Accounting

1.5 The Four Financial Statements

LEARNING OBJECTIVE 5

Describe the four financial statements and how they are prepared.

Companies prepare four financial statements from the summarized accounting data (see Helpful Hint):

HELPFUL HINT

The income statement, owner’s equity statement, and statement of cash flows are all for a period of time, whereas the balance sheet is for a point in time.

1.An income statement presents the revenues and expenses and resulting net income or net loss for a specific period of time.

2.An owner’s equity statement summarizes the changes in owner’s equity for a specific period of time.

3.A balance sheet reports the assets, liabilities, and owner’s equity at a specific date.

4.A statement of cash flows summarizes information about the cash inflows (receipts) and outflows (payments) for a specific period of time.

These statements provide relevant financial data for internal and external users. Illustration 1.9 shows the financial statements of Softbyte.

t0014

ILLUSTRATION 1.9Financial statements and their interrelationships

Note that the statements shown in Illustration 1.9 are interrelated:

1.Net income of $2,750 on the income statement is added to the beginning balance of owner’s capital in the owner’s equity statement.

2.Owner’s capital of $16,450 at the end of the reporting period shown in the owner’s equity statement is reported on the balance sheet.

3.Cash of $8,050 on the balance sheet is reported on the statement of cash flows.

Also, explanatory notes and supporting schedules are an integral part of every set of financial statements. We illustrate these notes and schedules in later chapters of this textbook.

Be sure to carefully examine the format and content of each statement in Illustration 1.9. We describe the essential features of each in the following sections.

Income Statement

The income statement reports the revenues and expenses for a specific period of time (see Alternative Terminology). (In Softbyte’s case, this is “For the Month Ended September 30, 2020.”) Softbyte’s income statement is prepared from the data appearing in the owner’s equity columns of Illustration 1.8.

ALTERNATIVE TERMINOLOGY

The income statement is sometimes referred to as the statement of operations, earnings statement, or profit and loss statement.

Alternative Terminology notes introduce synonymous terms you may come across in practice.

The income statement lists revenues first, followed by expenses. Finally the statement shows net income (or net loss). Net income results when revenues exceed expenses. A net loss occurs when expenses exceed revenues.

Although practice varies, we have chosen in our illustrations and homework solutions to list expenses in order of magnitude. (We will consider alternative formats for the income statement in later chapters.)

Note that the income statement does not include investment and withdrawal transactions between the owner and the business in measuring net income. For example, as explained earlier, Ray Neal’s withdrawal of cash from Softbyte was not regarded as a business expense.

Owner’s Equity Statement

The owner’s equity statement reports the changes in owner’s equity for a specific period of time. The time period is the same as that covered by the income statement (in Softbyte’s case, this is “For the Month Ended September 30, 2020”). Data for the preparation of the owner’s equity statement come from the owner’s equity columns of the tabular summary (Illustration 1.8) and from the income statement. The first line of the statement shows the beginning owner’s equity amount (which was zero at the start of the business). Then come the owner’s investments, net income (or loss), and the owner’s drawings. This statement indicates why owner’s equity has increased or decreased during the period.

What if Softbyte had reported a net loss in its first month? Let’s assume that during the month of September 2020, Softbyte lost $10,000. Illustration 1.10 shows the presentation of a net loss in the owner’s equity statement.

Softbyte

Owner’s Equity Statement

For the Month Ended September 30, 2020

Owner’s capital, September 1                    $      -0-

Add: Investments                            15,000

15,000

Less: Drawings  $  1,300

Net loss                10,000   11,300

Owner’s capital, September 30                  $  3,700

ILLUSTRATION 1.10Presentation of net loss

If the owner makes any additional investments, the company reports them in the owner’s equity statement as investments.

Balance Sheet

Softbyte’s balance sheet reports the assets, liabilities, and owner’s equity at a specific date (in Softbyte’s case, September 30, 2020). The company prepares the balance sheet from the column headings of the tabular summary (Illustration 1.8) and the month-end data shown in its last line.

Observe that the balance sheet lists assets at the top, followed by liabilities and owner’s equity. Total assets must equal total liabilities and owner’s equity. Softbyte reports only one liability—accounts payable—in its balance sheet. In most cases, there will be more than one liability. When two or more liabilities are involved, a customary way of listing is as shown in Illustration 1.11.

Liabilities

Notes payable   $  10,000

Accounts payable            63,000

Salaries and wages payable         18,000

Total liabilities    $91,000

ILLUSTRATION 1.11Presentation of liabilities

The balance sheet is a snapshot of the company’s financial condition at a specific moment in time (usually the month-end or year-end).

Statement of Cash Flows

The primary purpose of a statement of cash flows is to provide financial information about the cash receipts and cash payments of a company for a specific period of time (see Helpful Hint). To help investors, creditors, and others in their analysis of a company’s cash position, the statement of cash flows reports the cash effects of a company’s operating, investing, and financing activities. In addition, the statement shows the net increase or decrease in cash during the period, and the amount of cash at the end of the period.

HELPFUL HINT

The statement of cash flows helps users determine if the company generates enough cash from operations to fund its investing and financing activities.

Reporting the sources, uses, and change in cash is useful because investors, creditors, and others want to know what is happening to a company’s most liquid resource. The statement of cash flows provides answers to the following simple but important questions.

1.Where did cash come from during the period?

2.What was cash used for during the period?

3.What was the change in the cash balance during the period?

As shown in Softbyte’s statement of cash flows in Illustration 1.9, cash increased $8,050 during the period. Net cash provided by operating activities increased cash $1,350 (cash receipts from revenue less cash payments for expenses). Cash flow from investing activities decreased cash $7,000 (purchase of equipment). And cash flow from financing activities increased cash $13,700 (investment by owner less drawings by owner). At this time, you need not be concerned with how these amounts are determined. Chapter 17 will examine the statement of cash flows in detail.

People, Planet, and Profit InsightBeyond Financial Statements

p0017

Should we expand our financial statements beyond the income statement, owner’s equity statement, balance sheet, and statement of cash flows? Some believe we should take into account ecological and social performance, in addition to financial results, in evaluating a company. The argument is that a company’s responsibility lies with anyone who is influenced by its actions. In other words, a company should be interested in benefiting many different parties, instead of only maximizing stockholders’ interests.

A socially responsible business does not exploit or endanger any group of individuals. It follows fair trade practices, provides safe environments for workers, and bears responsibility for environmental damage. Granted, measurement of these factors is difficult. How to report this information is also controversial. But many interesting and useful efforts are underway. Throughout this textbook, we provide additional insights into how companies are attempting to meet the challenge of measuring and reporting their contributions to society, as well as their financial results, to stockholders.

Why might a company’s stockholders be interested in its environmental and social performance?

DO IT!5Financial Statement Items

Presented below is selected information related to Flanagan Company at December 31, 2020. Flanagan reports financial information monthly.

Equipment          $10,000 Utilities Expense              $  4,000

Cash      8,000     Accounts Receivable      9,000

Service Revenue              36,000   Salaries and Wages Expense       7,000

Rent Expense    11,000   Notes Payable   16,500

Accounts Payable            2,000     Owner’s Drawings           5,000

(a)Determine the total assets of Flanagan Company at December 31, 2020.

(b)Determine the net income that Flanagan Company reported for December 2020.

(c)Determine the owner’s equity of Flanagan Company at December 31, 2020.

ACTION PLAN

• Remember the basic accounting equation: assets must equal liabilities plus owner’s equity.
• Review previous financial statements to determine how total assets, net income, and owner’s equity are computed.