Financial Accounting

Unit 2: Accounting Principles and Practices

Financial Statements

Financial statements are how companies communicate their story.  Thanks to GAAP, there are four basic financial statements everyone must prepare . Together they represent the profitability and strength of a company. The financial statement that reflects a company’s profitability is the income statement. The statement of retained earnings - also called statement of owners equity shows the change in retained earnings between the beginning and end of a period (e.g. a month or a year). The balance sheet reflects a company’s solvency and financial position.  The statement of cash flows shows the cash inflows and outflows for a company over a period of time.

There are several accounting activities that happen before financial statements are prepared. Financial statements are prepared in the following order:

  1. Income Statement
  2. Statement of Retained Earnings - also called Statement of Owners' Equity
  3. The Balance Sheet
  4. The Statement of Cash Flows

The following video summarizes the four financial statements required by GAAP.

Remember the transaction analysis we were working on for Metro Courier?  Let's use those numbers to prepare the financial statements for Metro Courier Inc.  The final balances for January were:

Cash Asset $ 66,800
Accounts Receivable Asset $ 5,000
Supplies Asset $ 500
Prepaid rent Asset $ 1,800
Equipment Asset $ 5,500
Truck Asset $ 8,500
Accounts Payable Liability $ 200
Common Stock Equity $ 30,000
Retained Earnings Equity $ 0
Service Revenue Revenue $ 60,000
Salary Expense Expense $ 900
Utilities Expense Expense $ 1,200

Income Statement

The income statement, sometimes called an earnings statement or profit and loss statement, reports the profitability of a business organization for a stated period of time. In accounting, we measure profitability for a period, such as a month or year, by comparing the revenues earned with the expenses incurred to produce these revenues.  This is the first financial statement prepared as you will need the information from this statement for the remaining statements.  The income statement contains:

  • Revenues are the inflows of cash resulting from the sale of products or the rendering of services to customers. We measure revenues by the prices agreed on in the exchanges in which a business delivers goods or renders services.
  • Expenses are the costs incurred to produce revenues. Expenses are costs of doing business (typically identified as accounts ending in the word "expense").
  • REVENUES - EXPENSES = NET INCOME.  Net income is often called the earnings of the company. When expenses exceed revenues, the business has a net loss. 

Metro Courier Inc.  
Income Statement  
Month Ended January 31  
   Service Revenue $ 60,000
    Total Revenues $ 60,000
  Salary Expense 900
   Utility Expense 1, 200
   Total Expenses 2,100
Net Income ($60,000 - 2,100)  $ 57,900
The net income from the income statement will be used in the Statement of Equity.

 Statement of  Retained Earnings (or Owner's Equity)

The statement of retained earnings, explains the changes in retained earnings between two balance sheet dates. We start with beginning retained earnings (in our example, the business began in January so we start with a zero balance) and add any net income (or subtract net loss) from the income statement.  Next, we subtract any dividends declared (or any owner withdrawals in a partnership or sole-proprietor) to get the Ending balance in Retained Earnings (or capital for non-corporations)

Metro Courier Inc.  
Statement of Retained Earnings  
Month Ended January 31  
Beginning Retained Earnings, Jan 1 $   0
  Net income from month (from income statement)  57,900
Total increase $ 57,900
Dividends (or withdrawals for non-corporations)  - $0
Ending Retained Earnings, January 31   $ 57,900
The Ending balance we calculated for retained earnings (or capital) is reported on the balance sheet.

 Balance Sheet

The balance sheet,  lists the company’s assets, liabilities, and equity (including dollar amounts) as of a specific moment in time. That specific moment is the close of business on the date of the balance sheet. Notice how the heading of the balance sheet differs from the headings on the income statement and statement of retained earnings. A balance sheet is like a photograph; it captures the financial position of a company at a particular point in time. The other two statements are for a period of time. As you study about the assets, liabilities, and stockholders’ equity contained in a balance sheet, you will understand why this financial statement provides information about the solvency of the business.  

Metro Courier Inc.
Balance Sheet
January 31
Assets  Liabilities and Equity  
Cash $  66,800 Accounts Payable 200
Accounts Receivable 5,000   Total Liabilities 200
Supplies 500
Prepaid Rent 1,800 Common Stock 30,000
Equipment 5,500 Retained Earnings 57,900
Truck 8,500    Total Equity 87,900
    Total Assets $ 88,100  Total Liabilities + Equity $ 88,100
Remember in the transaction analysis, our final accounting equation was:   Assets $88,100 (Cash $66,800 + Accounts Receivable $5,000 + Supplies $500 + Prepaid Rent $1,800 + Equipment $5,500 + Truck $8,500) = Liabilities $200 + Equity $87,900 (Common Stock $30,000 + Net Income $57,900 from revenue of $60,000 –  salary expense $900 – utility expense $1,200).  The balance sheet is the same equation in an easier to read format.

 Statement of Cash Flows

The statement of cash flows shows the cash inflows and cash outflows from operating, investing, and financing activities. Operating activities generally include the cash effects of transactions and other events that enter into the determination of net income. Management is interested in the cash inflows to the company and the cash outflows from the company because these determine the company’s cash it has available to pay its bills when due.  We will examine the statement of cash flows in more detail later but for now understand it is a required financial statement and is prepared last.  The statement of cash flows uses information from all previous financial statements.

You should be able to update the Financial Statements column of our chart of accounts spreadsheet (need another copy, click Chart of Accounts)

Key Points

There are four financial statements produced by accountants, including

  • The income statement reports the revenues and expenses of a company and shows the profitability of that business organization for a stated period of time.  The net income (or loss) calculated is used in the statement of retained earnings.
  • The statement of retained earnings shows the change in retained earnings between the beginning of the period (e.g. a month) and its end.  The ending retained earnings is used by the balance sheet.
  • The balance sheet lists the assets, liabilities, and equity (including dollar amounts) of a business organization at a specific moment in time and proves the accounting equation.
  • The statement of cash flows which shows the cash inflows and cash outflows for a company for a stated period of time.  The statement of cash flows uses information from all previous financial statements.

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