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Fundamental

Financial Accounting
Concepts
Fourth Edition
by
Edmonds, McNair, Milam, Olds

PowerPoint® presentation by
J. Lawrence Bergin
Winona State University
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Welcome to the study of


Financial Accounting

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Chapter 1

Elements
of
Financial Statements

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What is accounting?
● The language of business

▲ Measures financial aspects of a


business

▲ Communicates this information to


decision makers

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Why should everyone in
business study accounting??
● Many business decisions are based
on accounting information.

● Since accounting information is


prepared according to “rules,” an
understanding of these rules is
necessary for the appropriate use
of the information.
“Rules” = Generally Accepted Accounting Principles (GAAP)

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The Accounting Equation


Assets = Claims
Assets = Liabilities + Equity
● Asset: something of value
Ex: Cash, Land, Buildings, Equipment, Inventories, Supplies,
Prepaid Insurance, Accounts Receivables from customers.
● Liability: something owed (creditors’
share of the assets)
Ex: Accounts Payable, Notes Payable, Mortgage Payable,
Interest Payable, Salaries Payable.
● Equity: what remains (owners’ share of
the assets)
Ex: Common Stock, Retained Earnings

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Equity: The Owners’ Share


● There are two sources of equity
▲ equity acquired from the owners by issuing
stock.
▲ equity “earned” by operations

● Expanded accounting equation:


Stockholders’ Equity

Common Retained
Assets = Liabilities + Stock + Earnings

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How is equity “earned by


operations”?
Answer: By earning “Net Income*”
(*also called “Net Earnings” or “Net Profit”.)
Revenue - Expenses = Net Income
(Loss) Amounts received or to be received
● Revenue: from having sold a product or
provided a service. [Ex: The amount
the customer pays at the cash
register.]

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How is equity “earned by


operations”?
Answer: By earning “Net Income*”
(*also called “Net Earnings” or “Net Profit”.

Revenue - Expenses = Net Income


(Loss) Amounts received or to be received
● Revenue: from having sold a product or
provided a service. [Ex: The amount
the customer pays at the cash
Assets or services “used up” in the
register.]
● Expenses: process of earning the revenue this
period. [Ex: What it cost the store
for the item it sold to the customer,
rent, wages, utilities, advertising,
taxes]

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Equity: The Owners’ Share-
cont’d.
● Dividends:
Company assets given to or withdrawn
by owners for their personal use.
[Other terms used: Withdrawals,
Drawings, and Distributions.]

● Retained Earnings:

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Equity: The Owners’ Share-
cont’d.
● Dividends:
Company assets given to or withdrawn
by owners for their personal use.
[Other terms used: Withdrawals,
Drawings, and Distributions.]

● Retained Earnings:
The Net Income [Earnings] kept
[Retained] in the business since its
beginning.
It is the total of all net income (minus all losses)
and minus all dividends since the
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Four Basic Financial Statements


● Balance Sheet
▲ Assets = Liabilities + Equity

● Income Statement (also called Statement of


Operations, Earnings Statement, Profit/Loss (or P&L)
Statement
▲ Revenues - Expenses = Net income (or Net
Earnings)
● Statement of Changes in
Stockholders’ Equity
▲ Beginning of period total equity + Stock issued
+ Net income - Dividends = End of period total
equity
● Statement
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Transaction Analysis
● What is a transaction?
▲ a business event involving a transfer of
something of value between entities
● What is transaction analysis?
▲ determining the effect of a business event on
the financial statements
● Where do you start?
▲ First, determine the transaction’s effects on
the accounting equation.
▲ Second, determine the effects on other
financial statements.

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Assets = Claims
Four Types of Transactions
that keep the equation in
● balance
Asset Source Transactions--an
Transactions asset increases
and a corresponding claims account increases
● Asset Use Transactions--an
Transactions asset decreases
and a corresponding claims account decreases
● Asset Exchange Transactions--one
Transactions asset
increases and another asset decreases

● Claims Exchange Transactions--one


Transactions claims
account increases and another decreases
(Claims Exchange Transactions will be introduced in Chapter
2.)
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Introducing the
Horizontal Financial Statements Model
The horizontal model is a
teaching/learning tool used to show
the impact a transaction has on the
three basic financial statements
(Balance Sheet, Income Statement and
Statement of Cash Flows).

Notice how the Balance Sheet section is


similar to the Accounting Equation.

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Record the six transactions that
follow in
the Horizontal Model below.
Balance Sheet Income Statement
Cashflow
Assets = Liabilities + Stk. Equity
Amount &
Cash + Land = A/Pay+N/Pay+C.Stk.+ R.E. Rev. - Exp. = N. I.
OA,IA,FA

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1- 17 Horizontal Model Transaction Analysis
Record the six transactions that
follow in
the Horizontal Model below.
Balance Sheet Income Statement
Cashflow
Assets = Liabilities + Stk. Equity
Amount &
Cash + Land = A/Pay+N/Pay+C.Stk.+ R.E. Rev. - Exp. = N. I.
OA,IA,FA

Abbreviations: Accounts Payable


Notes Payable
Common Stock

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Kleen Sweep,
Inc.
Following are six
transactions of
Kleen Sweep, Inc.,
a company that
provides janitorial
services for local
businesses.
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Kleen Sweep,
Inc.
1. Kleen Sweep was formed on Jan. 1, 2004 by issuing
Common Stock in exchange for $2,000 cash.
● The company provided services to customers for $500
cash.
● The company incurred $300 of expenses which were
paid in cash.
● The company purchased Land by paying $1,500 cash.
● The company borrowed $1,000 cash from the bank
by issuing a Note Payable on Dec. 31st.
● The company pays a $50 cash dividend to the
company’s owners (the stockholders).

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Horizontal Model Transaction Analysis


Transaction #1: Kleen Sweep was formed on Jan. 1, 2004
by issuing Common Stock in exchange for $2,000 cash.
Balance Sheet Income Statement
Cashflow
Assets = Liabilities + Stk. Equity
Amount &
1 Cash
2000 + Land = A/Pay+N/Pay +C.Stk.+ R.E. Rev. - Exp. = N.
2000 I. ??
2000
OA,IA,FA

What category of Cash flow “activity” is this?

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Classifications of Cash Flows


● Operating activities:
▲ Inflows: Collection of Revenues
▲ Outflows: Payment of Expenses, including interest
● Investing activities:
▲Inflows:Disposals of our Land, Building, Equipment
Collections of loans made to others
▲Outflows: Purchases of Land, Building, Equipment
Lending money to others (our “debtors”)
● Financing activities:
▲Inflows:Borrowing money from others (our “creditors”)
Cash received from issuing Common Stock
▲Outflows: Cash Dividends paid to stockholders
Repayment of loans to creditors, but not
interest
So, transaction #1 is what kind of Cash flow “activity”?
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Classifications of Cash Flows


● Operating activities:
▲ Inflows: Collection of Revenues
▲ Outflows: Payment of Expenses, including interest
● Investing activities:
▲Inflows:Disposals of our Land, Building, Equipment
Collections of loans made to others
▲Outflows: Purchases of Land, Building, Equipment
Lending money to others (our “debtors”)
● Financing activities:
▲Inflows:Borrowing money from others (our “creditors”)
Cash received from issuing Common Stock
▲Outflows: Cash Dividends paid to stockholders
Repayment of loans to creditors, but not
interest
So, transaction #1 is what kind of Cash flow “activity”?
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Horizontal Model Transaction Analysis


Transaction #1: Kleen Sweep was formed on Jan. 1, 2004
by issuing Common Stock in exchange for $2,000 cash.
Balance Sheet Income Statement
Cashflow
Assets = Liabilities + Stk. Equity
Amount &
1 Cash
2000 + Land = A/Pay+N/Pay +C.Stk.+ R.E. Rev. - Exp. = N.
2000 I. FA
2000
OA,IA,FA
Financing Activity

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Horizontal Model Transaction Analysis


Transaction #2: The Company provided services to
customers for $500 cash.
Balance Sheet Income Statement
Cashflow
Assets = Liabilities + Stk. Equity
Amount &
Cash + Land = A/Pay+N/Pay +C.Stk.+ R.E. Rev. - Exp. = N. I.
OA,IA,FA
2
1 500
2000 2000 500 500 500 500 FA
2000 OA

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Horizontal Model Transaction Analysis


Transaction #2: The Company provided services to
customers for $500 cash.
Balance Sheet Income Statement
Cashflow
Assets = Liabilities + Stk. Equity
Amount &
Cash + Land = A/Pay+N/Pay +C.Stk.+ R.E. Rev. - Exp. = N. I.
OA,IA,FA
2
1 500
2000 2000 500 500 500 500 FA
2000 OA

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Horizontal Model Transaction Analysis


Transaction #3: The Company incurred $300 of expenses
which were paid in cash.
Balance Sheet Income Statement
Cashflow
Assets = Liabilities + Stk. Equity
Amount &
Cash + Land = A/Pay+N/Pay +C.Stk.+ R.E. Rev. - Exp. = N. I.
OA,IA,FA
2
1 500
2000 2000 500 500 500500 FA
2000 OA
3 (300) (300) 300 (300) (300)OA

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Horizontal Model Transaction Analysis


Transaction #4: The Company purchased Land by
paying $1,500 cash.
Balance Sheet Income Statement
Cashflow
Assets = Liabilities + Stk. Equity
Amount &
Cash + Land = A/Pay+N/Pay +C.Stk.+ R.E. Rev. - Exp. = N. I.
OA,IA,FA
2 500
1 2000 2000 500 500 500 500 FA
2000 OA
3 (300) (300) 300 (300) (300)OA
4 (1500) 1500 (1500) IA

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Horizontal Model Transaction Analysis


Transaction #5: The Company borrowed $1,000 cash from
the bank by issuing a Note Payable on Dec. 31st.
Balance Sheet Income Statement
Cashflow
Assets = Liabilities + Stk. Equity
Amount &
Cash + Land = A/Pay+N/Pay +C.Stk.+ R.E. Rev. - Exp. = N. I.
OA,IA,FA
2 500
1 2000 2000 500 500 500 500 FA
2000 OA
3 (300) (300) 300 (300) (300)OA
4 (1500) 1500 (1500) IA
5 1000 1000 1000 FA

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Horizontal Model Transaction Analysis


Transaction #6: The Company pays a $50 cash dividend
to the company’s owners (the stockholders).
Balance Sheet Income Statement
Assets =
Cashflow Liabilities + Stk. Equity
Amount &
Cash + Land = A/Pay+N/Pay +C.Stk.+ R.E. Rev. - Exp. = N. I.
OA,IA,FA
2 500
1 2000 2000 500 500 500 500 FA
2000 OA
3 (300) (300) 300 (300) (300)OA
4 (1500) 1500 (1500) IA
5 1000 1000 1000 FA
6 (50) (50) (50)
FA

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Horizontal Model Transaction Analysis
Calculate the end-of-year balances of each

General Ledger account.


Balance Sheet Income Statement
Cashflow
Assets = Liabilities + Stk. Equity
Amount &
Cash + Land = A/Pay+N/Pay +C.Stk.+ R.E. Rev. - Exp. = N. I.
OA,IA,FA
2 500
1 2000 2000 500 500 500 500 FA
2000 OA
3 (300) (300) 300 (300) (300)OA
4 (1500) 1500 (1500) IA
5 1000 1000 1000 FA
6 (50) (50) (50)
B
FA 1650 1500 0 1000 2000 150 500 300 200 1650 Bal
Notice where these balances will appear on the financial
statements we will prepare shortly.

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Which of the 2004 ending balances are
carried forward to become the beginning
balances of 2005?
1. Carry forward all Balance Sheet
account balances.
2. Do NOT carry forward any Income
Statement account balances; i.e.
Revenues and Expenses.
Closing Entries are used to transfer the Revenue and

Expense balances to the Retained Earnings account.


3. On the Cashflow Statement, the 2004
ending cash balance is carried
forward to become the 2005
beginning cash balance.
(but, the OA, IA, FA categories start 2005 at $0.)
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Horizontal Model Transaction Analysis
Show the balances that will be carried over to start the
next year, 2005. (B5 = Balance at beginning of 2005)
Balance Sheet Income Statement
Cashflow
Assets = Liabilities + Stk. Equity
Amount &
Cash + Land = A/Pay+N/Pay +C.Stk.+ R.E. Rev. - Exp. = N. I.
OA,IA,FA
2 500
1 2000 2000 500 500 500 2000
500 FA
OA
3 (300) (300) 300 (300) (300)OA
4 (1500) 1500 (1500) IA
5 1000 1000 1000 FA
6 (50) (50) (50)FA
B4 1650 1500 0 1000 2000 150 500 300 200 1650 Bal
Bal. Sheet balances are carried forward. Inc.Statem’t balances are
not.
B5 1650 1500 0 1000 2000 150 0 0 0 1650 Bal.

Now let’s prepare the financial statements.


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Kleen Sweep, Inc.
Income Statement
For the Year Ended December 31, 2004

Revenue
Date line must specify:
• the length of time covered by the statement, and
• -the
Expenses
period’s ending date.

Net income

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Kleen Sweep, Inc.
Income Statement
For the Year Ended December 31, 2004

Revenue $ 500

- Expenses 300

Net income $ 200

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1- 35 Kleen Sweep, Inc.
Statement of Changes in Stockholders’
Equity
For the Year Ended December 31, 2004
Beginning Common Stock $
Plus: Common Stock Issued
Ending Common Stock $

Beginning Retained Earnings $


Plus: Net income
Less: Dividends
Ending Retained Earnings $
Total Stockholders’ Equity $

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1- 36 Kleen Sweep, Inc.
Statement of Changes in Stockholders’
Equity
For the Year Ended December 31, 2004
Beginning Common Stock $ 0
Plus: Common Stock Issued 2,000
Ending Common Stock $ 2,000

Beginning Retained Earnings $


Plus: Net income
Less: Dividends
Ending Retained Earnings $

Total Stockholders’ Equity $

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1- 37 Kleen Sweep, Inc.
Statement of Changes in Stockholders’
Equity
For the Year Ended December 31, 2004
Beginning Common Stock $ 0
Plus: Common Stock Issued 2,000
Ending Common Stock $ 2,000

Beginning Retained Earnings $ 0


Plus: Net income 200
Less: Dividends
Ending Retained Earnings $

Total Stockholders’ Equity $

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1- 38 Kleen Sweep, Inc.
Statement of Changes in Stockholders’
Equity
For the Year Ended December 31, 2004
Beginning Common Stock $ 0
Plus: Common Stock Issued 2,000
Ending Common Stock $ 2,000

Beginning Retained Earnings $ 0


Plus: Net income 200
Less: Dividends (50)
Ending Retained Earnings $
150
Total Stockholders’ Equity $ 2,150

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Kleen Sweep, Inc.
Balance Sheet
As of December 31, 2004
Assets Balance Sheet date line specifies one
Cash $
POINT in time, NOT a period of time.
Land
Total Assets $

Liabilities
Note payable $
Stockholders’ Equity
Common Stock $
Retained Earnings
Total Stockholders’ Equity
Total Liabilities and Stockholders’ Equity $

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Kleen Sweep, Inc.
Balance Sheet
As of December 31, 2004
Assets
Cash $ 1,650
Land
Total Assets $

Liabilities
Note payable $
Stockholders’ Equity
Common Stock $
Retained Earnings
Total Stockholders’ Equity
Total Liabilities and Stockholders’ Equity $

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Kleen Sweep, Inc.
Balance Sheet
As of December 31, 2004
Assets
Cash $ 1,650
Land 1,500
Total Assets $ 3,150

Liabilities
Note payable $
Stockholders’ Equity
Common Stock $
Retained Earnings
Total Stockholders’ Equity
Total Liabilities and Stockholders’ Equity $

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Kleen Sweep, Inc.
Balance Sheet
As of December 31, 2004
Assets
Cash $ 1,650
Land 1,500
Total Assets $ 3,150

Liabilities
Note payable $ 1,000
Stockholders’ Equity
Common Stock $
Retained Earnings
Total Stockholders’ Equity
Total Liabilities and Stockholders’ Equity $

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Kleen Sweep, Inc.
Balance Sheet
As of December 31, 2004
Assets
Cash $ 1,650
Land 1,500
Total Assets $ 3,150

Liabilities
Note payable $ 1,000
Stockholders’ Equity
Common Stock $ 2,000
Retained Earnings
Total Stockholders’ Equity
Total Liabilities and Stockholders’ Equity $

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Kleen Sweep, Inc.
Balance Sheet
As of December 31, 2004
Assets
Cash $ 1,650
Land 1,500
Total Assets $ 3,150

Liabilities
Note payable $ 1,000
Stockholders’ Equity
Common Stock $ 2,000
Retained Earnings 150
Total Stockholders’ Equity 2,150
Total Liabilities and Stockholders’ Equity $

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Kleen Sweep, Inc.
Balance Sheet
As of December 31, 2004
Assets
Cash $ 1,650
Land 1,500
Total Assets $ 3,150

Liabilities
Note payable $ 1,000
Stockholders’ Equity
Common Stock $ 2,000
Retained Earnings 150
Total Stockholders’ Equity 2,150
Total Liabilities and Stockholders’ Equity $ 3,150

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1- 46 Kleen Sweep, Inc.
Statement of Cash Flows
For the Year Ended December 31, 2004
Cash flows from operating activities
$

Net cash flow from operating activities $


Cash flows from investing activities
$
Net cash flow from investing activities $
Cash flows from financing activities
$
Net cash flow from financing activities $
Net increase (decrease) in cash $
Plus: Cash Balance, Jan. 1, 2004
Cash Balance, Dec. 31, 2004 $

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Kleen Sweep, Inc.
Statement of Cash Flows
For the Year Ended December 31, 2004
Cash flows from operating activities
Cash receipts from revenues $ 500
Cash payments for expenses (300)
Net cash flow from operating activities $ 200

Cash flows from investing activities

Cash flows from financing activities

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Kleen Sweep, Inc.
Statement of Cash Flows
For the Year Ended December 31, 2004
Cash flows from operating activities
Cash receipts from revenues $ 500
Cash payments for expenses (300)
Net cash flow from operating activities $ 200

Cash flows from investing activities


Cash payment for Land $(1,500)
Net cash flow from investing activities $(1,500)

Cash flows from financing activities

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Kleen Sweep, Inc.
Statement of Cash Flows
For the Year Ended December 31, 2004
Cash flows from operating activities
Cash receipts from revenues $ 500
Cash payments for expenses (300)
Net cash flow from operating activities $ 200

Cash flows from investing activities


Cash payment for Land $(1,500)
Net cash flow from investing activities $(1,500)
Cash flows from financing activities
Cash receipts from stock issue $ 2,000
Cash receipts from bank loan 1,000
Cash payments for dividends (50)
Net cash flow from financing activities $ 2,950

Net increase in cash $


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Kleen Sweep, Inc.
Statement of Cash Flows
For the Year Ended December 31, 2004
Cash flows from operating activities
Cash receipts from revenues $ 500
Cash payments for expenses (300)
Net cash flow from operating activities $ 200

Cash flows from investing activities


Cash payment for Land $(1,500)
Net cash flow from investing activities $(1,500)
Cash flows from financing activities
Cash receipts from stock issue $ 2,000
Cash receipts from bank loan 1,000
Cash payments for dividends (50)
Net cash flow from financing activities $ 2,950

Net increase in cash $ 1,650


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Kleen Sweep, Inc.
Statement of Cash Flows
For the Year Ended December 31, 2004
Cash flows from operating activities
Cash receipts from revenues $ 500
Cash payments for expenses (300)
Net cash flow from operating activities $ 200
Cash flows from investing activities
Cash payment for Land $(1,500)
Net cash flow from investing activities $(1,500)
Cash flows from financing activities
Cash receipts from stock issue $ 2,000
Cash receipts from bank loan 1,000
Cash payments for dividends (50)
Net cash flow from financing activities $ 2,950
Net increase in cash $ 1,650
Plus: Cash balance, Jan. 1, 2004 0
Cash balance, Dec. 31, 2004 $ 1,650

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What are
Consolidated
Financial Statements?
Financial Statements that show the
combined results of a “Parent”
company and all the “subsidiary”
companies in which the parent has a
“controlling interest” (usually more
than 50% ownership).
Many of the “real world” financial
statements you look at in this course
will be consolidated statements.

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Summary of General Ledger Accounts


for 2004 Transactions
Assets = Liabilities + Stockholders’ Eq.
Trans. Notes Common Ret. Titles of Nominal accts.
affected that resulted in
Event Cash + Land = Payable + Stock + Earn. the change in Ret.
Earn.
1 2,000 2,000
2 500 500 + Revenue
3 (300) (300) + Expenses
4 (1,500) 1,500
5 1,000 1,000
6 (50) (50) + Dividends
Bal. 1,650 + 1,500 = 1,000 + 2,000 + 150

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Price-Earnings Ratio
This ratio is used by analysts to evaluate
the future prospects of a company.
● The higher the PE ratio, the more
optimistic investors are about a
company’s future.
Selling price of one share of stock
Earnings per share*

* Earnings per share = Net income divided by

the weighted average number of common shares of


outstanding stock. [Why is the “weighted average”
number of shares used?]
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Percentage Change
The percentage change in any two numbers can be
calculated by dividing the DIFFERENCE between the
two numbers by the base year amount.

Given the following data:


2004 Net Income = $ 80,000
2005 Net Income = $100,000
What was the percentage growth in Net Income from
2004 to 2005?
100,000 – 80,000 = 20,000
80,000 = 80,000 = 25.0%

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Wow!
You have learned a
lot in only one
chapter!!

Now, you should go over each


of these “slides” on your own.
Make sure you UNDERSTAND
how and why everything is
done.
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Chapter 1

The
End
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