Chapter 1: Financial Statements

Financial Statements Overview Financial statements summarize a company's financial performance and position over a specific period or at a specific point in time. They are prepared in a specific order to ensure proper linkage between them. Below are the four key financial statements and their purposes, along with their interrelationships: 1. Income Statement • • Purpose: Reports the company's revenues and expenses for a specific period, and shows whether the company earned a net income or incurred a net loss. Components: o Revenues: Generated from operations, such as consulting services and rental income. o Expenses: Costs incurred to generate the revenue, like rent, salaries, etc. o Net Income: Calculated as revenues minus expenses. Example: FastForward's income statement for December showed: • • • Revenues: $5,800 from consulting and $300 from renting test facilities. Expenses: Rent and salaries. Net Income: $4,400 (Revenues - Expenses). 2. Statement of Retained Earnings • • Purpose: Reports changes in retained earnings over a period, reflecting how net income and dividends affect the company's equity. Components: o Beginning Retained Earnings: For a new company, this is $0. For an existing business, it's the retained earnings from the previous period. o Net Income: Transferred from the income statement. o Dividends: Payments made to shareholders, reducing retained earnings. o Ending Retained Earnings: Carried forward to the balance sheet. Example: FastForward’s statement of retained earnings for December: • • • Beginning retained earnings: $0 (since the business is new). Net income: $4,400 (from the income statement). Dividends: $200 paid to shareholders. • Ending retained earnings: $4,200. 3. Balance Sheet • • Purpose: Shows the company's financial position at a specific point in time by reporting its assets, liabilities, and equity. Components: o Assets: Resources owned by the company (e.g., cash, supplies, equipment). o Liabilities: Obligations to creditors (e.g., accounts payable). o Equity: The owner's claim on the assets, which includes common stock and retained earnings. Example: FastForward’s balance sheet as of December 31: • • • • Assets: $40,400 (including cash, supplies, equipment). Liabilities: $6,200 owed to creditors. Equity: $34,200 (including common stock and retained earnings). The accounting equation is balanced: Assets=Liabilities+Equity 40,400=6,200+34,200 4. Statement of Cash Flows • • Purpose: Reports cash inflows and outflows over a period, categorized into operating, investing, and financing activities. Components: o Operating Activities: Cash received and paid in day-to-day business (e.g., consulting revenues, salaries, rent). o Investing Activities: Cash spent on long-term assets (e.g., equipment purchases). o Financing Activities: Cash from investors or loans, and cash paid out as dividends. Example: FastForward’s statement of cash flows for December: • • • • Operating activities: $1,000 net inflow (cash from consulting services minus cash paid for rent, supplies, and salaries). Investing activities: $26,000 cash outflow (purchase of equipment). Financing activities: $29,800 net inflow (owner’s investment minus dividend payment). Ending cash balance: $4,800, which matches the cash amount in the balance sheet. How Financial Statements Interrelate • • • Net Income from the income statement is added to retained earnings in the statement of retained earnings. The ending balance of retained earnings from the statement of retained earnings is carried over to the balance sheet. Cash on the balance sheet is reconciled with the statement of cash flows, ensuring all transactions are accurately captured. Preparing Financial Statements for Accel (Example) Using the given information, Accel's financial statements for the year ending December 31 would look like this: 1. Income Statement (for the period ended December 31): o Revenues: $X o Expenses: $Y o Net Income: $Z (Revenues - Expenses) 2. Statement of Retained Earnings (for the period ended December 31): o Beginning retained earnings: $0 o Net income: $Z o Dividends: $X o Ending retained earnings: $Y 3. Balance Sheet (as of December 31): o Assets: Cash, equipment, etc. o Liabilities: Accounts payable, etc. o Equity: Common stock + retained earnings This structure provides a comprehensive view of a company’s financial performance and position.