Financial statements

( 1) Financial statements provide information to help managers, creditors and owners of all types of organizations make decisions. The three major financial statements are the balance sheet, the income statement, and the cash flow statement. Below are the definitions of each.

(2) Balance sheets show the status of a company at a single point in time. In contrast, statements of cash flows and income statements show the performance of a company over a period of time. Both explain why the balance sheet items have changed. As the diagram below shows, these statements thus link the balance sheets in consecutive periods:

►Question/Answer session:

1. Define each of the three financial statements.

2. Explain the difference between balance sheet and two other financial statements.

‘THEORY-3’ POINT

Balance sheet

(1) The balance sheet shows the financial status of a company at a particular point in time. It has two counterbalancing sections. The left side lists the resources of the firm or everything the firm owns and controls. The right side lists the claims against the resources. The resources and claims form the balance sheet equation:

(2) Companies usually produce balance sheets when needed by managers and at the end of each quarter for reporting to the public.

►Question/Answer session:

Explain how the balance sheet equation works and define its both sections.

►Below is an example of the balance sheet with the explanation of some of its accounts:

Balance sheet					December 17, 20_ _
Assets
Current assets:
	Cash and cash equivalents
	Accounts receivable						Xxx
	Inventories						Xxx
	Prepaid rent						Xxx
		Total current assets					Xxx
Noncurrent assets:
	Property, plant and equipment						Xxx
	Accumulated depreciation						Xxx
	Goodwill						Xxx
	Trademarks and other intangibles						Xxx
		Total noncurrent assets					Xxx
Total assets							2,729,744
Liabilities and shareholders' equity
Current liabilities:
	Accounts payable						Xxx
	Accrued expenses payable						Xxx
	Income tax payable						Xxx
		Total current liabilities					Xxx
Noncurrent liabilities:
	Long-term debt						Xxx
	Deferred tax liability						Xxx
	Other noncurrent liabilities						Xxx
		Total noncurrent liabilities					Xxx
Shareholders' equity:
	Paid-in capital						Xxx
	Retained earnings						Xxx
		Total shareholders' equity					Xxx
Total liabilities and shareholders’ equity							2,729,744

1. Current assets are cash and other assets that a company expects to convert to cash or sell or consume within the coming year or within the normal operating cycle if no longer than 1 year.

2. Noncurrent assets are assets that a company expects to convert to cash or sell or consume within the period, which is more than 1 year.

3. Current liabilities are liabilities that fall due within the coming year or within the normal operating cycle if longer than 1 year.

4. Noncurrent liabilities are liabilities that fall due within the period, which is more than 1 year.

5. Cash equivalents are highly liquid short-term investments that a company can easily and quickly convert into cash, such as money market funds and Treasury bills.

6. Accounts receivable (trade receivables, receivables) are an amount owed to a company by customers as a result of delivering goods or services and extending credit in the ordinary course of business.

7. Accounts payable are a liability that results from a purchase of goods or services on open account.

8. Inventories are goods held by a company for the purpose of sale to customers.

9. Depreciation is the systematic allocation of the acquisition cost of long-lived¹ or fixed assets to the expense accounts of particular periods that benefit from the use of the assets.

10. Goodwill is the excess of the cost of an acquired company over the sum of the fair market value of its identifiable individual assets less the liabilities.

11. Trademark is a distinctive identification of a manufactured product or of a service taking the form of a name, a sign, a slogan, a logo, or an emblem.

12. Tangible assets (fixed assets, plant assets) are physical items that can be seen and touched, such as land, natural resources, buildings, and equipment.

13. Intangible assets are contractual or legal rights or economic benefits, such as franchises, patents, trademarks, copyrights, and goodwill, that are not physical in nature.

14. Shareholders’ equity (stockholders’ equity, owners’ equity (in case of partnership)) is the total assets of a company minus its liabilities.

15. Paid-in capital is the total capital investment in a corporation by its owners both at and subsequent to the inception of business.

16. Retained earnings (retained income) are total cumulative owners’ equity generated by income or profits.

(3) To illustrate the balance sheet, let’s suppose that Eugene opens his own book store, Book Corner, on January 2, 200... He invests from his personal savings $30,000. Then Eugene borrows $50,000 from a local bank. Now he has $80,000 in cash. The opening balance sheet of this new business is as follows:

Book Corner
Balance sheet
January 2, 20_ _
Assets			Liabilities and Qwners' Equity
Cash	$80,000		Liabilities (note payable)	$50,000
			Eugene, capital	$30,000
Total assets	$80,000		Total liabilities and owners' equity	$80,000

(4) The balance sheet lists the company’s assets on the left. They are balanced on the right by an equal amount of liability and owners’ equity. Note that we always keep the left and right sides in balance.

(5) When someone starts a business, the owners’ equity is equal to the total amount invested by the owner or owners. As illustrated by ‘Eugene, capital’ in the Book Corner example, accountants often use the term ‘capital’ instead of ‘owners’ equity’ to designate an owner’s investment in the business.

Balance sheet transactions

(1) A transaction is any event that affects the financial position of an entity and that an accountant can reliably record in money terms. When accountants record a transaction, they make at least two entries so the total assets always equal the total liabilities plus owners’ equity. We must maintain the equality of the balance sheet equation for every transaction. This is a double-entry accounting system.

(2) Let’s make some transactions of Book Corner to see how typical transactions affect the balance sheet.

Transaction 1, Initial investment.

The first transaction was the investment by the owner on January 2, 20_ _. Eugene deposited $30,000 in a business bank account entitled Book Corner. The transaction affects the balance sheet equation as follows:

Assets		=	Liabilities	+	Owners' Equity
	Cash				Eugene, Capital
(1)	30,000	=			30,000
					(Owner's investment)

This transaction increases both the assets and the owners’ equity but does not affect liabilities.