Financial Statements

Financial Statements
(See related pages)

P1 Identify and prepare basic financial statements and explain how they interrelate.

This section shows how financial statements are prepared from the analysis of business transactions. The four financial statements and their purposes are:

Income statementFinancial statement that subtracts expenses from revenues to yield a net income or loss over a specified period of time; also includes any gains or losses.—describes a company’s revenues and expenses along with the resulting net income or loss over a period of time due to earnings activities.
Statement of owner’s equityReport of changes in equity over a period; adjusted for increases (owner investment and net income) and for decreases (withdrawals and net loss).—explains changes in equity from net income (or loss) and from any owner investments and withdrawals over a period of time.
Balance sheetFinancial statement that lists types and dollar amounts of assets, liabilities, and equity at a specific date.—describes a company’s financial position (types and amounts of assets, liabilities, and equity) at a point in time.
Statement of cash flowsA financial statement that lists cash inflows (receipts) and cash outflows (payments) during a period; arranged by operating, investing, and financing.—identifies cash inflows (receipts) and cash outflows (payments) over a period of time.

We prepare these financial statements using the 11 selected transactions of FastForward. (These statements are technically called unadjusted—we explain this in Chapters 2 and 3.)

1-2

Income Statement

FastForward’s income statement for December is shown at the top of Exhibit 1.10. Information about revenues and expenses is conveniently taken from the Equity columns of Exhibit 1.9. Revenues are reported first on the income statement. They include consulting revenues of $5,800 from transactions 5 and 8 and rental revenue of $300 from transaction 8. Expenses are reported after revenues. (For convenience in this chapter, we list larger amounts first, but we can sort expenses in different ways.) Rent and salary expenses are from transactions 6 and 7. Expenses reflect the costs to generate the revenues reported. Net income (or loss) is reported at the bottom of the statement and is the amount earned in December. Owner’s investments and withdrawals are not part of income.

Point: Net income is sometimes called earnings or profit.

Statement of Owner’s Equity

Point: Decision makers often compare income to the operating section of the statement of cash flows to help assess how much income is in the form of cash.

Point: The statement of owner’s equity is also called the statement of changes in owner’s equity. Note: Beg. Capital + Net Income – Withdrawals = End. Capital

The statement of owner’s equity reports information about how equity changes over the reporting period. This statement shows beginning capital, events that increase it (owner investments and net income), and events that decrease it (withdrawals and net loss). Ending capital is computed in this statement and is carried over and reported on the balance sheet. FastForward’s statement of owner’s equity is the second report in Exhibit 1.10. The beginning capital balance is measured as of the start of business on December 1. It is zero because FastForward did not exist before then. An existing business reports the beginning balance as of the end of the prior reporting period (such as from November 30). FastForward’s statement shows that Taylor’s initial investment created $30,000 of equity. It also shows the $4,400 of net income earned during the period. This links the income statement to the statement of owner’s equity (see line ). The statement also reports Taylor’s $200 cash withdrawal and FastForward’s end-of-period capital balance.

Balance Sheet

FastForward’s balance sheet is the third report in Exhibit 1.10. This statement refers to FastForward’s financial condition at the close of business on December 31. The left side of the balance sheet lists FastForward’s assets: cash, supplies, and equipment. The upper right side of the balance sheet shows that FastForward owes $6,200 to creditors. Any other liabilities (such as a bank loan) would be listed here. The equity (capital) balance is $34,200. Note the link between the ending balance of the statement of owner’s equity and the equity balance here—see line . (This presentation of the balance sheet is called the account form: assets on the left and liabilities and equity on the right. Another presentation is the report form: assets on top, followed by liabilities and then equity at the bottom. Either presentation is acceptable.)

Decision Maker boxes are role-playing exercises that stress the relevance of accounting.

Decision Maker

Answer — p. 26

Retailer You open a wholesale business selling entertainment equipment to retail outlets. You find that most of your customers demand to buy on credit. How can you use the balance sheets of these customers to help you decide which ones to extend credit to?

Statement of Cash Flows

FastForward’s statement of cash flows is the final report in Exhibit 1.10. The first section reports cash flows from operating activities. It shows the $6,100 cash received from clients and the cash paid for supplies, rent, and employee salaries. Outflows are in parentheses to denote subtraction. Net cash provided by operating activities for December is $1,000. If cash paid exceeded cash received, we would call it “cash used by operating activities.” The second section reports investing activities, which involve buying and selling assets such as land and equipment that are held for long-term use (typically more than one year). The only investing activity is the $26,000 purchase of equipment. The third section shows cash flows from financing activities, which include the long-term borrowing and repaying of cash from lenders and the owner’s cash investments and withdrawals. FastForward reports $30,000 from the owner’s initial investment and the $200 cash withdrawal. The net cash effect of all transactions is a $29,800 cash inflow. The final part of the statement shows FastForward increased its cash balance by $4,800 in December. Since it started with no cash, the ending balance is also $4,800—see line .

Exhibit 1.10	Financial Statements and Their Links

Point: Statement of cash flows has three main sections: operating, investing, and financing.

Point: Payment for supplies is an operating activity because supplies are expected to be used up in short-term operations (typically less than one year).

Point: A statement’s heading identifies the company, the statement title, and the date or time period.

Point: Arrow lines show how the statements are linked. Net income is used to compute equity. Ending capital is used to prepare the balance sheet. Cash from the balance sheet is used to reconcile the statement of cash flows.

Point: The income statement, the statement of owner’s equity, and the statement of cash flows are prepared for a period of time. The balance sheet is prepared as of a point in time.

Point: A single ruled line denotes an addition or subtraction. Final totals are double underlined. Negative amounts are often in parentheses.

Point: Investing activities refer to long-term asset investments by the company, not to owner investments.

Quick Check

Answers—p. 26

Explain the link between the income statement and the statement of owner’s equity.
Describe the link between the balance sheet and the statement of owner’s equity.
Discuss the three major sections of the statement of cash flows.

Decision Analysis (a section at the end of each chapter) introduces and explains ratios helpful in decision making using real company data. Instructors can skip this section and cover all ratios in Chapter 17.

Decision Analysis

Return on Assets

A3 Compute and interpret return on assets.

A Decision Analysis section at the end of each chapter is devoted to financial statement analysis. We organize financial statement analysis into four areas: (1) liquidity and efficiency, (2) solvency, (3) profitability, and (4) market prospects—Chapter 13 has a ratio listing with definitions and groupings by area. When analyzing ratios, we need benchmarks to identify good, bad, or average levels. Common benchmarks include the company’s prior levels and those of its competitors.

This chapter presents a profitability measure, that of return on assets. Return on assets is useful in evaluating management, analyzing and forecasting profits, and planning activities. Dell has its marketing department compute return on assets for every order. Return on assetsMeasure of a company's ability to use its assets to generate sales; computed by dividing net sales by average total assets. (ROA), also called return on investment (ROI), is defined in Exhibit 1.11.

Exhibit 1.11	Return on Assets

Net income is from the annual income statement, and average total assets is computed by adding the beginning and ending amounts for that same period and dividing by 2. To illustrate, Best Buy reports net income of $984 million in 2005. At the beginning of fiscal 2005, its total assets are $8,652 million and at the end of fiscal 2005, they total $10,294 million. Best Buy’s return on assets for 2005 is:

Is a 10.4% return on assets good or bad for Best Buy? To help answer this question, we compare (benchmark) Best Buy’s return with its prior performance, the returns of competitors (such as Circuit City, RadioShack, and CompUSA), and the returns from alternative investments. Best Buy’s return for each of the prior five years is in the second column of Exhibit 1.12, which ranges from 1.3% to 10.4%. These returns show an increase in its productive use of assets in recent years. We also compute Circuit City’s returns in the third column of Exhibit 1.12. In four of the five years, Best Buy’s return exceeds Circuit City’s, and its average return is higher for this period. We also compare Best Buy’s return to the normal return for similar merchandisers of electronic products (fourth column). Industry averages are available from services such as Dun & Bradstreet’s Industry Norms and Key Ratios and Robert Morris Associates’ Annual Statement Studies. When compared to the industry, Best Buy performs well.

Exhibit 1.12	Best Buy, Circuit City, and Industry Returns

Each Decision Analysis section ends with a role-playing scenario to show the usefulness of ratios.

Decision Maker

Answer — p. 26

Business Owner You own a small winter ski resort that earns a 21% return on its assets. An opportunity to purchase a winter ski equipment manufacturer is offered to you. This manufacturer earns a 19% return on its assets. The industry return for this manufacturer is 14%. Do you purchase this manufacturer?

Quick Studies 1-11, 1-12

Exercises 1-13, 1-14, 1-15, 1-16, 1-17, 1-18

Problems 1-3A, 1-4A, 1-5A, 1-6A, 1-7A, 1-8A, 1-9A, 1-10A, 1-11A, 1-3B, 1-4B, 1-5B, 1-6B, 1-7B, 1-8B, 1-9B, 1-10B, 1-11B

Reporting in Action, Comparative Analysis, Taking it to the Net, Global Decision

Log In
You must be a registered user to view the premium content in this website. If you already have a username and password, enter it below. If your textbook came with a card and this is your first visit to this site, you can use your registration code to register, or purchase access.
Username:
Password:
	Forgot your password?

Site Preferences	(Log out)

		Send mail as:

TA email:
Other email:

"Floating" navigation?
Drawer speed:

Notes		(What is this?)

Add a note
1.	(optional) Enter a note here:
2.	(optional) Select some text on the page (or do this before you open the "Notes" drawer).
3.	Highlighter Color:
4.

Search
Search for:
Search in:

Home > Chapter 1 > Financial Statements

	Course-wide Content
		Generic Working Papers Video Library Cogg Hill Practice Set Student Learning Tools Appendices Text Updates Tech Support

	Quizzes
		Interactive Quiz A Interactive Quiz B
	More Resources
		Glossary Flashcards PowerPoint Presentations Narrated Slides Excel Templates BusinessWeek Articles More Taking it to the ... Problem Set C Topic Tackler Plus Video Segments Demo Problems iPod® Content
	eBook
		Chapter Opener Transaction Analysis a... Importance of Accounting Fundamentals of Accoun... Financial Statements Demonstration Problem Appendix 1A Return and... Appendix 1B Business A... Summary Guidance Answers to De... Guidance Answers to Qu... Key Terms Multiple Choice Quiz Discussion Questions Quick Study Exercises Problem Set A Problem Set B Problem Set C Serial Problem Beyond the Numbers Answers to Multiple Ch...

	Instructor Resources
		Cogg Hill SM Instructor ALEKS Peachtree Solution files CYGL Solutions IM Student Learning To... Text Updates

	Course-wide Content
		Generic Working Papers Video Library Cogg Hill Practice Set Student Learning Tools Appendices Text Updates Tech Support

	Instructor Resources
		Instructors Manual Solutions Manual Sols. Problem Set C Net Solutions Sols to Excel Templates Text Exhibits
	Quizzes
		Interactive Quiz A Interactive Quiz B
	More Resources
		Glossary Flashcards PowerPoint Presentations Narrated Slides Excel Templates BusinessWeek Articles More Taking it to the ... Problem Set C Topic Tackler Plus Video Segments Demo Problems iPod® Content
	eBook
		Chapter Opener Transaction Analysis a... Importance of Accounting Fundamentals of Accoun... Financial Statements Demonstration Problem Appendix 1A Return and... Appendix 1B Business A... Summary Guidance Answers to De... Guidance Answers to Qu... Key Terms Multiple Choice Quiz Discussion Questions Quick Study Exercises Problem Set A Problem Set B Problem Set C Serial Problem Beyond the Numbers Answers to Multiple Ch...