Introduction to Financial Statments

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Chapter 2 INTRODUCTION TO FINANCIAL STATEMENTS
Principles of Accounting, Volume 1: Financial Accounting

Chapter Outline
• 2.1 Describe the Income Statement, Statement of Owner’s Equity,
Balance Sheet, and Statement of Cash Flows, and How They
Interrelate
• 2.2 Define, Explain, and Provide Examples of Current and Noncurrent
Assets, Current and Noncurrent Liabilities, Equity, Revenues, and
Expenses
• 2.3 Prepare an Income Statement, Statement of Owner’s Equity, and
Balance Sheet

Module 2.1 Describe the Income Statement, Statement of Owner’s
Equity, Balance Sheet, and Statement of Cash
In business—and accounting in particular—it is necessary to distinguish the business entity
from the individual owner(s). Accountants should only record business transactions in
business records. This separation is also reflected in the legal structure of the business.
Types of Business Structures
Table 2.1
Sole Proprietorship Partnership Corporation
Number of Owners Single individual Two or more individuals One of more owners
Ease of Formation Easier to form Harder to form Difficult to form
Ability to Raise Capital Difficult to raise capital Harder to raise capital Easier to raise capital
Liability Risk Unlimited liability Unlimited liability Limited liability
Taxation Consideration Single taxation Single taxation Double taxation

All businesses, regardless of legal structure, generate financial statements:
• Income Statement
• Statement of Owner’s Equity
• Balance Sheet
• Statement of Cash Flows
Purpose of financial statements:
• Stakeholders, such as investors, creditors, regulators, and employees are
interested in the performance of an organization for various reasons, but
the common goal of using the financial statements is to understand the
information each contains that is useful for making financial decisions.
Financial Statements

Figure 2.5
Baking requires an understanding of the different ingredients, how the ingredients are used, and how the ingredients will
impact the final product (a). If used correctly, the final product will be beautiful and, more importantly, delicious, like the cake
shown in (b). In a similar manner, the study of accounting requires an understanding of how the accounting elements relate
to the final product—the financial statements. (credit (a): modification of “U.S. Navy Culinary Specialist Seaman Robert
Fritschie mixes cake batter aboard the amphibious command ship USS Blue Ridge (LCC 19) Aug. 7, 2013, while underway in
the Solomon Sea 130807-N-NN332-044” by MC3 Jarred Harral/Wikimedia Commons, Public Domain; credit (b): modification
of “Easter Cake with Colorful Topping” by Kaboompics .com/Pexels, CC0)

The income statement shows the organization’s financial performance for a given
period of time.
Revenue: the value of goods
and services the organization
sold or provided to customers
Expenses: a cost associated
with providing goods or
services to customers
Net Income (Net Loss):
determined by comparing
revenues and expenses
Income Statement
Modified for PPT.

EA9. Prepare an income statement using the following information for
DL Enterprises for the month of July 2018.
Sample Exercise

Net income can be expressed in general form as:
Net Income

PA1. The following information is taken from the records of Baklava Bakery for the year
2019.
A. Calculate net income or net loss for January.
B. Calculate net income or net loss for February.
C. Calculate net income or net loss for March.
D. For each situation, comment on how a stakeholder might view the firm’s performance.
(Hint: Think about the source of the income or loss.)
Sample Problem

Your Turn: Coffee Shop Products
Think about the coffee shop in your area. Identify items the coffee shop
sells that would be classified as revenues. Remember, revenues for the
coffee shop are related to its primary purpose: selling coffee and
related items. Or, better yet, make a trip to the local coffee shop and
get a first-hand experience.

Your Turn: Coffee Shop Expenses
While thinking about or visiting the coffee shop in your area, look
around (or visualize) and identify items or activities that are the
expenses of the coffee shop. Remember, expenses for the coffee shop
are related to resources consumed while generating revenue from
selling coffee and related items. Do not forget about any expenses that
might not be so obvious—as a general rule, every activity in a business
has an associated cost.

Revenues and expenses occur from the doing what the business is in business to do. For example, Chris is
in the landscaping business, so revenues would be from performing landscape services and expenses
would be the costs associated with generating those revenues.
Chris’s business, as well as any other business, is likely to periodically have gains and losses in addition to
revenues and expenses. Here is how gains and losses affect the income statement:
Gains result from selling
ancillary business items for
more than the items are
worth, such as buildings, land,
or equipment that help
support the business’s
operations.
Losses result from selling
ancillary business items for
less than the items are worth.
It is obvious that gains have the same effect on Net Income as
revenues; they increase net income. Losses have the same
effect as expenses; they decrease net income.
Gains and Losses
Modified for PPT.

Introduction to Financial Statments

EA1. For each independent situation below, calculate the missing
values.
Sample Exercise

The statement of owner’s equity, the second financial statement created by
accountants, shows how the equity (or value) of the organization has
changed over time. Similar to the income statement, the statement of
owner’s equity is for a specific period of time. Equity is the value of an item
that remains after considering what is owed for that item.
Beginning Balance is $0 because
this is the first month of business.
Net Income is added to the
beginning balance; the first part
of how the financial statements
interrelate.
Statement of Owner’s Equity
Modified for PPT.

Investments by owners: represent an exchange of cash or other assets
for which the investor is given an ownership interest in the
organization.
Distributions to owners: periodic rewards issued to the owners in the
form of cash or other assets. Distributions to owners represent some of
the value (equity) of the organization.
Possible Changes to Owner’s Equity Other than Net Income

Assets: resources used to generate revenue
Liabilities: amounts owed to others (called creditors)
Equity: refers to book value or net worth, this amount
is the ending balance of the Statement of Owner’s
Equity
Figure 2.2
“Balance Sheet for Chris’ Landscaping.” Modified for PPT. (attribution: Copyright, Rice University, OpenStax, under CC BY-NC-SA 4.0
license)
Balance sheet: a statement that lists what the organization owns (assets), what it
owes (liabilities), and what it is worth (equity) on a specific date.

The income statement, statement of owner’s equity, and the balance sheet are
interrelated. Each statement provides unique information, but the statements are
connected.
Modified for PPT.

Statement of cash flows is a statement that lists the cash inflows and
cash outflows for the business for a period of time.
There are two “bases” of accounting. A basis indicates when revenues
and expenses will be recorded.
1. Cash basis accounting: transactions (i.e., a sale or a purchase) are
not recorded in the financial statements until there is an exchange of
cash. This type of accounting is permitted for nonprofit entities and
small businesses that elect to use this type of accounting.
2. Accrual basis accounting: transactions are generally recorded in the
financial statement when the transactions occur, and not when paid;
although in some situations, the two events could happen on the
same day.
Statement of Cash Flows

Transactions by Cash Basis versus Accrual Basis of Accounting
Table 2.2 Businesses often sell items for cash as well as on account, where payment terms are extended for a period of time (for
example, thirty to forty-five days). Likewise, businesses often purchase items from suppliers (also called vendors) for cash or, more
likely, on account. Under the cash basis of accounting, these transactions would not be recorded until the cash is exchanged. In
contrast, under accrual accounting the transactions are recorded when the transaction occurs, regardless of when the cash is
received or paid.
Transaction Under Cash Basis Accounting Under Accrual Basis Accounting
$200 sale for cash Recorded in financial
statements at time of sale
Recorded in financial
$200 sale on account Not recorded in financial
statements until cash is
received
$160 purchase for cash Recorded in financial
statements at time of purchase
$160 purchase on account Not recorded in financial
statements until cash is paid

Sample Exercise
EA7. Forest Company had the following transactions during the month
of December. What is the December 31 cash balance?

Current versus noncurrent distinction
• An asset that will be used or consumed in one year or less will be
classified as a current asset. If the asset will be used or consumed
over more than one year, it is classified as a noncurrent asset.
• A liability that will be settled in one year or less (generally) is classified
as a current liability, while a liability that is expected to be settled in
more than one year is classified as a noncurrent liability.
Module 2.2 Define, Explain, and Provide Examples of Current and
Noncurrent Assets, Current and Noncurrent

Current Assets Noncurrent Assets
Cash Buildings, Land, Equipment
Accounts Receivable Notes Receivable
Inventory Patents
Current Liabilities Noncurrent Liabilities
Accounts Payable Notes Payable
Notes Payable
Current versus Noncurrent Examples

Stakeholders use financial information to make decisions. Providing the
amounts of the assets and liabilities answers the “what” question for
stakeholders (that is, it tells stakeholders the value of assets), but it
does not answer the “when” question for stakeholders.
For example, knowing that an organization has $1,000,000 worth of
assets is valuable information, but knowing that $250,000 of those
assets are current and will be used or consumed within one year is
more valuable to stakeholders. Likewise, it is helpful to know the
company owes $750,000 worth of liabilities, but knowing that
$125,000 of those liabilities will be paid within one year is even more
valuable. In short, the timing of events is of particular interest to
stakeholders.
Why Current versus Noncurrent Distinction Matters

Think It Through: Borrowing
When money is borrowed by an individual or family from a bank or
other lending institution, the loan is considered a personal or consumer
loan. Typically, payments on these types of loans begin shortly after the
funds are borrowed. Student loans are a special type of consumer
borrowing that has a different structure for repayment of the debt. If
you are not familiar with the special repayment arrangement for
student loans, do a brief internet search to find out when student loan
payments are expected to begin.
Now, assume a college student has two loans—one for a car and one
for a student loan. Assume the person gets the flu, misses a week of
work at his campus job, and does not get paid for the absence. Which
loan would the person be most concerned about paying? Why?

Business Legal
Structure
Term for Owner’s
Investment
Term for Owner’s
Distributions
Terminology for
Equity
Sole proprietorship Capital Withdrawal Owner’s capital
Partnership Capital Withdrawal Partner’s capital
Corporation Common stock Dividend Retained earnings
Equity and Legal Structure

To help understand the balance sheet equation concept, assume a
family purchased a home valued at $200,000 and made a down
payment of $25,000 while financing the remaining balance with a
$175,000 bank loan. The accounting equation would be:
Balance Sheet Equation
$200,000 = $175,000 + $25,000

Your Turn: The Accounting Equation
On a sheet of paper, use three columns to create your own accounting
equation. In the first column, list all of the things you own (assets). In the
second column, list any amounts owed (liabilities). In the third column, using
the accounting equation, calculate, you guessed it, the net amount of the
asset (equity). When finished, total the columns to determine your net
worth. Hint: do not forget to subtract the liability from the value of the asset.
Here is something else to consider: is it possible to have negative equity? It
sure is . . . ask any college student who has taken out loans. At first glance
there is no asset directly associated with the amount of the loan. But is that,
in fact, the case? You might ask yourself why make an investment in a college
education—what is the benefit (asset) to going to college? The answer lies in
the difference in lifetime earnings with a college degree versus without a
college degree. This is influenced by many things, including the supply and
demand of jobs and employees. It is also influenced by the earnings for the
type of college degree pursued. (Where do you think accounting ranks?)

Figure 2.4
Graphical Representation of the Accounting Equation. Both assets and liabilities are categorized as current and noncurrent.
Also highlighted are the various activities that affect the equity (or net worth) of the business. (attribution: Copyright Rice
University, OpenStax, under CC BY-NC-SA 4.0 license)
Notice that assets have the + sign (increases) on the right side of the
columns, while liabilities and owner’s equity have the + sign (increases) on
the left side of the columns.

Transactions that Affect the Value (Equity) of the
Organization
Transactions that DO NOT Affect the Value (Equity) of
the Organization
Revenues (increase equity) Exchanges of assets for assets
Expenses (decrease equity) Exchanges of liabilities for liabilities
Gains (increase equity) Acquisitions of assets by incurring liabilities
Losses (decrease equity) Settlements of liabilities by transferring assets
Investments by owners (increase equity)
Distributions to owners (decrease equity)
Changes in assets and liabilities can either increase or
decrease the value (equity) of the organization
depending on the net result of the transaction.

Elements of the financial statements: Those categories or accounts that accountants use to record transactions and
prepare financial statements.
• Revenue: value of goods and services the organization sold or provided
• Expenses: costs of providing the goods or services for which the organization earns revenue
• Gains: similar to revenue, but relate to “incidental or peripheral” activities of the organization
• Losses: similar to expenses, but related to “incidental or peripheral” activities of the organization
• Assets: items the organization owns, controls, or has a claim to
• Liabilities: amounts the organization owes to others (also called creditors)
• Equity: net worth (or net assets) of the organization
• Investment by owners: cash or other assets provided to the organization in exchange for an ownership interest
• Distribution to owners: cash, other assets, or ownership interest (equity) provided to owners
• Comprehensive income: defined as the “change in equity of a business enterprise during a period from
transactions and other events and circumstances from nonowner sources” (SFAC No. 6, p. 21). While further
discussion of comprehensive income is reserved for intermediate and advanced studies in accounting, it is worth
noting that comprehensive income has four components, focusing on activities related to foreign currency,
derivatives, investments, and pensions.
Module 2.3 Prepare an Income Statement, Statement of Owner’s
Equity, and Balance Sheet

Figure 2.6
Trial Balance for Cheesy Chuck’s Classic Corn. Accountants record and summarize accounting information into accounts,
which help to track, summarize, and prepare accounting information. This table is a variation of what accountants call a “trial
balance.” A trial balance is a summary of accounts and aids accountants in creating financial statements. Modified for PPT.
(attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)
A trial balance is a listing of all accounts
and their balances.
Income Statement Accounts
Balance Sheet Accounts
Owner’s Equity Accounts

Figure 2.7
Income Statement for Cheesy Chuck’s Classic Corn. The income statement for Cheesy Chuck’s shows the business had Net
Income of $5,800 for the month ended June 30. This amount will be used to prepare the next financial statement, the
statement of owner’s equity. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

Figure 2.8
Statement of Owner’s Equity for Cheesy Chuck’s Classic Corn. The statement of owner’s equity demonstrates how the net
worth (also called equity) of the business changed over the period of time (the month of June in this case). Notice the
amount of net income (or net loss) is brought from the income statement. In a similar manner, the ending equity balance
(Capital for Cheesy Chuck’s because it is a sole proprietorship) is carried forward to the balance sheet. (attribution: Copyright
Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

Figure 2.9
Balance Sheet for Cheesy Chuck’s Classic Corn. The balance sheet shows what the business owns (Assets), owes (Liabilities),
and is worth (equity) on a given date. Notice the amount of Owner’s Equity (Capital for Cheesy Chuck’s) was brought forward
from the statement of owner’s equity. Modified for PPT. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA
4.0 license)
Obtained from
Statement of
Owner’s Equity

In addition to reviewing the financial statements in order to make decisions, owners and other
stakeholders also utilize financial ratios to assess the financial health of the organization. There
are various ratio categories and different ratios within each of those categories. One category of
ratios is liquidity ratios.
• Liquidity refers to the business’s ability to convert assets into cash in order to meet short-term
cash needs. Examples of the most liquid assets include accounts receivable and inventory.
These assets can be turned into cash more quickly than land or buildings, for example.
• Working capital is current assets minus current liabilities; it is not a ratio, but it is used to
assess the dollar amount of assets a business has available to meet its short-term liabilities.
• The current ratio is closely related to working capital; it represents the current assets divided
by current liabilities. The current ratio utilizes the same amounts as working capital (current
assets and current liabilities) but presents the amount in ratio, rather than dollar, form.
Current Ratio = Current Assets ÷ Current Liabilities
Financial Ratios

Summary
• Financial statements provide financial information to stakeholders to help them in
making decisions.
• There are four financial statements: income statement, statement of owner’s equity,
balance sheet, and statement of cash flows.
• The income statement measures the financial performance of the organization for a
period of time. The income statement lists revenues, expenses, gains, and losses, which
make up net income (or net loss).
• The statement of owner’s equity shows how the net worth of the organization changes
for a period of time. In addition to showing net income or net loss, the statement of
owner’s equity shows the investments by and distributions to owners.
• The balance sheet shows the organization’s financial position on a given date. The
balance sheet lists assets, liabilities, and owners’ equity.
• The statement of cash flows shows the organization’s cash inflows and cash outflows for
a given period of time. The statement of cash flows is necessary because financial
statements are usually prepared using accrual accounting, which records transactions
when they occur rather than waiting until cash is exchanged.

Summary (continued)
• Three broad categories of legal business structures are sole proprietorship, partnership,
and corporation, with each structure having advantages and disadvantages.
• The accounting equation is Assets = Liabilities + Owner’s Equity. It is important to the
study of accounting because it shows what the organization owns and the sources of (or
claims against) those resources.
• Owners’ equity can also be thought of as the net worth or value of the business. There
are many factors that influence equity, including net income or net loss, investments by
and distributions to owners, revenues, gains, losses, expenses, and comprehensive
income.
• There are ten financial statement elements: revenues, expenses, gains, losses, assets,
liabilities, equity, investments by owners, distributions to owners, and comprehensive
income.
• There are standard conventions for the order of preparing financial statements (income
statement, statement of owner’s equity, balance sheet, and statement of cash flows) and
for the format (three-line heading and columnar structure).
• Financial ratios, which are calculated using financial statement information, are often
beneficial to aid in financial decision-making. Ratios allow for comparisons between
businesses and determining trends between periods within the same business.

Introduction to Financial Statments

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