Introduction to Financial Statements

Our text begins by showing the end result of the accounting process and works backwards by teaching you how to achieve the end result. This approach does seem to make sense, as it is easier to find your way if you know where you are going.

In financial accounting, the final destinations are the financial statements and the information they contain. The main financial statements are the Balance Sheet, the Income Statement, the Statement of Retained Earnings, and the Statement of Cash Flows. We will concentrate more on the first three statements now than on the Statement of Cash Flows.

There are three ways in which a business can be organized. These are as a Sole Proprietorship, a Partnership, or a Corporation. In addition, there are three types of activities that businesses can perform- Service, Merchandising, and Manufacturing. It is important to understand the differences between each but also to recognize that the financial statements apply to all. We will start with corporations that provide services because:

1. Corporations account for the majority of businesses in the world in terms of sales and assets. The largest corporations have more resources than many small countries.

2. Service businesses have the simplest accounting procedures of the three types of business activities.

The financial information about each business item is measured in dollars and recorded in its own separate category, which is called an account. Though a company may have literally thousands of accounts, all accounts are derived from three basic account types (or classifications). They are:

ASSETS - items that the business owns (economic resources) and are expected to provide the company with future benefits.

Examples:

Cash

Accounts Receivable

Supplies

Land Equipment

Prepaid Insurance

LIABILITIES - items that the business owes (economic obligations)

Examples:

Accounts Payable

Salaries Payable

Mortgage Payable

Unearned Revenue

STOCKHOLDER'S EQUITY - The assets minus the liabilities-- in other words, what is left over for the owner. On the most basic level, what you own minus what you owe is what you are worth.

The stockholder's equity for a corporation is divided into two parts. Capital Stock represents the owners' (stockholder's) investment in the company. Retained Earnings is just what it says -- equity arising from earnings which have not been distributed back to the stockholders in the form of dividends. Retained Earnings is important to the stockholder because they can only receive dividends if Retained Earnings has a positive balance.

Stockholder's equity is increased by the owners making investments into the business or by the business earning revenue. It is decreased by the owners being paid dividends or by the business incurring expenses in the process of earning revenue.

The relation between the three classifications of accounts is expressed as the ACCOUNTING EQUATION and is the basic structure for all accounting systems.

ASSETS = LIABILITIES + STOCKHOLDERS' EQUITY

The left side of the equation shows what assets the business owns and the right side shows how the assets were acquired. Either through borrowing (liabilities),the stockholders' investment (capital stock), or from earnings (retained earnings). Remember that both capital stock and retained earnings are part of stockholders' equity. A simple example is the concept of home equity. If you own a $1,000,000 castle on the beach (asset) but have a $200,000 mortgage(liability), your equity is $800,000 (did I mention it’s OK to dream when we make up examples?).

When all accounting information is processed, there are only three possibilities for the impact on the accounting equation.

1- A Plus (+) and a Plus (+) increase both sides of the equation.

2- A Minus (-) and a Minus (-) decrease both sides of equation.

3- A Plus (+) and a Minus (-) increase and decrease on the same side of the equation.

With the Accounting Equation defined we are ready to take a look at the financial statements.

INCOME STATEMENT -- This is the statement that answers the question "Did we make a profit?" It measures the performance of a business over a period of time by comparing revenue earned against expenses incurred. The difference between the two is the net income or loss for the period.

Revenue is the inflow of assets from providing services. Assets increase on one side of the equation and retained earnings (stockholders' equity) will increase on the other side. Revenue is recognized when it is earned as opposed to collected. For example, if you painted a house in July, but did not collect the money until August, it would be recorded in July when you actually performed the service. The asset you would receive in July is Accounts Receivable, which represents money owed to the company. Collecting the money in August is merely converting one asset (Accounts Receivable) into a more desirable asset(Cash). You would not record any more revenue in August because you did not provide any more services. Revenue transactions will have a + and a + impact on the accounting equation (increase both sides of the equation).

Expenses are the outflow of assets (either surrendered or consumed) from producing revenue. As assets decrease on one side of the equation, retained earnings will decrease on the other side. We recognize expenses when they are incurred, as opposed to when they are paid. For example, if you painted the house in July, but did not pay for the paint until August, it would still be an expense in July when you actually used the paint. Accounts Payable (liability)which represents money owed by the company would be recorded in July to show that you still owe for the paint. Paying this off in August reduces the liability. You would not record any more expense because you did not use anymore paint. The final impact of an expense transaction on the accounting equation is a – and a – (decrease both sides of equation).

STATEMENT OF RETAINED EARNINGS -- This statement shows the changes to retained earnings over a period of time. As you may have realized from the definitions of revenue and expenses they are actually sub-classifications of retained earnings summarized into one income or loss amount on the income statement. This amount and any dividends (earning distributed to stockholders) must be used in calculating the end of period balance of retained earnings. Note that dividends are not tax deductible and CANNOT be included as an expense on the Income Statement. Otherwise corporations would distribute all income as dividends reducing income and taxes to zero. The IRS has a strong opinion on this! Sports teams have lifetime records of wins and losses. The statement of retained earnings is the lifetime record of wins and losses for a corporation.

BALANCE SHEET -- Shows the financial position of the business at period end. This statement is for a point in time as opposed to the Income Statement and the Statement of Retained Earnings, which both cover a period of time. The Balance Sheet is a formal presentation of the accounting equation, showing assets on one side and how they were acquired (liabilities and stockholders’ equity) on the other side.

Note that the three statements must be prepared in order as each is dependent on the previous for information. The net income flows to retained earnings and retained earnings flows to the balance sheet. No information is lost; it is just stored in different format for analysis.

STATEMENT OF CASH FLOWS –is based on a simple premise. No matter how good the other three statements look, if you run out of cash you are up the creek with no paddle in sight. This statement concentrates on where the cash is coming from and where is it going. Cash flows are divided into three activities:

1. Operating Activities – How much cash is being provided by basic operations. This should be a positive number.

2. Investing Activities – Cash flow related to the investment in long-term assets. This can easily be a negative number for a growing business.

3. Financing Activities -- Cash flow related to stock and bond transactions to finance the company.

The tie in with the other statements is that the bottom line of the Cash Flow Statement must match the ending cash balance on the Balance Sheet.

ANNUAL REPORTS -- All U.S. Corporations must provide its stockholders with an annual report that includes the four financial statements mentioned above, along with other information of importance. Notes to Financial Statements are included to clarify information given in the financial statements. Other financial information and explanations are included in the Management Discussion and Analysis. Also, an Auditor’s Report is included, which contains the opinion of an outside auditor as to the accuracy and validity of the information included in the annual report statements.