BASIC

FINANCIAL STATEMENTS

Chapter No. 2

Text Book:
Accounting
By
Meigs, Williams, Haka, Bettner
11th edition
• Business
Any profit oriented activity is called business.
• How Do We Measure Performance?
We should have certain facts about the
activities. These facts about business activities
pass through a system, known as Accounting
System, which performs two functions:
• To develop an Accounting information in
such a way that:-
 Information is recorded.
  Information is classified.
 Information is summarized.
• To communicate this information
to users (decision makers)
Accounting is a basis for business
decisions.
• What type of reports are generated?
Two types of reports are generated:
 Financial Statements
 Special Reports
• Financial Statements
A set of following four statements. These are
open documents.
–Balance Sheet
–Statement of Owner’s Equity
–Income Statement
–Statement of Cash Flow
•Special Reports
Special Reports are specific reports, other than
Financial Statements, like General Purpose
reports, Income Tax Returns etc. These reports may
be on daily, weekly, or quarterly basis etc.
•Why We Study the Financial Statement?
We study these reports to find out
– Solvency (ability to pay debts)
– Profitability
– Future Prospects (ability to grow)
• What is an Accounting System?
An accounting system consists of personnel,
procedures, devices, and record etc for the sake of
developing accounting information and
communicating it to users (decision makers).
• Financial Statements:
Balance Sheet (Statement of Financial
Position):
The Balance Sheet is a position Statement that
shows where the company stands in financial
terms at a specific date.
Income Statement:
The Income Statement is an activity statement
that shows detailed results of the company’s
profit related activities for a period of time
( for example , a month, a quarter, or a year).
 Statement of Cash Flows:
The Statement of Cash Flows is an activity
statement that shows the details of the
company’s activities involving cash during a
period of time.
 Statement of Owner’s Equity:
The Statement of Owner’s Equity is an
activity statement that shows the details of the
owner’s claim to the assets of the business
during a period of time.
 Balance Sheet
Every business prepares a balance sheet at the
end of the year, and many companies prepare
one at the end of each month. It consists of
listing of the assets, the liabilities, and the
owner’s equity of a business.
Balance Sheet has two parts –Title & Body.
Title consists of three sub-sections:
(a) Name of Business entity
(b) Name of Financial Statement
(c) Date on which Balance Sheet is prepared
Body of the Balance Sheet consists of three
sections:
(a) Assets:
Assets are the economic (or business)
resources owned by the company. Cash is listed
first among the assets, followed by Notes
Receivables, Accounts Receivables, Supplies,
& other assets. Cash is a liquid asset. Less
liquid assets, such as Land, Bldg & Equipment
etc are written afterwards.
Receivables are any cash which we have to
receive from others. Notes mean Promissory
Notes (written promise)& if nothing exists in
writing & we do credit on understanding, such
Receivables mean Accounts Receivables.
Supplies mean the items which have been
purchased & these will be used subsequently in
the process of business. Payables are any cash
which we have to pay to others. Notes mean
Promissory Notes (written promise)& if nothing
exists in writing & we do credit on some
understanding, such Payables mean Accounts
Payables.
(b) Liabilities:
Debt or obligation of an entity that resulted from
past transactions. This represents the claim of
creditors on the assets( other than the
owner).
(c) Owner’s Equity:
This represents the claim of owner on the assets
• Claims of the Outsiders are Liabilities
• Claims of the Owners are Owner’s
Equity
Accounting Equation is
Assets = Liabilities + Owner’s Equity

The amount of total Assets is always equal to

the total amount of Liabilities and Owner’s
Equity. This is why it is called Balance
Sheet.
 Overnight Auto Services
Balance Sheet
Dec.31,2007
Assets Liabilities & Owner’s equity
$ Liabilities
Cash 10,000 $
Notes Receivables 20,000
Notes Payable 25,000
Accounts Receivables 30,000
Supplies 15,000
Accounts Payable 70,000
Land 85,000 Salaries Payable 5,000
Building 100,000 Total Liabilities 100,000
Office Equipment 40,000
Owner’s Equity
Rehman’s Capital 200,000
Total(Assets) 300,000

Total(Liabilities & Owner’s

300,000
Equity)
 Income Statement
The Income Statement is a separate representation of
the company’s revenues & expense for a period of
time. Generally the time period is one year & is known
as accounting year. It actually explains how the
company’s financial position changed during the
period (Profitability)
Revenue is the price of goods & services which we
sell.
Expense is the cost of goods & services we use to
generate revenue.
Revenue = $ 2200
Expense = $ 1400
Net Income = $ 800
 ABC Company
Income Statement
For the month ended November 30, 2008

$ $
Revenue
Repair Service Revenue 2200
Operating Expense
Wages Expense 1200
Utilities Expense 200 1400
Net Income 800
 Statement of Cash Flows: This shows how
cash position changed during the period.
Revenue/ Operating
Operating Expenses Activities

Assets Investing
Activities

Capital / Loan Financing

Activities
• Operating Activities (Revenue / Expense)
should be positive (generation of funds within
the organization).
• Investing Activities ( Assets)
means any cash which we pay for buying
assets or cash receivables because of selling
assets. This should be negative showing
expansion in the business ( Business is
expanding).
 ABC Company
Statement of Cash Flows
For the month ended Nov.30, 2007
Cash flow from operating activities $ $
Cash received from sales revenue 2,200
Cash paid for expenses ( 1,400)
Net cash provided by operating expenses 800
Cash flow from investing activities
Purchase of lands (58,200)
Purchase of tools and machinery ( 6,600)
Sale of tools(receipt) 600
Net cash used by investing activities (64,200)
Cash flow from financing activities
Investment by McBryan 80,000
Net cash provided by financing activities 80,000
Net Cash Increase during Nov.30, 2007 16,600
Balance of cash on Nov.1, 2007 0
Balance cash on Nov.30, 2007 16,600
Event
Event means anything that happens. Human life
is full of events. So many events take place in
the family life, social life & business life of a
person. The events may be classified into two:
Monetary Events: Events which are related
with money i.e., which change the financial
position of a person or organization.
Non-Monetary Events: Events which are not
related to money i.e., which do not change the
financial position of a person or organization.
In business accounting only those events which
change the financial position of a business and
which call for accounting are recognized as events.
In other words, all monetary events are regarded as
“business transactions.”
An event (or a business transaction) must qualify
following conditions to become a transaction:
1.It is complete event
2.The effect of which can be expressed in terms of
money
3.It causes immediate change in the financial
position.
Double Entry System
Every business transaction causes at least two
changes in the financial position of a business
concern at the same time—hence both the
changes are recorded in the book of accounts.
Anything which is not a transaction must not be
recorded.
For example we buy machinery for Rs. 100,000,
obviously it is a business transaction. It has
brought two changes—machinery increases by
Rs. 100,000 and cash decreases by an equivalent
amount. Both the changes must be recorded. In
account language these two changes are termed
as “a debit change” and “a credit change.” Thus
we see that for every transaction there will be
two entries—one debit entry and another credit
entry. For each debit there will be a
corresponding credit entry of an equal amount.
Conversely for every credit, there will be a
corresponding debit entry of an equal amount.
Such system is known as Double Entry System.
Transaction is always in Past Tense.
• State with reasons whether the following
events are transactions to my business.
1.I started a business with Rs. 500,000.00
2.I bought furniture for Rs. 100,000.00 for
business.
3.I submitted a tender for goods worth Rs.
10(M).
4.I appointed a cashier on a salary of Rs. 20,000
per month.
5.I paid salary Rs. 35,000 p.m.to an accountant
of the firm.
6. I took away goods worth Rs. 10,000from the
business for my personal use.
7. Paid rent of my house from my own funds.
1. It is a transaction. It changed the financial
position of my business. Cash (assets)
increases by Rs.500,000 and Owner’s equity
also increases by an equal amount.
2. It is a transaction. It changed the financial
position of my business. Furniture (asset)
increase by Rs. 100,000 and cash (asset)
decreases by an equal amount.
3. It is not a transaction. It did not change the
financial position of my business.
4. It is not a transaction. Mere appointment of
the cashier did not change the financial
position of my business.
5. It is a transaction. It changed the financial
position of my business. Cash(asset) decrease
by Rs. 35.000 and an expense (salary)
decreases by an equal amount.
6. It is a transaction. Goods decreases by Rs. 10,
000 and Equity also decreases by an equal
amount.
7. It is not a transaction.
The Accounting Cycle
Capturing Economic Events
Transaction is the starting point and producing
the Financial Statements is the End point. In
between there is an accounting process:
TRANSACTION JOURNAL LEDGER

FINANCIAL
TRIAL BALANCE
STATEMENYS
 Rules of Debit & Credit
This explains that when we have to write
something in the debit side and when in the credit
side.

ASSETS
BALANCE SHEET’s
LIABILITIES &
ACCOUNTS
OWNER's EQUITY

REVENUE & INCOME STATEMENT

EXPENSE ACCOUNTS
 Rules of Debit & Credit
This explains that when we have to write
something in the debit side and when in the
credit side.
Increases are Recorded
ASSETS & as Debits
EXPENSES Decreases are Recorded
as Credits

LIABILITIES Increases are Recorded

OWNER’s EQUITY & as Credits
REVENUE Decreases are Recorded
as Debits
The Journal
The information about each business transaction
is initially recorded in an accounting record
called the Journal. The journal is chronological
(day by day) record of business transactions.
At convenient intervals, the debit and credit
amounts recorded in the journal are transferred
(posted) to the Ledger. The journal is an
internal document.
Date Account Titles and explanation Debit Credit
2008

Nov 1 Cash 80,000

McBryan Capital 80,000
McBryan invested cash
Nov 3 Land 52000
Cash 52000
Purchased land for cash
Nov 5 Building 36,000
Cash 6,000
Notes Payable 30,000
Purchased Building for cash 6000 & Notes
payable 36000
Nov 17 Tools & Equipment 13,800
Accounts Payable 13,800
Purchased Tool & Equipment on accounts
Date Account Titles and explanation Debit Credit
2008

Nov 20 Accounts Receivables 18,000

Tools & Equipment 18,000
Sold some of tools & equipment on accounts
Nov 25 Cash 600
Accounts Receivables 600
Received Cash on Accounts
Nov 26 Accounts Payable 6,800
Cash 6,800
Paid Cash on Accounts
Remember that:
• No currency sign is to be shown in Journal,
Ledger and Trial Balance. Currency sign is to
be shown in all the four Financial Statements,
being the external documents.
• Every debit amount has an equal credit amount
• Posting simply means updating the ledger.
The Ledger
An accounting system includes a separate record
for each item that appears in the financial
statements. For example, a separate record is
kept for the asset “cash,” showing all increases
and decreases in cash resulting from the money
transactions in which cash is received or paid.
A similar record is kept for every other asset,
for every liability, for owner’s equity etc. The
record used to keep track of the increases and
decreases in the financial statement items is
termed as ledger account or simply account.
The entire group of accounts is kept together in
an accounting record called a Ledger.
An account has three sections:
1.a title;
2.a left side, called as debit side; and
3.a right side called as credit side;
This form of an account is called a T- account
because of its resemblance to the T-letter.
Title of Accounts

Debit Side Credit Side

Receipts are recorded on the left side and
payments are placed on the right side and then
we see the net impact of these transactions.
Examples
Nov.1: McBryan invested cash $ 80,000 in OAS
Analysis: The cash is increased by $ 80,000 &
the McBryan Equity is increased by the same
amount.
Debit / Credit Rules: Increase in assets is
recorded by debits; Increase in owner’s equity is
recorded by credits.
 Cash Owner’s Equity

1/11 80,000 3/11 52,000 1/11 80,000

5/11 6,000

Nov.3: Purchased land for cash $ 52,000

Analysis: The asset land is increase by $ 52,000
and the asset cash is decreased by $ 52,000
Debit / Credit Rule: Increase in assets are
recorded by debits; Decrease in assets is
recorded by credits.
 Building

Land
5/11 36,000

1/11 52,000

Nov.5: Purchased building for $36,000, paid

cash $ 6000 & Notes Payable $ 3,000.
Analysis: the asset building is increased: Cash is
decreased & Notes Payable is increased.
 Notes Payables

5/11 30,000

We see that equality of debits & credits is

maintained in all transactions. Now we do
Trial Balance to check the arithmetical
accuracy of ledger and to further ensure that
equality of debit & credit is maintained.
 Overnight Auto Service
Trial Balance
On November 26, 2009
Debit Credit
Cash
Accounts Receivables
Land Building
Tools & Machinery
Notes Payable Accounts
Payable
McBryan Capital
117,000 117,000
Trial Balance
Trial Balance is an internal document and not an
external document. Now if the total of two
columns agree, we say that we have done the
recording in the ledger correctly. From the
ledger, we prepare the Balance Sheet.
Types of Business
There are three main types of businesses: those
selling services (such as dry cleaners, auto
workshops, beauty saloons, airline companies
etc); those selling goods (such as food sellers,
automobile dealers etc);those manufacturing
goods (such as automobile manufactures, sugar
mills, textile mills etc).
A business entity is an economic unit which
enters into business transactions that must be
recorded, summarized and reported.
The entity (business organization) is regarded as
separate from its owner or owners; the entity
owns its own property; the entity has its own
debts.
The purpose of accounting is to provide useful
information about an organization (an entity) to
people who need such information but not about
the personal affairs of the owner or owners.
Forms of Business Organization
There are three main forms of business
organizations:
Sole Proprietorships
The simplest form of business organization “to
organize and operate "is a single or sole
proprietorship. This is the most common type
of ownership and is founded in businesses such
as small retail shops, service stations etc. This
unincorporated business, owned by one person,
is called a sole proprietorship. The owner is
personally responsible for the debts of the
business. If the business becomes insolvent,
creditors can force the owner to sell his or her
personal assets to pay the business debts.
The advantage is its simplicity whereas the
unlimited liability is a disadvantage to the owner.
Partnership
An incorporated business owned by two, or more,
persons voluntarily acting as partners (co-workers),
who agree to share their property and/or skills etc to
operate the business is called partnership. Like the
sole proprietorship, a partnership business is simple
to organize. The owners of a partnership are
personally responsible for all debts of the business.
Joint Stock Companies (Corporations)
This is the only type of business organization
recognized under the law as an entity separated
from its owners. Therefore the owners of a Joint
Stock Company are not personally responsible /
liable for the debts of the business. The owners
can loose no more than the amounts they have
invested in the business—a concept known as
limited liability. Because of this concept, the
corporations are the most attractive form of
business organizations to many investors.
Ownerships of a corporation is divided into
transferable shares of capital stock and the
owners are called stockholders. Stock certificates
are issued by the corporation to each stockholder
showing the number of shares that he or she
owns. The stockholders are free to sell some or
all of these shares to other investors at any time.
This transferability of ownership adds to the
attractiveness of the corporate form of
organization, because the investors can more
easily get their money out of the business.
Balance Sheet in case of Sole Proprietorship
Owner’s Equity
McBryan Capital $ 80,000
Balance Sheet in case of Partnership
Partner’s Equity
McBryan Capital $ 100.000
Smith Capital 80,000
Total Partner’s Capital 180,000
Balance Sheet in case of Corporation
Stockholder’s Equity
Capital Stock
80000 shares of $ 10 each $ 800,000
Retained Earning 100,000
Total Shareholder’s Equity 980,000
Capital Stock
Capital Stock represents the amount that the
stockholders originally invested in the
business in exchange for shares of the
company’s stock.
Retained Earning
Retained Earning represents the increase in
stockholder’s equity that has accumulated over
the years as a result of profitable operations.
Assignment-4
Assume that Michael McBrown, an experienced
auto engineer, opens his own automotive repair
business “Overnight Auto Service.” A distinctive
feature of overnight's operations is that all repair
work is done at night. This strategy offers
customers the convenience of dropping off their
cars in the evening and picking them up the
following morning.
McBryan started business on November 1,2008.
Following are the transactions:
Nov 1: McBryan started the business by
depositing $ 80,000 in a company’s bank
account.
Nov 3: Purchased Land for $ 5,2000 paying cash.
Nov 5: Purchased a building for $ 36,000 paying
$ 6,000 in cash and issuing a note payable
for the remaining $ 30,000.
Nov 17: Purchased tools & machinery on
accounts for $ 13,800.
Nov 20: Sold some of the tools & machinery on
accounts for $ 1,800.
Nov 25: Received cash $ 600 on account.
Nov 26: Paid cash on account $ 6,800.
Nov 30: Received cash $ 2,200 from customers
for repair service provided during the
month.
Nov 30: Paid cash $ 1400 for expense ($ 200 for
utilities & $ 1200 for salaries).
Develop a Balance Sheet showing the
company’s financial position, transaction wise.