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Book Cover
Financial and Managerial Accounting: The Basis for Business Decisions, 12/e
Jan R. Williams, University of Tennessee
Susan F. Haka, Michigan State University
Mark S. Bettner, Bucknell University
Robert F. Meigs

Basic Financial Statements

Chapter Summary

Chapter 2 - Summary

LO 1

Explain the nature and general purpose of financial statements.

Financial statements are declarations of information in financial terms about an enterprise that are believed to be fair and accurate. They describe certain attributes of the enterprise that are important for decision makers, particularly investors (owners) and creditors.

LO 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.

Accountants prepare financial statements by applying a set of standards or rules referred to as generally accepted accounting principles. Consistent application of these standards permits comparisons between companies and between years of a single company. Generally accepted accounting principles allow for significant latitude in how certain transactions should be accounted for, meaning that professional judgment is particularly important.

LO 3

Demonstrate how certain business transactions affect the elements of the accounting equation: Assets = Liabilities+ Owner's Equity.

Business transactions result in changes in the three elements of the basic accounting equation. A transaction that increases total assets must also increase total liabilities and owner's equity. Similarly, a transaction that decreases total assets must simultaneously decrease total liabilities and owner's equity. Some transactions increase one asset and reduce another. Regardless of the nature of the specific transaction, the accounting equation must stay in balance at all times.

LO 4

Explain that the statement of financial position, often referred to as the balance sheet, is an expansion of the basic accounting equation.

The statement of financial position, or balance sheet, presents in great detail the elements of the basic accounting equation. Various types of assets are listed and totaled. The enterprise's liabilities are listed, totaled, and added to the owner's equity. The balancing feature of this financial statement is one of its dominant characteristics because the statement is simply an expansion of the basic accounting equation.

LO 5

Explain that the income statement reports an enterprise's financial performance for a period of time in terms of the relationship of revenues and expenses.

Revenues are created as the enterprise provides goods and services for its customers. Many expenses are required to be able to provide those goods and services. The difference between the revenues and expenses is net income or net loss.

LO 6

Explain that 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.

Cash is one of the most important assets, and the statement of cash flows shows in detail how the enterprise's cash balance changed between the beginning and ending of the accounting period. Operating activities relate to ongoing revenue and sales transactions. Investing activities relate to the purchase and sale of various types of assets (for example, land, buildings, and equipment). Financing activities describe where the enterprise has received its permanent debt and equity financing. The statement of cash flows combines information about all of these activities into a concise statement of changes in cash that reconciles the beginning and ending cash balances.

LO 7

Explain important relationships among the statement of financial position, income statement, and statement of cash flows, and how these statements articulate.

The three primary financial statements are based on the same underlying transactions. They are not alternatives to each other, but rather represent three different ways of looking at the financial activities of the reporting enterprise. Because they are based on the same transactions, they relate, or "articulate," very closely with each other.

LO 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.

Owner's equity is one of three major elements in the basic accounting equation. Regardless of the form of organization, owner's equity represents the interest of the owner(s) in the assets of the reporting enterprise. For a sole proprietorship, owner's equity consists only of the interest of a single owner. For a partnership, the ownership interests of all partners are added together to determine the total owners' equity of the enterprise. For a corporation, which usually has many owners, the total contribution to the enterprise represents its owners' equity. In all cases, the enterprise's net income is added to owner's equity.

LO 9

Discuss and illustrate the importance of nonfinancial information to supplement the information in the primary financial statements.

All important aspects of an enterprise's activities usually cannot be captured in financial terms. Financial statements typically are accompanied by notes that provide qualitative information that supplements and helps interpret the financial information included in the body of the financial statements.

LO 10

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.

Financial statements are particularly important for investors and creditors in their attempts to evaluate future cash flows from the enterprise to them. Management is interested in the enterprise looking as positive as possible in its financial statements and may take certain steps to improve the overall appearance of the enterprise. A fine line, however, exists between the steps management can take and the steps that are unethical, or even illegal.

Throughout this text we emphasize how accounting information is the basis for business decisions. In this chapter you were introduced to business transactions and how they lead to the preparation of three basic financial statements: statement of financial position (balance sheet), income statement, and statement of cash flows. These statements constitute one of the primary products of the accountant's work, and they provide investors, creditors, and other parties with pertinent information that is useful for decision making.

As you continue your study of financial accounting in Chapter 3, you will learn how business transactions are actually recorded, how they move through an accounting system, and how they eventually lead to the preparation of financial statements.