Introduction to Financial Statements:
Describe the Financial Statement with all thair important features | Asset, Liabilities, Owner Equity, also describe important term?
we learned that investors and creditors are particularly interested in cash flows that they expect to receive in the future, Creditors, for example, are interested in the ability of an enterprise, to which they have made loans or solid merchandise on credit, to meet its payment obligations. which may include payment of interest. Similarly, investors are interested in the market value of their stock holdings, as well as dividends that the enterprise will pay to them while they own the stock.
One of the primary ways investors and creditors assess the probability that an enterprise will be able to make future cash payments is to study, analyze., and understand the enterprise s financial statements. as discussed in
A financial statement is simply a declaration of whet is believed to be true about an enterprise. communicated in terms of a monetary unit, such as the dollar. When accountants prepare financial statements. they are describing in Financial terms certain attributes of the enterprise that they believe fairy represent its financial activities this chanter, we introduce three primary financial statements.
Statement of financial position (often referred as the balance sheet
income statement
Statement of cash flows
In introducing these statements. we use the form of business ownership referred to as a corporation. The corporation is a unique form of organization that allows many owners to combine their resources into a business enterprise that is larger than would be possible based on the financial resources of a single owner or a small number of owners. While businesses of any size may be organized as corporations, most large businesses are corporations because
of their need for a large amount of capital that the corporate form of business organization makes possible. Later in this chapter we introduce two other forms of business organization
the sole proprietorship and the partnership which are alternatives to the corporate form for some business enterprises.
The names of the three primary financial statements describe the information you find in 'each. The statement of financial position, or balance sheet, is a financial statement that describes where the enterprise stands at a specific date. It is sometimes described as a snap-4shot of the business in financial or dollar terms (that is. what the enterprise "looks like" at a specific date).
As businesses operate, they engage in transactions that create revenues and incur expenses that are necessary to earn those revenues. An income statement is an activity statement that
shows the revenues and expenses for a designated period of time. Revenues already have resulted in positive cash flows, or are expected to do so in the near future, as a result of transactions with customers.
For example, a company might sell a product for $100. This revenue transaction results in are immediate positive cash flow into the enterprise if the customer nave cash at the time of the transaction. An expected future cash flow results if it is a credit transaction in which payment is to be received later. Expenses have the opposite effect in that they result in an immediate cash flow out of the enterprise (if a cash transaction or an expected future flow of cash out of the enterprise (if a credit transaction). For example, if a company incurs a certain expense of S75 and pays it at that time, an immediate cash outflow takes place.
If payment is delayed until some future date, the transaction represents an expected future cash outflow. Revenues result in positive cash flows either past, present, or future while
expenses result in negative cash flows either past, present, or future. Positive and negative indicate the directional impact on cash. The term net income (or nor loss) is simply the difference between all of an enterprise's revenues and expenses for a designated period of time.
The statement of cash flows is particularly important in understanding an enterprise for purposes of investment and credit decisi1ons, As its name implies, the statement of cash flows shows the ways cash changed during a designated period the cash received from revenues and other transactions as well as the cash paid for certain expenses and other acquisitions during the period. While the primary focus of investors and creditors is on cash flows to themselves rather than to the enterprise, information about cash activity of the enterprise is an
important signal to investors and creditors about the prospects of future cash flows to them.
A Starting Point:
Statement of Financial Position
All three financial statements contain important information, but each includes different information. For that reason, it is important to understand all three financial statements and how they relate to cache other. The way they relate is sometimes referred to as articulation, a term we will say more about later in this chapter
A logical starting point for understanding financial statements is the statement of financial position, also called the balance sheet. The purpose of this financial statement is to demonstrate where the company stands, in financial terms, at a specific point in time. As we will see later in this chapter, the other financial statements relate to the statement of financial position and show how important aspects of a company s financial position change over time.
Beginning with the statement of financial position also allows us to understand certain basic accounting principles and terminologies that are important for understanding all financial statement.
Every business prepares a balance sheet at the end of the year, and many companies prepare one at the end of each month, week, or even day. It consists of a listing of the assets, the
liabilities, and the owners' equity of the business. The date is important, as the financial position of a business may change quickly. Exhibit 2-1 shows the financial position of Vagabond ravel Agency.
Let us briefly describe several features of the statement of financial position,
an example. First, the heading communicates three things:
(1) the name of the business,
(2) the name of the financial statement, and
(3) the date. The body of the balance
sheet consists of three distinct sections:
assets,
liabilities, and
owners equity
Notice that cash is listed first among the assets, followed by notes receivable, accounts receivable, supplies, and any other assets that will soon be converted into cash or used up in business operations.
Following these assets are the more permanent assets, such as equipment, buildings, and land.
Moving to the right side of the balance sheet, liabilities are shown before owners' equity
Each major type of liability (such as notes payable, accounts payable, and salaries payable) is listed separately, followed by a figure for total liabilities.
Owners equity is separated into two parts capital stock and retained earnings. Capital stock represents the amount that owners originally paid into the company to become owners.
It consists of individual shares and each owner has a set number of shares. Notice in this illustration that capital stock totals $150,000. This means that the assigned value of the shares held by owners, multiplied by the number of shares, equals $150,000.
For example, assuming an assigned value of S10 per share, there would be 15,000 shares ($10 X 15,000 = $150,0000).
Alternatively, the assigned value might be $5 per share, which case there would be 30,000 shares (S5x 30,000 S150,000).
The retained earnings component of owners" equity is the accumulated earnings of previous years that remain within the enterprise. Retained earnings is considered part of the equity of the owners and serves to enhance their investment in the
business.
Finally, notice that the amount of total assets ($300,000) is equal to the total amount of liabilities and owners' equity (also $300,000). This relationship always exists in fact, the equality of these totals is why this financial statement is frequently called a balance sheet.
The Concept of the Business Entity Generally accepted accounting principles Require that financial statements describe the activities of a specific economic entity. This concept is called the entity principle.
A business entity is an economic unit that engages in identifiable business activities.
For Accounting purposes, the business entity is regarded as separate from the personal actionist of its owners For example, Vagabond is a business organization operating as a travel agency Its owners are have personal bank accounts, homes, cars, and even other businesses. These items are not involved in the operation of the travel agency and do not appear in Vagabond financial statements.
If the owners were to commingle their personal activities with the transactions of the business, the resulting financial statements would fail to describe clearly the financial activities the business organization. Distinguishing business from personal activities of the owners may require judgment by the accountant.
ASSETS:
Assets are economic resources that are owned by a business and are expected to benefit future operations. In most cases, the benefit to future operations comes in the form of positive future cash flows. The positive future cash flows may come directly as the asset is converted into
cash (collection of a receivable) or indirectly as the asset is used in operating the business to create other assets that result in positive future cash flows (buildings and land used to
manufacture a product for sale). Assets may have definite physical
such as buildings, machinery, or an inventory of merchandise. On the other hand, some assets exist not in physical or tangible form, but in the form of valuable legal claims or rights; examples
are amounts due from customers, investments in government bonds, and patent rights held by
the company.
One of the basic and at the same time, most controversial problems in accounting is determining the correct dollar amount for the various assets of a business. At present, generally accepted accountıng principles call for the valuation of some assets in a balance sheet at cost, rather than at their current value. The specific accounting principles supporting cost as the basis for asset valuation are discussed below.
A Starting
The Cost Principle Assets such as land, buildings, merchandise, and equipment are typical of the many economies resources that are required in producing revenue for the business. The prevailing accounting view is that such assets should be presented in the statement of financial position at their cost. When we say that an asset is shown at its historical cost, we mean the original amount the business entity paid to acquire the asset. This amount may be different from what it would cost to purchase the same asset today or the amount that would
be received if the asset were sold today.
For example, let us assume that a business buys a tract of land for use as a building site, paying ST 00,000.in cash. The amount to be entered in the accounting records for the asset is
the cost of $100,000. If we assume a booming real estate market, a fair estimate of the market value of the land 10 years later might be $250,000. Although the market price or economic
value of the land has risen greatly, the amount shown in the company 's accounting records and in its balance sheet would continue unchanged at the cost of $100,000. This policy of accounting for many assets at their cost is often referred to as the cost principle of accounting
Exceptions to the cost principle are found in some of the most liquid assets (that is, assets that are expected to soon become cash). Amounts receivable from customers are generally included in the balance sheet at their net realizable value, which is an amount that approximates the cash that is expected to be received when the receivable is collected. Similarly, certain investments in other enterprises are included in the balance sheet at their current market value if management's plan includes conversion into cash in the near future.
In reading a balance sheet, it is important to keep in mind that the dollar amounts listed for many assets do not indicate the prices at which the assets could be sold or the prices at which they could be replaced. A frequently misunderstood feature of a balance sheet is that it does
not show how much the business currently is worth, although it contains valuable information in being able to calculate such a value. The Going-Concern Assumption Why don't accountants change the recorded
amounts of assets to correspond with changing market prices for these parties?
One reasons that assets like land and buildings are being used to house the business and were acquired for use and not for resale in fact, these assets usually could not be sold without disrupting the business. The balance sheet of a business is prepared on the assumption that the business is a continuing enterprise, or a going concern. Consequently, the present estimated prices at which assets like land and buildings could be sold are of less importance than if these properties were intended for sale. These are frequently among the largest dollar amounts of a company's assets. Determining that an enterprise is a going concern may require judgment by the accountant,
The Objectivity Principle
Another reason for using cost rather than current market values in accounting for many assets is the need for a definite, factual basis for valuation. The cost of land, buildings, and many other assets that have been purchased can be definitely
determined. Accountants use the term objective to describe asset valuations that are factual and can be verified by independent experts. For example, if land is shown on the balance sheet at cost, a CPA who performed an audit of the business would be able to find objective evidence that the land was actually measured at the cost incurred in acquiring it. On the other hand, estimated market values for assets such as buildings and specialized machinery are not factual and objective. Market values are constantly changing, and estimates of the prices at which assets could be sold are largely a natter of judgment.
At the time an asset is acquired, the cost and market value are usually the same. With the passage of time. however, the current market value of assets is likely to differ considerably
from its historical cost. As you will! learn, for some assets we adjust the amount in the balance sheet as the value changes. For other assets, we retain historical cost as the basis of the asset in the balance sheet
The Stable-Dollar Assumption A limitation of measuring assets at historical cost is that the value of the monetary unit or dollar is not always stable. Inflation is a term used to describe the situation where the value of the monetary unit decreases, meaning that it will purchase issue than it did previously. Deflation, on the other hand, is the opposite situation in which the value of the monetary unit increases, meaning that it will purchase more than it did previously. Typically, countries like the United States have experienced inflation rather than deflation. When inflation becomes severe, historical cost amounts for assets lose their , relevance as a basis for making business decisions.
Accountants in the United States prepare financial statements under an assumption that the dollar is a stable unit of measurement, as is the gallon, the acre, or the mile. The cost principle
and the stable-dollar assumption work well in periods of stable prices but are less satisfactory under conditions of rapid inflation.
For example, if a company bought land 20 years ago for $100,000 and purchased a second similar tract of land today for $500,000, the total cost
of land shown by the accounting records would be $600,000 following the historical cost principle. This treatment ignores the fact that dollars spent 20 years ago had greater parching power than today's dollar. Thus the $600,000 total for the cost of land is a mixture of two Sizes" of dollars with different purchasing power
Many countries experience prolonged and serious inflation. Inflation can undermine the stable-currency assumption. Accounting rules have been designed in some foreign countries to address the impact of inflation on. A company's financial position.
For example, Mexican corporate law requires Mexican companies to adjust their balance sheets to current purchasing power by using indexes provided by the government. Because
inflation is significant, the indexes are used to devalue the Mexican currency (pesos) to provide a more transparent representation of the company's financial condition. After much research into this problem, at one time the FASB required on a trial basis that
large corporations annually disclose financial data adjusted for the effects of inflation. At the present time, this disclosure is optional, as Judged appropriate by the accountant who prepares the financial state rents.
LIABILITIES
Liabilities are financial obligations or debts. They represent negative future cash flows for the enterprise. The person or organization to whom the debt is owed is called a creditor.
All businesses have liabilities; even the largest and most successful companies often purchase merchandise, supplies, and services "on account." The liabilities arising from such purchases are called accounts payable. Many businesses borrow money to finance expansion or
the purchase of high-cost assets and pay for them over time. When obtaining a loan, the borrower usually must sign a formal note payable. A note payable is a written promise to repay the amount owed by a particular date and usually calls for the payment of interest as well
Accounts payable, in contrast to notes payable, involve no written promises and generally do not call for interest payments. In essence, a note payable is a more formal arrangement than
an account payable, but they are similar in that both require the company to make payment in
the future.
Liabilities are usually listed in the order in which they are expected to be repaid. Liabilities that are similar may be combined to avoid unnecessary detail in the financial statement.
For example, if a company had several expenses payable at the end of the year (for example wages, interest, taxes), it might combine these into a single line called accrued expenses. The word accrued is an accounting term communicating that the payment of certain expenses has been delayed or deferred.
Liabilities represent claims against the borrower's assets. As we shall see, the owners of a business also have claims on the company's assets. But in the eyes of the law, creditors claims take priority over those of the owners. This means that creditors are entitled to be paid in full, even if such payment would exhaust the assets of the business and leave nothing for
its owners.
OWNERS' EQUITY
Owners equity represents the owners 'claims on the assets of the business. Because labilities Or creditors' claims have legal priority over those of the owners, owners equity is a residual amount. If you are the owner of a business, you are entitled to assets that are left after the
claims of creditors have been satisfied in full. Therefore, owners equity is always equal to total assets minus total liabilities For example, using the data from the illustrated balance
sheet of Vagabond Travel Agency
Vagabond has total assets of...
And total liabilities of
$300,C
Therefore, the owners' equity must be.
(80,0
$220,00
Owners equity does not represent a specific claim to cash or any other particular as Rather, it is the owners' overall financial interest in the entire company Increases in Owners' Equity
The owners equity in a business comes from primary sources:
1. Investments of cash or other assets by owners.
2. Earnings from profitable operation of the business.
Decreases in Owners' Equity Decreases in owners' equity also are caused in two ways:
1. Payments of cash or transfers of other assets to owners.
2. Losses from unprofitable operation of the business.
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