Topic 2

FINANCIAL STATEMENTS
FOR DECISION MAKING

©2015 John Wiley & Sons Australia Ltd

LEARNING OBJECTIVES

1. Identify the common types of business entities

2. Discuss the functions carried out by managers
3. Outline the basic financial statements used in
business to report to users for decision-making
purposes
4. Explain the main assumptions made and the
characteristics of information to be used in the
preparation of financial statements
5. Analyse the effects of business transactions on the
accounting equation and on financial statements
 TYPES OF BUSINESS ENTITIES
• Single proprietorship or sole trader
• Owned by one person
• Simple to set up
• Common form of business structure
• Separate accounting entity, not separate legal entity

• Partnership
– Owned by two or more partners
– Simple to set up
– Separate accounting entity, not separate
legal entity
TYPES OF BUSINESS ENTITIES

• Company or corporation
• Owned by shareholders
• Separate accounting entity
• Separate legal entity
• Limited liability
• Protection for owners
 MANAGEMENT FUNCTIONS
PLANNING
What to do
How to do it

CONTROLLING ORGANISING
Evaluating actual
DECISION Developing the
versus planned MAKING organisational
performance structure
DIRECTING
Performing
according to plan
BASIC FINANCIAL STATEMENTS

•Accounting is an information system

➢Designed to communicate financial information
➢To interested users
➢For making economic decisions
•Financial statements
➢Are the outcome of the accounting process
➢Are a primary information source for users
➢Are useful for many decisions
 3 PRIMARY INFORMATION TYPES
What information do users want/need?
• Financial Performance
• The ability of the entity to utilise its assets effectively and
efficiently.
• What are the business goals (i.e. profit/nor for profit)?
• Financial Position
• The financial resources controlled by the entity
• Financial structure
• Measure of liquidity and solvency
BUSINESS ACTIVITIES
Cash Movements
The ability of the entity to generate cash flow, focussing
on three areas:
1. Operating Activities
The provision of and payment for goods and services
2. Investing Activities
The acquisition and disposal of long term assets
3. Financing Activities
The raising of funds for an entity to carry out its operating
and investing activities.
 THE BALANCE SHEET

• Reports financial position of an entity at a specific

point in time
• Shows assets, liabilities and equity of the entity
• Represents the accounting equation
Assets = Liabilities + Equity
• Alternative formats (same information)
➢ Account format
➢ Narrative format
THE BALANCE SHEET (Account Format)
MINH’S TV REPAIRS
Balance Sheet
As at 30 June 2016
ASSETS LIABILITIES
Cash at bank $ 23 165 Accounts payable $ 10 380
Accounts receivable 8 895 Mortgage payable 100 500
Repair Supplies 7 305 110 880
Repair Equipment 55 350
Land 30 000 EQUITY
Building 127 500 Minh Vu, Capital 143 340
$968 440 $254 220

A = L + Eq
THE ACCOUNTING EQUATION (re-arranged)

A = L + Eq = Account format
A – L = L – L + Eq
A – L = L – L + Eq
A – L = Eq = Narrative format

Same equation – different format

 MINH’S TV REPAIRS
Balance Sheet
As at 30 June 2016
ASSETS
Cash at bank $ 23 165
Accounts receivable 8 895
Repair Supplies 7 305
Repair Equipment 55 350
THE BALANCE SHEET
Land 30 000
Building 127 500
(Narrative format) $254 220
LIABILITIES
A – L = Eq Accounts payable $ 10 380
Mortgage payable 100 500
110 880
143 340
EQUITY
Minh Vu, Capital 143 340
$143 340
 THE BALANCE SHEET
Definitions of elements
•Assets
• Resources controlled by the entity as a result of past
transactions or events from which future economic benefits
are expected to flow to the entity
•Liabilities
• Present obligations of an entity arising from past
transactions or events, the settlement of which is expected
to result in an outflow of resources from the entity
THE BALANCE SHEET
Definitions of elements
•Equity
➢The residual interest of the owner/s in the assets
(less liabilities) of the entity

Assets - Liabilities = Net Assets

Net Assets = Equity

➢Sometimes called Capital or Accumulated

Surplus/Funds
THE INCOME STATEMENT
• Reports financial performance over a specific time
period (e.g. month, year, etc.)
• Shows income and expenses
• Income > Expenses = Profit
• Income < Expenses = Loss
• Sometimes called Profit or Loss statement or
Operating Statement
THE INCOME STATEMENT
MINH’S TV REPAIR
Income Statement
For the year ended 30 June 2016
INCOME
Repair income $221 250
EXPENSES
Advertising expense $ 10 125
Repair supplies expense 45 855
Salaries and wages expense 63 900
Rent expense 20 130
Telephone expense 10 095
Light and power expense 23 970 174 075
PROFIT $47 175
THE INCOME STATEMENT
Definitions of elements
•Income
➢Increases in economic benefits in the form of
inflows or enhancements of assets or decreases of
liabilities that results in equity, other than those
relating to equity participants
•Expenses
• Decreases in economic benefits in the form of
outflows or incurrences of liabilities that result in
decreases in equity, other than those relating to
equity participants
THE STATEMENT OF “Linking” statement between the
CHANGES IN EQUITY Income Statement and the
Balance Sheet

DON’S AUTO REPAIR

STATEMENT OF CHANGES IN EQUITY
FOR THE YEAR ENDED 30 JUNE 2012 from
Income Statement
Don Brady, Capital – 1 July 2011 $437 330
Add: Profit for the year 136 350
573 680 to
Balance Sheet
Less: Drawings 87 000
Don Brady, Capital – 30 June 2012 $486 680
 THE STATEMENT OF CHANGES IN EQUITY

Balance sheet Income statement Balance sheet

as at beginning of year N for the period as at ending of year N
A1 – L1 = E1 Inc – Exp = Profit A2 – L2 = E2

2
1
4
Statement of owner’s equity
For the period
E1 + Profit – Drawings = E2
3
 THE STATEMENT OF CASH FLOWS

• The income statement reports in income earned and

expenses incurred – NOT on cash flows
• A statement of cash flows is therefore necessary to
report on the cash inflows and outflows of the entity
• This allows users to assess the sources and applications
of cash
• Also the ability of the entity to remain solvent
 MINH’S TV REPAIRS
Statement of Cash Flows
For the year ended 30 June 2016
THE STATEMENT OF CASH FLOWS
CASH FLOWS FROM OPERATING ACTIVITIES
Cash received from customers $ 212 355
Cash paid to suppliers and employees (171000)
Net cash from operating activities $41 355
CASH FLOWS FROM INVESTING ACTIVITIES
Purchases of land and buildings (157 500)
Purchases of repair equipment (55 300)
Net cash from investing activities (212 850)
CASH FLOWS FROM FINANCING ACTIVITIES
Amount borrowed under mortgage 100 500
Investment by owner 118 665
Drawings by owner (22 500)
Net cash from financing activities 196 665
Net increase (decrease) in cash held 25 170
Cash at beginning of year -
21
Cash at end of year $ 25 170
 1 - 36
INFO ON THE FINANCIAL STATEMENTS
Financial
Question Answer Statement
How well did the
company perform
during the period?

What is the worth

of company at a
point in time?

What is the cash

the period?
 RETAINED EARNINGS
• Cumulative total of net income, net loss, and dividends since start
of business

Revenues for
the period
–
Expenses for
the period
Start of End of
the period = the period
Beginning + Net income Ending
Dividends
balance of or (or Net loss) for the balance of
– =
retained – for the period retained
earnings period earnings
 1 - 55
REALATIONSHIP AMONG FS
 RELATIONSHIPS
BETWEEN STATEMENTS
 1 - 31
EXAMPLE 1

State which of the following items could be identified as

revenue of the business. Explain your reasoning in each
case:
1. Perform cleaning services for customer and
received $500 payment;
2. Sold the product to the customer, payment will
be received next month;
3. Received $3,000 for 3 months rent in advance from
tenants at the beginning of first month.
 1 - 34
EXAMPLE 2

State which of the following items could be identified as

expense of the business. Explain your reasoning in each
case:
1. Using cleaning services and paid $500;
2. Incurred $300 utility expense for the month,
company has 15 days to settle the balance;
3. Bought a prepaid mobile phone card. The balance
will be expired after 60 days from the top up date.
 1 - 46
EXPANDED ACCOUNTING EQUATION
UNDERLYING ASSUMPTIONS OF FINANCIAL STATEMENTS

• Accounting Entity Assumption

➢ Identify clearly the boundaries of the entity being
accounted for
➢Personal transactions of the owner must remain separate
from the transactions of the entity
• Accrual Basis Assumption
• Accounting is an “event” driven process
• The effects of transactions are recognised when they occur,
not when the cash is received/paid
UNDERLYING ASSUMPTIONS OF FINANCIAL STATEMENTS

• Going Concern Assumption

➢Unless we have evidence to the contrary, we assume
an entity will continue to operate in the future

• Period Assumption
➢ The life of the entity can be “broken up” into equal
time intervals
➢ Profit is determined for particular periods of time in
order to be comparable.
QUALITATIVE CHARACTERISTICS OF FINANCIAL STATEMENTS

• Relevance
➢Information is useful for decision making
➢Can influence economic decisions by users
• Faithful Representation
➢Information presented faithfully, without bias or undue error
➢Economic substance over form
• Comparability and Consistency
➢Users can identify similarities and differences between two sets
of economic data
QUALITATIVE CHARACTERISTICS OF FINANCIAL STATEMENTS

• Verifiability
➢ Different, independent observers can reach consensus that
information faithfully represents what it claims to
• Understandability
➢ Expect a reasonable knowledge of business and economic
activity and financial accounting
➢Study the information with reasonable diligence
• Materiality
➢ The extent to which omission or misstatement would be
misleading to users
• Benefits and Costs
➢Benefits of providing information must justify cost of providing
 THE EFFECTS OF TRANSACTIONS ON THE
ACCOUNTING EQUATION

Assets = Liabilities + Equity

• The accounting equation always balances
• Transactions result in changes in assets, liabilities and
owners equity
• Elements of the accounting equation change with each
transaction, but equality of accounting equation
remains unchanged
 1 - 53
FINANCIAL STATEMENTS – REVIEW
Question 1
Which of the following financial statements is prepared
as of a specific date?

a. Statement of financial position.

b. Statement of profit and loss.

c. Statement of changes in equity.

d. Statement of cash flows.

 1 - 54
FINANCIAL STATEMENTS – REVIEW
Question 2
Net income will result during a time period when?

a. assets exceed liabilities.

b. assets exceed revenues.

c. expenses exceed revenues.

d. revenues exceed expenses.

 1 - 54
FINANCIAL STATEMENTS – REVIEW
Question 3
Net income will result during a time period when?

a. assets exceed liabilities.

b. assets exceed revenues.

c. expenses exceed revenues.

d. revenues exceed expenses.

 1 - 54
FINANCIAL STATEMENTS – REVIEW (Question 4)
Account name Type of account Statement
Cash
Supplies
Supplies expense
Account receivable
Common stock
Service revenue
Vehicle
Bank loans
 1 - 54
FINANCIAL STATEMENTS – REVIEW
Account name Type of account Statement
Land
Wage expense
Income tax expense
Retained earnings
Sales revenue
Dividends
Tax payables
Unearned revenue
 1 - 60
FINANCIAL STATEMENTS – REVIEW
Question 5: Prepare FS for the month ended 30 Nov
2015 from data given below:

Cash $10,100 Rent Expense 1,500

Accounts 1,000 Accounts 200
receivable Payable
Sales revenue 6,200 Wages expense 1,200
Equipment 25,000 Inventory 1,800
Notes payable 15,000 Dividends 500
Common Stock 20,000 Supplies 300
 1 - 61
FINANCIAL STATEMENTS – REVIEW

Question 6
John buy gift wrapping paper from a local
supplier and sell it on the corner of his local street.
He began the venture with $100 in cash. On the first
day of trading he purchased wrapping paper for $100.
This called stock (of goods) or inventory. Later in the day
he sold three quarters of his inventory for $110 cash.
 1 - 62

THE FINANCIAL STATEMENTS - EXAMPLE

1. What cash movements took place in the first
day of trading?
Cash movement for day 1

Opening balance

Sale of wrapping paper

Purchase of wrapping paper

Closing balance
 1 - 63

THE FINANCIAL STATEMENTS - EXAMPLE

2. How much did wealth increase as a result of
operations in the first day of trading?

Statement of Profit and Loss

Sales

Cost of good sold

Profit