two or
more persons voluntarily acting as partners (co-
owners).
b. Widely used for small businesses as well as
some large professional practices, including CPA
firms and law firms.
c. Owners of a partnership are personally
responsible for all debts of the business.
d. From an accounting standpoint, a partnership is
viewed as a business entity separate from the
personal affairs of its owners.
2-42
Forms of Business: Corporation
3. Corporations
a. Recognized under the law as an entity
separate from its owners.
b. Owners of a corporation are not personally
liable for the debts of the business.
c. These owners can lose no more than the
amounts they have invested in the
business—a concept known as limited
liability.
2-43
Corporations (cont.)
d. Ownership of a corporation is divided into
transferable shares of capital stock.
e. Owners are called stockholders or
shareholders.
f. Stockholders are generally free to sell some
or all of these shares to other investors at
any time.
g. Corporations are the dominant form of
business organization in terms of the dollar
volume of business activity.
2-44
Reporting Ownership Equity in the
Statement of Financial Position
2-45
Liquidity and Profitability
Liquidity is the ability of the business to pay its
debts as they come due.
 Critical to the survival of the business.
 A business that is not liquid may be forced into
bankruptcy by its creditors.
Profitability refers to a company’s ability to

generate net income from the business.
 Profitable operations increase owner’s equity.
2-46
Short-Run vs. Long-Run
 In the short-run, liquidity and profitability may
be independent of each other.
 Over the long term, liquidity and profitability go
hand in hand.
 A key indicator of a company’s short-term
liquidity is the relationship between the
company’s liquid assets and the liabilities
requiring payment in the near future.
2-47
Adequate Disclosure
 Adequate disclosure means that users of
financial statements are informed of all
information necessary for the proper
interpretation of the statements.
 Disclosures are made in the body of the
financial statements and in the notes
accompanying the statements.
 It is common for the notes to the financial
statements to be longer than the statements
themselves.
2-48
Adequate Disclosure (cont.)
Items that may require disclosure include but are
not limited to:
 Significant accounting policies
 Subsequent events
 Unsettled lawsuits
 Contractual commitments
 Assets pledged as collateral
2-49
Management’s Interest in Financial
Statements
 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
its financial statements.
2-50
End of Chapter 2
2-51

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Chapter 2

*In most cases, the benefit to future operations

Assets = Liabilities + Owners’ Equity

$300,000 = $80,000 + $220,000

On January 26, Ace Towing pays Overnight $600 as

On January 27, Overnight made a partial payment

On January 31, Overnight paid operating expenses

Net income is the difference between revenues

Net Income = Revenues − Expenses

Investments by the owners and payments to

Profitability refers to a company’s ability to

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