2

Types of Financial Statements

Learning Objectives By the end of this chapter, you should be able to: • Identify the four key financial statements. • Describe what each type of financial statement presents to the reader. • Identify the major components of each type of financial statement. • State the basic accounting equation. • State the formula for the statement of retained earnings. • List the things to look for in the notes to the financial statements.

INTRODUCTION

Chapter 2 will familiarize you with the four key financial statements: the balance sheet, the income statement, the statement of retained earnings, and the statement of cash flows. The accounting profession strives to provide the financial statement user with a consistent, informative document that discloses major revenue, expense, asset, liability, and equity balances in an accurate manner. This consistent disclosure is especially important to people outside a firm, such as an outside financial analyst, because the financial statement may be one of the few sources of company information available.

To meet generally accepted accounting principles, all financial statements contain the following:

1. The auditor’s opinion

2. Balance sheet

3. Income statement

4. Statement of retained earnings

5. Statement of cash flows

6. Notes to the financial statements

In addition to these six items, the financial statements may contain optional supplementary schedules for further information.

ELEMENTS OF FINANCIAL STATEMENTS

The Financial Accounting Standards Board (FASB), in its Statement of Financial Accounting No. 3, defined the elements of financial statements as follows (FASB, 1980):

Assets

Assets are probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.

Liabilities

Liabilities are probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.

Equity

Equity is residual interest in the assets of an entity that remains after deducting its liabilities. In a business enterprise, the equity is the ownership interest.

Investments by Owners

Investments by owners are increases in net assets of a particular enterprise resulting from transfers to it from other entities of something of value to obtain or increase ownership interests (or equity) in it. Assets are most commonly received as investments by owners, but that which is received may also include services, or satisfaction, or conversion of liabilities of the enterprise. In corporations, investments by an owner can take various forms, including the purchase of common stock and preferred stock.

Distributions to Owners

Distributions to owners are decreases in net assets of a particular enterprise resulting from transferring assets, rendering services, or incurring liabilities by the enterprise to owners. Distributions to owners decrease ownership interests (or equity) in an enterprise. In a corporation, distribution to owners is usually in the form of a cash dividend.

Revenues

Revenues are inflows or other enhancements of assets of an entity or settlement of liabilities (or a combination of both) during a period resulting from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major or central operations.

Expenses

Expenses are outflows or other using-up of assets or incurrence of liabilities (or a combination of both) during a period resulting from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity’s ongoing major or central operations.

Gains

Gains are increases in equity (net assets) from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity during a period, except those that result from revenues or investments by owners.

Losses

Losses are decreases in equity (net assets) resulting from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity during a period, except those that result from expenses or distributions to owners.

These definitions are formal, somewhat difficult to understand, and all-encompassing. To simplify the definitions of the financial statement elements we will explore first in this chapter—assets, liabilities, and equity—we will use the following definitions:

• Assets are things of value owned by a business.

• Liabilities are debts owed by a business.

• Equity represents the interest or rights due the owners or shareholders after all liabilities have been settled.

Assets, liabilities, and equity are presented on the balance sheet and represent balances at a certain point in time. The balance of the elements at that point in time is the cumulative balance of all transactions since the inception of the business.

The balance sheet elements are affected by other account balances that are not reported on the balance sheet, such as distributions (dividends) to owners, revenues, expenses, gains, and losses. These items—specifically revenues and expenses—summarize transactions over a period of time, for instance, from January 1 to December 31 of a particular year, and are presented on the income statement and the changes in equity statement. Revenue, expense, gains, and loss accounts are often called temporary accounts since their balances are closed into the equity account at the end of the period and are set to zero to begin summarizing a new period. The process of closing accounts is similar to resetting a scoreboard back to zero at the end of a game.

To this point we have briefly explored the elements of financial statements. The following sections review the components of the various statements and their major groupings. We begin exploring the components of financial statements by first looking at the balance sheet.

THE BALANCE SHEET

The balance sheet is a snapshot of a business at a given date. Also called a statement of financial position or a statement of financial condition, the balance sheet identifies a business’ assets, liabilities, and owners’ equity as of a certain date. An example of a comparative balance sheet is shown in Exhibit 2–1. A comparative balance sheet shows balances of accounts as of two dates. The balance sheet is a cumulative document representing the current balances of the various accounts since the inception of the business to a given point in time.

The balance sheet is the line-by-line version of the basic accounting equation:

Assets = Liabilities + Owners’ Equity

The balance sheet is subdivided into subsections of types of assets, liabilities, and owners’ equity.

Assets

Assets can be subdivided into four major categories:

1. Current assets

2. Long-term investments

3. Property, plant, and equipment, including fixed assets (tangible and intangible) and wasting assets (natural resources)

4. Other assets

Current Assets

Current assets are those that will most likely be converted into cash, be sold, or be consumed within a period of one year or within the normal operating cycle of the business. Under the general classification of assets, they form the first subcategory in that they are listed first on the balance sheet. Examples of current assets include:

• Cash

• Accounts receivable (money owed to the company from customers)

• Inventories

Long-Term Investments

Long-term investments include such assets as:

• Stocks and bonds owned by the business

• Land held for future use or speculative purposes

• The cash surrender value of life insurance policies

• Investments set aside in special funds, such as pension or plant-expansion funds

Property, Plant, and Equipment

Property, plant, and equipment, also called fixed assets, are used in the operation of the business and have a useful life of more than one year. They may be broken down further into:

• Tangible fixed assets

• Intangible fixed assets

• Natural resources

Property, plant, and equipment can be thought of as assets that businesses use to produce and distribute goods and services.

Other Assets

This is a catch-all for assets that cannot be classified properly elsewhere. Examples include:

• Long-term, prepaid expenses

• Refundable deposits on long-term leases

• Organization costs

Liabilities

Liabilities are usually classified in the following major subcategories:

• Current

• Long-term

Let’s first look at the current liabilities, which, like the current assets, are listed prior to long-term items.

Current Liabilities

Current liabilities are debts and other liabilities owed by the company that will be satisfied within one year. Cash flow from the sale or liquidation of current assets will, under ordinary circumstances, be used to satisfy the current liabilities. Current liabilities include:

• Accounts payable

• Wages payable

• Taxes payable

Long-Term Liabilities

Liabilities that will not be satisfied within one year are classified as long term. To be more descriptive and therefore disclose more information for the statement user, information concerning interest rates, maturity dates, and the nature of any security pledged for a long-term debt is usually included on the balance sheet or in the notes to the financial statements. Examples of long-term liabilities are:

• Unsecured bank loans that are payable over a period greater than one year

• Bonds that are issued by the firm and that will mature on a date more than one year into the future

• Long-term mortgages

Owners’ Equity

Owners’ equity for a corporation is usually divided into four subcategories:

1. Capital stock at the par or stated value

2. Additional paid-in capital or amounts paid over par

3. Retained earnings (representing the undistributed earnings of the entity)

4. Treasury stock

Capital Stock

Capital stock is a broad description for the ownership interest in a corporation. The true ownership interest in a corporation is called common stock. Common stock normally carries full ownership rights, including:

• The right to receive dividends

• The right to vote for directors

• The right to receive assets upon the dissolution of the company

• The right to maintain proportionate percentage of ownership in the company through the pre-emptive right to buy new shares of common stock prior to their sale to the general public

• The right to examine the company’s books

There are also many types of nonvoting common stock and classes of preferred stock. Preferred stock, which is also an ownership interest, may be voting or nonvoting and usually has preference in the receipt of dividends; thus the term preferred. This preference with respect to dividends means that the preferred stockholder will receive the preferred stock cash dividend prior to the common stockholder receiving a common stock cash dividend. However, unlike common stock, preferred dividends are usually fixed; for instance, at a certain percentage of par value. A complete discussion of the various types of stock is beyond the scope of this course, but the analyst should be aware of the types presented in the equity section of a balance sheet. The footnotes to a balance sheet usually contain details concerning capital stocks.

Additional Paid-In Capital

Another possible equity account is called additional paid-in capital. Additional paid-in capital is capital contributed by stockholders and other outsiders. In other words, it is the total in excess of the par, or stated value of the stock, and is kept separate from retained earnings and capital stock balances. The par or stated value is the stated amount of value per share specified in the corporate charter. Par value is an arbitrary monetary figure that is not to be confused with the market value of the stock. For example, if the par value of a common stock was $100 and the company issued 1,000 shares at $150 per share, there would be $50 per share of paid-in capital, for a total of $50,000 of additional paid-in capital. The results of this sale of stock are shown below:

Common Stock (1,000 shares, $100 par)	$100,000
Additional Paid-In Capital	$50,000
Total Capital	$150,000

Some balance sheets, like the one shown in Exhibit 2–1, do not show an amount for additional paid-in capital. This is because some companies do not assign a par value to the stock; rather, the company issues no-par stock. For example, assuming the same facts as in the previous example, with the exception that the stock being issued is no par, the total value of the stock being issued, $150,000 (1,000 shares × $150 per share), would be recorded as common stock.

Retained Earnings

Only two things can happen to a company’s earnings: They can be paid to the stockholders in the form of dividends, or they can be reinvested in the company in the form of retained earnings. Retained earnings are accumulated earnings that are not distributed to the shareholders; they have been retained to provide for future growth. Retained earnings can be restricted or unrestricted. Restricted retained earnings do not constitute a pool of resources; they are unavailable for disbursement as dividends.

Treasury Stock

Treasury stock is the company’s own stock that has been reacquired by the firm. Shares of stock acquired as treasury stock have not been cancelled or retired, but are being held by the company for possible future resale or reissuance. There are several reasons why a firm might repurchase its own stock. They include:

• The company may wish to change its capital structure and may use the proceeds from debt or another class of stock to buy back stock.

• The company may be trying to fight an unfriendly corporate takeover by buying up the excess shares a suitor would need to gain a controlling interest.

• The stock may be needed to make awards for employee stock plans or stock option plans.

• The company may be trying to boost earnings per share.

One misconception is that treasury stock is an asset of the company. As Exhibit 2–1 shows in the 20X2 column, treasury stock is a negative equity account—it is stock that was once issued but is no longer outstanding. Its balance is a debit balance, and it is therefore subtracted from owners’ equity.

INCOME STATEMENT

The terms income statement, profit and loss statement, and statement of operations all refer to the financial statement that discloses a company’s profit or loss during a specified period of time. The income statement shows revenues earned during a period of time, the expenses incurred to produce that revenue, and the income or loss for that period.

In a previous section of this chapter, the formal definitions of the terms revenue and expense were presented. A more informal and possibly easier set of definitions for revenue and expense are as follows:

• Revenue—the price of goods sold and services rendered during a given accounting period

• Expense—the cost of the goods and services used in the process of earning revenue

When income statements are prepared, management or its accountants extract revenues from internal records, sales, and other income totals. The revenue-recognition principle provides that revenue is recognized when:

1. The earning process is complete or virtually complete.

2. An exchange transaction has taken place.

Revenue is usually recognized at the point of sale or transfer of rights to the goods from the seller to the buyer, i.e., at the time of shipping.

Expenses are subtracted from revenues to arrive at net income or loss for the period. An accounting principle called the matching concept gives guidance on how expenses are to be recognized. The matching concept compares incurred costs and expenses of a specific accounting period against revenue earned during the same period in order to determine net income earned for that period. This does not mean that an exact matching must occur. Sometimes this precision may be difficult to achieve. Matching means that the periodically recognized revenues presented in the income statement are properly matched with the identified expenses for the same period.

An illustration of the matching concept is the handling of the cost of machinery acquired by a company. Ordinarily, a machine provides benefits to a company for more than the period in which it was purchased. Under the matching concept, an apportioning of the cost over the periods benefited is essential for the correct calculation of income. A proper allocation of the cost to these periods could be achieved by taking the cost of the asset, reduced by any estimated scrap or residual value, and then dividing it by the number of accounting periods served. This allocation of asset cost is called straight-line depreciation. Exhibit 2–2 shows a comparative example income statement with net incomes of $78,186 and $117,037 for the years 20X1 and 20X2, respectively. It also shows the key components of the income statements as:

• Sales

• Cost of goods sold

• Operating expenses

• Other income (other expenses)

• Net income (loss)

Sales

The sales figure on the income statement represents the total of invoices billed to customers during the period covered by the income statement. Therefore, the sales figure usually represents both cash and credit sales. Often, the sales figure represents net sales. Net sales are defined as the total of invoices billed to customers during the period, less sales discounts and returns and allowances.

The net sales formula is:

Gross Sales – Sales Discounts – Sales Returns and Allowances

Sales discounts are granted to customers who pay bills early. Sales returns represent merchandise that was sold and then returned by the customer. Sales allowances are discounts granted to the customer because the product was defective or not up to the quality level expected by the customer.

Cost of Goods Sold

The cost of goods sold is composed of those expenses incurred to manufacture or purchase merchandise that has been sold. The cost of goods sold takes into account material costs as well as labor and factory expenses. Often a separate report, such as the one shown in Exhibit 2–3, called the cost of goods sold, is prepared. The cost of goods sold report shows how the cost of goods sold expense, shown on the income statement, was computed. Sometimes, the cost of goods sold calculation is included on the income statement; in that case, a cost of goods sold report separate from the income statement is not necessary. The cost of goods sold is found by using the following formula.

Beginning Inventory + Purchases and Freight In

– Purchase Returns and Allowances and Discounts on Purchases

– Ending Inventory

By subtracting the cost of goods sold from sales, you derive gross profit. Gross profit is a preliminary indication of profitability. Also called gross profit on sales or gross margin, this profit is called gross because operating expenses must be subtracted from it.

Operating Expenses

Operating expenses are the day-to-day expenses incurred in running a firm. Falling into the category of operating expenses are:

• Selling and administrative expenses

• Depreciation

• Interest

If operating expenses are less than gross income, as is the case in Exhibit 2–2, then the result is a profit from operations. If the opposite is true, with operating expenses greater than gross profit, then the result would be a loss from operations.

Other Income (Other Expenses)

Revenues from sources other than the principal activity of the business are called other income. This type of income is also called non-operating income. Examples of other income include income from investments (such as dividend or interest income), rent, and capital gains from the sale of plant assets. Expenses that are not incurred in normal operations are called other expenses. Examples of other expenses could include the loss incurred from the damages caused by a hurricane.

Net Income (Loss)

The bottom-line figure on the income statement is net income (loss). Net income increases owners’ equity, whereas net loss decreases owners’ equity. As was mentioned in the balance sheet section earlier, only two things can happen to net income:

1. It can be reinvested in the firm (retained earnings).

2. All or a portion of it can be paid out to the owners of the firm in the form of dividends.

With the income statement completed, the statement of retained earnings can be prepared. In fact, the income statement and statement of retained earnings are often combined into one statement.

STATEMENT OF RETAINED EARNINGS

This statement details the changes in the retained earnings accounts for the same period as the income statement. The statement consists of the beginning balance of retained earnings, the net income (loss), any dividends paid out, and the ending balance of retained earnings. The example statement of retained earnings shown in Exhibit 2–4 is based on the information given in the financial statements shown in Exhibits 2–1 and 2–2. The formula for the statement of retained earnings is as follows:

Beginning Retained Earnings + Net Income – Dividends

= Ending Retained Earnings

STATEMENT OF CASH FLOWS

The statement of cash flows originated as a management tool. Its purpose was to show where the cash came from and where it went during a particular period. In 1987, the FASB made the statement of cash flows mandatory with Opinion No. 95. What this means is that the statement of cash flows became a required part of the basic set of financial statements.

The statement of cash flows provides the user with a detailed summary of all the cash provided during the period and the uses to which the cash was put. It is extremely important because it reflects the operating, financing, and investment activities of an organization. The statement is useful for managers in evaluating past financing and investing activities and in planning future financing and investing activities. The statement is also useful to creditors and investors in their analysis of a firm’s financial condition. Chapter 6 discusses this important statement in greater detail. Exhibit 2–5 presents one of the two alternative formats for this report: the indirect method.

NOTES TO THE FINANCIAL STATEMENTS AND SUPPLEMENTAL INFORMATION

Notes to the financial statements are a very important source of information for the analyst. Notes provide additional information about a company’s operations and financial position and are considered an integral part of the financial statements. They can amplify or explain information in the financial statements or add supplemental information that might be of interest to decision-makers who will read the statements.

The full-disclosure principle requires that information that could influence a financial statement reader’s judgment must be disclosed in the financial statements. Since some variables cannot be reflected in the numbers, they can be disclosed in the notes. Many contingent liabilities and material events subsequent to the balance sheet date are disclosed in the notes to the financial statements. In addition, details on accounting policies, debt, future commitments, other material transactions including those with related parties (such as transactions between a parent company and its subsidiaries or transactions between management and principal owners), as well as many nonfinancial events that may affect future operations should be presented in the notes.

Notes to financial statements cover such issues as:

• Significant accounting policies and practices—The accounting policies that are most important to the portrayal of the company’s financial condition and results must be disclosed in the notes to the financial statements.

• Income taxes—Detailed information about the company’s current and deferred income taxes. The information is broken down by level—federal, state, local, and/or foreign.

• Pension plans and other retirement programs—The notes contain specific information about the assets and costs of these programs, and indicate whether and by how much the plans are over- or under-funded.

• Stock options—Stock options granted to officers and employees, including the method of accounting for stock-based compensation and the effect of the method on reported results.

• Property, plant, and equipment holdings

• Maturity patterns of bond issues

• Significant uncertainties—i.e., any pending litigation

• Details of capital stock issues

Financial statement users need to understand all the significant risks of an entity, and therefore disclosures should be made as of the balance sheet date about items and events that could significantly affect the reported amounts in the near term (within one year). Possible significant risks related to products, markets, locations, and the industry within which the business is operating should be revealed through supplemental notes.

Analysis of financial statements is not complete until the notes to the financial statements are read and analyzed for any transactions or information that will affect the future operations of the enterprise. Notes help give the complete picture.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The Management Discussion and Analysis (MD&A) is a section of a company’s annual report in which management discusses numerous aspects of the company, both past and present. The MD&A provides an overview of the previous year of operations. Management will also write about the upcoming year, outlining future goals and approaches to new projects. The MD&A is a very important section of an annual report, especially for those analyzing the fundamentals of a company. It contains useful information. However, investors should keep in mind that the section is unaudited.

The content in a MD&A can include a discussion of the business environment and risks that the company operates within, segment-wise performance, liquidity and capital sources, environmental matters (potential liabilities related to environmental obligations), market risk, inflation and other uncertainties, and critical accounting estimates.

This chapter introduced the four financial statements: the balance sheet, the income statement, the statement of retained earnings, and the statement of cash flows. The financial statement user must understand the components of each of these statements. Each section of a financial statement reports something unique, and classifications (current versus long-term) within the balance sheet help users analyze such issues as liquidity and debt burden.

The balance sheet is the line-by-line version of the basic accounting equation:

Assets = Liabilities + Owners’ Equity

The income statement shows revenues earned during a period of time, the expenses incurred to produce that revenue, and the income or loss for that period. The statement of retained earnings details the changes in the retained earnings accounts for the same period as the income statement. The statement consists of the beginning balance of retained earnings, the net income (loss), any dividends paid out, and the ending balance of retained earnings. The formula for the statement of retained earnings is as follows:

Beginning Retained Earnings + Net Income – Dividends

= Ending Retained Earnings

The statement of cash flows was also introduced in this chapter with an example of the statement prepared under the indirect method. The statement can also be prepared using the direct method, but the mechanics of that method are beyond the scope of this course. The statement of cash flows shows the sources and uses of cash during the period covered by the financial statements. It is an important financial statement since it is the only one prepared on a cash basis (under GAAP rules), and since a company’s obligations are almost exclusively settled with cash, the statement of cash flows is of great interest to investors and creditors.

The notes to the financial statements are important sources of information for analysts. Accounting procedures, accounting policies, estimates and significant near-term risks should be disclosed by management as supplementary notes that need to be read and analyzed by statement users to get the whole picture.

ANSWERS TO “THINK ABOUT IT...” QUESTIONS FROM THIS CHAPTER

1. A.	LTI
B.	PPE
C.	LTI
D.	CA
E.	CA
F.	PPE
G.	PPE
H.	LTI
I.	CA
J.	LTI

2. A.	CL
B.	CL
C.	LTL
D.	LTL
E.	CL

3. Common stock	$100,000
Additional paid-in capital	250,000
Less: Treasury stock	(70,000)
Retained earnings	55,000
Total equity	$335,000

4. A.	2
B.	1
C.	4
D.	3
E.	3

5. Gross Sales	$10,000,000
Sales Discounts	(300,000)
Sales Returns and Allowances	(350,000)
Net Sales	$9,350,000

6. Cost of Goods Sold
Beginning Inventory	$600,000
Add: Purchases and Freight In	700,000
Less: Purchase Returns and Allowances and Discounts on Purchases	25,000
Less: Ending Inventory	625,000
Cost of Goods Sold	$650,000
Gross Profit:
Net Sales	$1,200,000
Less: Cost of Goods Sold	650,000
Gross Profit	$550,000

7. A.	BOTH
B.	SRE
C.	SRE
D.	IS
E.	SRE

8. A.	SRE
B.	BS
C.	IS
D.	BS
E.	BS
F.	IS
G.	IS
H.	IS
I.	BS
J.	IS

9. a.	$130,000
b.	$50,000
c.	$30,000
d.	$130,000