CHAPTER 2

Financial statements
for decision making
PowerPoint Presentation by
Phil Johnson
©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 Accounting Equation

Economic
Resources
Claims to
Economic Resources
 Assets
• What is an asset?
It is something a company owns which has
future economic value.
– land
– building
– equipment
– goodwill
 Liabilities
• What is a liability?
It is something a company owes. They are
debts that are payable to outsiders called
creditors.
– money
– service – legal retainers
 Owners’ Equity
• What is owners’ equity?
It is what’s left of the assets after liabilities
have been deducted. Also called residual
interest.
– the same as net assets
– the owner’s claim on the entity’s assets
 Owners’ Equity
• 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
Transactions that Affect
Owners’ Equity
 Income

• What is income?
It refers to all increases in equity other than
investments by owners.
Net Income = Revenues - Expenses
 Revenues
• What are revenues?
They are amounts received or to be received
from customers for sales of products or services.
– sales
– performance of services
– rent received
– interest received
 Expenses
• What are expenses?
They are amounts that have been paid or will be paid
later for costs that have been incurred to earn
revenue. Expenses decrease equity by using up assets or
increasing liabilities in order to deliver goods or services to
customers
– salaries and wages
– electricity and gas
– supplies used
– advertising
 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 9 310 110 880
Repair Equipment 55 350
Land 30 000 EQUITY
Building 127 500 Minh Vu, Capital 143 340
$254 220 $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

 THE BALANCE SHEET
MINH’S TV REPAIRS
(Narrative format)
Balance Sheet
As at 30 June 2016
ASSETS
Cash at bank $ 23 165
Accounts receivable 8 895
Repair Supplies 9 310
Repair Equipment 55 350
Land 30 000

A – L = Eq
Building 127 500
$254 220
LIABILITIES
Accounts payable $ 10 380
Mortgage payable 100 500
110 880
143 340
EQUITY
Minh Vu, Capital 143 340
$143 340
 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 STATEMENT OF
CHANGES IN EQUITY
“Linking” statement between the
Income Statement and the Balance Sheet
MINH’S TV REPAIRS
Statement of Changes in Equity
For the year ended 30 June 2016
from
Minh Vu, Capital – 1 July 2015 $118 665 Income Statement

Add: Profit for the year 47 175

165 840
to
Less: Drawings 22 500 Balance Sheet

Minh Vu, Capital – 30 June 2016 $143 340

 THE STATEMENT OF
CHANGES IN EQUITY

Balance sheet Income statement Balance sheet

as at beginning of year for the period as at end of year
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
 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
• This can be demonstrated by looking at the first 3
transactions from the example in the text
 EXAMPLE
Cynthia’s Beauty Services
1. Cynthia Jones deposits $53000 in a
business bank account
Assets = Liabilities + Equity
Cash at C. Jones,
Bank Capital
(1) $53 000 = $53000
 EXAMPLE
Cynthia’s Beauty Services
2. Cynthia purchases a van for $32000 and
massage and manicuring tables for $6000

Assets = Liabilities + Equity

Cash at Massage & Van C. Jones,
Bank Manicure Capital
tables
(1) $53 000 = $53 000
(2) -38 000 + 6 000 + 32 000
15 000 + 6 000 + 32 000 = $53 000

$53 000 = $53 000

 EXAMPLE
Cynthia’s Beauty Services
3. Cynthia purchases nail supplies for $2500 on
credit
Assets = Liabilities + Equity
Cash at Massage & Van Nail Accounts C. Jones,
Bank ManicureAssets Supplies = Payable
Liabilities + Capital
Equity
tables
Cash at Massage & Van C. Jones,
(1) $53 000
Bank Manicure = $53 000
Capital
(2) -38 000 tables
+ 6 000 + 32 000
(1) $53
15 000 + 6 000 + 32 000 = $53 000
(2)
(3) -38 000 + 6 000 + 32 000 + 2 500 = + 2 500
15 000 + 6 000 + 32 000 + 2 500 = + 2 500 $53 000

$53 000
$55 500 = $55 500 $53 000
 Accounting for Business
Transactions
Transaction 1: Starting the business - Paula Lee invests $30,000 to
begin Paula Lee eTravel.
Transaction 2: Purchase of Land - Lee purchases land, paying
$20,000 in cash.
Transaction 3: Purchase of office supplies - She buys office
supplies, agreeing to pay $500 in 30 days.
Transaction 4: Earning of service revenue - She earns and collects
$5,500 revenues.
Transaction 5: Earning of service revenue on credit - Lee performs
services, and the client agrees to pay $3,000 within one month.
 Accounting for Business
Transactions
Transaction 6: Payment of expenses - During the month, she pays
$3,300 for expenses incurred.
Transaction 7: Payment on account - Lee pays $300 to the store
from which she purchased $500 worth of supplies.
Transaction 8: Personal transaction – Lee remodels her home at a
cost of$40,000, paying cash from personal funds.
Transaction 9: Collection on account – Lee collects $1,000 from
the client for the services performed.
Transaction 10: Sale of land – Lee sells land for $9,000.
Transaction 11: Withdrawal of cash – Lee withdraws $2,000 cash
from the business for personal use.
 Accounting for business transactions
Assets Liabilities Owners´
equity
Cash Land Office Accounts Accounts Paula Lee,
supplies receivable payable capital
(1) +30 000 (1) +30 000

(2) -20 000 (2) +20 000

(3) +500 (3) +500

(4) +5 500 (4) 5 500

(5) +3 000 (5) +3 000

(6) -3 300 (6) -3 300

 Accounting for business transactions
Assets Liabilities Owners´
equity
Cash Land Office Accounts Accounts Paula Lee,
supplies receivable payable capital
(7) -300 (7) -300

(9) +1 000 (9) -1 000

(10) +9 000 (10) -9 000

(11) -2 000 (11) -2 000

 KEY POINTS FROM EXAMPLE
• Every transaction affects at least two
components of the equation
• This gives rise to the term:
Double-Entry Accounting

• After each transaction is recorded the

accounting equation must remain balanced

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