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Chapter 2Chapter 2

Preparing financial statements and Preparing financial statements and analyzing business transactionsanalyzing business transactions

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Primary objective - provide information to help Primary objective - provide information to help people make decisionspeople make decisions

AssumptionsAssumptions Separate entity - do not include any financial Separate entity - do not include any financial

information about ownersinformation about owners Time period - life of a business can be divided into Time period - life of a business can be divided into

meaningful time periodsmeaningful time periods Historical cost - measuring assets at the time of Historical cost - measuring assets at the time of

their purchasetheir purchase Going concern - company will continue operating in Going concern - company will continue operating in

the futurethe future

Objectives, assumptions, and Objectives, assumptions, and qualities of financial reportingqualities of financial reporting

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Qualities - information Qualities - information Relevant - useful to decision makersRelevant - useful to decision makers Reliable - accurate, verifiable, and unbiased and Reliable - accurate, verifiable, and unbiased and

therefore a faithful representationtherefore a faithful representation Comparability - can be compared across firms - Comparability - can be compared across firms -

same accounting principlessame accounting principles Consistency - same accounting principles and Consistency - same accounting principles and

methods from period to periodmethods from period to period Materiality and conservatism in financial reportingMateriality and conservatism in financial reporting

Materiality - size or significanceMateriality - size or significance Conservatism - select the treatment that is least likely to Conservatism - select the treatment that is least likely to

overstate income or overstate assetsoverstate income or overstate assets

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Balance sheetBalance sheet Classified balance sheet - shows a subtotal for Classified balance sheet - shows a subtotal for

many itemsmany items Assets Assets

Current asset - plan to turn into cash or use to earn Current asset - plan to turn into cash or use to earn revenue in the next fiscal year.revenue in the next fiscal year.

Non-current asset - not be used up within 12 months.Non-current asset - not be used up within 12 months.

Liabilities Liabilities Current - obligations that can be settled with current Current - obligations that can be settled with current

assetsassets Non-current - be aid off in a period longer than one yearNon-current - be aid off in a period longer than one year Interest - cost of using someone else’s moneyInterest - cost of using someone else’s money

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Shareholder’s equityShareholder’s equity Contributed capital - owners make capital Contributed capital - owners make capital

contributionscontributions Retained earnings - owner’s claims to earningsRetained earnings - owner’s claims to earnings

Revenue recognition principle - revenue Revenue recognition principle - revenue should be recognized when it is earned and should be recognized when it is earned and its collection is reasonably assuredits collection is reasonably assured

Matching principle - expenses are Matching principle - expenses are recognized in the same period as the recognized in the same period as the revenue they helped generaterevenue they helped generate

Balance sheetBalance sheet

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Stone Company had $1,000 of supplies at the Stone Company had $1,000 of supplies at the beginning of 2006. Stone Company beginning of 2006. Stone Company purchased $10,000 supplies on account in purchased $10,000 supplies on account in 2006 and paid $8,000 for those supplies by 2006 and paid $8,000 for those supplies by year-end. Stone had $1,500 of supplies left year-end. Stone had $1,500 of supplies left at the end of 2006. What amount of supplies at the end of 2006. What amount of supplies expense should be recorded for 2006?expense should be recorded for 2006?

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The amount of supplies used $9,500, should The amount of supplies used $9,500, should be deducted from revenue in 2006. The be deducted from revenue in 2006. The amount purchased or aid is not considered amount purchased or aid is not considered an expense under the accrual basis.an expense under the accrual basis.

Accrual basis accounting - means that Accrual basis accounting - means that accountants recognize revenue when it is accountants recognize revenue when it is earned and expenses when they are earned and expenses when they are incurred to earn that revenue - no matter incurred to earn that revenue - no matter when the cash is received or aid.when the cash is received or aid.

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Earnings per share - EPS - net income Earnings per share - EPS - net income divided by the average number of divided by the average number of outstanding shares of (common) stockoutstanding shares of (common) stock

Statement of shareholders’ equity Statement of shareholders’ equity Statement of retained earnings - bb retained Statement of retained earnings - bb retained

earnings + net income - dividends +/- other earnings + net income - dividends +/- other adjustments = eb retained earningsadjustments = eb retained earnings

Statement of cash flows - explain in detail the Statement of cash flows - explain in detail the change in the cash balance during the change in the cash balance during the accounting periodaccounting period Operating, investing, financingOperating, investing, financing

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Notes to financial statementsNotes to financial statements

Provide information about any Provide information about any circumstances or events that would make a circumstances or events that would make a difference to the users of the statements - difference to the users of the statements - called full disclosure principle.called full disclosure principle.

Materiality - importance of the item or Materiality - importance of the item or transaction on the company’s financial transaction on the company’s financial performance or financial position.performance or financial position.

ConservatismConservatism

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Analyzing transactionsAnalyzing transactions Steps - record a transactionSteps - record a transaction

Determine which are affected by the transaction Determine which are affected by the transaction - asset, liability, equity, revenue, expense;- asset, liability, equity, revenue, expense;

Identify the specific account, and whether it Identify the specific account, and whether it increases or decreasesincreases or decreases

Determine the amount; andDetermine the amount; and Record the transaction in the accounting Record the transaction in the accounting

equationequation

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Order of presentation of statementsOrder of presentation of statements•Income statement always reared first

•Second - statement of changes in shareholders’ equity

•Third - balance sheet

•Final statement - statement of cash flows

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Financial statement equationsFinancial statement equationsIncome statement - revenues - expenses = Income statement - revenues - expenses = net incomenet incomeStatement of retained earnings - bb retained Statement of retained earnings - bb retained earnings + net income - dividends = eb earnings + net income - dividends = eb retained earningsretained earningsBalance sheet - assets = liabilities + Balance sheet - assets = liabilities + stockholder’s equitystockholder’s equity

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Financial statement analysisFinancial statement analysis•Current ratio - divide current assets by current liabilities

•Used to determine a firm’s ability to fund its current operations

•Internal controls - designed to protect the accounting system from both intentional errors and fraud.

•Preventive controls - help prevent errors in an accounting system

•Detective controls - help a company find errors.

•Corrective controls - correct any errors that have been discovered.

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Assign #3: pg. 79-81, E2-1A, E2-gA, E2-10A (due 2/17)Assign #4: pg. 86-88, P2-3A, P2-8A (due 2/22)