FIN: Ch. 2. Basic Financial Statements

Increases in Owners' Equity; the owners' equity in a business comes from two primary sources, what are they?

1. Investments of cash or other assets by owners. 2. Earnings from profitable operation of the business.

Decreases in Owners' Equity are caused in two ways, what are they?

1. Payments of cash or transfers of other assets to owners. 2. Losses from unprofitable operation of the business.

These accounting principles support cost as the basis for asset valuation...

1. Stable-dollar assumption 2. Cost Principle 3. Objectivity Principle 4. Going-Concern Assumption

What are the three priamry financial statements?

1. Statement of financial position (commonly referred to as a balance sheet). 2. Income statement. 3. Statement of cash flows.

What is 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 i.e. inflation and deflation. However, accountants use the stable-dollar assumption to tell us that we will only record accounting information that can be expressed in monetary units, usually dollars in the United States and assumes that the dollar remains relatively stable.

Explain certain accounting principles that are important for an understanding of financial statements and how professional judgment by accountants may affect the application of those principles.

Accountants use the cost principle to valuate many assets "at cost" - they use two arguments to justify this: the going-concern assumption and the objectivity principle. The going-concern assumption deems that certain assets of a business are not for sale but are critically important to the function of the business unsold therefore their current market sale price is nominal and, in terms of cash flows, unimportant. The objectivity principle says that "at cost" valuations can be checked and verified and speculated by market fluctuations. The accountants judgement is needed to categorize the "at cost" part of the balance sheet as to what is best for the entity. A limitation to the cost principle is the stable-dollar assumption or the assumptions within.

What is the net realizable value?

An amount that approximates the cash that is expected to be received when the receivable is collected. Accounts receivable from customers are generally included in the balance sheet at their net realizable value. (Exception to the cost principle)

What is the objectivity principle?

Another reason for using cost rather than current market values in accounting for many assets is the need for a definite, factual basis for valuation - can be verified by independent experts, objective evidence can be found for anything purchased at cost.

What is articulation in terms of the three basic financial statements?

Articulation is the way all three financial statements relate to each other.

What's another way of looking at a balance sheet in terms of a formula?

Assets - Liabilities = Owners' Equity

Capital stock

Capital stock represents the amount that owners originally paid into the company to become owners. It consists of individual shares and each owner has a set number of shares. Capital stock represents the total, so if the capital stock is $150,000 and is priced at $10 a share, then there have been 15,000 shares sold.

Income Statement

Depicts revenue and expenses for a designated period of time. Net income is defined as the excess of revenues over expenses. Financial statements begin with a three-line title comprised of the company name, the name of the statement, and the period covered by the report. The income statement lists revenues and expenses that were incurred over a period of time. Most companies prepare monthly income statements. In the long-run, revenues will generate positive cash inflows to the company and expenses will result in negative cash flows to the company. Just remember, revenues and expenses that appear on the income statement may not always produce cash flows in the current accounting period. Net income (or net loss) is simply the difference between revenues and expenses. When revenues exceed expenses, the result is net income. When expenses exceed revenues, the result is a net loss.

Statement of Cash Flows

Depicts the way cash has changed during a designated period of time. The statement of cash flows will be covered in detail in a later chapter. The statement of cash flows is divided into three major sections: (1) cash flows from operating activities; (2) cash flows from investing activities, and (3) cash flows from financing activities. The statement describes cash inflows and outflows over a period of time.

Balance Sheet

Describes where an enterprise is on a specific date. The balance sheet (also referred to as the statement of position) describes the financial position of a company at a specific point in time. A balance sheet may be prepared monthly, quarterly, or annually depending on the needs of management and external users. The balance sheet is sometimes referred to as the statement of financial position.

What is the entity principle?

Generally accepted accounting principles require that financial statements describe the affairs of a specific economic entity. This concept is called the entity principle. pg 40

Accounts payable

Liabilities arising from the purchases of merchandise, supplies, and services. Accounts payable, in contrast to notes payable, involve no written promises and generally do not call for interest payments. An accounting entry that represents an entity's obligation to pay off a short-term debt to its creditors. The accounts payable entry is found on a balance sheet under the heading current liabilities. Accounts payable are often referred to as "payables". Another common usage of AP refers to a business department or division that is responsible for making payments owed by the company to suppliers and other creditors.

Accrued expenses

Liabilities that are similar may be combined to avoid unnecessary detail in the financial statement - the combination of these expenses into a single line is called accrued expenses. The word accrued is an accounting term communicating that the payment of certain expenses has been delayed or deferred. pp 43

Financial Statement

Simply a declaration of what is believed to be true about an enterprise, communicated in terms of a monetary unit, such as the dollar.

Owners' Equity or Retained Earnings

Simply the accumulated earnings of previous years that remain within the enterprise. Retained earnings is considered part of the equity of the owners and serves to enhance their investment in the business.

What is the going-concern assumption?

The balance sheet of a business is prepared on the assumption that the business is a continuing enterprise, or a going concern. This is why accountants don't change their values to correspond with changing market prices, such assets are being used to house the business and were acquired for use and not for resale - the going-concern assumption may be for the judgment of the accountant.

Corporation

The corporation is unique form of organization that allows many owners to combine their resources into a business enterprise that is larger than would be possible based on the financial resources of a single or a small number of owners.

One of the most basic and at the same time most controversial problems in accounting is determining the correct dollar amount for the the various assets of a business. What is the cost principle?

The cost principle: assets such as land, buildings, merchandise, and equipment are typical of the many economic resources that are required in producing revenue for business. The prevailing accounting view is that such assets should be presented at their cost. Let's say land was purchased at $100k, then there's a real estate boom and the land value become $250k, in the accountants book the land is still valued at $100k - this is the cost principle of accounting. Exceptions to the cost principle are found in some of the most liquid assets (that is, assets that are expected to soon become cash).

What is historical cost?

The original amount the business entity paid to acquire the asset.

Statement of cash flows

The statement of cash flows shows the ways cash changed during a designated period- the cash received fro revenues and other transactions as well as the cash paid for certain expenses an other acquisitions during the period.

Net income

The term net income or net loss is simply the difference between all of an enterprise's revenues and expenses for a designated period of time.

Explain the nature and general purpose of financial statements. L01 ppg 38

To demonstrate where the company stands, in financial terms, at a specific point in time by depicting positive and negative impacts of cash.

What is the relationship between balance sheets and statements of cash flows?

We have a balance sheet on the date at the beginning of period, and we have a balance sheet on the date at the end of period, those two balance sheets together give us the information used for the income statements and statements of cash flows.

Inflation

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.

The relationship between assets (cash, notes receivable, accounts receivable, supplies, land, building, office equipment) versus Liabilities and Owners' Equity (Liabilities: Notes Payable, Accounts Payable, Salaries Payable, Owners Equity: Capital Stock, Retained Earnings), is....

always equal, this relationship always exists in fact, the equality of these totals is why this financial statement is frequently called a balance sheet. pp 40

Assets

are economic resources that are owned by a business and are expected to benefit future operations. The positive future cash flows may come directly as the asset is converted into cash (collection of a receivable) or indirectly as the asset is used in operating the business to create other assets that result in positive future cash flows (buildings and land used to manufacture a product for sale.) Some assets exist in the form of valuable legal claims or rights examples are amounts due from customers, investments in government bonds, and patent rights.

Liabilities

financial obligations or debts. On a balance sheet, liabilities are usually listed in the order in which they are expected to be repaid.

The statement of financial position or balance sheet

is a financial statement that describes where the enterprise stands at a specific date.

Note payable

is a written promise to repay the amount owed by a particular date and usually calls for the payment of interest as well. A note payable is a more formal arrangement (as compared to an account payable) calling for interest payments often, but are similar in that they require the company to make payment in the future.

Income statement

is an activity statement that shows the revenues and expenses for a designated period of time. Revenues result in positive cash flows - either past, present, or future. Positive or negative indicate the directional impact on cash.

Deflation

is the opposite situation of inflation in which the value of the monetary unit increases, meaning that it will purchase more than it did previously.

Owners' equity

represents the owners' claims on the assets of the business.

Creditor

the person or organization to whom the debt is owed.