Financial statements are the end result of the financial accounting process. Firms prepare three major financial statements: the balance sheet, the income statement, and the statement of cash flows. The following sections briefly describe these statements.
The Balance Sheet – The balance sheet shows a firm’s assets, liabilities, and owners’ equity. Assets are valuable resources that a firm owns or controls. The simplified balance sheet shown in Figure. Cash obviously has value. Accounts receivable are amounts owed to Newton Company by its customers; these have value because they represent future cash inflows. Inventory is merchandise acquired that is to be sold to customers. Newton expects its inventory to be converted into accounts receivable and ultimately into cash. Finally, equipment (perhaps delivery vehicles or showroom furniture) enables Newton to operate its business.
Liabilities – Liabilities are obligations of the business to convey something of value in the future. Newton’s balance sheet shows two liabilities. Accounts payable are unwritten promises that arise in the ordinary course of business. An example of this would be Newton purchasing inventory on credit, promising to make payment within a short period of time. Notes payable are more formal, written obligations. Notes payable often arise from borrowing money.
The final item on the balance sheet is owners’ equity, which refers to the owners’ interest in the business. It is a residual amount that equals assets minus liabilities. The owners have a positive financial interest in the business only if the firm’s assets exceed its obligations.
The Income Statement – Just as each of us is concerned about our income, investors and creditors are interested in the ability of an organization to produce income (sometimes called earnings or profits). The income statement summarizes the earnings generated by a firm during a specified period of time.
Income statements contain at least two major sections: revenues and expenses. Revenues are inflows of assets from providing goods and services to customers. Newton’s income statement contains one type of revenue: sales to customers. This includes sales made for cash and sales made on credit.
Expenses – Expenses are the costs incurred to generate revenues. Newton’s income statement includes three types of expenses. Cost of goods sold is the cost to Newton of the merchandise that was sold to its customers. General and administrative expenses include salaries, rent, and other items. Tax expense reflects the payments that Newton must make to the Internal Revenue Service and other taxing authorities. The difference between revenues and expenses is net income (or net loss if expenses are greater than revenues).
The Statement of Cash Flows – From a financial accounting perspective, income is not the same as cash. For example, suppose that a sale is made on credit. Will this sale be recorded on the income statement? Yes. It meets the definition of a revenue transaction: an inflow of assets (the right to receive cash in the future) in exchange for goods or services. Moreover, including this transaction in the income statement provides financial statement readers with useful information about the firm’s accomplishments. However, no cash has been received. Thus, the income statement does not provide information about cash flows.
Financial statement users, though, are also interested in a firm’s ability to generate cash. After all, cash is necessary to buy inventory, pay workers, purchase equipment, and so on. The statement of cash flows summarizes a firm’s inflows and outflows of cash. Figure 1.6 illustrates Newton Company’s statement of cas, which has three sections. One section deals with cash flows from operating activities, such as the buying and selling of inventory. The second section contains information about investing activities, such as the acquisition and disposal of equipment. The final section reflects cash flows from financing activities. These activities include obtaining and repaying loans, as well as obtaining financing from owners.
Notes to Financial Statements – A full set of financial statements includes a number of notes that clarify and expand the material presented in the body of the financial statements. The notes indicate the accounting principles (rules) that were used to prepare the statements, provide detailed information about some of the items in the financial statements, and, in some cases, provide alternative measures of the firm’s assets and liabilities.
Notes to financial statements are not illustrated in this chapter because they are highly technical and apply to specific accounting topics covered in subsequent chapters. Notes are, however, emphasized throughout much of this tutorial.
Annual Reports – All large firms, and many smaller ones, issue their financial statements as part of a larger document referred to as an annual report. In addition to the financial statements and their accompanying notes, the annual report includes descriptions of significant events that occurred during the year, commentary on future plans and strategies, and a discussion and analysis by management of the year’s results.