Financial Accounting



Financial Accounting

Professor Jane Kaplan

Professor Notes

Chapter 2 – Basic Financial Statements

• Business Activities – The Source of Accounting Information

o A business is an organization that exists for the purpose of making a profit for its owners

o A business creates a profit if it can sell goods and services to customers at prices that are greater than the total costs incurred to provide those goods and services

o Profit is a measure of the value created by a business for its owners

o To start a business, owners may contribute capital

o Contributions by owners as well as profits that are retained by the business are known as shareholders’ equity

o Owners may also borrow from a creditor to help finance the start of a business

o Financing activities occur when owners or creditors provide resources to a company or when a company transfers resources to owners, as in a dividend, or to creditors, as in the repayment of a loan.

• Accounting for Business Activities

o Accounting measures, records, reports, and analyzes business activities using accounts

o An account is a record of increases and decreases in the dollar amount associated with a specific resource or activity

o Accounting transactions are descriptions of business actions or events that are measured in dollar values and recorded in accounts

o Financial accounting records transactions by using the accounting equation

o The accounting equation shows the fundamental relationship between resources and claims to resources

o Accounting Equation:

ASSETS = LIABILITIES + SHAREHOLDERS’ EQUITY

o Assets are the resources owned or controlled by a business that will provide a future benefit

o Liabilities are obligations that will be discharged or settled in the future

o Shareholders’ equity represents the owners’ claims to a company’s resources

o Accounting measures business activities in terms of dollar values and records these activities in accounts

o A review of a company’s transactions reveal the events that occurred, when they occurred, the amounts involved, and the resources and claims that were exchanged

• Happy Feet Dance Studios

o On January 2, Fred and Ginger, the owners of Happy Feet contributed $15,000 cash and borrowed $5,000 from a bank.

o These events are recorded as increases or decreases in the appropriate accounts

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o Accounts associated with these transactions:

▪ Cash – the financial resources that can be used to pay for resources and obligations of a company

▪ Contributed capital – the amounts contributed by owners to a company

▪ Notes Payable – a liability account used to identify amounts a company owes to creditors with whom a formal document or note has been signed

• Investing Activities

o Activities involving the acquisition or disposal of long term resources used by a business are investing activities

o Long-term resources, such as equipment, land, buildings, furniture, and fixtures are acquired from suppliers

o Cash or a promise of future payment, is transferred to suppliers of these resources

• On January 5, Happy Feet paid $2,000 for sound equipment

• On January 6, the company bought furniture and fixtures for $4,000, paying $1,000 in cash and financing the remainder with a note payable

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o The January 6 entry above shows the equipment purchase and the furniture purchase as a single transaction including the borrowing of $3,000 from the bank and the payment of an additional $3,000

o Alternately we could record the purchases as a 2 step process (shown below)

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• Operating Activities

o A business operates by obtaining or creating products or services and selling those products or services to customers

o Operating activities are those activities necessary to acquire and sell goods and services

o When goods and services are sold to customers revenue is created

o Revenue can be thought of as the reward earned by serving customers

o In addition to goods and services for sale, operating activities use resources like employee labor, supplies, and utilities

o The consumption of these resources creates expenses

o Expenses are the amount of resources consumed in the process of acquiring and selling goods and services

o When goods or services are sold to a customer, revenue is earned

o The amount of revenue earned is equal to the amount of resources received from the customer in exchange for the goods

o Here cash is received from the customer when they receive their dance lessons

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o Because revenue and expenses occurred in these transactions, we expand the equation to include them

o Retained Earnings, a component of Shareholders’ Equity, are the accumulated profits of a business that have been reinvested in the business

o Revenues increase retained earnings, and expenses decrease retained earnings

o Amounts paid to owners from a company’s profits also decrease Retained Earnings

o Retained Earnings represents earned capital whereas contributed capital represents investment by owners

o Revenue is generously measured by the amount of cash received, or expected to be received – Accounts Receivable – from a customer in exchange for the goods or services delivered

o Revenue is generally recorded at the time that goods or services are delivered

o A company earns revenue for its owners

o Remember that owners have a claim to profits earned; therefore, revenue is part of shareholders’ equity

o It represents an increase in the value of a company for its owners

o Utility expense identifies the cost to the company of utilities used in the process of earning revenues

o Expenses are normally measured by the cost of resources used, and they are recorded at the time of use

o Expenses are recorded as they contribute to the earning of revenue

o An expense reduces shareholders equity because it identifies the use of equity because it identifies the use of resources for which owners have a claim

o It represents a decrease in the value of a company for its owners

o Revenues increase shareholders’ equity

o Expenses decrease shareholders’ equity

o Revenues minus expenses equal profit

o Other common expenses for a business like Happy Feet include wages paid to employees, rent, and supplies used

o Because these resources were paid for at the time they were consumed, cash decreases in each transaction

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• Financial Reporting and Analysis

o The purpose of measuring and recording business activities is to provide useful information to those who need to make decisions

o Accounting reports information to decision-makers in the form of financial statements

o Financial statements are reports that summarize the results of a company’s accounting transactions for a reporting period

o To prepare financial statements a company needs to compute the balances in its accounts at the end of the reporting period

o The following schedule provides a summary of account balances for Happy Feet on January 31

o Balances for Expenses, which reduce shareholders’ equity, are shown in parentheses

o All of the summary balances shown in this schedule are the results of the transactions recorded for Happy Feet

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• Income Statement

o The income statement reports revenues and expenses for a fiscal period

o It helps decision-makers determine how well a company has performed in creating profit for its owners

o A fiscal period is any time period for which a company wants to report its financial activities, such as months, quarters, and years

o The following is an example of an income statement for Happy Feet for the month ended January 31

o The income statement includes all the revenues and expenses recorded for January

o Net income equals the amount of profit earned by a business during a fiscal period

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• The Balance Sheet

o The Balance Sheet identifies a company’s assets, and claims to those assets by creditors and owners at a specific date

o It is a “snapshot” at the point in time of a company’s financial position

o It reports dollar amounts associated with a company’s assets and the sources of financing for those assets, liabilities, and shareholders’ equity

o It reports resources and claims to these resources at a particular point in time

o The following balance sheet is prepared for Happy Feet at January 31

o Notice that Retained Earnings is the total amount of net income earned over the life of the company less the portion of net income paid out to owners

o January was the first month of operations for Happy Feet, so the company has earned net income for only one month

o The Income Statement reported net income for January at $1,000

o None of the net income was paid to owners

o Therefore, Retained Earnings at January 31 is $1,000

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o Happy Feet’s Balance Sheet follows

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o Retained Earnings is separated from Contributed Capital to distinguish between the amount of investment by owners and the amount of profit earned by the company

• The Statement of Cash Flows

o The Statement of Cash Flows reports events that alter a company’s cash account during a reporting period

o The statement reports all cash receipts and cash disbursements as an operating, investing, or financing activity.

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o The final line of this statement reports the cash balance at the end of the month and corresponds with the amount reported as cash on Happy Feet’s Balance Sheet

o The Statement of Cash Flows shows how much cash a company has, where that cash came from, and how the company used its cash during the reporting period

• Financial Analysis

o Common analytical tools involve the calculation of ratios

o One example is Return on Assets (ROA), which is the ratio of net income to total assets

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o This ratio can be interpreted as the amount a company earned for each dollar of total investment

o Thus Happy Feet earned 4.16 cents for each dollar of investment in January

• A primary purpose of accounting is to help people make decisions about business activities

• Accounting is the link between business activities and business decisions

• Debits and Credits

ASSETS = LIABILITIES + SHAREHOLDERS’ EQUITY

Assets |= |Liabilities |+ |Capital

Stock |+ |Retained

Earnings |- |Dividends

Declared |+ |Revenues |- |Expenses | |Debit |Credit | |Debit |Credit | |Debit |Credit | |Debit |Credit | |Debit |Credit | |Debit |Credit | |Debit |Credit | |+ |- | |- |+ | |- |+ | |- |+ | |+ |- | |- |+ | |+ |- | | | | | | | | | | | | | | | | | | | | | | |

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Bennett S. LeBow College of Business

Business Activities

Operating

Investing

Financing

Accounting

Measuring

Recording

Reporting

Analyzing

Business Decisions

Actions Based on Business Decisions

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