Ch. 2 Financial Statements and Adjusting Entries
2.3 Financial Statements: Review
Learning Objectives
After finishing this section, students will be able to:
- Create a multi-step income statement.
- Create a statement of owner’s equity.
- Create a classified balance sheet.
- Create a direct cash flow statement.
One method used by everyone who evaluates financial statements is to calculate financial ratios. Financial ratios take numbers from your income statements and/or your balance sheet to evaluate important financial outcomes that will impact user decisions.
There are ratios to evaluate your liquidity, solvency, profitability, and efficiency. Liquidity ratios look at your ability to pay the debts that you owe in the near future. Solvency will show if you can pay your bills not only in the short term but also in the long term. Profitability ratios are calculated to see how much profit is being generated from a company’s sales. Efficiency ratios will be calculated to see how efficient a company is using its assets in running its business. You will be introduced to these ratios and how to interpret them in your finance course.
Multi-step Income Statement
The multi-step income statement was discussed in 1.3 Financial Statements: Income Statement. Please take time to review.
Statement of Owner’s Equity
The statement of owner’s equity was discussed in 1.4 Financial Statements: Statement of Stockholders’ Equity. Please take time to review.
Please note that the most common error on the Balance Sheet comes from not calculated Retained Earnings correctly on the Statement of Owner’s Equity.
Classified Balance Sheet
Classified balance sheets show more about the makeup of our assets and liabilities, allowing us to better analyze the current health of our company and make future strategic plans. Classification means to put accounts into groups based on characteristics (operating period, presence, etc). A company’s typical operating period (sometimes called an operating cycle) is a year, This does not mean a calendar year but 365 days.
In 1.2 Accounting Quick Reference and Terms, the balance sheets accounts are labeled with classifications to help you. If you haven’t printed it yet, I encourage you to do so.
Classifications that appear under the asset section are:
- Current assets are accounts that will be turn into cash in less than one operating cycle or one year.
- Long-term investment are stocks, bonds, or other types of investments that management intends to hold for more than one operating cycle or one year, whichever is longer.
- Property, plant, and equipment are tangible assets (those that have a physical presence) held for more than one operating cycle or one year, whichever is longer.
- As the market value of property, plant, and equipment increase, the value on the accounting records remain the same as the original purchase price.
- Intangible assets do not have a physical presence but give the company a long-term future benefit. Some examples include goodwill, patents, copyrights, and trademarks.
Classifications that appear under the liability section are:
- Current liabilities are a debt or obligation due within a company’s standard operating period, typically a year, although there are exceptions that are longer or shorter than a year.
- Long-term liabilities are a debt or obligation due in more than one operating cycle or one year, whichever is longer.
An example of a classified balance sheet can be found in horizontal model section below.
Statement of Cash Flows
The statement of cash flows was discussed in 1.7 Financial Statements: Direct Statement of Cash Flows. Please take time to review.
Timing of Issuing Financial Statements
The Fiscal Year and the Calendar Year
A company may choose its yearly reporting period to be based on a calendar or fiscal year. If a company uses a calendar year, it is reporting financial data from January 1 to December 31 of a specific year. This may be useful for businesses needing to coincide with a traditional yearly tax schedule. It can also be easier to track for some businesses without formal reconciliation practices, and for small businesses.
A fiscal year is a twelve-month reporting cycle that can begin in any month and records financial data for that consecutive twelve-month period. For example, a business may choose its fiscal year to begin on April 1, 2019, and end on March 31, 2020. This can be common practice for corporations and may best reflect the operational flow of revenues and expenses for a particular business. In addition to annual reporting, companies often need or choose to report financial statement information in interim periods.
Interim Periods
An interim period is any reporting period shorter than a full year (fiscal or calendar). This can encompass monthly, quarterly, or half-year statements. The information contained on these statements is timelier than waiting for a yearly accounting period to end. The most common interim period is three months, or a quarter. For companies whose common stock is traded on a major stock exchange, meaning these are publicly traded companies, quarterly statements must be filed with the SEC on a Form 10-Q. The companies must file a Form 10-K for their annual statements.
Comparison of the Three Financial Statements
Another way to think of the connection between the income statement and balance sheet (which is aided by the statement of owner’s equity) is by using a sports analogy. The income statement summarizes the financial performance of the business for a given period of time. The income statement reports how the business performed financially each month—the firm earned either net income or net loss. This is similar to the outcome of a particular game—the team either won or lost.
The balance sheet summarizes the financial position of the business on a given date. Meaning, because of the financial performance over the past twelve months, for example, this is the financial position of the business as of December 31. Think of the balance sheet as being similar to a team’s overall win/loss record—to a certain extent a team’s strength can be perceived by its win/loss record.
Stakeholders need to know the financial performance (as measured by the income statement—that is, net income or net loss) and financial position (as measured by the balance sheet—that is, assets, liabilities, and owners’ equity) of the business. However, since these financial statements are prepared using accrual accounting, stakeholders do not have a clear picture of the business’s cash activities. The statement of cash flows solves this inadequacy by specifically focusing on the cash inflows and cash outflows. Think of the statement of cash flow as being similar to the details of the game that caused them to win or lose.
Because different companies have different sizes, you do not necessarily want to compare the financial statements of two different companies. For example, you would not want to compare a local retail store with Walmart. In most cases you want to compare a company with its past financial statement information. This can be done by comparing weeks, months, quarters, or years.
| Income Statement | Balance Sheet | Cash Flow | |
|---|---|---|---|
| Time | Period of time | A point in time | Period of time |
| Purpose | Profitability | Financial position | Cash movements |
| Measures | Revenue, expenses, profitability | Assets, liabilities, shareholders’ equity | Increases and decreases in cash |
| Starting Point | Revenue | Cash balance | Net income |
| Ending Point | Net income | Retained earnings | Cash balance |
Horizontal Model: Financial Statements
We will use Printing Plus’ horizontal model from the past sections to create the four financial statements.
| Balance Sheet | Income Statement | Stmt of Cash Flows | ||||||||||||||||||||||||||
| Cash | + | Accounts Receivable | + | Inventory | + | Equipment | = | Accounts Payable | + | Salaries Payable | + | Unearned Revenue | + | Income Tax Payable | + | Common Stock | + | Retained Earnings | Revenue | – | Expense | = | Net Income | Cash | OA,IA,FA | Description | ||
| J3 | 20,000 | + | + | + | = | + | + | + | + | 20,000 | + | 20,000 | FA | Stock | ||||||||||||||
| J5 | + | + | + | 3,500 | = | 3,500 | + | + | + | + | + | – | – | Equipment | ||||||||||||||
| J9 | 4,000 | + | + | + | = | + | + | 4,000 | + | + | + | 4,000 | OA | Cust. Pay | ||||||||||||||
| J10 | + | 5,500 | + | + | = | + | + | + | + | + | 5,500 | 5,500 | – | 5,500 | – | – | Revenue | |||||||||||
| J12 | -300 | + | + | + | = | + | + | + | + | + | -300 | 300 | -300 | -300 | OA | Utility Exp | ||||||||||||
| J14 | -100 | + | + | + | = | + | + | + | + | + | -100 | -100 | FA | Dividends | ||||||||||||||
| J17 | 2,800 | + | + | + | = | + | + | + | + | + | 2,800 | 2,800 | 2,800 | 2,800 | OA | Revenue | ||||||||||||
| J18 | -3,500 | + | + | + | = | -3,500 | + | + | + | + | + | -3,500 | IA | Equipment | ||||||||||||||
| J20 | -3,600 | + | + | + | = | + | + | + | + | + | -3,600 | 3,600 | -3,600 | -3,600 | OA | Wages Exp | ||||||||||||
| J23 | 5,500 | + | -5,500 | + | + | = | + | + | + | + | + | 5,500 | OA | Cust. Pay | ||||||||||||||
| J27 | + | 1,200 | + | + | = | + | + | + | + | + | 1,200 | 1,200 | 1,200 | OA | Revenue | |||||||||||||
| J30 | + | + | 500 | + | = | 500 | + | + | + | + | + | Inventory | ||||||||||||||||
| 24,800 | + | 1,200 | + | 500 | + | 3,500 | = | 500 | + | + | 4,000 | + | + | 20,000 | + | 5,500 | 9,500 | – | 3,900 | = | 5,600 | 24,800 | Totals | |||||
| a | – | + | + | -100 | + | = | + | + | + | + | + | -100 | – | 100 | = | -100 | – | – | COGS | |||||||||
| b | – | + | + | + | = | + | + | -600 | + | + | + | 600 | 600 | – | = | 600 | – | – | Revenue | |||||||||
| c | – | + | + | + | = | + | 1,500 | + | + | + | + | -1500 | – | 1,500 | = | -1,500 | – | – | Salaries Exp | |||||||||
| d | – | + | + | + | = | + | + | + | 987 | + | + | -987 | – | 987 | = | -987 | – | – | Income Tax Exp | |||||||||
| 24,800 | + | 1,200 | + | 400 | + | 3,500 | = | 500 | + | 1,500 | + | 3,400 | + | 987 | + | 20,000 | + | 3,513 | 10,100 | – | 6,487 | = | 3,613 | 24,800 | Totals | |||
Income Statement
Based on our limited knowledge of Cost of Goods sold, we will assume all expenses are selling, general, and administrative expense. Adding the descriptions to the model will make matching the number to accounts in the Income Statement easier. When you have finished the Income Statement, make sure Net Income matches the Net Income total in the horizontal model.
| Printing Plus | ||
| Income Statement | ||
| For the Month Ended June 30, 20X8 | ||
| Revenue | $10,100 | |
|---|---|---|
| Cost of Good Sold | 100 | |
| Gross Margin | 10,000 | |
| Operating Expenses | ||
| Salaries Expense | 1,500 | |
| Utility Expense | 300 | |
| Wages Expense | 3,600 | |
| Total Operating Expenses | 5,400 | |
| Income Before Taxes | 4,600 | |
| Tax Expense | 987 | |
| Net Income | $3,613 | |
Statement of Stockholders’ Equity
The detail to calculate common stock and retained earnings are found in the transactions. Ending common stock and ending retained earnings are the same amount in the horizontal model totals.
| Printing Plus | ||
| Statement of Stockholders’ Equity | ||
| For August 20XX | ||
| Beginning Common Stock | $0 | |
|---|---|---|
| + Common Stock Issued | 20,000 | |
| Ending Common Stock |
$20,000 | |
| – | ||
| Beginning Retained Earnings | 0 | |
| + Net Income | 3,613 | |
| – Dividends | 100 | |
| Ending Retained Earnings | 3,513 | |
| Total Stockholders’ Equity | $23,513 | |
Classified Balance Sheet
| Printing Plus | ||
| Balance Sheet | ||
| as of June 30, 20X8 | ||
| Assets | ||
|---|---|---|
| Current Assets | ||
| Cash | $24,800 | |
| Accounts Receivable | 1,200 | |
| Inventory | 400 | |
| Total Current Assets | $26,400 | |
| Property, Plant, and Equipment | ||
| Equipment | 3,500 | |
| Total Property, Plant, and Equipment | 3,500 | |
| Total Assets | $29,900 | |
| Liabilities and Stockholders’ Equity | ||
| Liabilities | ||
| Current Liabilities | ||
| Accounts Payable | $500 | |
| Salaries Payable | 1,500 | |
| Unearned Revenue | 3,400 | |
| Income Tax Payable |
987 | |
| Total Current Liabilities | $6,387 | |
| Stockholders’ Equity | ||
| Common Stock | 200 | |
| Retained Earnings | 3,132 | |
| Total Stockholders’ Equity | 15,632 | |
| Total Liabilities and Stockholder’s Equity | $29,900 | |
Statement of Cash Flows
As we bring the numbers into the Statement of Cash Flow, DO NOT change the signs on the number in the cash column. Remember to complete the cash reconciliation at the bottom of the statement to make sure the ending cash balance is the same the amount on the Balance Sheet.
| Printing Plus | ||
| Statement of Cash Flows | ||
| as of June 30, 20X8 | ||
| Cash flows from operating activities | ||
|---|---|---|
| Received payments from customers | $12,300 | |
| Paid for wages expenses | -3,600 | |
| Paid for utilities expenses | -300 | |
| Net cash flows from operating activities | 8,400 | |
| Cash flows from investing activities | ||
| Purchased Equipment | -3,500 | |
| Net cash flows from investing activities | -3,500 | |
| Cash flows from financing activities | ||
| Issued Common Stock | 20,000 | |
| Paid cash dividends | -100 | |
| Net cash flows from financing activities | 19,900 | |
| Net cash flow | 24,800 | |
| Beginning cash balance | 0 | |
| Ending cash balance | $24,800 | |
2.3a Example
Watch video from 17:24 to end.
Instructions:
- Using the Horizontal Model from 2.2a Example for Wood, Corp., prepare financial statements.
- Prepare an Income Statement for Jan 20X9.
- Prepare a Statement of Stockholders’ Equity for Jan 20X9.
- Prepare a CLASSIFIED Balance Sheet as of Jan 20X9.
- Prepare a Statement of Cash Flows as of Jan 20X9.
2.3a Practice
Using the Horizontal Model from 2.2a Practice, prepare an Income Statement, Statement of Stockholder’s Equity, Classified Balance Sheet, and Statement of Cash Flows as of December 31, Year 4.
Check Figures:
Look at the Horizontal Model Solution in 2.2a Practice, do the numbers in the model match the numbers on your financial statements. Using this method allows you to remember the big picture of financial statements so you don’t get lost in the details.
2.3a Homework
Instructions:
- Using the Horizontal Model from 2.2a Example for Grazy Strokes Glass Blowers, prepare financial statements.
- Prepare an Income Statement for August 20X4.
- Prepare a Statement of Stockholders’ Equity for August 20X4.
- Prepare a CLASSIFIED Balance Sheet as of August 20X4.
- Prepare a Statement of Cash Flows as of August 20X4.
Licensing and Attribution:
Content on this page is adapted from the following openly licensed resource(s):
Principles of Accounting, Volume 1: Financial Accounting by Mitchell Franklin, Patty Graybeal, and Dixon Cooper licensed under a Creative Commons Attribution-NonCommercial-ShareAlike 4.0 International License
