Task Team of FUNDAMENTAL ACCOUNTING
School of Business, Sun Yat-sen University
Lesson notes
Lesson 9: Financial Statements
Learning objectives
1. Learn what financial statements are and how these accounting tools work in their future profession
2. Be acquainted with the functions and formats of these financial statements
3. Learn some details relating to preparation of these financial statements.
4. Explain important relationships among the balance sheet, income statement, and cash flow statement,
and how these statements relate to each other
Teaching hours
Students major in accounting: 9 hours
Others:
6 hours
Teaching contents:
Opening Story
The financial statement sits imposingly in front of you, a stream of numbers rolling endlessly down
the page. You’re a new board member, studying the numbers, hoping to decipher their meaning. Then
you’re hit with the accounting jargon: balance sheets and income statements; cash basis and accrual basis.
You think you hear the financial statements quietly laugh at you, and you begin to wonder if the board
should hire a psychiatrist instead of an accountant.
Don’t despair. Financial statements may seem confusing initially, but they’re not as difficult as you
think. Here’s a look at the basics.
“Show me the money!”
Cuba Gooding Jr. uttered an immortal line in the movie Jerry Maguire,
“Show me the money!” Well, that is what financial statements do. They show
you the money.
The questions are:
* Do they show you where a company’s money came from?
* Do they show you where it went, and where it is now.
* How accountants make all these ends satisfied?
What Are the Financial Statements?
Organizations report their accounting information to internal and external users in the form of
financial statements. Statements reveal an organization’s financial health and performance. The financial
statement is a picture of the company in financial terms. Each financial statement relates to a specific date
or covers a particular period.
Task Team of FUNDAMENTAL ACCOUNTING
School of Business, Sun Yat-sen University
Stock/ resources and obligations at a point in time: Balance sheet.
Flow/activity over a period of time: Income statement, Statement of cash flows.
The instructor might facilitate some discussion on the importance of financial statements to a company
and its investors and creditors and why management may take steps to improve the appearance of the
company in its financial statements.
How Are Financial Statements Prepared?
The first step in understanding financial statements is to determine whether they were prepared on a
cash, accrual, or modified cash accounting basis. Why? Financial statements vary greatly depending on the
accounting method. The reader must know which accounting method was used in order to accurately read
the statement.
The three methods are defined as follows:
Cash Basis. Cash basis accounting is similar to a personal checkbook. Financial records track when
cash is received or paid out. Income is recorded when a deposit is made to the bank. Expenses are recorded
when a check is written to pay a bill.
Cash basis financial statements are easy to understand and to prepare. The disadvantage, however, is
they don’t give a full picture of the financial condition. The records omit information on unpaid bills or
uncollected assessments.
Accrual Basis. Accrual basis accounting tracks any and all transactions, even if cash is not received or
paid out. For example, income is recorded when the dues are assessed, not necessarily when they are
collected. The same is true for expenses. Expenses are recorded when they are incurred. For example, if the
association buys new equipment, the purchase is recorded even if the bill has not been paid. Because it
tracks all income and expenses, accrual basis accounting more accurately records the financial activity of a
particular time period.
Modified Cash Basis. Most associations use modified cash basis accounting for their record keeping.
It is a compromise between the cash basis and accrual basis. With this method, most transactions are
recorded on the cash basis, but some are logged on an accrual basis. For example, accounts receivable
(amounts owners owe the association) and income commonly are recorded as they are billed (accrual basis).
Expenses are recorded as the bills are paid (cash basis). Other accrual adjustments, such as prepaid
expenses and income tax accruals, are not made.
Modified cash basis is less complex than accrual basis financial statements. During the annual review
or audit, however, a CPA often must convert the financial statements to accrual basis.
What Are the Functions of Financial Statements?
Accounting information is conveyed through a standardized set of reports. The four fundamental
financial statements are the income statement, statement of retained earnings, balance sheet, and statement
of cash flows.
Useful for investment decisions. (All financial statements)
Comprehensible. (All financial statements)
About economic resources and claims on resources (Balance Sheet).
Task Team of FUNDAMENTAL ACCOUNTING
School of Business, Sun Yat-sen University
About financial performance during a period (Income Statement).
About cash flows (Statement of Cash Flows).
The financial statements can help you to better understand the performance and position of a business,
so that the students can be directed to participate in the in-class discussion on the following topics:
1. How well did the company perform (or operate) during the period?
2. Why did the company’s retained earnings change during the period?
3. What is the company’s financial position at the end of the period?
4. How much cash did the company generate and spend during the period?
What Financial Statements Are Required by the GAAPs?
This section will explain 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.
First of all, to make it clear to the students that some financial statements are required by the
regulators, we review the concept of GAAP here. The rules that make acceptable accounting practices are
referred to as Generally Accepted Accounting Principles (GAAP). Information presented using these
principles is considered to be relevant, reliable, consistent and comparable.
INCOME STATEMENT
A summary of an entity's results of operation for a specified period of time is revealed in the income
statement, as it provides information about revenues generated and expenses incurred. The differences
between the revenues and expenses are identified as the net income or net loss.
This financial statement is use 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.
BALANCE SHEET
The balance sheet focuses on the accounting equation by revealing the economic resources owned by
an entity and the claims against those resources (liabilities and owners' equity). The balance sheet is
prepared as of a specific date, whereas the income statement and statement of retained earnings cover a
period of time.
This financial statement demonstrates how certain business transactions affect the elements of the
accounting equation: Assets = Liabilities + Shareholders' (Owners') Equity. After learning this, students are
supposed to understand how the balance sheet is an expansion of the basic accounting equation.
Assets: properties or economic resources owned by the business. Common characteristic is the ability
to provide probable future economic benefits to the business.
Liabilities: debts or obligations of a business or claims against assets. A common characteristic is
capacity to reduce future assets or to require future services or products.
Equity: is the owner’s claim to the assets or the residual interest in the assets of an entity after
deducting liabilities; also called net assets.
STATEMENT OF CASH FLOWS
This financial statement is a bit more complex, detailing an enterprises cash flows, broken down
Task Team of FUNDAMENTAL ACCOUNTING
School of Business, Sun Yat-sen University
according to operating, investing, and financing sources. Its coverage is best deferred until you have had a
chance to progress further in your study of accounting.
This financial statement is used to explain how the cash flow statement presents the change in cash for
a period of time in terms of the company's operating, investing, and financing activities.
ILLUSTRATIVE STATEMENTS
The following portrays sample final statements for Beauty Photo Store.
Beauty Photo Store
Balance Sheet
January 31,2005
Assets
Cash
Supplies
Equipment
$
Liabilities
8,400
3,600
26,000
Accounts payable
Notes payable
Total liabilities
$
$
200
6,000
6,200
Owner's Equity
Total assets
$
38,000
Wang Fang, capital
Total liabilities and
owner's equity
31,800
$ 38,000
Beauty Photo S tore
Income S tatement
For Month Ended January 31, 2005
Revenues:
S ales revenue
Rental revenue
Total revenues
Operating Expenses:
Rent expense
$ 1,000
S alaries expense
700
Total operating expenses
Net income
$ 3,800
300
$ 4,100
1,700
$ 2,400
Task Team of FUNDAMENTAL ACCOUNTING
School of Business, Sun Yat-sen University
Beauty Photo Store
Statement of Owner's Equity
For month ended January 31,2005
wang Fang, capital, January 1
Add:
Investment by owner
$
Net income
Total
Less: Withdrawal by owner
Wang Fang, capital, January 31
$
-
$
32,400
32,400
600
31,800
30,000
2,400
Be auty Photo Store
State me nt of Cash Flows
For Month Ende d January 31, 2005
Cash flows from operating activities:
Cash received from clients
Cash paid for supplies
Cash paid for rent
Cash paid to employee
Net cash used by operating acitivities
Cash flows from investing activities:
Purchase of equipment
Net cash used by investing activities
Cash flows from financing activities:
Investment by owner
Partial repayment of note
Withdrawal by owner
Net cash provided by financing activities
Net increase in cash
Cash balance, January 1
Cash balance, January 31
$
4,100
(2,500)
(1,000)
(700)
$
(100)
$ (20,000)
(20,000)
$ 30,000
(900)
(600)
$
$
28,500
8,400
8,400
Additional examples (if there is some extra time): The following are three financial statements of Tony
Blow Corporation. Please take time to review these statements, noting carefully how the net income on the
income statement flows through to the statement of retained earnings, and how the ending retained earnings
flows through to the balance sheet.
Tony Blow Corporation
Income Statement
For the year ending December 31, 20X3
Revenues
Services to customers
$750,000
Interest income
15,000
Total revenues
$765,000
Expenses
Salaries
$235,000
Task Team of FUNDAMENTAL ACCOUNTING
School of Business, Sun Yat-sen University
Rent
Other operating expenses
Total expenses
Net income
115,000
300,000
650,000
$115,000
Quartz Corporation
Statement of Retained Earnings
For the year ending December 31, 20X3
Beginning retained earnings $400,000
Plus: Net income
115,000
$515,000
Less: Dividends
35,000
Ending retained earnings
$480,000
Assets
Cash
$192,000
Accounts receivable 248,000
Land
450,000
Other assets
10,000
Total assets
$900,000
Quartz Corporation
Balance Sheet
December 31, 20X3
Liabilities
Salaries payable
Accounts payable
Total liabilities
Stockholders' equity
Capital stock
Retained earnings
Total stockholders' equity
Total Liabilities and equity
$ 34,000
166,000
$200,000
$220,000
480,000
700,000
$900,000
Summary
There are two major types of financial statements-stock reports and flow reports;
Financial statement can serve as an important device to disclose information to investors in order for
them to make better decisions;
Four major financial statements are compared, explained and illustrated in this lesson;
In this section, the former case of The Beauty Photo Store is picked up again here, and its four major
financial statements are illustrated to show its performance and financial positions.
Case for Open Discussion
You’re a new board member, studying the numbers, hoping to decipher their meaning. Then you’re hit
with the accounting jargon: balance sheets and income statements; cash basis and accrual basis. You think
you hear the financial statements quietly laugh at you, and you begin to wonder if the board should hire a
psychiatrist instead of an accountant.
Suggested Questions:
1) How are financial statements prepared?
Task Team of FUNDAMENTAL ACCOUNTING
School of Business, Sun Yat-sen University
2) Do they make things simpler?
3) What information can we infer from these statements?
4) How can we make use of them?