The Balance Sheet A balance sheet is the financial statement that reports a firm’s financial condition at a specific time. As highlighted in the sample balance sheet in Figure 17.5 (for our hypothetical vegetarian restaurant Very Vegetarian introduced in Chapter 13), assets are listed in a separate column from liabilities and owners’ (or stockholders’) equity. The assets are equal to, or balanced with, the liabilities and owners’ (or stockholders’) equity. The balance sheet is that simple. figure 17.5: SAMPLE VERY VEGETARIAN BALANCE SHEET Current assets: Items that can be converted to cash within one year. Fixed assets: Items such as land, buildings, and equipment that are relatively permanent. Intangible assets: Items of value such as patents and copyrights that don’t have a physical form. Current liabilities: Payments that are due in one year or less. Long-term liabilities: Payments not due for one year or longer. Owner’s equity: The value of what stockholders own in a firm (also called stockholder’s equity). balance sheet Financial statement that reports a firm’s financial condition at a specific time and is composed of three major accounts: assets, liabilities, and owners’ equity. Let’s say you want to know what your financial condition is at a given time. Maybe you want to buy a house or car and therefore need to calculate your available resources. One of the best measuring sticks is your balance sheet. First, add up everything you own—cash, property, and money owed you. These are your assets. Subtract from that the money you owe others—credit card debt, IOUs, car loan, and student loan. These are your liabilities. The resulting figure is your net worth, or equity. This is fundamentally what companies do in preparing a balance sheet: they follow the procedures set in the fundamental accounting equation. In that preparation, it’s important to follow generally accepted accounting principles (GAAP). Since it’s critical that you understand the financial information on the balance sheet, let’s take a closer look at what is in a business’s asset account and what is in its liabilities and owners’ equity accounts. Classifying Assets Assets are economic resources (things of value) owned by a firm. Assets include productive, tangible items such as equipment, buildings, land, furniture, and motor vehicles that help generate income, as well as intangible items with value like patents, trademarks, copyrights, and goodwill. Goodwill represents the value attached to factors such as a firm’s reputation, location, and superior products. Goodwill is included on a balance sheet when one firm acquires another and pays more for it than the value of its tangible assets. Intangible assets like brand names can be among the firm’s most valuable resources. Think of the value of brand names such as Starbucks, Coca-Cola, McDonald’s, and Apple. Not all companies, however, list intangible assets on their balance sheets. assets Economic resources (things of val ...

1. The Balance Sheet
A balance sheet is the financial statement that reports a firm’s
financial condition at a specific time. As highlighted in the
sample balance sheet in Figure 17.5 (for our hypothetical
vegetarian restaurant Very Vegetarian introduced in Chapter
13), assets are listed in a separate column from liabilities and
owners’ (or stockholders’) equity. The assets are equal to, or
balanced with, the liabilities and owners’ (or stockholders’)
equity. The balance sheet is that simple.
figure 17.5: SAMPLE VERY VEGETARIAN BALANCE
SHEET
Current assets: Items that can be converted to cash within one
year.
Fixed assets: Items such as land, buildings, and equipment that
are relatively permanent.
Intangible assets: Items of value such as patents and copyrights
that don’t have a physical form.
Current liabilities: Payments that are due in one year or less.
Long-term liabilities: Payments not due for one year or longer.
Owner’s equity: The value of what stockholders own in a firm
(also called stockholder’s equity).
balance sheet
Financial statement that reports a firm’s financial condition at a
specific time and is composed of three major accounts: assets,
liabilities, and owners’ equity.
Let’s say you want to know what your financial condition is at a
given time. Maybe you want to buy a house or car and therefore
need to calculate your available resources. One of the best
measuring sticks is your balance sheet. First, add up everything
you own—cash, property, and money owed you. These are your
assets. Subtract from that the money you owe others—credit
card debt, IOUs, car loan, and student loan. These are your
liabilities. The resulting figure is your net worth, or equity.

2. This is fundamentally what companies do in preparing a balance
sheet: they follow the procedures set in the fundamental
accounting equation. In that preparation, it’s important to
follow generally accepted accounting principles (GAAP).
Since it’s critical that you understand the financial information
on the balance sheet, let’s take a closer look at what is in a
business’s asset account and what is in its liabilities and
owners’ equity accounts.
Classifying Assets
Assets are economic resources (things of value) owned by a
firm. Assets include productive, tangible items such as
equipment, buildings, land, furniture, and motor vehicles that
help generate income, as well as intangible items with value
like patents, trademarks, copyrights, and goodwill. Goodwill
represents the value attached to factors such as a firm’s
reputation, location, and superior products. Goodwill is
included on a balance sheet when one firm acquires another and
pays more for it than the value of its tangible assets. Intangible
assets like brand names can be among the firm’s most valuable
resources. Think of the value of brand names such as Starbucks,
Coca-Cola, McDonald’s, and Apple. Not all companies,
however, list intangible assets on their balance sheets.
assets
Economic resources (things of value) owned by a firm.
Accountants list assets on the firm’s balance sheet in order of
their liquidity, or the ease with which they can convert them to
cash. Speedier conversion means higher liquidity. For example,
an account receivable is an amount of money owed to the firm
that it expects to receive within one year. It is considered a
liquid asset because it can be quickly converted to cash. Land,
however, is not considered a liquid asset because it takes time,
effort, and paperwork to sell. It is considered as a fixed or long-
term asset. Assets are thus divided into three categories,
according to how quickly they can be turned into cash:
liquidity
The ease with which an asset can be converted into cash.

3. 1.Current assets are items that can or will be converted into
cash within one year. They include cash, accounts receivable,
and inventory.
current assets
Items that can or will be converted into cash within one year.
2.Fixed assets are long-term assets that are relatively permanent
such as land, buildings, and equipment. (On the balance sheet
we also refer to these as property, plant, and equipment.)
fixed assets
Assets that are relatively permanent, such as land, buildings,
and equipment.
3.Intangible assets are long-term assets that have no physical
form but do have value. Patents, trademarks, copyrights, and
goodwill are intangible assets.
intangible assets
Long-term assets (e.g., patents, trademarks, copyrights) that
have no real physical form but do have value.
Liabilities and Owners’ Equity Accounts
Liabilities are what the business owes to others—its debts.
Current liabilities are debts due in one year or less. Long-term
liabilities are debts not due for one year or more. The following
are common liability accounts recorded on a balance sheet (look
at Figure 17.5 again):
liabilities
What the business owes to others (debts).
1.Accounts payable are current liabilities or bills the company
owes others for merchandise or services it purchased on credit
but has not yet paid for.
accounts payable
Current liabilities are bills the company owes to others for
merchandise or services purchased on credit but not yet paid
for.
2.Notes payable can be short-term or long-term liabilities (like
loans from banks) that a business promises to repay by a certain
date.
notes payable

4. Short-term or long-term liabilities that a business promises to
repay by a certain date.
3.Bonds payable are long-term liabilities; money lent to the
firm that it must pay back. (We discuss bonds in depth in
Chapters 18 and 19.)
bonds payable
Long-term liabilities that represent money lent to the firm that
must be paid back.
As you saw in the fundamental accounting equation, the value
of things you own (assets) minus the amount of money you owe
others (liabilities) is called equity. The value of what
stockholders own in a firm (minus liabilities) is called
stockholders’ equity or shareholders’ equity. Because
stockholders are the owners of a firm, we also call stockholders’
equity owners’ equity, or the amount of the business that
belongs to the owners, minus any liabilities the business owes.
The formula for owners’ equity, then, is assets minus liabilities.
(Nickels 473-475)
Nickels, William. Understanding Business, 10th Edition.
McGraw-Hill Learning
Solution
s, 40913. VitalBook file.
The Income Statement
The financial statement that shows a firm’s bottom line—that is,
its profit after costs, expenses, and taxes—is the income
statement. The income statement summarizes all the resources,
called revenue, that have come into the firm from operating
activities, money resources the firm used up, expenses it

5. incurred in doing business, and resources it has left after paying
all costs and expenses, including taxes. The resources (revenue)
left over or depleted are referred to as net income or net loss
(see Figure 17.7).
figure 17.7: SAMPLE VERY VEGETARIAN INCOME
STATEMENT
Revenue: Value of what’s received from goods sold, services
rendered, and other financial sources.
Cost of goods sold: Cost of merchandise sold or cost of raw
materials or parts used for producing items for resale.
Gross profit: How much the firm earned by buying or selling
merchandise.
Operating expenses: Cost incurred in operating a business.
Net income after taxes: Profit or loss over a specific period
after subtracting all costs and expenses, including taxes.
income statement
The financial statement that shows a firm’s profit after costs,
expenses, and taxes; it summarizes all of the resources that have
come into the firm (revenue), all the resources that have left the
firm (expenses), and the resulting net income or net loss.
net income or net loss
Revenue left over after all costs and expenses, including taxes,
are paid.
The income statement reports the firm’s financial operations

6. over a particular period of time, usually a year, a quarter of a
year, or a month. It’s the financial statement that reveals
whether the business is actually earning a profit or losing
money. The income statement includes valuable financial
information for stockholders, lenders, potential investors,
employees, and of course the government. Because it’s so
valuable, let’s take a quick look at how to compile the income
statement. Then we will discuss what each element in it means.
Drew Albert owns popular CJ’s All-American Grill in Walnut
Creek, California. The restaurant earns revenue by selling
American fare like this “danger dog.” What is the difference
between revenue and gross profit? Between gross profit and net
income before taxes?
Revenue
Revenue is the monetary value of what a firm received for
goods sold, services rendered, and other payments (such as rents
received, money paid to the firm for use of its patents, interest
earned, etc.). Be sure not to confuse the terms revenue and
sales; they are not the same thing. True, most revenue the firm
earns does come from sales, but companies can also have other
sources of revenue. Also, a quick glance at the income
statement shows you that gross sales refers to the total of all
sales the firm completed. Net sales are gross sales minus

7. returns, discounts, and allowances.
Cost of Goods Sold
The cost of goods sold (or cost of goods manufactured)
measures the cost of merchandise the firm sells or the cost of
raw materials and supplies it used in producing items for resale.
It makes sense to compare how much a business earned by
selling merchandise and how much it spent to make or buy the
merchandise. The cost of goods sold includes the purchase price
plus any freight charges paid to transport goods, plus any costs
associated with storing the goods.
cost of goods sold (or cost of goods manufactured)
A measure of the cost of merchandise sold or cost of raw
materials and supplies used for producing items for resale.
In financial reporting, it doesn’t matter when a firm places a
particular item in its inventory, but it does matter how an
accountant records the cost of the item when the firm sells it.
To find out why, read the Spotlight on Small Business box on p.
478 about two different inventory valuation methods.
When we subtract the cost of goods sold from net sales, we get
gross profit or gross margin. Gross profit (or gross margin) is
how much a firm earned by buying (or making) and selling
merchandise. In a service firm, there may be no cost of goods
sold; therefore, gross profit could equal net sales. Gross profit
does not tell you everything you need to know about the firm’s
financial performance. To get that, you must also subtract the

8. business’s expenses.
gross profit (or gross margin)
How much a firm earned by buying (or making) and selling
merchandise.
Operating Expenses
In selling goods or services, a business incurs certain operating
expenses such as rent, salaries, supplies, utilities, and
insurance. Other operating expenses that appear on an income
statement, like depreciation, are a bit more complex. For
example, have you ever heard that a new car depreciates in
market value as soon as you drive it off the dealer’s lot? The
same principle holds true for assets such as equipment and
machinery. Depreciation is the systematic write-off of the cost
of a tangible asset over its estimated useful life. Under
accounting rules set by GAAP and the Internal Revenue Service
(which are beyond the scope of this chapter), companies are
permitted to recapture the cost of these assets over time by
using depreciation as an operating expense.
operating expenses
Costs involved in operating a business, such as rent, utilities,
and salaries.
depreciation
The systematic write-off of the cost of a tangible asset over its
estimated useful life.
SPOTLIGHT ON SMALL business: What’s Coming and Going

9. at the College Bookstore?
www.aicpa.org
Generally accepted accounting principles (GAAP) sometimes
permit an accountant to use different methods of accounting for
a firm’s inventory. Let’s look at two possible treatments—FIFO
and LIFO.
Say a college bookstore buys 100 copies of a particular
textbook in July at $100 a copy. When classes begin, the
bookstore sells 50 copies of the text to students at $120 each.
Since the book will be used again next term, the store places the
50 copies it did not sell in its inventory until then.
In late December, when the bookstore orders 50 additional
copies of the text to sell for the coming term, the publisher’s
price has increased to $110 a copy due to inflation and other
production and distribution costs. The bookstore now has in its
inventory 100 copies of the same textbook from different
purchase cycles. If it sells 50 copies to students at $120 each at
the beginning of the new term, what’s the bookstore’s cost of
the book for accounting purposes? Actually, it depends.
The books are identical, but the accounting treatment could be
different. If the bookstore uses a method called first in, first out
(FIFO), the cost of goods sold is $100 for each textbook,
because the textbook the store bought first—the first in—cost
$100. The bookstore could use another method, however. Under

10. last in, first out (LIFO), its last purchase of the textbooks, at
$110 each, determines the cost of each of the 50 textbooks sold.
If the book sells for $120, what is the difference in gross profit
(margin) between using FIFO and using LIFO? As you can see,
the inventory valuation method used makes a difference.
We can classify operating expenses as either selling or general
expenses. Selling expenses are related to the marketing and
distribution of the firm’s goods or services, such as advertising,
salespeople’s salaries, and supplies. General expenses are
administrative expenses of the firm such as office salaries,
depreciation, insurance, and rent. Accountants are trained to
help you record all applicable expenses and find other relevant
expenses you can deduct from your taxable income as a part of
doing business.
Net Profit or Loss
After deducting all expenses, we can determine the firm’s net
income before taxes, also referred to as net earnings or net
profit (see Figure 17.7 again). After allocating for taxes, we get
to the bottom line, which is the net income (or perhaps net loss)
the firm incurred from revenue minus sales returns, costs,
expenses, and taxes over a period of time. We can now answer
the question “Did the business earn or lose money in the
specific reporting period?”
As you can see, the basic principles of the balance sheet and
income statement are already familiar to you. You know how to

11. keep track of costs and expenses when you prepare your own
budget. If your rent and utilities exceed your earnings, you
know you’re in trouble. If you need more money, you may need
to sell some of the things you own to meet your expenses. The
same is true in business. Companies need to keep track of how
much money they earn and spend, and how much cash they have
on hand. The only difference is that they tend to have more
complex problems and a good deal more information to record
than you do.
Most businesses incur operating expenses including rent,
salaries, utilities, supplies, and insurance. What are some of the
likely operating expenses for this firm?
Users of financial statements are interested in how a firm
handles the flow of cash coming into a business and the cash
flowing out of the business. Cash flow problems can plague
both businesses and individuals. Keep this in mind as we look at
the statement of cash flows next.
The Statement of Cash Flows
The statement of cash flows reports cash receipts and cash
disbursements related to the three major activities of a firm:
statement of cash flows
Financial statement that reports cash receipts and disbursements
related to a firm’s three major activities: operations,
investments, and financing.

12. Operations are cash transactions associated with running the
business.
Investments are cash used in or provided by the firm’s
investment activities.
Financing is cash raised by taking on new debt, or equity capital
or cash used to pay business expenses, past debts, or company
dividends.
Accountants analyze all changes in the firm’s cash that have
occurred from operating, investing, and financing in order to
determine the firm’s net cash position. The statement of cash
flows also gives the firm some insight into how to handle cash
better so that no cash-flow problems occur—such as having no
cash on hand for immediate expenses.26
Figure 17.8 on p. 480 shows a sample statement of cash flows,
again using the example of Very Vegetarian. As you can see,
the statement of cash flows answers such questions as: How
much cash came into the business from current operations, such
as buying and selling goods and services? Did the firm use cash
to buy stocks, bonds, or other investments? Did it sell some
investments that brought in cash? How much money did the firm
take in from issuing stock?
figure 17.8: SAMPLE VERY VEGETARIAN STATEMENT OF
CASH FLOWS
Cash receipts from sales, commissions, fees, interest, and

13. dividends. Cash payments for salaries, inventories, operating
expenses, interest, and taxes.
Includes cash flows that are generated through a company’s
purchase or sale of long-term operational assets, investments in
other companies, and its lending activities.
Cash inflows and outflows associated with the company’s own
equity transactions or its borrowing activities.
Cash flow is the difference between money coming into and
going out of a business. Careful cash flow management is a
must for a business of any size, but it’s particularly important
for small businesses and for seasonal businesses like ski resorts.
Have you read of any firms that were forced into bankruptcy
because of cash flow problems?
We analyze these and other financial transactions to see their
effect on the firm’s cash position. Managing cash flow can
mean success or failure of any business, which is why we
analyze it in more depth in the next section.
The Need for Cash Flow Analysis
Cash flow, if not properly managed, can cause a business much
concern. Understanding cash flow analysis is important and not
difficult to understand.27 Let’s say you borrow $100 from a
friend to buy a used bike and agree to pay her back at the end of
the week. You then sell the bike for $150 to someone else, who
also agrees to pay you by the end of the week. Unfortunately,

14. by the weekend your buyer does not have the money as
promised, and says he will have to pay you next month.
Meanwhile, your friend wants the $100 you agreed to pay her by
the end of the week!
What seemed a great opportunity to make an easy $50 profit is
now a cause for concern. You owe $100 and have no cash. What
do you do? If you were a business, you might default on the
loan and possibly go bankrupt, even though you had the
potential for profit.
It’s possible for a business to increase its sales and profits yet
still suffer cash flow problems.28Cash flow is simply the
difference between cash coming in and cash going out of a
business. Poor cash flow constitutes a major operating problem
for many companies and is particularly difficult for small and
seasonal businesses.29 Accountants sometimes face tough
ethical challenges in reporting the flow of funds into a business.
Read the Making Ethical Decisions box to see how such an
ethical dilemma can arise.
MAKING ethical decisions: Barking Up the Wrong Financial
Statement
www.fasb.gov
The recession of the late 2000s hit small manufacturers very
hard. Many did not survive the downturn. You are the lone
accountant employed by Keegan’s Feast, a small producer of
premium dog food that sells directly online. Many of the

15. company’s customers became cost-conscious during the
downturn and purchased lower-cost brands. Fortunately with the
economy recovering, many of the firm’s old customers are
returning and things are looking up. The problem is the
company’s cash flow suffered during the recession, and the firm
needs immediate funding to continue to pay its bills. You know
the CEO has prepared a proposal to a local bank asking for
short-term financing. Unfortunately, you are aware that
Keegan’s financial statements for the past year will not show
good results. Your expectation is the bank will not approve the
loan on the basis of the financial information even though the
firm seems to be coming back.
Before you close the books for the end of the year, the CEO
suggests you might “improve” the company’s financial
statements by treating the sales made at the beginning of
January of the current year as if they were made in December of
the past year. He is confident the company auditors will not
discover the discrepancy.
You know this is against the rules of the Financial Accounting
Standards Board (FASB), and you refuse to alter the
information. The CEO warns that without the bank loan, the
business is likely to close, meaning you and everyone else will
be out of a job. You know he’s probably right, and also know
it’s unlikely the firm’s employees will find new jobs. What are
your alternatives? What are the likely consequences of each?

16. What will you do?
How do cash flow problems start? Often in order to meet the
growing demands of customers, a business buys goods on credit
(using no cash). If it then sells a large number of goods on
credit (getting no cash), the company needs more credit from a
lender (usually a bank) to pay its immediate bills. If a firm has
reached its credit limit and can borrow no more, it has a severe
cash flow problem. It has cash coming in at a later date, but no
cash to pay current expenses. That problem could,
unfortunately, force the firm into bankruptcy, even though sales
may be strong—all because no cash was available when it was
most needed. Cash flow analysis shows that a business’s
relationship with its lenders is critical to preventing cash flow
problems. Accountants can provide valuable insight and advice
to businesses in managing cash flow, suggesting whether they
need cash and how much.30 After the Progress Assessment, we
will see how accountants analyze financial statements using
ratios.
cash flow
The difference between cash coming in and cash going out of a
business.
progress assessment
What are the key steps in preparing an income statement?
What’s the difference between revenue and income on the
income statement?

17. Why is the statement of cash flows important in evaluating a
firm’s operations?
(Nickels 476-482)
Nickels, William. Understanding Business, 10th Edition.
McGraw-Hill Learning