Introduction to Accounting and Business (Part G)
by
Charles Lamson
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Financial Statements
After transactions have been recorded and summarized (as in part 7), reports are prepared for users. The accounting reports that provide this information are called financial statements. The principal financial statements of a proprietorship are the income statement, the statement of owner's equity, the balance sheet, and the statement of cash flows. The order in which the statements are normally prepared and the nature of the data presented in each statement are as follows:
The basic features of the four statements and their interrelationships are illustrated in Exhibits 1-4 in this post, and the data for the statements were taken from the summary of transactions of NetSolutions from part 7. All financial statements should be identified by the name of the business, the title of the statement, and the date or period of time. The date presented in the income statement, the statement of owner's equity, and the statement of cash flows are for a period of time. The data presented in the balance sheet are for a specific date.  You should note the use of indents, captions, dollar signs, and rulings in the financial statements. They aid the reader by emphasizing the sections of the statement. Income Statement The income statement reports the revenues and expenses for a period of time, based on the matching concept. This concept is applied by matching the expenses with the revenue generated during a period by those expenses. The income statement also reports the excess of the revenue over the expenses incurred. This excess of the revenue over the expenses is called net income or net profit. If the expenses exceed the revenue, the excess is a net loss. The effects of revenue earned and expenses incurred during the month for NetSolutions were shown in the equation as increases and decreases in owner's equity (capital). Net income for a period has the effect of increasing owner's equity (capital) for the period, whereas a net loss has the effect of decreasing owner's equity (capital) for the period. The revenue, expenses, and the net income of $3,050 for NetSolutions are reported in the income statement in Exhibit 1. The order in which the expenses are listed in the income statement varies among businesses. One method is to list them in order of size, beginning with the larger items. Miscellaneous expense is usually shown as the last item, regardless of the amount.
EXHIBIT 1   Statement of Owner's Equity The statement of owner's equity reports the changes in the owner's equity for a period of time. It is prepared after the income statement because the net income or net loss for the period must be reported in this statement. Similarly, it is prepared before the balance sheet, since the amount of owner's equity at the end of the period must be reported on the balance sheet. Because of this, the statement of owner's equity is often viewed as the connecting link between the income statement and balance sheet. Three types of transactions affected owner's equity for NetSolutions during November: (1) the original investment of $25,000, (2) the revenue and expenses that resulted in net income of $3,050 for the month, and (3) a withdrawal of $2,000 by the owner. This information is summarized in the statement of owner's equity in Exhibit 2. EXHIBIT 2  Balance Sheet The balance sheet in Exhibit 3 reports the amounts of NetSolutions assets, liabilities, and owner's equity at the end of November. These amounts are taken from the last line of the summary of transactions presented earlier. The form of balance sheet shown in Exhibit 3 is called the account form because it resembles the basic format of the accounting equation, with assets on the left side and the liabilities and owner's equity sections on the right side. In a later post, an alternative form of balance sheet called the report form is illustrated. It presents the liabilities and owner's equity sections below the assets section. EXHIBIT 3  The assets section of the balance sheet normally presents assets in the order that they will be converted into cash or used in operations. Cash is presented first, followed by receivables, supplies, prepaid insurance, and other assets. The assets of a more permanent nature are shown next, such as land, buildings, and equipment.  In the liabilities section of the balance sheet in Exhibit 3, accounts payable is the only liability. When there are two or more categories of liabilities, each should be listed and the total amount of liabilities presented as follows.  Statement of Cash Flows The statement of cash flows consists of three sections, as we see in Exhibit 4: (1) operating activities, (2) investing activities, and (3) financing activities. Each of these sections is briefly described below. EXHIBIT 4  Cash Flows from Operating Activities This section reports a summary of cash receipts and cash payments from operations. The net cash flow from operating activities ($2,900 in Exhibit 4) will normally differ from the amount of net income for the period ($3,050 in Exhibit 1). This difference occurs because revenues and expenses may not be recorded at the same time that cash is received from customers or paid to creditors. Cash Flows from Investing Activities This section reports the cash transactions for the acquisition and sale of relatively permanent assets. Cash Flows from Financing Activities This section reports the cash transactions related to cash investments by the owner, borrowings, and cash withdrawals by the owner. Preparing the statement of cash flows requires an understanding of concepts that we have not discussed yet in this analysis. Therefore, we will illustrate the preparation of the statement of cash flows in a later post.  Financial Analysis and Interpretation As we discussed in an earlier post, financial statements are useful to bankers, creditors, owners, and other stakeholders in analyzing and interpreting the financial performance and condition of a business. Throughout this analysis, we will discuss various tools that are often used in practice to analyze and interpret the financial performance and condition of a business. The first such tool we will introduce is especially useful in analyzing the ability of a business to pay its creditors. The relationship between liabilities and owner's equity, expressed as a ratio, is calculated as follows:  To illustrate, NetSolutions ratio of liabilities to owner's equity at the end of November is 0.015, as calculated below. Ratio of liabilities to owner's equity = $400/$26,050 = 0.0150 Corporations normally refer to total owner's equity as total stockholders' equity. Thus you should substitute total stockholders' equity for total owner's equity when computing this ratio for a corporation. The rights of creditors to a business's assets take precedence over the rights of the owners or stockholders. Thus, the lower the ratio of liabilities to owner's equity, the better able the business is to withstand poor business conditions and still fully meet its obligations to creditors.
To illustrate, a ratio of 1 indicates that the liabilities and owner's equity are equal. In other words, if the business suffers a loss equal to the total liabilities, the amount of total assets available to creditors will not drop below their claims on the assets. If this were to happen, the creditors could collect their claims and the owner would be left with nothing. *WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 19-22* end |
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