2
Preparing Chapter Financial Statements and Analyzing Business Transactions
Financial Reporting
The Process of preparing and presenting financial information, to include: The four financial statements:
Income Statement Statement of Changes in Shareholders' Equity Balance Sheet Statement of Cash Flows
The Financial Accounting Standards Board
Establishes the guidelines for financial statements. These broad principles are referred to as Generally Accepted Accounting Principles. The goal is to increase the quality and usefulness of the information
It takes good information
To make good decisions
Is the Information Useful?
It must be capable of making a difference in the decision making process
Qualities of Accounting Information
Information is only good if it is: Relevant Reliable Comparable Consistent
Relevant Information is....
Important to the company Has the potential to influence decisions Provided on a timely basis
"Someone else "We longer "I "Nowould our hear that be bought it this able to is selling neighbor expand relevant" morning " ourtheir land" operations..."
Reliable Information is....
Neutral Verifiable
"Is this information accurate and free of bias?"
And independent of the specific person who prepared it
Comparable Information
Each company has prepared its information using the same set of rules Allows meaningful comparisons of two companies
"Are we doing better or worse than they are? Why?
Consistent Information
The company uses the same set of rules from year to year Allows meaningful comparisons of a company's performance at two points in time
"How are we doing this year versus last year?
Assumptions and Principles underlying financial reporting
Assumptions:
Separate
Entity Assumption Monetary Unit Assumption Time-period Assumption Going-Concern Assumption
Principles:
Historical
Cost Principle Revenue Recognition Principle Matching Principle
Separate Entity Assumption
Financial Statements of a business only contain information about that firm Exclude transactions of the owners
Monetary Unit Assumption
Only items that can be expressed in monetary units (dollars in the United States) Will be included in the Financial Statements
Time-Period Assumption
The life of a business can be divided into artificial time periods for financial reporting These time periods are presented at the top of each financial statement
Going-Concern Assumption
A company will remain in business for the foreseeable future
Historical Cost Principle
Assets are recorded on the Balance Sheet at cost Cost includes all costs necessary to get the asset ready for its intended purpose
$5,000
Revenue Recognition Principle
Revenues are recorded on the Income Statement When the earnings process is complete And the amount is reasonably assured Generally at the time the goods or services are provided
$6,000 of consulting work was performed in the month of January
Matching Principle
Expenses are recorded on the Income Statement In the Same Time Period As the Revenue they helped Generate
$1,420 of expenses were incurred to generate the $6,000 of revenues
Accrual-Basis Accounting
Revenues and Expenses are recorded on the Income Statement At the time the economic activity occurs Regardless of cash flow
$4,580 Net Income = growth in total asset base, not necessarily growth in Cash. $6,000 Revenue = Total work done in January for Cash and Credit Customers $1,420 Expense = Total costs incurred in January whether paid in Cash or with credit
Take a closer look at the Balance Sheet
Adding Subtotals to the Balance Sheet is called Classifying the Balance Sheet These subtotals allow the reader to make decisions as to the type, amount and the timing of item under review
Current Assets
Current Assets are those that will be converted to cash or used in the next 12 months
Non-Current Assets
Non-Current (also Assets called Plant Assets) are those that will be Not Be converted to cash or used in the next 12 months
Non-Current Assets will not be used in the next 12 months
Current Liabilities
Current Liabilities are those that will be paid off or worked off in the next 12 months
Non-Current Liabilities
Non-Current Liabilities are those that will Not Be paid off or worked off in the next 12 months
Non-Current Liabilities will not be paid off in the next 12 months
Stockholders' Equity
Is the Residual Claim on the Net Assets of the Corporation, after the claims of creditors have been satisfied.
Contributed Capital represents the investment by the stockholders in exchange for ownership interest
Retained Earnings represents the cumulative profitability of the corporation in excess of dividends
Transaction Analysis in simplest terms
Is the process of Analyzing the impact a transaction has on the Accounting Equation
1) Did the transaction change the amount of Assets?
2) Did the transaction change the amount of Liabilities?
3) If the change in Assets does not equal the change in Liabilities, evaluate the impact on Equity.
If Shareholder's Equity changed...
Either the Income Statement or Statement of Shareholders' Equity will be affected
If the transaction is between the business and its owners, it is a Statement of Shareholders' Equity transaction
If the transaction is between the business and non-owners, it is an Income Statement transaction.
Let's try it....
Transactions in January 1) Clint and some of his friends contribute $2,000 to start the business. This transaction increases Assets and Contributed Capital by $2,000.
$2,000
$2,000
This transaction affects the Balance Sheet and the Statement of Changes in Shareholders' Equity
2) Clint's Consulting Company borrows $4,000 from a local bank. The loan will be repaid in six months.
This transaction increases Assets and Liabilities by $4,000.
Transactions that don't change Equity only affect the Balance Sheet
3) The firm spends $1,400 cash for operating expenses.
This transaction decreases Assets and Shareholders' Equity by $1,400.
This is an example of the Matching Principle. The expense is recorded in the same time period as the revenue it helped generate.
Cash will be reduced on the Balance Sheet and Operating Expenses will reduce Income on the Income Statement.
4) Clint's Consulting acquires office equipment at a cost of $5,000 for cash.
This transaction Increases the Asset Office Equipment, and decreases another Asset - Cash by $5,000.
This is an example of the Historical Cost Principle. The asset is recorded at cost
This transaction is restricted to the Balance Sheet
5) Clint's earned $6,000 for service revenue, all paid in cash by clients.
This transaction Increases the Asset Cash, and increases the Retained Earnings portion ThisShareholders' Equity by $6,000. of is an example of
the Revenue Recognition Principle. Revenue is recorded when it is earned.
This transaction increases Assets on the Balance Sheet, and Net Income on the Income Statement.
6) Clint's Consulting paid $20 interest to the bank.
This transaction Decreases the Asset Cash, and decreases the Retained Earnings portion of Shareholders' Equity by $20.
This is an example of the Matching Principle. The expense is recorded in the same time period as the revenue it helped generate.
This transaction decreases Assets on the Balance Sheet, and Net Income on the Income Statement.
The totals are used to create the financial statements.
The Revenues and Expenses will be reported on the Income Statement
Income Statement
Net Income will transfer to the Statement of Shareholders' Equity
Statement of Shareholders' Equity
Transferred from the Income Statement
This amount is transferred to the Balance Sheet
Balance Sheet
From the Statement of Shareholders' Equity
Statement of Cash Flows
End Chapter 2