Basic Financial Statements Chapter 2 Chapter 2: Basic Financial Statements

Introduction to Financial Statements Income Statement Statement of Cash Flows Balance Sheet Three primary financial statements. There are three fundamental financial statements used in accounting. The income statement shows revenues and expenses. The balance sheet is a listing of all asset, liability, and equity account balances that do not appear on the income statement. The statement of cash flows shows how the company receives and spends its cash. This chapter will look at the financial statements of a corporation. We will use a corporation to describe these statements.

A Starting Point: Statement of Financial Position The statement of financial position, commonly referred to as the balance sheet, is an inventory of assets, liabilities, and equity at the end of the month. Our total assets are equal to $300,000. This includes cash of $22,500, notes receivable of $10,000, supplies of $2,000, and the balances in the remaining asset accounts. Liabilities include notes payable of $41,000, accounts payable of $36,000 and salaries payable of $3,000. The accounts in the owners’ equity section of the balance sheet are capital stock of $150,000 and retained earnings of $70,000. Notice that the total assets are equal to the total liabilities plus owners’ equity.

The Concept of the Business Entity A business entity is separate from the personal affairs of its owner. Vagabond Travel Agency The business entity principle states that the transactions of individual owners of a business and those of the business must be separate.

Assets Assets are economic resources that are owned by the business and are expected to benefit future operations. Assets are resources owned or controlled by an entity. They include such items as cash, accounts receivable (amounts owed to the company by customers), land, building and equipment, and supplies.

Assets These accounting principles support cost as the basis for asset valuation. Cost Principle Stable-Dollar Assumption The cost principle tells us that accounting information is based upon actual cost incurred. We refer to this as historical cost. The going-concern assumption states that in the absence of information to the contrary, the business entity is assumed to continue operations into the foreseeable future. The objectivity principle states that accounting information must be unbiased and based upon independent evidence. The stable-dollar assumption tells us that we will only record accounting information that can be expressed in monetary units, usually dollars in the United States. Going-Concern Assumption Objectivity Principle

Liabilities Liabilities are debts that represent negative future cash flows for the enterprise. Liabilities represent the claims of creditors on an entity’s assets. Liabilities include accounts payable (amounts owed to creditors for assets purchased on account), taxes payable, and wages payable (amounts owed to our employees at the end of the accounting period).

Owners’ Equity Owners’ equity represents the owners’ claims on the assets of the business. The equities of an entity include investments by owners, withdrawals by owners, and earnings retained by the business. Investments by owners and net income increase owners’ equity. Payments to owners and net losses decrease owners’ equity.

The Accounting Equation Assets = Liabilities + Owners’ Equity $300,000 = $80,000 + $220,000 The basic accounting equation states that assets are equal to liabilities plus equity of a company. The equation makes sense because it states that assets must be equal to the claims against those assets. There are two broad categories of claims against an asset: Claims by creditors (called liabilities), or after all creditor claims are satisfied, the residual owners (the stockholders) have a claim on those assets.

Here is an example of an income statement Here is an example of an income statement. Overnight Auto Service has revenues for services for $2,200, and two operating expenses totaling $1,400. So the net income for the period of January 20-31, 2015 is $800. Remember, net income is the excess of revenues over expenses incurred during the accounting period. Investments by owners and payments to owners do not appear on the income statement. These amounts appear on the company’s balance sheet. Investments by and payments to the owners are not included on the Income Statement.

Here is the statement of cash flows for Overnight for the period of January 20-31, 2015. Notice the three sections of the statement: Cash flows from operating activities, investing activities and financing activities. Cash flows from operating activities include the cash received from revenue transactions and the cash paid for expenses. Overnight Auto Service had a cash outflow for investing activities. The company invested in the land, a building, and tools; however, the company recovered some of the cost of tools by selling some excess tools to Ace Towing. The only financing activity was the original investment by the owners of Overnight Auto Service. The cash inflows and outflows resulted in an increase in cash of $16,600 during the month. Because the cash account had a zero balance at the beginning of the month, the ending balance in the cash account is $16,600.

Relationships Among Financial Statements Date at beginning of period Date at end of period Time Statement of Financial Position (Balance Sheet) Statement of Financial Position (Balance Sheet) All the financial statements are interrelated. We can start with the balance sheet at the beginning of an accounting period, analyze the income and cash flows of the company, and arrive at the ending balances that will appear on the balance sheet. Income Statement Statement of Cash Flows

Financial Statement Articulation This is the balance sheet for Overnight Auto Service at the end of January. Net income impacts the retained earnings of the company. The statement of cash flows not only provides the balance in the cash account, but also details information about the acquisition and disposition of assets and liabilities as well as changes in the owners’ equity balance. It’s clear to see how all the financial statements articulate with each other.

Financial Reporting and Financial Statements Financial statements are just one source of financial accounting information. Statement of Cash Flows Balance Sheet Income Statement Other Information: Nonfinancial disclosures Management interpretation Industry Competitors National economy Financial statements are only one source of information about the operations of a company. The financial statements of a company can be compared to those of other companies in the same industry, major national or international competitors, and to the norms for the national economy.

The Need for Adequate Disclosure Income Statement Balance Sheet Statement of Cash Flows Notes to the financial statements often provide facts necessary for the proper interpretation of the statements. In addition to the basic financial statements, companies prepare notes to the financial statements. These notes are meant to provide the reader with additional insights into the operations and financial position of the company.

End of Chapter 2 End of Chapter 2.