CHAPTER -2

BASIC FINANCIAL STATEMENTS

 Forms of Business Organizations

 Accountants frequently refer to a business

organization as an accounting entity or a business
entity.
 For accounting purpose, each business
organization or entity has an existence separate
from its owner(s), creditors, employees, customers
& other business
 This separate existence of business organization is
called business entity concept.
 Thus , in the accounting records of the business
entity, the activities of each business should be
kept separate from the activities of other
businesses & from the personal & financial
activities of the owner(s).
 In modern business world, most business
enterprises are organized as:
1. Sole proprietorships,
2. Partnerships,&
3. Corporations
1. Sole proprietorship
 Is unincorporated business owned by an individual &
often managed by that same person.
 No legal formalities are necessary to organize such
businesses, & usually business operations can begin
with only a limited investment.
 From an accounting view point, a sole proprietorship
is a business entity separate from the other affairs of
its owner.
 From the legal point of view, however, the business&
its owner are not regarded as separate entities.
 Thus, the owner is personally liable for the debts of
the business.
2. Partnership
 Is an unincorporated business owned by two or more
persons associated as partners.
 As in case of the sole proprietorship, the owners of a
partnership are personally responsible for all debts of
the business.
 From an accounting stand point, a partnership is
viewed as a business entity separate from the personal
affairs of its owners.
 A benefit of partnership form over sole proprietorship
form is the ability to bring together large amount of
capital investment from multiple owners.
3. Corporation
A corporation is a business incorporated under the law
of a state and owned by a few stockholders or
thousands of stockholders.
 It is unique in that it is a separate legal business entity.
 The owners of the corporation are stockholders or
shareholders.
 The corporate form of business protects the personal
assets of the owners from the creditors of the
corporation.
 ?
Explain the 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.
 Introduction to Financial Statements
 Business entities may have many objectives &
goals.
 The two primary objectives of every business
are profitability and solvency.
 Profitability is the ability to generate income.
 Solvency is the ability to pay debts as they
become due.
 Unless a business can produce satisfactory
income & pay its debts as they become due ,
the business can’t survive to realize its other
objectives.
 The financial statement that reflects a co.’s
profitability is the income statement.
 The statement of retained earnings shows the
change in retained earnings between the
beginning and end of a period.
 The balance sheet reflects the company’s
solvency.
 The statement of cash flows shows the cash
inflows and outflows for a co. over a period of
time
A Starting Point: Statement of Financial Position
(Balance Sheet)
Is a list of balances in the assets, liability &
owners’ ( stockholders’) equity accounts.
This “list depicts the position of assets ,
liabilities,& owners’ ( stockholders’) equity of a
specific business at a specific point of time.”
 It is prepared on a specified date because the
figure shown in the balance sheet is true on
that date only.
The totals of the assets should be equal to the
totals of liabilities & owners’ ( stockholders’)
equity. If it is not so, it means that there is some
error.
 Objective of Balance Sheet
 Principal Objective: The main purpose of preparing
balance sheet is to know the financial position of the
business at a particular date.
 Subsidiary Objectives: Though the main aim is to know
the exact financial position of the firm at a particular
date, yet it serves other purpose as well such as:
1. It gives information about the actual and real
owner’s( stockholders’) equity.
2. It helps the firm to make provisions against
possible future losses. A provision is made in the
form of the Reserves.
 Characteristics of Balance Sheet:
 It is a statement and not an account.
 It is always prepared on a particular date, & thus
shows the position at that date & not for a period.
 It has no debit side & credit side.
 It shows the financial position of the business concern.
 It shows what the firm owes to others & also what
others owe to the firm
 The totals of assets always are equal with the totals of
liabilities & owners’(SH) equity.
 Uses of balance Sheet
 The balance sheet is described as a
snapshot/photograph/picture of the financial
position of a business entity.
 The various groups interested in the company can
draw useful inferences from an analysis of the
information contained in the balance sheet.
 It proves that the accounting equation (Assets =
Liabilities + Owner's Equity) is in balance.
 It shows the nature & value of the assets.
 It shows what the firm owes to others and also
what others owe to the firm.
 Elements of the Balance Sheet
1. Assets: An asset is something of value the
company owns such as cash, marketable
securities, accounts receivable, inventory, prepaid
expenses, property, plant, equipment, long-term
investments, patents, copyrights, trademarks, &
franchise licenses.
2. Liabilities: Liabilities are the company's existing
debts owed to third parties.
3. Examples include amounts owed to suppliers for
goods or services received (accounts payable), to
employees for work performed (wages payable),
and to banks for principal & interest on loans
(notes payable & interest payable).
3. Owner's equity (OE): represents the amount
owed to the owner or owners by the company.
 In a corporation, ownership is represented by
shares of stock, so the owner’s equity is called
stockholders' equity or shareholders' equity
(SHE).
 Because creditors’ claim have legal priority
over those of owners, OE/SHE is a residual
amount.
 Therefore, OE/SHE is always equal to total
assets minus total liabilities.
 Statement of Owner's Equity
 The statement of owner's equity is prepared after
the income statement.
 It shows the beginning & ending owner's equity
balances & the items affecting owner's equity
during the period.
 These items include investments, the net income or
loss from the income statement, &
withdrawals/drawings.
 Because the specific revenue & expense
categories that determine net income or loss
appear on the income statement, the statement of
owner's equity shows only the total net income or
loss.
 Statement of Retained Earnings
 It explains the changes in retained earnings
between two balance sheets.
 These changes usually consists of the addition
of NI ( or deduction of NL) & the deduction of
dividends.
 Dividends are the means by which a corporation
rewards its shareholders (owners) for providing
it with the investment funds.
 A dividend is a distribution of income to owners
rather than an expense of doing business.
 Statement of Cash Flows
 The statement of cash flows tracks the
movement of cash during a specific accounting
period.
 It assigns all cash exchanges to one of three
categories operating, investing, or financing to
calculate the net change in cash and then
reconciles the accounting period's beginning &
ending cash balances.
 As its name implies, the statement of cash flows
includes items that affect cash.
 Statement of cash flows has 3 sections
1. Cash flows from the operating activities are the
cash effects revenues & expense transactions that
are included in the income statements.
2. Cashflows from the investing activities are the
cash effects of purchasing & selling assets.
3. Cash flows from financing activities are the cash
effects of owners investing in the company, owners
withdrawal from the company & creditors loaning
money to the co. & repayment of either or both.
 Presentations of Owner’s Equity in Balance Sheet
 Sole proprietorship
 Owner’s Equity:

Mr. X, Capital…………………………….. xx
 Partnership
 Partners’ Capital:

Partner A, Capital…………………….xx
Partner B, Capital……………………..xx
Total partners’ equity xxx
 Corporation
 Stockholders’ Equity:

Capital Stock……………………………………xx
Retained Earnings…………………………….xx
Total Stockholders’ Equity xxx
Relationships among Financial Statements
____________________TIME_________________
B/Sheet Income St’t B/S
St’t of CF
 At the beginning & ending point in time, a co.
prepare a st’t of financial position (B/S) that gives a
static look in financial terms of where the co.
stands.
 The other 2 FSs of IS & SOE cover the intervening
period of time b/n the two B/Ss & explain the
important changes that occurred during the period.
 Generally Accepted Accounting Principles (GAAP)
 Accountants use GAAPs to guide them in recording &
reporting financial information.
 The current set of principles that accountants use rests
upon some underlying assumptions & principles such
as:
 Business entity assumption
 Cost principle
 Going concern principle
 Objectivity Concept
 Monetary unit assumption
 Realization principle
Business Entity Assumption
 Financial records must be separately
maintained for each economic entity.
 Economic entities include businesses,
governments, school districts, churches, and
other social organizations.
 Business records must not include the personal
assets or liabilities of the owners.
Cost Principle
 Assets are recorded at cost, which equals the
value exchanged at the time of their acquisition.
 All assets are carried in the books of accounts
from year to year at their acquisition cost (also
called historical cost) irrespective of any change
in their market value.
 Acquisition cost is considered highly objective,
reliable, definite and free from bias
 Thus when a machine is purchased for $
500,000, transportation expenses are $ 20,000,
installation expenses are $ 10,000, the
machine is valued at $530,000. This is the
historical cost of machine.
Going Concern Principle
 This concept assumes that the business will
exist for certain foreseeable(lewedefit
yemikeset) future with the specified goal or for
specified duration.
 Thus recording & valuation of long-term assets
& liabilities are based on this assumption.
 Fixed assets are recorded on historical costs &
written down over the expected life of the assets.
 Similarly long-term liabilities, i.e., debentures,
preference shares, long-term loans are raised &
their terms of repayment are settled on this
assumption.
 The going concern concept is the backbone of
accounting & is based on the following
assumptions:
a) Business has an indefinite life.
b) Assets are depreciated on the basis of their
expected life without caring for their current
values.
 Objectivity Concept
 This concept implies that all accounting records should
be supported by proper documents, e.g., invoices,
cash memos, correspondence, agreements etc.
 These documents supply the information on the basis
of which entries are made in the books of account.
 The accounting entries are based on objectively
verifiable evidence.
 Monetary Unit Assumption
 In accounting, a record is made only of those facts or
transactions that can be expressed in monetary terms.
 It provides a common yardstick/guage, i.e., money for
measuring, recording & summarizing the transaction.
 Events,which cannot be expressed in money
terms, do not find a place in account books.
 Theapplication of money measurement concept
makes accounting data and information relevant,
simple, understandable, homogeneous and
comparable.
 The main advantage of money measurement
concept is that even a layman is able to
understand & appreciate the things stated in
terms of money.
 However, the concept suffers from the following
flaws:
a. Money does not have a constant value. The
value of money changes because of inflation or
deflation in the country.
b. All business assets cannot be measured in
money terms. It is very difficult to calculate the
value of goodwill or measure the competency or
morale of employees.
Realization Principle
Revenue should be recognized at the time
goods are sold and services are rendered
• Matching principles
Expenses should be recorded in the period
in which they are used up.
 The Accounting Equation
Assets = Liabilities+ Owners’ Equity/SHE
 Assets: things of value owned by the business or the
economic resources of the business.
 Liabilities: are debts owed by the business.
 Equities: are claims to, or interests in assets.
Assets –Liabilities= Owners Equity/SHE
Owners’ Equity/SHE= Net Assets
 Example
A = L + OE/ SHE
a) $300,000 = 150,000 + 150,000
b) ? = 562,500 + 375,000
c) 307,500 = ? + 142,500
 Effects of Business Transactions(BT) on
Accounting Equation
 Business transactions/economic events are any
events that directly affects the financial position
of an organization.
 BT can be classified as external & internal
 External business transaction involve an
exchange between the co. & other external
separate business entity.
 Internal transaction directly affect the financial
position of a co. but don’t involve an exchange
transaction with an other entity.
 These events must be recorded to properly
reflect a co.’s financial position & results of
operations.
 Each transaction affecting the accounting
equation will have a dual effect because
resources always must equal claims to those
resources.
 ?
Explain how the income statement reports
an enterprise’s financial performance for a
period of time in terms of the relationship
of revenues & expenses.