Basic Financial Statements
A D V E R T I S E M E N T
Chapter 2 introduces you to the basic financial
statements used to communicate a company's financial information to outsiders -
parties other than the company's directors and managers, who are the
What is a
What does it tell us?
Why should we care?
T hese are good
questions and they deserve an answer.
A business is a
financial entity separate from its owners. Each business must keep financial
records. A number of federal and state laws require this. But even if there were
no laws, it would still be a good idea anyway.
Businesses provide vital goods and services to those living in the community.
They provide jobs for people, and tax dollars that improve our roads, parks and
schools. It is in everyone's best interest that our community's businesses be
B usiness owners
take a risk. What if no one wants to buy their goods or services? The owner has
spent time and money to start a business, purchased land, buildings and
equipment, hired people to work in the business.... all this done with the hope
that the business will be successful. And if the business is NOT a success, the
owner may have lost his or her life's savings, workers must find jobs, and
creditors may go unpaid.
information may not make a business successful, but it helps the owner make
sound business decisions. It can also help a bank or creditor evaluate the
company for a loan or charge account. And the IRS will be interested in
collecting the appropriate amount of income tax. So financial information will
serve many purposes.
information comes in many forms, but the most important are the Financial
Statements. They summarize relevant financial information in a format that is
making important business decisions. If this were not possible, the whole
process would be a waste of time. Too much information may be equally useless.
Financial statements summarize a large number of Transactions into a small
number of significant categories. To be useful, information must be organized.
statements have generally agreed-upon formats and follow the same rules of
disclosure. This puts everyone on the same level playing field, and makes it
possible to compare different companies with each other, or to evaluate
different year's performance within the same company. There are three main
- Income Statement
- Balance Sheet
- Statement of Cash Flows
Each financial statement tells it's own
story. Together they form a
comprehensive financial picture of the company, the results of its operations,
its financial condition, and the sources and uses of its money. Evaluating past
performance helps managers identify successful strategies, eliminate wasteful
spending and budget appropriately for the future. Armed with this information
they will be able to make necessary business decisions in a timely manner.
The accounting process in a nutshell:
1) Capture and Record a business transaction,
2) Classify the transaction into appropriate Accounts,
3) Post transactions to their individual Ledger Accounts,
4) Summarize and Report the balances of Ledger Accounts in
There are 5 types of Accounts.
3) Owners' Equity (Stockholders' Equity for a corporation)
All the accounts in an accounting system are listed in a
Chart of Accounts. They are listed in the order shown above. This helps us
prepare financial statements, by conveniently organizing accounts in the same
order they will be used in the financial statements.
The Balance Sheet lists the balances in all Asset,
Liability and Owners' Equity accounts.
The Income Statement lists the balances in all Revenue
and Expense accounts.
The Balance Sheet and Income Statement must accompany each
other in order to comply with GAAP. Financial statements presented separately do
not comply with GAAP. This is necessary so financial statement users get a true
and complete financial picture of the company.
All accounts are used in one or the other statement, but not
both. All accounts are used once, and only once, in the financial statements.
The Balance Sheet shows account balances at a particular date. The Income
Statement shows the accumulation in the Revenue and Expense accounts, for a
given period of time, generally one year. The Income Statement can be prepared
for any span of time, and companies often prepare them monthly or quarterly.
It is common for companies to prepare a Statement of Retained
Earnings or a Statement of Owners' Equity, but one of these statement is not
required by GAAP. These statements provide a link between the Income Statement
and the Balance Sheet. They also reconcile the Owners' Equity or Retained
Earnings account from the start to the end of the year.
The Statement of Cash Flows is the third financial
statement required by GAAP, for full disclosure. The Cash Flow statement shows
the inflows and outflows of Cash over a period of time, usually one year. The
time period will coincide with the Income Statement. In fact, account balances
are not used in the Cash Flow statement. The accounts are analyzed to determine
the Sources (inflows) and Uses (outflows) of cash over a period of time.
There are 3 types of cash flow (CF):
1) Operating - CF generated by normal business operations
2) Investing - CF from buying/selling assets: buildings, real
estate, investment portfolios, equipment.
3) Financing - CF from investors or long-term creditors
The SEC (Securities and Exchange Commission) requires
companies to follow GAAP in their financial statements. That doesn't mean
companies do what they are supposed to do. Enron executives had millions of
reasons ($$) to falsify financial information for their own personal gain.
Auditors are independent CPAs hired by companies to determine whether the rules
of GAAP and full disclosure are being followed in their financial statements. In
the case of Enron and Arthur Andersen, auditors sometimes fail to find problems
that exist, and in some cases might have also failed in their responsibilities
as accounting professionals.
The Accounting Equation
You may have heard someone say "the books are in balance" when
referring to a company's accounting records. This refers to the use of the
double-entry system of accounting, which uses equal entries in two or more
accounts to record each business transaction. Because the dollar amounts are
equal we say the transaction is "in balance." You can think of it like an old
two pan balance scale, which measures things in dollars, instead of pounds.
Double-entry accounting follows one simple rule, called the
accounting equation. It is a simple algebraic equation, expressed as an
equality. E = MC2 OOPS! That's not it.
The Accounting Equation really is:
another way to think about it
everything we own = who provided the financing
Remember in Chapter 1, I told you that each transaction
describes both an object and form of financing. In the accounting
equation, Assets are the objects, and are on the Left side of the equation.
Financing activities are on the Right side of the equation. Liabilities
represent borrowings and credit arrangements. Owners' Equity represents
investments by owners, residual net worth and retained earnings from ongoing
The accounting equation uses "simple math" and involves only
addition and subtraction. In fact, almost all the math you will do in this
course is simple math. We will occasionally use multiplication and division, but
all changes to accounts will be addition or subtraction.
Think for a moment about a new company. It's accounting
system consists of a new, "fresh" set of books, no entries have ever been made,
all accounts have a zero balance.
The books are in balance!!
If each, and every, transaction is a entered as a "balanced"
entry, the books will stay in balance.
There are three general types of transactions and entries.
1) Routine, daily operating events - represents over 99% of all
2) Occasional events involving major assets, liabilities and
owners' equity transactions.
3) Adjusting and Closing entries - made to prepare statements
and close the books at the end of the year.
Here are some examples of common type 2 transactions.
Before and after each one, the books must be in balance. In Chapter 3 we will
see how these are actually entered into the books, in the form of journal
Owner deposits $100 in the company checking account.
Cash is an Asset, on the Left side. Owners'
Equity is on the Right side.
The amounts are equal
A $1000 computer is purchased on credit.
Computer is an Asset, on the Left side.
A Charge account is a Liability and is on the Right side.
The owner transfers a parcel of land to the company, and signs a
contract for a building to be constructed. The land is worth $10,000 and the
building will cost $90,000. The building will be paid for with a bank loan.
Land and Building are Assets, on the Left side. Bank
loan is a Liability and is on the Right side. This is a compound entry, and
involves more than two accounts.
Balance Sheet accounts can increase or decrease, so you will be
adding to or subtracting from their balance after each transaction.
The accounting equation can be expressed in 3 ways:
It is common to abbreviate the accounting equation as A=L+OE.
Using the numbers from the balance sheet above we get the following equations:
- Assets = Liabilities + Owners' Equity
- Liabilities = Assets - Owners' Equity
- Owners' Equity = Assets - Liabilities
If you know any two of the amounts you can calculate the third.
- 33,000 = 14,000 + 19,000 [A=L+OE]
- 14,000 = 33,000 - 19,000 [L=A-OE]
- 19,00 = 33,000 - 14,000 [OE=A-L]
Quick Quiz Try solving these equations for practice.
Click for answers
Try making up several examples on your own for practice.
We can see the Accounting Equation reflected in the layout of
the Balance Sheet, as shown below. Notice that Total Assets equals the sum of
Total Liabilities and Total Owners' Equity, shown in bold below.
December 31, 2002
|Liabilities & Owners' Equity
|Common Stock, $1 par
|Total Owners' Equity
|Total Liabilities & Owners'
Accounts and the Chart of Accounts
An Account is a record used to summarize increases and
decreases in a particular asset or liability, revenue or expense, or in owner's
equity. Accounts usually have very simple and generic titles such as Cash,
Accounts Payable, Sales, and Inventory. These are simple and descriptive terms
under which many different transactions can be recorded.
Accounts are organized in a Chart of Accounts . This
is a simple list of account titles presented in the following order: Assets,
Liabilities, Owners' Equity, Revenue, Expenses. Organizing accounts in the
correct order makes it much easier to prepare financial statements and enter
When doing homework problems students should read carefully
and look for a Chart of Accounts, or for references to specific accounts, that
should be used in that problem. If you don't find these, you should review the
examples in the textbook chapter material for the correct accounts to use.
Here is a sample Chart of Accounts, showing accounts in the
correct order. Account group dividers are usually omitted in actual practice.
They are shown here for illustrative purposes, so the student can see how the
Chart of Accounts is organized, and how it relates to the financial statements.
ABC Company, Inc.
Chart of Accounts
|Balance Sheet Accounts
---- Asset Accounts ----
Vehicles & Equipment
---- Liability Accounts ----
Notes Payable - Current
Notes Payable - Long Term
---- Stockholders' Equity
|Income Statement Accounts
---- Revenue Accounts ----
Sales Returns & Allowances
---- Expense Accounts ----
Payroll Tax Expense
Income Tax Expense