Basic Financial Statements

Chapter 2

Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
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Chapter 2: Basic Financial Statements

1
 Introduction to Financial
Statements

Three primary
Balance Sheet

Income Statement financial

Statement of Cash Flows statements.

We will use a corporation to describe these

statements.
2-2

There are three fundamental financial statements used in accounting.

The income statement shows revenues and expenses.
The balance sheet is a listing of all asset, liability, and equity account balances
that do not appear on the income statement.
The statement of cash flows shows how the company receives and spends its
cash.

This chapter will look at the financial statements of a corporation.

2
 Introduction to Financial
Statements
Balance Sheet
Describes
where the
Income Statement enterprise
stands at a
Statement of Cash Flows
specific date.

2-3

The balance sheet (also referred to as the statement of position) describes the
financial position of a company at a specific point in time. A balance sheet
may be prepared monthly, quarterly, or annually depending on the needs of
management and external users. The balance sheet is sometimes referred to
as the statement of financial position.

3
 Introduction to Financial
Statements
Balance Sheet

Income Statement
Depicts the
revenue and
Statement of Cash Flows expenses for a
designated
period of time.

2-4

Net income is defined as the excess of revenues over expenses. Financial

statements begin with a three-line title comprised of the company name, the
name of the statement, and the period covered by the report. The income
statement lists revenues and expenses that were incurred over a period of
time. Most companies prepare monthly income statements.

In the long-run, revenues will generate positive cash inflows to the company
and expenses will result in negative cash flows to the company. Just
remember, revenues and expenses that appear on the income statement may
not always produce cash flows in the current accounting period. Net income
(or net loss) is simply the difference between revenues and expenses. When
revenues exceed expenses, the result is net income. When expenses exceed
revenues, the result is a net loss.

4
 Introduction to Financial
Statements
Balance Sheet

Income Statement

Statement of Cash Flows

Depicts the
ways cash has
changed during
a designated
period of time.

2-5

The statement of cash flows will be covered in detail in a later chapter. The
statement of cash flows is divided into three major sections: (1) cash flows
from operating activities; (2) cash flows from investing activities, and (3) cash
flows from financing activities. The statement describes cash inflows and
outflows over a period of time.

5
 A Starting Point: Statement of
Financial Position
VAGABOND TRAVEL AGENCY
STATEMENT OF FINANCIAL POSITION
DECEMBER 31, 2015
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
Office Equipment 15,000 Total Liabilities $ 80,000
Building 90,000 Owners' Equity:
Land 100,000 Capital Stock 150,000
Retained Earnings 70,000
Total $300,000 Total $300,000

2-6

The statement of financial position, commonly referred to as the balance

sheet, is an inventory of assets, liabilities, and equity at the end of the month.
Our total assets are equal to $300,000. This includes cash of $22,500, notes
receivable of $10,000, supplies of $2,000, and the balances in the remaining
asset accounts.

Liabilities include notes payable of $41,000, accounts payable of $36,000 and

salaries payable of $3,000. The accounts in the owners’ equity section of the
balance sheet are capital stock of $150,000 and retained earnings of $70,000.

Notice that the total assets are equal to the total liabilities plus owners’
equity.

6
 The Concept of the Business
Entity

A business
entity is
Vagabond separate from
Travel the personal
Agency
affairs of its
owner.

2-7

The business entity principle states that the transactions of individual owners
of a business and those of the business must be separate.

7
 Assets
VAGABOND TRAVEL AGENCY
STATEMENT OF FINANCIAL POSITION
DECEMBER 31, 2015
Assets Liabilities & Owners' Equity
Cash
Assets are
$ 22,500 Liabilities:
Notes Receivable 10,000 Notes economic
Payable $ 41,000
Accounts Receivable 60,500 Accounts Payablethat 36,000
resources are
Supplies 2,000 Salaries Payable 3,000
Office Equipment 15,000 owned
Total Liabilitiesby the
$ 80,000
Building business
90,000 Owners' Equity: and are
Land 100,000 Capital Stock 150,000
expected
Retained Earnings to benefit
70,000
Total future operations.
$300,000 Total $300,000

2-8

Assets are resources owned or controlled by an entity. They include such

items as cash, accounts receivable (amounts owed to the company by
customers), land, building and equipment, and supplies.

8
 Assets
These accounting principles support
cost as the basis for asset valuation.

Cost
Stable-Dollar Principle
Assumption

Going-Concern
Objectivity Assumption
Principle

2-9

The cost principle tells us that accounting information is based upon actual
cost incurred. We refer to this as historical cost.

The going-concern assumption states that in the absence of information to

the contrary, the business entity is assumed to continue operations into the
foreseeable future.

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.

9
 Liabilities
VAGABOND TRAVEL AGENCY
STATEMENT OF FINANCIAL POSITION
DECEMBER 31, 2015
Assets Liabilities & Owners' Equity
CashLiabilities are $ 22,500 Liabilities:
Notes Receivable 10,000 Notes Payable $ 41,000
debts that
Accounts Receivable 60,500 Accounts Payable 36,000
represent
Supplies 2,000 Salaries Payable 3,000
Office Equipment 15,000 Total Liabilities $ 80,000
negative future
Building 90,000 Owners' Equity:
cash flows for
Land 100,000 Capital Stock
Retained Earnings
150,000
70,000
the enterprise.
Total $300,000 Total $300,000

2-10

Liabilities represent the claims of creditors on an entity’s assets. Liabilities

include accounts payable (amounts owed to creditors for assets purchased on
account), taxes payable, and wages payable (amounts owed to our employees
at the end of the accounting period).

10
 Owners’ Equity
VAGABOND TRAVEL AGENCY
STATEMENT OF FINANCIAL POSITION
DECEMBER 31, 2015

Owners’ equity
Cash
Assets Liabilities & Owners' Equity
$ 22,500 Liabilities:
represents the
Notes Receivable
Accounts Receivable
10,000
60,500
Notes Payable
Accounts Payable
$ 41,000
36,000
owners’ claims
Supplies 2,000 Salaries Payable 3,000
Office Equipment 15,000 Total Liabilities $ 80,000
on the assets of
Building 90,000 Owners' Equity:
the business.
Land 100,000 Capital Stock 150,000
Retained Earnings 70,000
Total $300,000 Total $300,000

2-11

The equities of an entity include investments by owners, withdrawals by

owners, and earnings retained by the business. Investments by owners and
net income increase owners’ equity. Payments to owners and net losses
decrease owners’ equity.

11
 The Accounting Equation
Assets VAGABOND
= Liabilities + AGENCY
TRAVEL Owners’ Equity
STATEMENT OF FINANCIAL POSITION
$300,000 = DECEMBER
$80,000 31,+ 2015 $220,000
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
Office Equipment 15,000 Total Liabilities $ 80,000
Building 90,000 Owners' Equity
Land 100,000 Capital Stock 150,000
Retained Earnings 70,000
Total $300,000 Total $300,000

2-12

The basic accounting equation states that assets are equal to liabilities plus
equity of a company. The equation makes sense because it states that assets
must be equal to the claims against those assets.

There are two broad categories of claims against an asset: Claims by creditors
(called liabilities), or after all creditor claims are satisfied, the residual owners
(the stockholders) have a claim on those assets.

12
 Let’s analyze
transactions
for Overnight
Auto Service.

2-13

Let’s look at how specific business transactions impact the basic financial
statement.

13
 On January 20, Michael McBryan started
Overnight Auto Service. He and his family
invested $80,000 and received 8,000
shares of stock at $10 per share.
OVERNIGHT AUTO SERVICE
BALANCE SHEET
JANUARY 20, 2015
Assets Owners' Equity
Cash $ 80,000 Capital Stock $ 80,000

Total $ 80,000 Total $ 80,000

2-14

On January 20th, Michael McBryan, an experienced auto mechanic, opened

his own automotive repair business, Overnight Auto Service. On that day, he
received a charter from the state to begin a small, closely held corporation
whose owners consisted of himself and several family members. Capital stock
issued to these investors included 8,000 shares at $10 per share. Let’s see
how the balance sheet would look immediately after this transaction.

The cash account of Overnight Auto Service increased by eighty thousand

dollars and the capital stock of the company also increased by eighty
thousand dollars. Notice that the basic accounting equation is in balance.
Total assets are equal to total liabilities plus owners’ equity.

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 On January 21, Overnight purchased the
land from the city for $52,000 cash.
OVERNIGHT AUTO SERVICE
BALANCE SHEET
JANUARY 21, 2015
Assets Owners' Equity
Cash $ 28,000 Capital Stock $ 80,000
Land 52,000

Total $ 80,000 Total $ 80,000

2-15

On January 21, Overnight purchased the land from the city for $52,000 cash.
Let’s see how the balance sheet looks now.

The cash account has been reduced by the $52,000 spent and the land
account has been increased by the same amount. One asset, cash, was merely
traded for another, the land. Owners’ equity is not changed by the transaction
and the basic accounting equation is still in balance.

15
 On January 22, Overnight purchased an old
garage for $36,000. Overnight paid $6,000
down in cash and issued a 90-day note
payable for the remaining $30,000 owed.
OVERNIGHT AUTO SERVICE
BALANCE SHEET
JANUARY 22, 2015
Assets Liabilities and Owners' Equity
Cash $ 22,000 Liabilities:
Land 52,000 Notes Payable $ 30,000
Building 36,000 Owners' Equity:
Capital Stock 80,000

Total $110,000 Total $110,000

2-16

In the next transaction, Overnight purchased the old garage building from
Metropolitan Transit Authority for $36,000. Overnight made a cash down
payment of $6,000 and issued a 90-day non-interest-bearing note payable for
the $30,000 balance owed. Let’s update the balance sheet.

The cash account decreased by $6,000 and the Building account increased by
$36,000. There was a net increase in the asset side of the equation of
$30,000. The liability account, notes payable, increased by $30,000.

Total assets are now equal to $110,000. Total liabilities are equal to $30,000
and owners’ equity is equal to $80,000. The accounting equation is still in
balance.

16
 On January 23, Overnight purchased tools
and automotive repair equipment for
$13,800 on account, due within 60 days.
OVERNIGHT AUTO SERVICE
BALANCE SHEET
JANUARY 23, 2015
Assets Liabilities and Owners' Equity
Cash $ 22,000 Liabilities:
Tools & Equipment 13,800 Notes Payable $ 30,000
Building 36,000 Accounts Payable 13,800
Land 52,000 Total Liabilities $ 43,800
Owners' Equity:
Capital Stock 80,000

Total $123,800 Total $123,800

2-17

On January 23, Overnight purchased tools and automotive repair equipment

from Snappy Tools for $13,800. The tools and equipment are purchased on
account. Overnight has 60 days to pay the balance on the account. Let’s
update the balance sheet.

The tools and equipment account increased by $13,800 and the liability
account, accounts payable, increased by the same amount. The balance sheet
is getting progressively more complicated.

17
 Overnight realized that the company had purchased more
tools and equipment than it needed.
On January 24, Overnight sold some of the new tools to Ace
Towing for $1,800, a price equal to Overnight’s cost. Ace
agreed to pay the amount within 45 days.

OVERNIGHT AUTO SERVICE

BALANCE SHEET
JANUARY 24, 2015
Assets Liabilities and Owners' Equity
Cash $ 22,000 Liabilities:
Accounts Receivable 1,800 Notes Payable $ 30,000
Tools & Equipment 12,000 Accounts Payable 13,800
Building 36,000 Total Liabilities $ 43,800
Land 52,000 Owners' Equity:
Capital Stock 80,000

Total $123,800 Total $123,800

2-18

After taking delivery of the new tools and equipment, Overnight found that it
had purchased more than it needed. On January 24, Overnight sold some of
its new tools to Ace Towing for $1,800, a price equal to Overnight’s cost. Can
you update the balance sheet? Try before proceeding to the next slide.

The asset account, Tools and Equipment, decreased by $1,800 and the asset
account, accounts receivable, increased by the same amount. Once again, one
asset, tools and equipment, has been exchanged for another asset, accounts
receivable. How did you do?

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 On January 26, Ace Towing pays Overnight
$600 as a partial settlement of its accounts
receivable.
OVERNIGHT AUTO SERVICE
BALANCE SHEET
JANUARY 26, 2015
Assets Liabilities and Owners' Equity
Cash $ 22,600 Liabilities:
Accounts Receivable 1,200 Notes Payable $ 30,000
Tools & Equipment 12,000 Accounts Payable 13,800
Building 36,000 Total Liabilities $ 43,800
Land 52,000 Owners' Equity:
Capital Stock 80,000

Total $123,800 Total $123,800

2-19

On January 26, Overnight received $600 from Ace Towing as partial

settlement of its account receivable from Ace. Let’s prepare the updated
balance sheet on January 26th.

The cash account increases by $600 and accounts receivable decreases by the
same amount. Notice that total assets are still equal to total liabilities plus
owners’ equity.

19
 On January 27, Overnight made a partial
payment of $6,800 on its account payable
to Snappy Tools.
OVERNIGHT AUTO SERVICE
BALANCE SHEET
JANUARY 27, 2015
Assets Liabilities and Owners' Equity
Cash $ 15,800 Liabilities:
Accounts Receivable 1,200 Notes Payable $ 30,000
Tools & Equipment 12,000 Accounts Payable 7,000
Building 36,000 Total Liabilities 37,000
Land 52,000 Owners' Equity:
Capital Stock 80,000

Total $117,000 Total $117,000

2-20

On January 27, Overnight made a partial payment of $6,800 on its account

payable to Snappy Tools. Its time to update the balance sheet.

The cash account decreases by $150 and accounts payable also decreases by
$150. The total assets are now recorded at $21,150. Total liabilities plus
owners’ equity is equal to the same amount.

20
 On January 31, Overnight recorded auto
repair services provided for the last week
of January of $2,200, received in cash.
OVERNIGHT AUTO SERVICE
BALANCE SHEET
JANUARY 31, 2015
Assets Liabilities and Owners' Equity
Cash $ 18,000 Liabilities:
Accounts Receivable 1,200 Notes Payable $ 30,000
Tools & Equipment 12,000 Accounts Payable 7,000
Building 36,000 Total Liabilities 37,000
Land 52,000 Owners' Equity:
Capital Stock 80,000
Retained Earnings 2,200
Total $119,200 Total $119,200

2-21

On January 31, Overnight recorded auto repair services provided for

the last week of January of $2,200, received in cash. Try updating the
balance sheet before moving to the next slide. Be careful with this one.

The cash account increases by $2,200 and retained earnings increases by the
same amount. The monies received represent earnings of the company that
have been retained. The $2,200 represents revenue earned by the business.
How did you do?

21
 On January 31, Overnight paid operating
expenses of $1,400 in cash.
OVERNIGHT AUTO SERVICE
BALANCE SHEET
JANUARY 31, 2015
Assets Liabilities and Owners' Equity
Cash $ 16,600 Liabilities:
Accounts Receivable 1,200 Notes Payable $ 30,000
Tools & Equipment 12,000 Accounts Payable 7,000
Building 36,000 Total Liabilities 37,000
Land 52,000 Owners' Equity:
Capital Stock 80,000
Retained Earnings 800
Total $117,800 Total $117,800

2-22

In the final transaction on January 31, Overnight had to pay some operating
expenses, namely $200 for utilities and $1,200 for wages. Let’s make the final
update to the balance sheet on January 31st.

The cash account decreased by $1,400 and so did the retained earnings of the
company. Overnight used $1,400 of its earnings to pay for expenses.

Now, let’s review how Overnight’s transactions affected the accounting

equation.

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 2-23

All of these transactions have been placed on this slide, in the appropriate
columns for the accounts they’ve impacted. Let’s verify the balance in each
account and get ready to prepare the financial statements for Overnight Auto
Service.

23
 Let’s prepare the Income Statement and Statement of
Cash Flows for Overnight Auto Service for the period
of January 20-31, 2015.

These transactions
impact the
Statement of Cash
Flows.

These transactions
impact the Income
Statement.
2-24

All of the transactions that impacted the cash account will appear on the
statement of cash flows.

The revenues and expenses that caused the change in retained earnings will
appear on the income statement of the company.

Let’s begin by preparing the income statement and statement of cash flows
for Overnight Auto Service for the period from January 20 through January 31,
2015.

24
 OVERNIGHT AUTO SERVICE
INCOME STATEMENT
FOR THE PERIOD JANUARY 20 - 31, 2015
Sales Revenues $ 2,200
Operating Expenses:
Wages $ 1,200
Utilities 200 $ 1,400
Net Income $ 800

Investments by and payments to the owners

are not included on the Income Statement.
2-25

Overnight Auto Service has revenues for services for $2,200, and two
operating expenses totaling $1,400. So the net income for the period of
January 20-31, 2015 is $800. Remember, net income is the excess of revenues
over expenses incurred during the accounting period.

Investments by owners and payments to owners do not appear on the income

statement. These amounts appear on the company’s balance sheet.

25
 OVERNIGHT AUTO SERVICE
STATEMENT OF CASH FLOWS
FOR THE PERIOD JANUARY 20-31, 2015
Cash flows from operating activities:
Cash received from revenue transactions $ 2,200
Cash paid for expenses (1,400)
Net cash provided by operating activities $ 800
Cash flows from investing activities:
Purchase of land $ (52,000)
Purchase of building (6,000)
Purchase of tools (6,800)
Sale of tools 600
Net cash used by investing activities (64,200)
Cash flows from financing activities:
Sale of Capital Stock 80,000
Increase in cash for the period $ 16,600
Cash balance, January 20, 2015 -
Cash balance, January 31, 2015 $ 16,600
2-26

Here is the statement of cash flows for Overnight for the period of January 20-
31, 2015. Notice the three sections of the statement: Cash flows from
operating activities, investing activities and financing activities.

26
 OVERNIGHT AUTO SERVICE
STATEMENT OF CASH FLOWS
FOR THE PERIOD JANUARY 20-31, 2015
Cash flows from operating activities:
Cash received from revenue transactions $ 2,200
Cash paid for expenses (1,400)
Net cash provided by operating activities $ 800
Cash flows from investing activities:
Operating activities include
Purchase of land
the cash
$ (52,000)
effects
Purchase of revenue and expense
of building (6,000)
Purchase of tools transactions. (6,800)
Sale of tools 600
Net cash used by investing activities (64,200)
Cash flows from financing activities:
Sale of Capital Stock 80,000
Increase in cash for the period $ 16,600
Cash balance, January 20, 2015 -
Cash balance, January 31, 2015 $ 16,600
2-27

Cash flows from operating activities include the cash received from revenue
transactions and the cash paid for expenses.

27
 OVERNIGHT AUTO SERVICE
STATEMENT OF CASH FLOWS
FOR THE PERIOD JANUARY 20-31, 2015
Cash flows from operating activities:
Cash received from revenue transactions $ 2,200
Cash paid for expenses (1,400)
Net cash provided by operating activities $ 800
Cash flows from investing activities:
Purchase of land $ (52,000)
Purchase of building (6,000)
Purchase of tools (6,800)
Sale of tools 600
Net cash used by investing activities (64,200)
Cash flows from financing activities:
Investing activities include the cash
Sale of Capital Stock 80,000
effects
Increase ofthepurchasing
in cash for period and selling $ 16,600
Cash balance, January 20, 2015 assets. -
Cash balance, January 31, 2015 $ 16,600
2-28

Overnight Auto Service had a cash outflow for investing activities. The
company invested in the land, a building, and tools; however, the company
recovered some of the cost of tools by selling some excess tools to Ace
Towing.

28
 OVERNIGHT AUTO SERVICE
STATEMENT OF CASH FLOWS
FOR THE PERIOD JANUARY 20-31, 2015
Cash flows from operating activities:
Cash received from revenue transactions $ 2,200
Cash paid for expenses (1,400)
Net cash provided by operating activities $ 800
Cash flows from investing activities:
Financing
Purchase of land activities include the cash
$ (52,000)
Purchase of building (6,000)
effects of transactions with the
Purchase of tools
owners
(6,800)
Sale of tools and creditors. 600
Net cash used by investing activities (64,200)
Cash flows from financing activities:
Sale of Capital Stock 80,000
Increase in cash for the period $ 16,600
Cash balance, January 20, 2015 -
Cash balance, January 31, 2015 $ 16,600
2-29

The only financing activity was the original investment by the owners of
Overnight Auto Service.

The cash inflows and outflows resulted in an increase in cash of $16,600

during the month. Because the cash account had a zero balance at the
beginning of the month, the ending balance in the cash account is $16,600.

Let’s finish by preparing the balance sheet for Overnight Auto Service.

29
 Now, let’s prepare the Balance Sheet for Overnight
Auto Service for January 20-31, 2015.

These balances will

appear on the
Balance Sheet.

2-30

Here are the account balances to use when preparing the balance sheet.

30
 OVERNIGHT AUTO SERVICE
BALANCE SHEET
JANUARY 31, 2015
Assets Liabilities
Cash $ 16,600 Notes payable $ 30,000
Accounts receivable 1,200 Accounts payable 7,000
Tools & equipment 12,000 Owners' Equity
Building 36,000 Capital stock 80,000
Land 52,000 Retained earnings 800
Total assets $ 117,800 Total liabilities & equity $ 117,800

Assets = Liabilities + Owners’ Equity

$117,800 = $37,000 + $80,800

2-31

Asset accounts are listed on the left side of the balance sheet and the
liabilities and owners’ equity accounts on the right.

Feel free to go back to the previous screen and see all the account balances
that appear on the balance sheet.

As a final check, make sure that the accounting equation is still in balance. The
total assets of $117,800 is exactly equal to the total of the company’s
liabilities plus owners’ equity. Notice that the balance sheet lists all assets,
liabilities, and equities on a certain date. In this example, the date is January
31, 2015.

31
 Relationships Among Financial
Statements

Date at Date at
beginning of end of
period period
Time

Statement of Financial Statement of Financial

Position (Balance Sheet) Position (Balance Sheet)

Income Statement
Statement of Cash Flows

2-32

All the financial statements are interrelated. We can start with the balance
sheet at the beginning of an accounting period, analyze the income and cash
flows of the company, and arrive at the ending balances that will appear on
the balance sheet.

32
 Financial Statement Articulation
OVERNIGHT AUTO SERVICE
STATEMENT OF CASH FLOWS
FOR THE PERIOD JANUARY 20-31, 2015 OVERNIGHT AUTO SERVICE
Cash flows from operating activities:
Cash received from revenue transactions $ 2,200 INCOME STATEMENT
Cash paid for expenses (1,400)
Net cash provided by operating activities $ 800
FOR THE PERIOD JANUARY 20 - 31, 2015
Cash flows from investing activities:
Purchase of land $ (52,000)
Sales Revenues $ 2,200
Purchase of building (6,000)
Purchase of tools (6,800) Operating Expenses:
Sale of tools 600
Net cash used by investing activities (64,200) Wages $ 1,200
Cash flows from financing activities:
Sale of Capital Stock 80,000 Utilities 200 $ 1,400
Increase in cash for the period $ 16,600
Cash balance, January 20, 2015
Cash balance, January 31, 2015
-
$ 16,600
Net Income $ 800

OVERNIGHT AUTO SERVICE

BALANCE SHEET
JANUARY 31, 2015
Assets Liabilities
Cash $ 16,600 Notes payable $ 30,000
Accounts receivable 1,200 Accounts payable 7,000
Tools & equipment 12,000 Owners' Equity
Building 36,000 Capital stock 80,000
Land 52,000 Retained earnings 800
Total assets $ 117,800 Total liabilities & equity $ 117,800

2-33

This is the balance sheet for Overnight Auto Service at the end of January.

Net income impacts the retained earnings of the company.

The statement of cash flows not only provides the balance in the cash
account, but also details information about the acquisition and disposition of
assets and liabilities as well as changes in the owners’ equity balance. It’s
clear to see how all the financial statements articulate with each other.

33
 Financial Reporting and Financial
Statements
Financial statements are
just one source of
financial accounting
Income
information. Statement
Balance
Sheet
Statement
of Cash
Flows

Other Information:
•Nonfinancial disclosures
•Management interpretation
•Industry
•Competitors
•National economy
2-34

Financial statements are only one source of information about the operations
of a company. The financial statements of a company can be compared to
those of other companies in the same industry, major national or
international competitors, and to the norms for the national economy.

34
 Forms of Business Organization

Sole
Proprietorships Partnerships Corporations

2-35

There are three general forms of business operations.

A proprietorship is a business owned by just one individual.
A partnership is owned by two or more individuals. Some partnerships have
several thousand partners.
A corporation is owned by individuals who normally are not active in the day-
to-day operations of that business. For example, you may become an owner
of IBM by purchasing shares of stock on the New York Stock Exchange. While
you are a part owner, you do not necessarily work for IBM nor are you active
in the operations of the company.

35
 Reporting Ownership Equity in the
Statement of Financial Position
Owner's equity:
Sole
Proprietorships Mic ha e l Mc Brya n, Ca pita l $ 80,800

Partners' equity:
Michael McBryan, Capital $ 40,400
Partnerships Reb ecca M cBryan , Cap ital 40,400
Total partners' equity $ 80,800

Owners' equity:
Corporations
Capital Stock $ 80,000
Retained Earnings 800
Total stockholders' equity $ 80,800
2-36

The owners’ equity section of the balance sheet will look different for each
type of business entity. For a sole proprietorship, there will be a capital
account for the owner, and a drawing account to record payments to the
owner.

For a partnership, each partner has a separate account, where changes are
tracked over time. There’s also a separate drawing account for payments
made to each partner.

To review, a corporation will show owners’ contributions in the capital stock

account and accumulated earnings of the company in the retained earnings
account.

You should be able to tell the form of business by looking at the equity section
of a balance sheet.

36
 The Use of Financial Statements
by External Parties

Two concerns:
Creditors Liquidity
Profitability

Investors
2-37

Creditors and investors have two major concerns about the operations and
financial position of any company.
First, the company must be liquid, that is, it must be able to pay all bills when
due.
Second, the company must be profitable in the long-run. Unprofitable
companies drain the cash position of the company, causing concern on the
part of creditors and investors.

37
 The Need for Adequate
Disclosure
Balance Sheet Notes to the
financial
Income Statement
statements
Statement of Cash Flows often provide
facts necessary
for the proper
interpretation of
the statements.

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In addition to the basic financial statements, companies prepare notes to the

financial statements. These notes are meant to provide the reader with
additional insights into the operations and financial position of the company.

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 Management’s Interest in
Financial Statements
Creditors are more likely to extend credit if
financial statements show a strong statement of
financial position—that is, relatively little debt
and large amounts of liquid assets.

Window dressing occurs when management

takes measures to make the company appear
as strong as possible in it financial statements.
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Creditors and investors are more likely to be interested in financially strong

companies. These companies usually have little or no debt and a significant
amount of assets that can be converted into cash quickly.

When management engages in measures to make the company appear

financially stronger than it really is, this is referred to as window dressing.
Window dressing may be legal, but it often impugns the integrity of the
management team.

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 End of Chapter 2

2-40

End of Chapter 2.

40