Financial and Managerial Accounting Chapter 16

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 important relationships among the statement of financial position, income statement, and statement of cash flows, and how these statements relate to each other. 8. Explain common forms of business organization – sole proprietorship, partnership, corporation – and demonstrate how they differ in terms of their presentation in the statement 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 41) d The stable-dollar assumption – see Case in Point (page 42) 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 (illustrated on pages 45- 48) 7 Effects of these business transactions on the accounting equation C Income statement (illustrated on page 50) D Statement of cash flows (illustrated on page 52) – see Case in Point (page 52) E Relationships among financial statements F Financial analysis and decision making – see Your Turn (page 55) G Forms of business organization 1 Sole proprietorships 2 Partnerships 3 Corporations 4 Reporting ownership equity in the statement of financial position (illustrated on pages 56 & 57) H 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 59) I Concluding remarks Topical coverage and suggested assignment Homework Assignment (To Be Completed Prior to Class) Class Meetings on Chapter Topical Outline Coverage Discussion Questions Brief Exercises Exercises 1 2 A-D E–I 3, 4, 5, 8 9, 14, 15 1, 3,4 7, 9, 10 1, 4, 6, 11, 12, 13 Problems 1, 3, 6 7, 8, 9 Critical Thinking Cases 1 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: Explain the role of generally accepted 1 Describe the nature of financial statements. 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. 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. 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. 2-4 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: Accounts Receivable Capital Stock Equipment Notes Payable 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. 2-6 Chapter 02 - Basic Financial Statements 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 Accounts receivable. . . 51,150 Land........................... 313,500 Building...................... 371,250 Equipment.................. 57,750 Total assets................. $826,650 Liabilities: Accounts payable ...................... $ 74,250 Total liabilities.......................... $ 74,250 Owners’ equity: Capital stock............................ 752,400 Total liabilities and owners’ equity............................. $826,250 During the first few days of January, the following transactions occurred: Jan 1 3 3 5 The business borrowed $99,000 from the bank, giving a note payable due in 90 days. Additional capital stock was issued in exchange for $44,550 cash. Equipment was purchased for $62,700 on credit. 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. On January 6, the accounts receivable balance is: a $24,750. b $38,775. c $77,550. d $63,525. 4 5 On January 6, the cash balance is: a $127,050. b $138,600. c 2-8 $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 Accounts receivable. . . 31,000 Land........................... 190,000 Building...................... 225,000 Equipment.................. 35,000 Total assets................. $501,000 Liabilities: Accounts payable ...................... $ 45,000 Total liabilities.......................... $ 45,000 Owners’ equity: Capital stock............................ 456,000 Total liabilities and owners’ equity............................. $501,000 During the first few days of January, the following transactions occurred: Jan 2 2 3 3 Equipment was purchased for $38,000 on credit. The business collected $16,000 of its accounts receivable and paid $23,000 of its accounts payable. The business borrowed $60,000 from the bank, giving a note payable due in 90 days. Additional capital stock was issued in exchange for $27,000 cash. Complete the following balance sheet for Manhattan Family Dentistry on January 4 of the current year. MANHATTAN FAMILY DENTISTRY Balance Sheet January 4, 20__ Assets Liabilities & Owners’ Equity Cash.............$ Accounts receivable... Land.......................... Building..................... Equipment................. Total assets. .$ Liabilities: Notes payable ............$ Accounts payable..................... Total liabilities...........$ Owners’ equity: Capital stock.......................... Total liabilities and owners’ equity..........................$ 2-9 CHAPTER 2 NAME 10-MINUTE QUIZ D # SECTION Complete the January 31, 20__, balance sheet of Countrywide Legal Services using the following information. (1) (2) (3) (4) Stockholders’ equity at January 1, 20__, included capital stock of $140,000. 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. Additional capital stock was issued in exchange for $50,000 cash. Retained earnings at January 31, 20___, amounted to $49,400. COUNTRYWIDE LEGAL SERVICES Balance Sheet January 31, 20__ Assets Cash....................... Accounts receivable Land....................... Liabilities & Owners’ Equity $ 90,000 Liabilities: Notes payable............................ $ Accounts payable...................... 135,00 45,60 0 Building.................. Equipment............. Total assets............ 0 Total liabilities......................... $ 35,000 Owners’ equity: Capital Stock.......... $ Retained earnings. . _______ Total liabilities and owners’ equity........................... $375,0 $ _______ 00 2-11 Chapter 02 - Basic Financial Statements SOLUTIONS TO CHAPTER 2 10-MINUTE QUIZZES QUIZ A 1 2 3 4 5 QUIZ B B A D C B 1 2 3 4 5 Learning Objective: 2, 4, 5, 6 B C D A C Learning Objective: 3, 4 QUIZ C MANHATTAN FAMILY DENTISTRY Balance Sheet January 4, 20__ Assets Liabilities & Owners’ Equity a Cash...........................$ 100,000 Liabilities: Accounts receivable. . . 15,000b Notes payable ........................... $ 60,000 Land........................... 190,000 Accounts payable....................... 60,000e Building...................... 225,000 Total liabilities..........................$ 120,000 Owners’ equity: Equipment.................. 73,000c Capital stock............................... 483,000d _________ Total liabilities and Total assets.................$603,000 owners’ equity............................. $603,000 Computations: a $20,000 + $16,000 (A/R collected) - $23,000 (paid on A/P) + $60,000 (borrowed) + $27,000 (invested) = $100,000 b $31,000 - $16,000 collected = $15,000 c $35,000 + $38,000 (equipment purchased) = $73,000 d $456,000 + $27,000 additional investment = $483,000 e A/P $45,000 + $38,000 - $23,000 (paid) = $60,000 Learning Objective: 4 2-12 QUIZ D COUNTRYWIDE LEGAL SERVICES Balance Sheet January 31, 20__ Assets Cash....................... Accounts receivable Land....................... Building.................. Liabilities & Owners’ Equity $ Liabilities: 90,000 c 50,000 Notes payable............................ $ 90,000f 45,60 135,00 Accounts payable...................... 0 b Total liabilities......................... $135,60 65,000 0 0 Equipment............. 35,000 Owners’ equity: Capital Stock.......... $190,00 0d Retained earnings. . 49,40 0 Total assets............ _______ $375,00 0a Total liabilities and owners’ equity........................... $239,4 00 $375,00 0 Computations: a Total assets must be equal to total liabilities plus owners’ equity of $375,000. b $200,000 (cost of land and building) less $135,000 for land = $65,000 for building. (Appraised value of property ignored.) c Accounts receivable must be $50,000 to achieve total assets of $375,000. d $140,000 (capital stock at January 1) plus $50,000 (additional investment). e Total liabilities must be $135,600 to achieve total liabilities plus owners’ equity of $375,000. f Notes payable must be $90,000 to achieve total liabilities of $135,600. Learning Objective: 4 2-13 Assignment Guide to Chapter 2 Brief Exercis es 1 – 10 Problems Exercis es 1 - 18 2 3 4 5 1 5 1 5 1 5 2 0 M M 6 Cases 7 8 9 1 1 Time estimate (in minutes) < 10 < 15 1 5 Difficulty rating 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 + Owner’s 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 important relationships among the statement of financial position, income statement, and statement of cash flows, and how these statements relate to each other. E E E M M 2 0 M 3 5 S 4 0 S 3 5 S 1, 5, 6, 7 3, 4 2, 3, 16 0 3 0 S 2 Ne 3 4 t 5 6 7 3 3 3 3 1 3 0 0 0 0 5 5 M M M E M M 20 Ö 4, 10 1, 2 1 Ö Ö Ö Ö Ö Ö Ö Ö Ö Ö Ö Ö Ö Ö Ö Ö Ö 5, 6 12, 13, 16, 17 7 Ö Ö 11, 14, 16 10 2-14 Ö Ö Ö Ö Ö 8. Explain common forms of business ownership – sole proprietorship, partnership, and corporation – and demonstrate how they differ in terms of their presentation in the statement 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. 8, 9 8 9, 15 Ö