handout 2

• Financial statements serve as "report cards" for businesses, providing a graphical representation of the company's financial condition over a specific time frame
• Financial statements must be prepared following specified and standardized accounting standards
• Advantages of financial statements:

  • Ability to generate cash and its sources and applications
  • Ability to repay debts
  • Identifying impending problems with profitability
  • Creating financial ratios for insight into the company's state
  • Investigating specific business transactions' details
  • Foundation for an annual report given to investors and stakeholders
• Drawbacks of financial statements:

  • Potential for fraudulent manipulation
  • Risk of lenders issuing debt to a company that cannot realistically repay
  • Historical nature can be misleading for predicting future performance
• The four financial statements are:

  1. Income Statement

  2. Statement of Owner’s Equity (Retained Earnings Statement)

  3. Balance Sheet (Statement of Financial Position)

  4. Statement of Cash Flow
• Accounting Equation:

  Assets = Liabilities + Owner’s equity

  • Assets are on the left side, liabilities and capital on the right side
  • Interpretations for a balanced equation:

  1. Increase in asset corresponds to an increase in liability

  2. Increase in asset corresponds to a capital increase

  3. Increase in asset corresponds to a decrease in another asset

  4. Decrease in asset corresponds to a decrease in liability

  5. Decrease in asset corresponds to a decrease in capital

  6. Increase in liability corresponds to a decrease in capital
• Expanded Accounting Equation:

  Assets = Liabilities + Shareholder’s Equity + Revenue – Expenses – Draws

  • Shows the relationship between income statement items and the balance sheet
• Double-Entry Accounting System:

  • Ensures accounting and transaction equations are equal
  • Changes in asset account must correspond to changes in related liability and owner’s equity account
• Major Accounts (Elements of Financial Statements):

  • Assets: tangible (like cash) and intangible (like goodwill or copyrights)
  • Receivables arise when a company provides a service or sells a product on credit
• Two categories of assets:

  • Current Assets: can be exchanged for cash within a single operating cycle or fiscal year, used for day-to-day operational expenses and investments
  • Include: Cash, Certificates of deposit, Equity or debt securities, Accounts receivable, Inventory, Prepaid Expenses (expenses paid in advance)
  • Fixed (Non-current) Assets: non-current resources used in production with a life of more than one year, recorded as property, plant, and equipment
• Two categories of liabilities:

  • Current Liabilities: debts to be paid back within the next twelve months
  • Include: Accounts payable, Principal and interest, Salaries and Wages, Notes payable due within one year, Income Taxes payable, Mortgage payable, Payroll taxes
  • Non-current (Long term) Liabilities: debts not due for more than twelve months
  • Include: Principal and interest due for more than one year, Bonds, debentures, and long-term loans, Deferred tax liabilities, Lease payments due for more than one year, Pension obligations
• Equity: sum invested in a company by owners in addition to retained earnings

  • Include: Owner’s Capital, Owner’s Withdrawals, Common Stocks, Preferred Stocks, Retained Earnings, Additional Paid-in Capitals, Other Comprehensive Income
• Two categories of revenue:

  • Operating Revenue: income from primary business exercises like sales
  • Include: Sales, Professional Services, Service Charges, Rental Income, Commission Earned
  • Non-operating Revenue: money earned from side businesses unrelated to day-to-day operations
  • Include: Dividends, Investment Income, Gains or losses from foreign exchange, Sales of assets, Interest income
• Two categories of expenses:

  • Operating Expense: expenses related to the company’s main activities
  • Include: Cost of Sales, Utilities Expense, Purchases, Freight In and Freight Out, Advertising Expense, Depreciation Expense, Interest Expense, Rent Expense, Salaries Expense, Supplies Expense, Licenses Fees and Taxes
  • Discretionary Expense: non-essential spending
  • Include: Company travel, Investments and innovations, Employee perks, Office improvements, Workshop investments, Employee training sessions
• Books of Accounts:

  • General Journal: keeps track of financial transactions by date
  • General Ledger: provides a reconciled balance by summarizing journal entries
  • Cash Receipt Journal: tracks all cash payments made and receivables collected
  • Cash Disbursement Journal: records cash outflows for payables and expenses
  • Sales Journal: tracks all company sales
  • Purchase Journal: keeps track of credit-based purchases and expenditures