Chapter 02—Basic Financial Statements
Financial and Managerial Accounting, 18e 2-1
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 indicated that
these objectives are met in large part by a set of general purpose 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 purposes 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.
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8. Explain common forms of business ownership—sole proprietorship, partnership, and
corporation—and demonstrate how they differ in terms of their statements of financial
position.
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
A. Introduction to financial statements
B. A starting point: statement of financial position
1. The concept of the business entity
2. Assets
a. The cost principle
b. The going-concern assumption
c. The objectivity principle—see Your Turn (page 46)
d. The stable-dollar assumption—see International Case in Point (page 46)
3. Liabilities
4. Owners’ equity
a. Increases in owners’ equity
b. Decreases in owners’ equity
5. The accounting equation
6. The effects of business transactions: an illustration
a. The business entity
b. Overnight’s accounting policies
c. The company’s first transaction
d. Purchase of an asset for cash
e. Purchase of an asset and financing part of the cost
f. Purchase of an asset on account
g. Sale of an asset
h. Collection of an account receivable
i. Payment of a liability
j. Earning of revenue
k. Payment of expenses
7. Effects of these business transactions on the accounting equation
C. Income statement (illustrated on pages 54 & 55)
D. Statement of cash flows (illustrated on page 56)—see Case in Point (page 56 )
E. Relationships among financial statements—see Pathways Connection and Your
Turn (page 59)
F. Forms of business organization
1. Sole proprietorships
2. Partnerships
3. Corporations
4. Reporting ownership equity in the statement of financial position (illustrated
on pages 60 & 61)
Chapter 02—Basic Financial Statements
Financial and Managerial Accounting, 18e 2-3
a. Sole proprietorships
b. Partnerships
c. Corporations
G. The 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
4. Management’s interest in financial statements—see Ethics, Fraud, &
Corporate Governance (page 63)
H. Concluding remarks
Topical Coverage and Suggested Assignments
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
*Homework assignment (to be completed prior to class)
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:
1. Describe the nature of financial statements. Explain the role of generally accepted
accounting principles in this process.
2. Illustrate 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.
Chapter 02—Basic Financial Statements
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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.
8. Explain the importance of adequate disclosure.
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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
2.8A 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. Case 2.3 gives students a great opportunity to exercise many of the skills and
concepts covered in chapter 2 as they analyze the balance sheets of two separate companies for
the purpose of making decisions. Students gain a better understanding of how external users such
as investors and creditors may use the information contained in the general purpose financial
statements to make better business decisions.
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.
We also urge instructors to spend some class time examining how various accounting
transactions impact the accounting equation. In the textbook, we walk through the transactions of
Overnight Auto Service. Subsequent to each transaction, we examine the changes that occurred
within the accounting equation. This understanding better prepares students to learn the rules of
double-entry bookkeeping, which are introduced in Chapter 3. Instructors may want to present
the balance sheet on January 20, 2018 alongside the balance sheet on January 31, 2018. This
enables students to see the culmination of all of the recorded transactions. Students can also
compare the financial position and liquidity of the company between the two reports.
Supplemental Exercises
Internet Exercise
Case 2-7 introduces students to the EDGAR database on the SEC website. Students learn
to retrieve the quarterly report (10Q) from the website. This is a good opportunity for instructors
to assist students in navigating the SEC website. When students initially visit the SEC website,
they may feel a bit overwhelmed. From the homepage, they should look in the “Information for”
section and select “EDGAR Filers.” Next, click on “Company Filings Search” in the left menu.
At this point, students have the option of searching by company name or ticker symbol if they
have that available. After retrieving the filings, they have options to view the documents as well
as the Interactive Data. We find this to be a valuable teaching moment in introducing students to
those basic financial research skills.
Chapter 02—Basic Financial Statements
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This chapter briefly introduces the stable dollar assumption. Students can become
familiar with the impact of inflation on monetary valuations using the Inflation Calculator at the
Westegg website. 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 02—Basic Financial Statements
Financial and Managerial Accounting, 18e 2-7
CHAPTER 2 NAME #
10-MINUTE QUIZ A SECTION
Indicate the best answer for each question in the space provided.
1 The financial statements of a business entity:
a Include the balance sheet, income statement, and income tax return.
b Provide information about the profitability and financial position of the company.
c Are the first step in the accounting process.
d Are prepared for a fee by the Financial Accounting Standards Board.
2 A balance sheet is designed to show the financial position of an entity:
a At a single point in time.
b Over a period of time such as a year or quarter.
c At December 31 of the current year.
d At January 1 of the coming year.
3 Accounts payable and notes payable are:
a Always less than the amount of cash a business owns.
b Creditors.
c Written promises to pay a certain amount, plus interest, at a definite future date.
d Liabilities.
4 The balance sheet of Dotty Designs includes the following items:
Cash
Accounts Payable
Supplies
Notes Receivable
This list includes:
a Four assets and three liabilities.
b Five assets and three liabilities.
c Five assets and two liabilities.
d Six assets and two liabilities.
5 An accounting entity may best be described as:
a An individual.
b A particular economic unit.
c A publicly owned corporation.
d Any corporation, regardless of size.
Chapter 02—Basic Financial Statements
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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 assets …………………….. $826,650 Total liabilities and owners’ equity………… $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.
1 On January 6, total assets of the business amount to:
a $826,650. b $994,950. c $957,000. d $950,400.
2 On January 6, owners’ equity amounts to:
a $752,400. b $44,550. c $796,950. d $895,950.
3 On January 6, the accounts payable balance is:
a $136,950. b $36,300. c $24,750. d $99,000.
4 On January 6, the accounts receivable balance is:
a $24,750. b $38,775. c $77,550. d $63,525.
5 On January 6, the cash balance is:
a $127,050. b $138,600. c $165,000. d $202,950.
Chapter 02—Basic Financial Statements
Financial and Managerial Accounting, 18e 2-9
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 assets …………………….. $501,000 Total liabilities and owners’ equity………… $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
Cash …………………………… $ Liabilities:
Accounts receivable ……….. Notes payable ……………………………….. $
Land …………………………….. Accounts payable …………………………….
Building ……………………….. Total liabilities …………………………….. $
Equipment …………………….. Owners’ equity:
Capital stock
Total assets …………………… $ Total liabilities and owners’ equity………. $
Chapter 02—Basic Financial Statements
2-10 Instructor’s Resource Manual
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 …………………………
135,000
Accounts payable ……………………………….
45,600
Building ……………………
Total liabilities……………………………….
$
Equipment …………………
35,000
Owners’ equity:
Capital Stock ………………..
$
Retained earnings ………….
_______
_______
Total assets ………………..
$
Total liabilities and owners’ equity ………
$375,000
Chapter 02—Basic Financial Statements
Financial and Managerial Accounting, 18e 2-11
SOLUTIONS TO CHAPTER 2 10-MINUTE QUIZZES
QUIZ A
1 B
QUIZ B
QUIZ C
MANHATTAN FAMILY DENTISTRY
Balance Sheet
January 4, 20__
Assets Liabilities & Owners’ Equity
Cash …………………………….. $ 100,000a Liabilities:
Chapter 02—Basic Financial Statements
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QUIZ D
COUNTRYWIDE LEGAL SERVICES
Balance Sheet
January 31, 20__
Assets
Liabilities & Owners’ Equity
Cash …………………………
$ 90,000
Liabilities:
Accounts receivable ……
50,000c
Notes payable ……………………………………
$ 90,000f
Land …………………………
Accounts payable ……………………………….
Building ……………………
Total liabilities……………………………….
Equipment …………………
Capital Stock ………………..
Retained earnings ………….
_______
Total liabilities and
Total assets ………………..
owners’ equity …………………………………..
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Assignment Guide to Chapter 2
Brief
Exercises
Exercises
Problems
Cases
Net
Item Number
1 – 10
1 – 17
1
2
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10
1
2
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7
Time estimate (in minutes)
< 10
< 15
1
5
15
15
15
20
20
35
40
35
30
30
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30
30
35
3
0
25
Difficulty rating
E
E
E
E
M
M
M
M
M
S
S
S
M
S
M
M
M
E
E
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.
4, 10
transactions affect the elements of
the accounting equation: Assets =
reports an enterprise’s financial
performance for a period of time in
terms of the relationship of revenues
and expenses.
12, 13, 16,
for a period of time in terms of the
financing activities.
11, 14, 16
financial position (balance sheet),
income statement, and statement of
cash flows relate to each other.
Chapter 02—Basic Financial Statements
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Brief
Exercises
Exercises
Problems
Cases
Net
8. Explain common forms of business
ownership—sole proprietorship,
partnership, and corporation—and
demonstrate how they differ in
terms of their statements of
financial position.
8, 9
8
management may take steps to
improve the appearance of the