Financial Statements

• External decision-makers (lenders, creditors and investors) use financial accounting and the financial statements it entails to decide whether or not to lend businesses money.
• Creditors are financial entities to whom money is owed, so all creditors are lenders, but not all lenders are creditors.
• Things that a business owns (assets) are equal to things that a business owes (liabilities & equity)
• Liabilities are things owed to third parties
• Accounts Payable are purchases of goods from suppliers on credit without a formal written contract
• Notes Payable are cash borrowings based on a formal written debt contract with banks
• Equity refers to things owed to the owners (owners’ claim on net assets) [i.e. profit is owed to owners]
• Stockholder’s Equity is profit for owners
• Retained Earnings is profit held for future use
• Accounts Receivables are promises to pay, which are collected in cash later
• The balance sheet is a snapshot of a business's assets, liabilities & equity at a single point in time.
• For external decision-makers, assets provide a basis for judging whether the company has sufficient resources to operate. If the company goes bust, assets can also be sold for cash.
• For external decision-makers, liabilities provide a basis for judging whether the company has sufficient sources of cash to pay its debts. They are also relevant for deciding whether to lend the company money based on how much it already owes and whether it can repay it. Finally, if debts are large, creditors may force the sale of assets to reduce these debts.
• Equity provides a protective cushion for external decision-makers if the business goes bust. Creditors’ claims come before the owners’, so current equity (and any more generated after the sale of assets) will cover creditors first.
• The income statement reports revenues and expenses in an accounting period.
• Revenues are amounts expected to be received for delivered goods, regardless of whether the customer has paid for them.
• Various terms are used to describe revenue sources, including provision of services, sale of goods, rental of property, and sales revenue.
• Expenses are the dollar amount of resources the entity used (not bought) to earn revenues.
• Expenses include the cost of goods sold, administrative, interest, and tax expenses.
• Profit is referred to as net income or net earnings
• Net income doesn’t normally equal the net cash generated by operations because of the time periods in which the transactions are recorded.
• Investors and creditors monitor a firm’s net income, which indicates its ability to sell goods for more than it costs to produce and deliver them.
• The Statement of Stockholders' Equity reports the changes in each one of the company’s stockholders’ equity accounts in an accounting period.
• Beginning Retained Earnings + Net Income - Dividends = Ending Retained Earnings
• Retained earnings increase by the portion of income reinvested into the business and are the net income in the income statement.
• The ending retained earnings are reported on the balance sheet.
• Creditors monitor a firm’s statement of stockholders’ equity because its dividend payment policy affects its ability to repay its debts. Investors look at retained earnings to determine whether the company is reinvesting enough income to support future growth.
• The income statement does not provide information regarding cash flows, as sales can be on credit, so a separate statement of cash flows needs to be made.
• Operating Activities are day-to-day processes for earning income
• Investing Activities are related to the acquisition or sale of PPE
• Financing Activities are related to the financing of the enterprise through investors and creditors
• The operating activities section in the Statement of Cash Flows is the most important as it indicates the company’s ability to generate cash from sales to meet its current cash needs.
• At the bottom of each financial statement, it is stated: “The notes are an integral part of these financial statements.” This is the accounting equivalent of a warning on a package of cigarettes. It warns users that failure to read the footnotes will result in an incomplete picture of the company’s financial health.
• The financial statement information must be relevant to external users, i.e., have the necessary details.
• The financial statement information must have faithful representation, i.e., not falsifying numbers.
• Timeliness, verifiability, comparability and understandability enhance the relevance and faithful representation of financial statements.
• Ethical conduct is determined in three steps:

  1. Identify the benefits of a decision
  2. Identify alternative courses of action
  3. Choose the one you want to see reported on the news
• Internal controls, external auditors, and a board of directors uphold the accuracy of a company's records.
• The headings of the Statement of Stockholders' Equity are common stock, additional paid-in capital and retained earnings.