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Business LibreTexts

2.5: Summary

  • Page ID
    2753
  • 2.1 Describe the Income Statement, Statement of Owner’s Equity, Balance Sheet, and Statement of Cash Flows, and How They Interrelate

    • Financial statements provide financial information to stakeholders to help them in making decisions.
    • There are four financial statements: income statement, statement of owner’s equity, balance sheet, and statement of cash flows.
    • The income statement measures the financial performance of the organization for a period of time. The income statement lists revenues, expenses, gains, and losses, which make up net income (or net loss).
    • The statement of owner’s equity shows how the net worth of the organization changes for a period of time. In addition to showing net income or net loss, the statement of owner’s equity shows the investments by and distributions to owners.
    • The balance sheet shows the organization’s financial position on a given date. The balance sheet lists assets, liabilities, and owners’ equity.
    • The statement of cash flows shows the organization’s cash inflows and cash outflows for a given period of time. The statement of cash flows is necessary because financial statements are usually prepared using accrual accounting, which records transactions when they occur rather than waiting until cash is exchanged.

    2.2 Define, Explain, and Provide Examples of Current and Noncurrent Assets, Current and Noncurrent Liabilities, Equity, Revenues, and Expenses

    • Assets and liabilities are categorized into current and noncurrent, based on when the item will be settled. Assets and liabilities that will be settled in one year or less are classified as current; otherwise, the items are classified as noncurrent.
    • Assets are also categorized based on whether or not the asset has physical substance. Assets with physical substance are considered tangible assets, while intangible assets lack physical substance.
    • The distinction between current and noncurrent assets and liabilities is important because it helps financial statement users assess the timing of the transactions.
    • Three broad categories of legal business structures are sole proprietorship, partnership, and corporation, with each structure having advantages and disadvantages.
    • The accounting equation is Assets = Liabilities + Owner’s Equity. It is important to the study of accounting because it shows what the organization owns and the sources of (or claims against) those resources.
    • Owners’ equity can also be thought of as the net worth or value of the business. There are many factors that influence equity, including net income or net loss, investments by and distributions to owners, revenues, gains, losses, expenses, and comprehensive income.

    2.3 Prepare an Income Statement, Statement of Owner’s Equity, and Balance Sheet

    • There are ten financial statement elements: revenues, expenses, gains, losses, assets, liabilities, equity, investments by owners, distributions to owners, and comprehensive income.
    • There are standard conventions for the order of preparing financial statements (income statement, statement of owner’s equity, balance sheet, and statement of cash flows) and for the format (three-line heading and columnar structure).
    • Financial ratios, which are calculated using financial statement information, are often beneficial to aid in financial decision-making. Ratios allow for comparisons between businesses and determining trends between periods within the same business.
    • Liquidity ratios assess the firm’s ability to convert assets into cash.
    • Working Capital (Current Assets – Current Liabilities) is a liquidity ratio that measures a firm’s ability to meet current obligations.
    • The Current Ratio (Current Assets/Current Liabilities) is similar to Working Capital but allows for comparisons between firms by determining the proportion of current assets to current liabilities.

    Key Terms

    accounting equation
    assets = liabilities + owner’s equity
    accounts payable
    value of goods or services purchased that will be paid for at a later date
    accounts receivable
    outstanding customer debt on a credit sale, typically receivable within a short time period
    accrual basis accounting
    accounting system in which revenue is recorded or recognized when earned yet not necessarily received, and in which expenses are recorded when legally incurred and not necessarily when paid
    asset
    tangible or intangible resource owned or controlled by a company, individual, or other entity with the intent that it will provide economic value
    balance sheet
    financial statement that lists what the organization owns (assets), owes (liabilities), and is worth (equity) on a specific date
    cash basis accounting
    method of accounting in which transactions are not recorded in the financial statements until there is an exchange of cash
    common stock
    corporation’s primary class of stock issued, with each share representing a partial claim to ownership or a share of the company’s business
    comprehensive income
    change in equity of a business enterprise during a period from transactions and other events and circumstances from nonowner sources
    corporation
    legal business structure involving one or more individuals (owners) who are legally distinct (separate) from the business
    current asset
    asset that will be used or consumed in one year or less
    current liability
    debt or obligation due within one year or, in rare cases, a company’s standard operating cycle, whichever is greater
    current ratio
    current assets divided by current liabilities; used to determine a company’s liquidity (ability to meet short-term obligations)
    distribution to owner
    periodic “reward” distributed to owner of cash or other assets
    dividend
    portion of the net worth (equity) that is returned to owners of a corporation as a reward for their investment
    elements of the financial statements
    categories or groupings used to record transactions and prepare financial statements
    equity
    residual interest in the assets of an entity that remains after deducting its liabilities
    expense
    cost associated with providing goods or services
    gain
    increase in organizational value from activities that are “incidental or peripheral” to the primary purpose of the business
    income statement
    financial statement that measures the organization’s financial performance for a given period of time
    initial public offering (IPO)
    when a company issues shares of its stock to the public for the first time
    intangible asset
    asset with financial value but no physical presence; examples include copyrights, patents, goodwill, and trademarks
    inventory
    value of products to be sold or items to be converted into sellable products
    investment by owner
    exchange of cash or other assets in exchange for an ownership interest in the organization
    liability
    probable future sacrifice of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events
    liquidity
    ability to convert assets into cash in order to meet primarily short-term cash needs or emergencies
    long-term asset
    asset used ongoing in the normal course of business for more than one year that is not intended to be resold
    long-term liability
    debt settled outside one year or one operating cycle, whichever is longer
    loss
    decrease in organizational value from activities that are “incidental or peripheral” to the primary purpose of the business
    net income
    when revenues and gains are greater than expenses and losses
    net loss
    when expenses and losses are greater than revenues and gains
    noncurrent asset
    asset that will be used or consumed over more than one year
    noncurrent liability
    liability that is expected to be settled in more than one year
    notes payable
    value of amounts borrowed that will be paid in the future with interest
    notes receivable
    value of amounts loaned that will be received in the future with interest
    partnership
    legal business structure consisting of an association of two or more people who contribute money, property, or services to operate as co-owners of a business
    publicly traded company
    company whose stock is traded (bought and sold) on an organized stock exchange
    retained earnings
    cumulative, undistributed net income or net loss for the business since its inception
    revenue
    inflows or other enhancements of assets of an entity or settlements of its liabilities (or a combination of both) from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major or central operations
    Securities and Exchange Commission (SEC)
    federal regulatory agency that regulates corporations with shares listed and traded on security exchanges through required periodic filings
    short-term asset
    asset typically used up, sold, or converted to cash in one year or less
    short-term liability
    liability typically expected to be paid within one year or less
    sole proprietorship
    legal business structure consisting of a single individual
    stakeholder
    someone affected by decisions made by a company; may include an investor, creditor, employee, manager, regulator, customer, supplier, and layperson
    statement of cash flows
    financial statement listing the cash inflows and cash outflows for the business for a period of time
    statement of owner’s equity
    financial statement showing how the equity of the organization changed for a period of time
    tangible asset
    asset that has physical substance
    working capital
    current assets less current liabilities; sometimes used as a measure of liquidity