4.27: Structures of Key Financial Statements

Learning Outcome

• Explain how key financial statements are structured

As you have seen, there are four basic financial statements: the Income Statement, the Statement of Owners’ Equity, the Balance Sheet, and the Statement of Cash Flows.

Income Statement

The income statement shows revenues less expenses, also known as net income. In accounting, the word “net” means the combined total of both negative and positive amounts. For financial statement purposes, accountants don’t identify account balances by debit and credit—that’s part of the internal process of accounting and bookkeeping that has to do with the double-entry system you studied earlier.

Here is the adjusted trial balance we created for our sample company:

Adjusted Trial Balance as of Jan 31, 20XX
		Debit	Credit
1101	Checking	16,050
1210	Merchandise Inventory	360
1320	Prepaid Rent	800
1620	Furniture and Equipment	2,750
2101	Accounts Payable		600
2201	Wages Payable		500
2550	Notes Payable		15,000
3310	Capital Contributions		5,000
4510	Merchandise Sales		400
5200	Cost of Goods Sold	240
5300	Wage Expense	500
5510	Rent Expense	200
5520	Insurance Expense	600
	Total debits must equal total credits	21,500	21,500

The income statement always begins with revenue and then continues with a list of expenses for a period of time, either a month, a quarter, or most commonly, a year. Large companies summarize expenses into major categories, such as Cost of Goods Sold, and a broad category called Selling, General and Administrative (SG&A). For our sample company, however, we have just a very few accounts, so we can list them out, subtotal the expenses, and subtract that amount from revenue to show net income or net loss.

Your Company
Income Statement
For the month ended January 31, 20XX
Merchandise Sales		$400
Expenses
Cost of Goods Sold	$240
Wage Expense	500
Rent Expense	200
Insurance Expense	600
Total Expenses		1,540
Net Income/(Loss)		$ (1,140)

The bottom line on the income statement is either an increase in owners’ equity, if it is net income, or a reduction in owners’ equity if it is a loss (expenses exceed revenues). It is like a moving picture of the company, showing amounts earned during the regular course of business (revenues) and the matching costs (expenses).

In our example from the previous section, expenses far exceeded revenues, which is common in the first few months of a new business, so the company is showing a net loss.

Statement of Owners’ Equity

The statement of owners’ equity, or owner’s equity if the company is a sole proprietorship, shows beginning owner capital, additions and subtractions to capital, including net income from the Income Statement. This gives the total owners’ capital at the end of the same specific time period as the Income Statement. This amount will be the beginning capital for the next Statement of Owners’ Equity. Both of the Income Statement and the Statement of Owners’ Equity, as well as the Statement of Cash Flows, show activities over a period of time, such as a year.

Your Company
Statement of Owner’s Equity
For the month ended January 31, 20XX
Beginning Capital	$–
Owner Contributions	5,000
Net Income/(Loss)	(1,140)
	3,860
Owner Withdrawals	—
Ending Capital
Ending Capital	$3,860

Notice that the Statement of Owner’s Equity reflects the expanded accounting equation:

Equity = Owner Contributions – Owner Withdrawals + Revenues – Expenses.

Balance Sheet

The balance sheet, unlike the previous two statements, shows a snapshot of the business at a moment in time. Notice that the Income Statement and the Statement of Owners’ Equity both identify the period of time covered, but the Balance Sheet indicates a specific date that is always the last day of the time period covered by the prior two statements. The balance sheet is based on the accounting equation and show total assets, total liabilities, and owners’ equity, and shows as well how they balance.

Your Company
Balance Sheet
As of January 31, 20XX
Assets
Current Assets
Cash and Cash Equivalents	$16,050
Merchandise Inventory	360
Prepaid Expenses	800
Total Current Assets	17,210
Property, Plant, and Equipment	2,750
Total Assets	$ 19,960
Current Liabilities
Accounts Payable	$600
Wages Payable	500
Total Current Liabilities	1,100
Long-term debt	15,000
Total Liabilities	$16,100
Owner’s Equity	3,860
Total Liabilities and Owner’s Equity	19,960

Notice that total assets of $19,960 is equal to total liabilities and equity of $19,960, and that the owner’s equity of $3,860 carried forward from the bottom line of the Statement of Owner’s Equity. Finally, the statement of cash flows reconciles beginning cash and cash equivalents from the balance sheet (ending cash from the prior set of financial statements) to ending cash from the current balance sheet, effectively reconciling accrual basis accounting to cash basis.

Your Company
Statement of Cash Flows
For the month ended January 31, 20XX
Cash provided by operating activities
Cash receipts from customers	$400
Cash payments to vendors	(1,600)
Cash provided by/(used by)operations	(1,200)
Cash provided by investing activities
Purchases of fixed assets	(2,750)
Cash provided by/(used by) investing	(2,750)
Cash provided by financing
Long-term borrowing	15,000
Owner contributions	5,000
Cash provided by/(used by) financing	20,000
Change in cash	16,050
Beginning cash balance	—
Ending cash balance	$16,050

In our sample company, both beginning equity and beginning cash were zero. This statement tells us that operations used $1,200 in cash, as opposed to accrual basis net income from the income statement in the amount of $1,140, and that investing in fixed assets used $2,750 in cash. It also tells us that cash was provided by a combination of borrowing and owner investment in the company.

Other Financial Statements

A Statement of Comprehensive Income is often included along with the Income Statement if the company has certain investments that are adjusted to fair market value. Some smaller companies not subject to the full disclosure of GAAP only prepare the three most basic financial statements, and exclude the Statement of Cash Flows and the Statement of Comprehensive Income, providing instead just the Income Statement, the Statement of Owners’ Equity, and the Balance Sheet.

practice questions

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