Chapter 2: The Financial Statements

Learning Objectives (Page 2)

• Understand the content and preparation of:

  • Balance Sheet

  • Income Statement

  • Retained Earnings Statement

• Differentiate between:

  • Permanent (retained earnings) and temporary equity accounts (revenues, expenses, dividends)

  • The closing process

• Understand the content of the Statement of Cash Flows

• Familiarize with underlying accounting concepts under U.S. GAAP

Statement of Financial Position (Balance Sheet) (Page 3)

• Accounting Equation: Assets = Liabilities + Equity

• Assets: Economic resources with future benefits

  • Current Assets: Cash, Accounts Receivable, Stocks/Bonds, Prepaid Rent, Prepaid Insurance, Inventory

  • Non-Current Assets: Land, Building, Equipment, Intangible Assets

• Liabilities: Debts or obligations

  • Current Liabilities: Accounts Payable, Dividends Payable, Salaries Payable, Interest Payable, Notes Payable

• Equity: Portion of assets owned by the company

  • Owner’s Capital (Sole Proprietorship/Partnership), Capital Stock (Corporation), Retained Earnings (Corporation)

Forms of Business (Page 5)

• Types: Sole Proprietorship, Partnership, Corporation

• Considerations: Personal liability, tax implications

Income Statement (Page 6)

• Net Income/Loss: Revenue - Expense

• Revenue: Earnings from goods/services and investments

  • Realization Principle: Revenue must be earned before recognition (Accrual Basis)

Expenses and the Matching Principle (Page 8)

• Expenses: Costs incurred for goods/services

• Matching Principle: Expenses recorded when incurred

• Impact: Expenses decrease net assets and owners’ equity

Income Statement Formats (Page 9)

• Single-Step vs. Multiple-Step:

  • Single-Step: Concise format

  • Multiple-Step: Highlights gross profit, operating income, and non-operating revenues/expenses

Depreciation (Page 10)

• Types:

  • Revenue Expenditures: Short-term benefits

  • Capital Expenditures: Long-term benefits, depreciated over time

• Depreciation: Allocation of asset cost over its useful life

  • Non-cash expense affecting net income

Ratios (Page 14)

• Current Ratio: Current Assets / Current Liabilities

• Quick Ratio: (Cash + Accounts Receivable + Marketable Securities) / Current Liabilities

• Debt Ratio: Total Liabilities / Total Assets

• Gross Profit Ratio: Gross Profit / Sales

• Earnings per Share: Net Income / Number of Shares

• Price-Earnings Ratio: Price of a stock / Earnings per Share

Amortization (Page 15)

• Intangible Assets: Amortized based on legal or economic life

• Example: Patent amortization calculated over its useful life

Statement of Retained Earnings (Page 17)

• Impact of Net Income/Loss: Increases or decreases retained earnings

• Dividends: Decrease retained earnings, not considered operational expenses

• Key Dates: Declaration, Record, Payment

Temporary Equity Accounts and Closing Process (Page 19)

• Temporary Accounts: Revenues, expenses, and dividends closed at year-end into retained earnings

• Purpose: Helps in understanding revenue and expense trends

Statement of Cash Flows (Page 20)

• Classification: Operating, Investing, Financing Activities

• Operating Activities: Cash flows from operations, adjustments for non-cash items

• Methods:

  • Indirect Method: Adjusts net income for non-cash items

  • Direct Method: Converts accrual-based income statement to cash-based

Underlying Concepts Under U.S. GAAP (Page 23)

• Cost Principle: Assets recorded at historical cost

• Stable Monetary Unit Assumption: Assumes stable dollar value

• Going Concern Assumption: Financial statements prepared under the assumption of ongoing operations

• Objectivity Principle: Financial reporting based on verifiable evidence

• Consistency Principle: Adherence to the same accounting principles over time

• Materiality Concept: Importance of financial statement items

• Conservatism Concept: Reporting losses but not gains unless realized

Financial Statement Preparation Order (Page 25)

1. Income Statement

2. Statement of Retained Earnings

3. Statement of Financial Position

4. Statement of Cash Flows

Worksheet Effects Example (Pages 26-28)

• Transactions: Issuing stock, purchasing land, billing clients, recording depreciation, declaring dividends

• Net Income Calculation: Revenue - Expenses

• Retained Earnings Calculation: Beginning balance + Net Income - Dividends

This note summarizes the key concepts and details from Chapter 2 of the financial statements, providing a structured overview of the