Chapter 2

06.09.2009

Chapter 2 Basic Financial Statements

A primary source of financial information is a company's financial statements. These statements provide tremendous insight into the the current financial status of the company and how the company has been suceessful in meeting its financial goals.

In this chapter we will be introducing three kinds of financial statements:

The statement of financial position (Balance Sheet)
The income statement
The cash flow statement

what is a statement?

A statement is simply a declaration of what is believed to be true about an entreprise

The statement of financial position or the balance sheet demonstrates where the company stand, in financial terms at a specific point in time. It is like a snapshot of the entreprise.

Name of the company

Balance Sheet

DD/MM/YYYY

Assets: Liabilities:

Cash Account Payable

Account Receivabale Note Payable

Note Receivable Salaries Payable

Supplies

Office equipment Owners' Equity:

Land Capital Stock

Building Retained Earnings

Total Total

we will base our study on the balance sheet above.

Its components: from the balance sheet above we can clearly notice that a statement of financial position is composed of three main parts:

- The Assets: the assets are economic ressources that are owned by a business and are expected to benefit future cash flows. Assets can either have a physical composition ( cash, land, building...) or a non physical one ( accoount receivable, prepaid rent,...).
  
  The problem with some assets is the determination of their dollar amount. (building, land, used cars,...) to asses accountants and CPAs in solving this problems some professional organization « FASB... » elaborated some principles such as:
  - The cost principle: states that assets like building cars land etc should be recorded in the balance sheet at their historical cost (the price at which the company had bought them)
  - The going concern principle states that because a company cannot stand up without its building and land, these kind of assets that are vital and less likely to be sold should not be recorded at their market value, but rather they should be recorded at their historical cost
  - The objectivity principle: states that because the market value of buildings and lands « just an example you can take any other suitable asset » are not objective, they can not be justified, and they may change from one second to another, these kind of assets should be recorded at their historical cost because at least this one can be justified and prooved.
  - The stable $ assumption. Because the monetary value of the $ or any other unit is not constant due to the inflation and deflation some consideration has been given to the use of balance sheets that would show assets at current appraised values or at replacement cost rathet that at historical cost.
- The Liabilities: liabilities are financial oblogations or debts, theyr represent negative cash flows for the entreprise. Liabilities represent claims against the borower's assets. As we shall see the owners of the business also have claims on the company's assets. But in the eyes of the law creditors' claims take priority over the owners' claims. That is why in the balance sheet, liabilities are listed above Owners' equity.
- Owners' Equity:owners' equity represents the owners' claims on the assets of the busines.
  - - - Increases in owners' equity are due to:
        
        investments of cash or other assets by owners
    - - earning from profitable operation of the business
      - Decreases in owners' equity are due to:
        
        payment of cash or transfers of other assets to owners
        
        losses from unprofitable operation of the business

2. Important ideas about the balance sheet

The assets are ranked following their ability of being convert to cash. That is why we start with cash, then account receivable, then note receivable....
Liabilities are listed with respect to the priority of payment. Account payable are in most cases due before note payable.
The total of liabilities plus owners' equity must be equal to the total amount of assets. This is the most important characteristique of the balance sheet. This feature is coming from the accounting equation:

ASSETS = LIABILITIES + OWNERS' EQUITY
To get used with recording the effetc of transactions on the balance sheet, please have a look at the text book pages 47 TO 50 « Financial Acconting 13e »

II. The Income Statement

The income statement is a summarization of the company revenue and expense transactions for a period of time.

Revenues are increases in the company's assets from its profit directed activities.
Expenses are decreases in the company's assets from its profit directed activities.
Net income = revenue – expenses
The heading of the income statement is as follow

The name of the company
Income Statement

The period of time

The income statement may describe the effect of many transaction such as revenue expenses payment of devidends sale of additional shares of capital stock.
The income statement reports on the financial performance of the company in terms of earning revenue and incuring expenses over a period of time and explains in part how the company's financial position chaged between the begining and the ending of that period.

III. The statement of cash flows

The statement of cash flows classify various cash flows into three categories:

Operating activities: are the cash effect of revenues and expenses of the company related to its area of work
Investing activities: are the cash effect of buying and selling assets.
Financing activities are the cash effect of owners investing in the company, creditors loaning money to the company and the repayment of either one or both.

The negative cash flow in the cash flow statement is in parentheses

For further reading please check the texte book (FINANCIAL ACCOUNTING 13e)