2.4: Summary

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