978-0077862381 Chapter 2 Lecture Note

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subject Authors Jan Williams, Joseph Carcello, Mark Bettner, Susan Haka

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Chapter 02 - Basic Financial Statements
2 BASIC FINANCIAL STATEMENTS
Chapter Summary
Financial statements are the primary means of communicating financial information to
users. Chapter 2 covers the income statement, balance sheet, and statement of cash flows.
Chapter 1 set forth the objectives of the financial reporting process, and offered the
observation that these objectives are met in large part by a set of financial statements. In this
chapter, we take up the task of introducing the balance sheet, income statement, and the statement
of cash flows.
The presentation is organized around the accounting equation. The equation serves as the
basis for elementary transaction analysis. A continuing illustration examines the impact of a
number of simple transactions upon the balance sheet of a simple service business. Revenue and
expense transactions have been included so that we might introduce the income statement and
statement of cash flows at an elementary level. This in turn has provided the opportunity to
discuss and illustrate statement articulation.
Before closing, the chapter emphasizes the importance of adequate disclosure regarding
both financial and nonfinancial information, thereby reinforcing the Chapter 1 theme that the
financial reporting process is broader than the financial statements.
The chapter also covers accounting principles dealing with asset valuation, as well as an
introduction to forms of business organization.
Learning Objectives
1. Explain the nature and general purpose of financial statements.
2. 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.
3. Demonstrate how certain business transactions affect the elements of the accounting equation:
Assets = Liabilities + Owners Equity.
4. Explain how the statement of financial position, often referred to as the balance sheet, is an
expansion of the basic accounting equation.
5. Explain how the income statement reports an enterprise’s financial performance for a period
of time in terms of the relationship of revenues and expenses.
6. Explain how the statement of cash flows presents the change in cash for a period of time in
terms of the company’s operating, investing, and financing activities.
7. Explain how the statement of financial position (balance sheet), income statement, and
statement of cash flows relate to each other.
8. Explain common forms of business organization–sole proprietorship, partnership, and
corporation–and demonstrate how they differ in terms of their statements of financial position.
Financial Accounting, 16e 2- 1
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Chapter 02 - Basic Financial Statements
9. Discuss the importance of financial statements to a company and its investors and creditors
and why management may take steps to improve the appearance of the company in its
financial statements.
Brief topical outline
AIntroduction to financial statements
BA starting point: statement of financial position
1The concept of the business entity
2Assets
a The cost principle
b The going-concern assumption
c The objectivity principlesee Your Turn (page 43)
d The stable-dollar assumption – see Case in Point (page 44)
3Liabilities
4Owners' equity
a Increases in owners' equity
b
Decreases
in owners' equity
5The accounting equation
6The effects of business transactions (illustrated on pages 46-50)
7Effects of these business transactions on the accounting equation
CIncome statement (illustrated on page 53)
DStatement of cash flows (illustrated on page 54) – see Case in Point (page 54)
ERelationships among financial statements
FFinancial analysis and decision making – see Your Turn (page 57)
GForms of business organization
1 Sole proprietorships
2 Partnerships
3 Corporations
4 Reporting ownership equity in the statement of financial position
(illustrated on pages 58 & 59)
HThe use of financial statements by external parties
1
The short run versus the
long run
2 Evaluating short-term liquidity
3 The need for adequate disclosure
4Management’s interest in financial statementssee
Ethics, Fraud & Corporate Governance (page 61)
IConcluding remarks
Topical coverage and suggested assignment
Homework Assignment
(To Be Completed Prior to Class)
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Chapter 02 - Basic Financial Statements
Class
Meetings
on Chapter
Topical
Outline
Coverage
Discussion
Questions
Brief
Exercises Exercises Problems Critical
Thinking
Cases
1 A - D 3, 4, 5, 8 1, 3, 4 1, 4, 6 1, 3, 6 1
2 E – I 9, 14, 15 7, 9, 10 11, 12, 13 7, 8, 9 3
Comments and observations
Teaching objectives for Chapter 2
The chapter introduces technical material, including the balance sheet, income statement,
statement of cash flows, several generally accepted accounting principles, the accounting
equation, and the effects of business transactions upon assets, liabilities, and owners' equity.
Our objectives in presenting this chapter are:
1Describe the nature of financial statements. Explain the role of generally accepted
accounting principles in this process.
2Illustrate and explain a balance sheet. Define the terms assets, liabilities, and owners'
equity, and discuss the basic accounting principles relating to asset valuation. Discuss the
uses and limitations of this financial statement.
3 Introduce the accounting equation and illustrate the effects of business transactions upon
this equation and upon a balance sheet.
4 Introduce the income statement, emphasizing the nature of revenues and expenses.
5 Introduce the statement of cash flows and distinguish among operating, investing, and
financing activities.
6 Explain and illustrate the concept of financial statement articulation.
7 Define proprietorship, partnership, and the corporation as forms of business organization, and
illustrate the effect of the form of organization on the presentation of owners equity in the
financial statements.
8Explain the importance of adequate disclosure.
Financial Accounting, 16e 2- 3
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Chapter 02 - Basic Financial Statements
General comments
Introducing the financial statements Our overriding objective in this chapter is to introduce
students to the balance sheet, income statement, and statement of cash flows. We find Problem 8
useful for this purpose. Exercise 1 defining assets and liabilities, stimulates student interest when
discussed in class. Also, it is short enough that they can be discussed without having been
assigned as homework. We also recommend Problem 9 or 10 for initiating a lively
classroom discussion of many of the concepts introduced in this chapter.
In covering Chapter 2, we like to continue the overview of the financial reporting process
begun in Chapter 1. Cases 2 and 6 provide a useful framework for this discussion, but there is not
enough time for both of them. Therefore, we rotate these cases in and out of our assignment
schedules. If Case 6 is discussed, it would be appropriate to explain, in simple terms, the meaning
and significance of debt covenants, in order to cultivate student appreciation of the importance of
the accounting issues in this case.
Have you considered using annual reports? One method of bringing the "real world" into the
classroom is through the use of annual reports. Annual report information can be obtained
through the SEC’s EDGAR database available on the Internet, or from individual company home
pages.
We encourage students to review these reports throughout the course and to note any
similarities and variations between their reports and the textbook treatment of various topics.
These comparisons increase students' interest in the course, prompt interesting questions, and
demonstrate the diversity, which exists in practice.
Any annual report works fine. In fact a diversity of reports sparks comparisons and
discussions among students, and prevents one company from being asked to supply an
unreasonable number of reports. The reports need not be current to be useful. Once obtained,
they may be passed on to future students for at least several semesters.
An aside In discussing the valuation of assets in the balance sheet of a business, the text stresses
the cost principle. Therefore, the statement is made that the balance sheet of a business does not
show "how much the company is worth." A different standard prevails, however, in the
preparation of personal financial statements for an individual. In an individual's personal balance
sheet, generally accepted accounting principles require assets to be valued at estimated market
values. In addition, the estimated income tax liability, which would result from selling the assets
at these values also, is included in an individual's balance sheet. Thus, the owners' equity section
of a personal balance sheet shows the individual's net worth.
Why have we not discussed personal financial statements in the text? The answer is that very
few individuals prepare personal financial statements in conformity with generally accepted
accounting principles. Most individual financial statements are prepared in conjunction with loan
applications. In these cases, the lender usually supplies its own preprinted forms, which specify
the lender's standards for the valuation of assets and liabilities. These standards often vary from
generally accepted accounting principles. For example, most lenders do not ask a borrower to
estimate the income tax liability, which would result from liquidating appreciated assets at their
market values.
Supplemental Exercises
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Chapter 02 - Basic Financial Statements
Internet Exercise
Case 2-2 instructs students to perform an analysis of an annual report. Have students
download an annual report from a company web site and use this to complete the Case. Many
companies make their report available on their web site, and most of the sites are relatively easy to
locate through a search engine.
This chapter briefly introduces the stable dollar assumption. Students can become
familiar with the impact of inflation on monetary valuations at www.westegg.com/inflation/.
This site provides a calculator that allows a monetary amount in one year to be converted into an
equivalent amount in a second year.
CHAPTER 2 NAME #
10-MINUTE QUIZ A SECTION
Indicate the best answer for each question in the space provided.
1The financial statements of a business entity:
aInclude the balance sheet, income statement, and income tax
return.
bProvide information about the profitability and financial position
of the company.
cAre the first step in the accounting process.
dAre prepared for a fee by the Financial Accounting Standards
Board.
2A balance sheet is designed to show the financial position of an
entity:
aAt a single point in time.
bOver a period of time such as a year or quarter.
cAt December 31 of the current year.
dAt January 1 of the coming year.
3Accounts payable and notes payable are:
aAlways less than the amount of cash a business owns.
bCreditors.
cWritten promises to pay a certain amount, plus interest, at a
de%nite future date.
dLiabilities.
4The balance sheet of Dotty Designs includes the following items:
Accounts
Receivable
Cash
Capital Stock Accounts
Payable
Equipment Supplies
Notes Payable Notes
Receivable
Financial Accounting, 16e 2- 5
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Chapter 02 - Basic Financial Statements
This list includes:
aFour assets and three liabilities.
bFive assets and three liabilities.
cFive assets and two liabilities.
dSix assets and two liabilities.
5An accounting entity may best be described as:
aAn individual.
bA particular economic unit.
cA publicly owned corporation.
dAny corporation, regardless of size.
CHAPTER 2 NAME #
10-MINUTE QUIZ B SECTION
Presented below is the balance sheet for Sabino Family Dentistry on January 1 of the
current year.
SABINO FAMILY DENTISTRY
Balance Sheet
January 1, 20__
Assets Liabilities & Stockholders’
Equity
Cash........................... $ 33,000 Liabilities:
Accounts receivable. . . 51,150 Accounts payable ...................... $ 74,250
Land........................... 313,500 Total liabilities.......................... $ 74,250
Building...................... 371,250 Owners’ equity:
Equipment.................. 57,750 Capital stock............................ 752,400
Total liabilities and
Total assets................. $826,650 ownersequity............................. $826,650
During the first few days of January, the following transactions occurred:
Jan 1 The business borrowed $99,000 from the bank, giving a note payable due
in 90 days.
3 Additional capital stock was issued in exchange for $44,550 cash.
3 Equipment was purchased for $62,700 on credit.
5 The business collected $26,400 of its accounts receivable and paid
$37,950 of its accounts payable.
Indicate your answer to each of the following questions in the space provided.
1On January 6, total assets of the business amount to:
a$826,650. b$994,950 c$957,000. d $950,400.
2On January 6, owners’ equity amounts to:
a$752,400. b$44,550. c$796,950. d $895,950.
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Chapter 02 - Basic Financial Statements
3On January 6, the accounts payable balance is:
a$136,950. b$36,300. c$24,750. d $99,000.
4On January 6, the accounts receivable balance is:
a$24,750. b$38,775. c$77,550. d $63,525.
5On January 6, the cash balance is:
a$127,050. b$138,600. c$165,000. d $202,950
CHAPTER 2 NAME #
10-MINUTE QUIZ C SECTION
Presented below is the balance sheet for Manhattan Family Dentistry on January 1
of the current year.
MANHATTAN FAMILY DENTISTRY
Balance Sheet
January 1, 20__
Assets Liabilities & Stockholders’
Equity
Cash........................... $ 20,000 Liabilities:
Accounts receivable. . . 31,000 Accounts payable ...................... $ 45,000
Land........................... 190,000 Total liabilities.......................... $ 45,000
Building...................... 225,000 Owners’ equity:
Equipment.................. 35,000 Capital stock............................ 456,000
Total liabilities and
Total assets................. $501,000 ownersequity............................. $501,000
During the first few days of January, the following transactions occurred:
Jan 2 Equipment was purchased for $38,000 on credit.
2 The business collected $16,000 of its accounts receivable and paid
$23,000 of its accounts payable.
3 The business borrowed $60,000 from the bank, giving a note payable due
in 90 days.
3 Additional capital stock was issued in exchange for $27,000 cash.
Complete the following balance sheet for Manhattan Family Dentistry on January 4
of the current year.
MANHATTAN FAMILY DENTISTRY
Balance Sheet
January 4, 20__
Assets Liabilities & Owners’
Equity
Financial Accounting, 16e 2- 7
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Chapter 02 - Basic Financial Statements
Cash.............$ Liabilities:
Accounts receivable... Notes payable ............$
Land.......................... Accounts payable.....................
Building..................... Total liabilities...........$
Equipment................. Owners’ equity:
Capital stock..........................
Total liabilities and
Total assets. $ owners’ equity..........................$
CHAPTER 2 NAME #
10-MINUTE QUIZ D SECTION
Complete the January 31, 20__, balance sheet of Countrywide Legal Services using
the following information.
(1) Stockholders’ equity at January 1, 20__, included capital stock of $140,000.
(2) The land and building were purchased by the business for a total price of
$200,000 on January 25, 20__, from a company forced out of business. On
January 31, an appraiser valued the property at $260,000.
(3) Additional capital stock was issued in exchange for $50,000 cash.
(4) Retained earnings at January 31, 20___, amounted to $49,400.
COUNTRYWIDE LEGAL SERVICES
Balance Sheet
January 31, 20__
Assets Liabilities & Owners Equity
Cash....................... $
90,000
Liabilities:
Accounts receivable Notes payable............................ $
Land....................... 135,00
0
Accounts payable...................... 45,60
0
Building.................. Total liabilities......................... $
Equipment............. 35,000 Owners’ equity:
Capital Stock.......... $
Retained earnings. . _______
_______ Total liabilities and
Total assets............ $
owners’ equity........................... $375,0
00
SOLUTIONS TO CHAPTER 2 10-MINUTE QUIZZES
QUIZ A QUIZ B
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Chapter 02 - Basic Financial Statements
Learning Objective: Learning Objective:
2, 4, 5, 6 3, 4
QUIZ C
MANHATTAN FAMILY DENTISTRY
Balance Sheet
January 4, 20__
Assets Liabilities & Owners’ Equity
Cash...........................$ 100,000aLiabilities:
Accounts receivable. . . 15,000bNotes payable ........................... $ 60,000
Computations:
a $20,000 + $16,000 (A/R collected) - $23,000 (paid on A/P) + $60,000
Learning Objective: 4
QUIZ D
COUNTRYWIDE LEGAL SERVICES
Balance Sheet
January 31, 20__
Assets Liabilities & Owners’ Equity
Cash....................... $
90,000
Liabilities:
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Chapter 02 - Basic Financial Statements
Computations:
aTotal assets must be equal to total liabilities plus owners’ equity of $375,000.
Learning Objective: 4
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Chapter 02 - Basic Financial Statements
Assignment Guide to Chapter 2
Brief
Exercis
es
Exercis
es
Problems Cases Ne
t
1 – 10 1 - 17
1
234567891
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123456 7
Time estimate (in minutes) < 10 < 15 1
5
1
5
1
5
1
5
2
0
2
0
3
5
4
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0
3
0
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Difficulty rating E E E E M M M M M S S S M S M M M E E
Learning Objectives:
Eows presents the change in cash
for a period of time in terms of
the company’s operating,
investing, and @nancing activities.
7 11, 14,
16
7. Explain how the statement of
@nancial position (balance sheet),
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Chapter 02 - Basic Financial Statements
8. Explain common forms of
business ownership–sole
statements of @nancial position.
9. Discuss the importance of
@nancial statements to a company

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