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Financial Statements and Accounting Concepts/Principles
Financial statements are the product of the financial accounting process. They are the means of communicating economic information about the entity to individuals who want to make decisions and informed judgments about the entity’s financial position, results of operations, and cash flows. Although each of the four principal financial statements has a unique purpose, they are interrelated, and all must be considered in order to get a complete financial picture of the reporting entity. Users cannot make meaningful interpretations of financial statement data without understanding the concepts and principles that relate to the entire financial accounting process. It is also important for users to understand that these concepts and principles are broad in nature; they do not constitute an inflexible set of rules, but instead serve as guidelines for the development of sound financial reporting practices.

LE ARNING O BJE CT I VE S ( LO )
After studying this chapter you should understand

1. What transactions are. 2. The kind of information reported in each financial statement and how financial statements are related to each other.

3. The meaning and usefulness of the accounting equation. 4. The meaning of each of the captions on the financial statements illustrated in this chapter. 5. The broad, generally accepted concepts and principles that apply to the accounting process. 6. Why investors must carefully consider cash flow information in conjunction with accrual accounting results.

7. Several limitations of financial statements. 8. What a corporation’s annual report is and why it is issued. 9. Business practices related to organizing a business, fiscal year, par value, and parent– subsidiary corporations.

Chapter 2

Financial Statements and Accounting Concepts/ Principles

33

Financial Statements
From Transactions to Financial Statements
An entity’s financial statements are the end product of a process that starts with transactions between the entity and other organizations and individuals. Transactions are economic interchanges between entities: for example, a sale ∕ purchase, or a receipt of cash by a borrower and the payment of cash by a lender. The flow from transactions to financial statements can be illustrated as follows: Procedures for sorting, classifying, and presenting (bookkeeping) Transactions Selection of alternative methods of reflecting the effects of certain transactions (accounting)

LO 1 Understand what transactions are.

Financial statements

1. What does it mean to say that there has been an accounting transaction between you and your school?

Q

What Does It Mean?
Answer on page 57

Transactions are summarized in accounts, and accounts are further summarized in the financial statements. In this sense, transactions can be seen as the bricks that build the financial statements. By learning about the form, content, and relationships among financial statements in this chapter, you will better understand the process of building those results—bookkeeping and transaction analysis—described in Chapter 4 and subsequent chapters. Current generally accepted accounting principles and auditing standards require that the financial statements of an entity show the following for the reporting period: Financial position at the end of the period. Earnings for the period. Cash flows during the period. Investments by and distributions to owners during the period. The financial statements that satisfy these requirements are, respectively, the: Balance sheet (or statement of financial position). Income statement (or statement of earnings, or profit and loss statement, or statement of operations). Statement of cash flows. Statement of changes in owners’ equity (or statement of changes in capital stock and∕or statement of changes in retained earnings). In addition to the financial statements themselves, the annual report will...
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