BASIC FINANCIAL STATEMENTS BASIC FINANCIAL STATEMENTS

UNIT IV
BASIC FINANCIAL
STATEMENTS

Introduction to Financial Statements
 What is financial statement?
 Financial statement is a structured representation of the
financial position (Balance Sheet), financial performance
(Income Statement) of an entity and the inflow and outflow
of cash (cash flow statement).
 The objective of financial statements is to provide
information about
 the financial position,
 financial performance and
 cash flows of an entity
 Financial statements is also help to assess the probability
that an enterprise will be able to make future cash.

Three Basic Financial Statements are
 These financial statements are windows to a company's
performance and health.
Income Statement
Balance Sheet
Statement of Cash Flows
Describes where the
enterprise stands at a
specific date.
Depicts the
revenue and
expenses for
a designated
period of
time.
Depicts the ways
cash has changed
during a
designated period
of time.

THE BALANCE SHEET
What is Balance sheet?
 The balance sheet represents a record of a company's assets,
liabilities and equity at a particular point in time. Balance
sheet is named by the fact that a business’s financial structure
balances in the following manner:
 Assets = Liabilities + Shareholders' Equity
 Assets represent the resources that the business owns or
controls at a given point in time. This includes items such as
cash, inventory, machinery, buildings etc.
 The other side of the equation represents the total value of the
financing the company has used to acquire those assets.
Liabilities represent debt, while equity represents the total
value of money that the owners have contributed to the
business – including retained earnings, which is the profit
made in previous years.

The Balance Sheet
ASSETS
Cash
Inventory
Land/Bldgs
Equipment
Accts Rcvbl
Securities
= +
LIABILITIES
Accts Payable
Wages Payable
Taxes Payable
Notes Payable
Short term
Long Term
EQUITY
Pref Stock
Common Stk
Retained
Earnings

Why do we need Balance sheet?
 Because
 Balance sheet provides investors with a snapshot of a company's
health as of the date provided on the financial statement.
 If a company assets are large relative to liabilities, it's in
good shape. Conversely, if a company with a large amount of
liabilities relative to assets has risk to creditors.
 The higher the debt ratio, the greater risk will be associated
with the firm's operation. In addition, high debt to assets ratio
may indicate low borrowing capacity of a firm, which in turn
will lower the firm's financial flexibility.

THE INCOME STATEMENT
What is Income Statement?
 The income statement shows an information about the
revenues, expenses and profit that was generated as a result
of the business' operations for that period and it measures a
company's performance over a specific time frame.
 The components of income Statement are:
 Revenue (how much the company earned)
 Expenses (how much the company has spent)
 Net Income before and after Tax (the profits of the
company)

 Because
 Income statement answers the question, "How well
is the company's business?
 “Does it performing well?
 Basically, the question is "Is it making money?"
Firms with low expenses and high profits relative
to revenues are typically more desirable for
investment because it brings more money directly
to a shareholder.
Why do we need an Income Statement ?

 The statement of cash flows represents a record of a
business' cash inflows and outflows over a period of time.
 It is the most sensitive statement and it focuses on the
following cash-related activities:
 Operating Cash Flow: Cash generated from day-to-day
business operations.
 Cash from Investing: Cash used for investing in assets,
as well as the proceeds from the sale of other
businesses, equipment or long-term assets
 Cash from financing: Cash paid or received from the
issuing and borrowing of funds
THE STATEMENT OF CASH FLOWS
What is statement of cash flow?

 Statement of cash flows is very important to investors, because
 It shows how much actual cash a company has generated.
 It shows the ability of firms to generate cash. Many
companies have shown “profits” on the income statement
but struggled later because of insufficient cash flows.
Because, the income statement includes non-cash revenues
or expenses, which the statement of cash flows excludes.
 It shows correct figures of firms, because cash flow
statement is very difficult for a business to manipulate its
cash situation. Earnings can be manipulated, but it's tough to
“fake” cash in the bank. For this reason some investors use
the cash flow statement as a more conservative measure of
a company's performance.
Why do we need Statement of Cash Flows ?

 The three financial statements (Balance sheet, Income
statement and cash flow statement) are all related.
 The changes of assets and liabilities that is indicated on
the balance sheet are also reflected in the revenues and
expenses which are stated on the income statement,
which shows the company’s gains or losses.
 Cash flows provide more information about cash assets
listed on a balance sheet and are related, but not
equivalent, to net income shown on the income
statement.
 Therefore, no one financial statement tells the
complete story of firms.
Bringing the financial statements All Together

ACCOUNTING PRINCIPLES
Certain accounting principles that are
important for an understanding of
financial statements and how professional
judgment by accountants may affect the
application of those principles are shown in
the next slides

The concept of business entity
ABC Company
A business entity is separated from
the personal affairs of its owner.

Assets
Cost Principle
Going-Concern
Assumption
Objectivity
Principle
Stable-Dollar
Assumption
These accounting
principles support
cost as the basis
for asset valuation.
The cost principle tells us that
accounting information is based
upon actual cost incurred.
We refer to this as historical cost.
The objectivity principle states that
accounting information must be
unbiased and based upon
independent evidence.
The stable-dollar assumption
tells us that we will only record
accounting information that can
be expressed in monetary units,
usually dollars in the United
States and the dollar will remain
constant across fiscal periods.
The going-concern assumption states
the business entity is assumed to
continue operations into the future.

Statement of Financial Position: A Starting Point
ABC Company
Balance Sheet
January 1, 2007
Assets Liabilities & Owners' Equity
Cash 22,500
$ Liabilities:
Notes receivable 10,000 Notes payable 41,000
$
Accounts receivable 60,500 Accounts payable 36,000
Supplies 2,000 Salaries payable 3,000
Land 100,000 Total liabilities 80,000
$
Building 90,000 Owners' Equity:
Office equipment 15,000 Capital stock 150,000
Retained earnings 70,000
Total 300,000
$ Total 300,000
$

Assets = Liabilities + Owners’ Equity
$300,000 = $80,000 + $220,000
ABC Company
Balance Sheet
January 1, 2007
Assets Liabilities & Owners' Equity
Cash 22,500
$ Liabilities:
Notes receivable 10,000 Notes payable 41,000
$
Accounts receivable 60,500 Accounts payable 36,000
Supplies 2,000 Salaries payable 3,000
Land 100,000 Total liabilities 80,000
$
Building 90,000 Owners' Equity
Office equipment 15,000 Capital stock 150,000
Total 300,000
$ Total 300,000
$

Business transactions affect the elements
of the accounting equation:
In the next slides will demonstrate how certain business
transactions affect the elements of the accounting equation
EXAMPLE TRANSACTION.ppt

Let’s analyze some transactions for Abeba’s Care Service company
On May 1, Abeba and her family invested $8,000 in her Care Service company
and received 800 shares of stock.
Abeba’s Care Service company
Balance Sheet
May 1, 2007
Assets
Cash 8,000
$ Capital Stock 8,000
$
Total 8,000
$ Total 8,000
$
Owners' Equity

On May 2, Abeba’s purchased an office
equipment for $2,500 cash.
Abeba’s Care Service Company
Balance Sheet
May 2, 2007
Assets
Cash 5,500
$ Capital Stock 8,000
$
Tools & Equipment 2,500
Total 8,000
$ Total 8,000
$
Owners' Equity

Assets = Liabilities +
Cash +
Accts.
Rec. +
Tools &
Equip. + Truck =
Notes
Payable +
Accts.
Pay. +
Capital
Stock +
Retained
Earnings
May 1 8,000
$ 8,000
$
Balances 8,000
$ 8,000
$
May 2 (2,500) 2,500
$
Balances 5,500
$ 2,500
$ 8,000
$
May 8 (2,000) 15,000
$ 13,000
$
Balances 3,500
$ 2,500
$ 15,000
$ 13,000
$ 8,000
$
May 11 300 300
$
Balances 3,500
$ 2,800
$ 15,000
$ 13,000
$ 300
$ 8,000
$
May 18 150
$ (150)
Balances 3,500
$ 150
$ 2,650
$ 15,000
$ 13,000
$ 300
$ 8,000
$
May 25 75 (75)
Balances 3,575
$ 75
$ 2,650
$ 15,000
$ 13,000
$ 300
$ 8,000
$
May 28 (150) (150)
Balances 3,425
$ 75
$ 2,650
$ 15,000
$ 13,000
$ 150
$ 8,000
$
May 29 750 750
Balances 4,175
$ 75
$ 2,650
$ 15,000
$ 13,000
$ 150
$ 8,000
$ 750
$
May 31 (50) (50)
Balances 4,125
$ 75
$ 2,650
$ 15,000
$ 13,000
$ 150
$ 8,000
$ 700
$
Owners' Equity
To explain how the statement of financial position, often referred to as the
balance sheet, is an expansion of the basic accounting equation.

Cash +
Accts.
Rec. +
Tools &
Equip. + Truck =
Notes
Payable +
Accts.
Pay. +
Capital
Stock +
Retained
Earnings
May 1 8,000
$ 8,000
$
Balances 8,000
$ 8,000
$
May 2 (2,500) 2,500
$
Balances 5,500
$ 2,500
$ 8,000
$
May 8 (2,000) 15,000
$ 13,000
$
Balances 3,500
$ 2,500
$ 15,000
$ 13,000
$ 8,000
$
May 11 300 300
$
Balances 3,500
$ 2,800
$ 15,000
$ 13,000
$ 300
$ 8,000
$
May 18 150
$ (150)
Balances 3,500
$ 150
$ 2,650
$ 15,000
$ 13,000
$ 300
$ 8,000
$
May 25 75 (75)
Balances 3,575
$ 75
$ 2,650
$ 15,000
$ 13,000
$ 300
$ 8,000
$
May 28 (150) (150)
Balances 3,425
$ 75
$ 2,650
$ 15,000
$ 13,000
$ 150
$ 8,000
$
May 29 750 750
Balances 4,175
$ 75
$ 2,650
$ 15,000
$ 13,000
$ 150
$ 8,000
$ 750
$
May 31 (50) (50)
Balances 4,125
$ 75
$ 2,650
$ 15,000
$ 13,000
$ 150
$ 8,000
$ 700
$
Owners' Equity
These transactions
impact the
Statement of Cash
Flows.
These transactions
impact the Income
Statement.
Let’s prepare the Income Statement and Statement of Cash Flows
for Abeba’s Care Service company for the month ending May 31,
2007.

Investments by and payments to the owners
are not included on the Income Statement.
To explain how the income statement reports an enterprise’s financial
performance for a period of time in terms of the relationship of
revenues and expenses.
Abeba's Care Service
Income Statement
For the Month Ended May 31, 2007
Sales Revenue 750
$
Operating Expense:
Gasoline Expense 50
Net Income 700
$

To explain how the statement of cash flows presents the change in cash
for a period of time in terms of the company’s operating, investing, and
financing activities.
Abeba's Care Service
Cash flows from operating activities:
Cash received from revenue transactions 750
$
Cash paid for expenses (50)
Net cash provided by operating activities 700
$
Cash flows from investing activities:
Purchase of office equipment (2,500)
$
Purchase of truck (2,000)
Collection for sale of repair parts 75
Payment for repair parts (150)
Net cash used by investing activities (4,575)
Cash flows from financing activities:
Investment by owners 8,000
Increase in cash for month 4,125
$
Cash balance, May 1, 2007 -
Cash balance, May 31, 2007 4,125
$

Abeba’s Care Service
$
$
$
$
$
Operating activities include
the cash effects of revenue
and expense transactions.

Abeba Care Service
$
$
$
$
$
Investing activities include the
cash effects of purchasing and
selling assets.

Abeba Care Service
$
$
$
$
$
Financing activities include the cash
effects of transactions with the owners
and creditors.

Cash +
Accts.
Rec. +
Tools &
Equip. + Truck =
Notes
Payable +
Accts.
Pay. +
Capital
Stock +
Retained
Earnings
May 1 8,000
$ 8,000
$
Balances 8,000
$ 8,000
$
May 2 (2,500) 2,500
$
Balances 5,500
$ 2,500
$ 8,000
$
May 8 (2,000) 15,000
$ 13,000
$
Balances 3,500
$ 2,500
$ 15,000
$ 13,000
$ 8,000
$
May 11 300 300
$
Balances 3,500
$ 2,800
$ 15,000
$ 13,000
$ 300
$ 8,000
$
May 18 150
$ (150)
Balances 3,500
$ 150
$ 2,650
$ 15,000
$ 13,000
$ 300
$ 8,000
$
May 25 75 (75)
Balances 3,575
$ 75
$ 2,650
$ 15,000
$ 13,000
$ 300
$ 8,000
$
May 28 (150) (150)
Balances 3,425
$ 75
$ 2,650
$ 15,000
$ 13,000
$ 150
$ 8,000
$
May 29 750 750
Balances 4,175
$ 75
$ 2,650
$ 15,000
$ 13,000
$ 150
$ 8,000
$ 750
$
May 31 (50) (50
Balances 4,125
$ 75
$ 2,650
$ 15,000
$ 13,000
$ 150
$ 8,000
$ 700
$
Owners' Equity
Now, let’s prepare the Balance Sheet for Abeba’s
Care Service company for May 31, 2007.
These balances will
appear on the
Balance Sheet.

$21,850 = $13,150 + $8,700
Cash 4,125
$ Notes payable 13,000
$
Accounts receivable 75 Accounts payable 150
Tools & equipment 2,650
Truck 15,000 Capital stock 8,000
Retained earnings 700
Total assets 21,850
$ Total liabilities & equity 21,850
$
Assets Liabilities
Owners' Equity
Abeba's Care Service Company
Balance Sheet
May 31, 2007

Relationships Among Financial
Statements
Date at
beginning
of period
Date at
end of
period
Balance
Sheet
Balance
Sheet
Time
Income Statement
To explain the important relationships among the statement of financial
position, income statement, and statement of cash flows, and how
these statements relate to each other.

Financial Statement Articulation
Abeba's Car service company
Cash flowsfrom operating activities:
$
$
Cash flowsfrom investing activities:
Purchase of lawn mower (2,500)
$
Cash flowsfrom financing activities:
$
$
Abeba's Car service company
Income Statement
Sales Revenue 750
$
Operating Expense:
Gasoline Expense 50
Net Income 700
$
Cash 4,125
$ Notes payable 13,000
$
Accounts receivable 75 Accounts payable 150
Tools & equipment 2,650
Truck 15,000 Capital stock 8,000
Retained earnings 700
Total assets 21,850
$ Total liabilities & equity 21,850
$
Assets Liabilities
Owners' Equity
Abeba’s Care Service Company
Balance Sheet
May 31, 2007

Forms of Business Organization
Sole
Proprietorships Partnerships Corporations

Forms of Business Organization
 Most business organizations are organized as a sole proprietorship, a
partnership or a corporation.
 Sole proprietorship:- is unincorporated business owned by a
single person. It is separated from the other
affairs of its owner. It is common for small
retailer stores, farms, service business and
professional practices, like in law, medicine and
accounting.
 Partnership: is unincorporated business owned by two or more
persons agree to act as partners (co-owners). It is widely
used for small business.
 Corporation: is a type of business organization that is recognized
under the law as an entity separate from its owners.
 GAAP can be applied to the financial statements of all three forms of
organization.

Characteristics of Business organizations
Sole proprietorship Partnership Corporation
Owner Proprietor—only
one owner
Partners—two or
more owners
Stockholders—
generally many owners
Life of organization Limited by the owner’s
choice, or death
Limited by the owner’s
choice, or death
Indefinite
Legal viewpoint Owner and business entity are not
regarded as separate
Owners and business entity
are not regarded as separate
Separate entity from owners
Accounting viewpoint Business entity is separated from other
affairs of owner
Business entity is separated
from other affairs of owners
Business entity is separated
from other affairs of owners
Separate taxable entity from
owner
No No Yes
Ease of formation Very easy Partnership agreement is
helpful
Articles of corporation
generally requires
Management Owner May be divided among
partners
Board of directors
Personal liability
of the owner(s) for
the business’s debts
Proprietor is
personally liable
Partners are
personally liable
Stockholders are not
personally liable
Transferability of ownership Only by sale of entire business or
creation of different entity
Can sell all or a portion of
partnership interest
Can easily transfer(sell) all or a
portion of stock

Reporting Ownership Equity in the Statement
of Financial Position
Owner's equity:
Abeba, capital 8,000
$
Sole
Proprietorships
Partners' equity
Alemu, capital 4,000
$
Kebede, capital 4,000
Total partners' equity 8,000
$
Partnerships
Owners' equity
Capital stock 7,000
$
Total stockholders' equity 8,000
$
Corporations

BASIC FINANCIAL STATEMENTS BASIC FINANCIAL STATEMENTS

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