16
Table of Contents
Week 5 Lecture: Financial Statements 2
The Four Basic Financial Statements 2
Linking Expanded Accounting Equation & Financial Statements 3
Linking Adjustments to Financial Statements 3
Calculating Financial Statement Balances 4
Review: Accounting Cycle Step 6 – Prepare Adjusted Trial Balance 4
Review: Worksheet Example – Draft Financial Statements 5
Review: Accounting Cycle Step 7 – Prepare Statements 6
The Classified Balance Sheet 8
Prepare the Statement of Cash Flows 11
Review: Accounting Cycle Step 8 – Close 13
Review: Accounting Cycle Step 9 – Prepare Post-Closing Trial Balance 13
Ratios – Building Blocks of Analysis 14
Liquidity and Efficiency Ratio – Current Ratio 14
Solvency Ratio – Debt Ratio 14
Profitability Ratios – Profit Margin & Return on Assets 15
Reference 16
Week 5 Lecture: Financial Statements
The Four Basic Financial Statements
Recall from last week’s lecture that the process of accounting for transactions begins with the accounting cycle. An accounting cycle refers to the steps necessary to prepare financial statements. The term cycle is used because the steps are repeated each reporting period.
Remember — there are ten steps in the accounting cycle. Last week we studied steps 6-9. This week, we will focus more in detail on step 7 – Prepare statements — Use adjusted trial balance to prepare financial statements. We will also review steps 6, 8 and 9 to facilitate our understanding of step 7.
(Wild, Shaw, & Chiappetta, 2017).
Recall from the week 1 lecture — there are four financial statements that organizations prepare as part of their reporting process:
Income statement — describes a company’s revenues and expenses along with the resulting net income or net loss — over a period-of-time due to earnings activities. Net income is sometimes called earnings or profit.
Statement of owner’s equity — explains changes in equity from net income (or net loss) and from any owner investments and withdrawals over a period-of-time. The statement of owner’s equity is also called the statement of changes in owner’s equity.
Balance sheet — describes a company’s financial position – by the types and amounts of assets, liabilities, and equity — at a point in time.
Statement of cash flows — identifies cash inflows (receipts) and cash outflows (payments) over a period-of-time. The Statement of Cash Flows is covered later in this lecture.
Linking Expanded Accounting Equation & Financial Statements
Remember the expanded accounting equation? We can show the relationship between the expanded accounting equation and the financial statements. The graphic below demonstrates that financial statements reflect different parts of the expanded accounting equation:
Expanded Accounting Equation — Relationship with Financial Statements
(Wild, Shaw, & Chiappetta, 2017).
For our understanding, the graphic above presents a visual representation of the relationship and components of the expanded accounting equation that we will use to prepare each financial statement.
Linking Adjustments to Financial Statements
Recall from the week 3 lecture that, during the accounting cycle for step 5 – adjust, we record adjustments to bring account balances up to date. An adjusting entry is made at the end of an accounting period to reflect a transaction or event that is not recorded yet. Each adjusting entry affects one or more income statement accounts and one or more balance sheet accounts – but never the cash account.
The graphic below summarizes the four types of transactions that must be adjusted and their link to financial statements. Each adjusting entry affects one or more income statement (revenue or expense) accounts and one or more balance sheet (asset or liability) accounts (but not cash).
(Wild, Shaw, & Chiappetta, 2017).
Calculating Financial Statement Balances
Using account balances, we can calculate the total balance for each financial statement as follows:
Income Statement:
Total revenues
Total expenses
= Net income (or loss)
Statement of Owner’s Equity:
Beginning Capital
+ Owner Investments
+ Net Income
− Withdrawals
= Ending Capital
Balance Sheet:
Assets = Liabilities + Owner’s Equity
Review: Accounting Cycle Step 6 – Prepare Adjusted Trial Balance
Recall for step 6 — Prepare adjusted trial balance, we summarize adjusted ledger accounts and amounts. The most efficient method for preparing the adjusted trial balance is to use a worksheet.
Preparing the worksheet allows companies to prepare a draft of the financial statements.
Worksheet Reminders:
A worksheet is not a required report or an accounting record, but its format is flexible and can be modified by companies to fit their business preferences and needs for an accounting period.
When a worksheet is used to prepare financial statements, it is typically created at the end of an accounting period — before the adjusting process.
A worksheet organizes information used to prepare adjusting entries, financial statements, and closing entries.
The complete worksheet includes a list of all accounts, account balances and their adjustments, and accounts are grouped and arranged into financial statement columns.
The worksheet includes two columns each for the following:
Unadjusted trial balance
Adjustments
Adjusted trial balance
Income statement
Balance sheet — including the statement of owner’s equity
Review: Worksheet Example – Draft Financial Statements
Using information for FastForward, we can explain and interpret the worksheet. Each step, 1 through 5, is color-coded and explained in the worksheet. This is an example of a manual worksheet created in Excel:
(Wild, Shaw, & Chiappetta, 2017).
The following video explains how to create the 10-column worksheet: Worksheet (Click to view)
The green columns labeled Unadjusted Trial Balance in the 10-column worksheet above contain the balances for all accounts before adjustments are made.
This video explains the unadjusted trial balance: Unadjusted Trial Balance (Click link to view video)
In the worksheet above, notice the yellow columns labeled as (2) Adjustments. The debit and credit amounts in these two columns are the amounts from the adjusting journal entries. For example, the debit and credit adjustment amounts labeled (b) 1,050 are for supplies expense and supplies, respectively.
All debit and credit adjustments are labeled (a) – (f) in the yellow columns.
The following video explains adjustments: Adjustments (Click link to view video)
The blue columns labeled (3) Adjusted Trial Balance in the worksheet contain the adjusted balances for all accounts after adjustments were made and posted.
This video explains the Adjusted Trial Balance: Adjusted Trial Balance (Click link to view video)
The orange columns labeled (4) Income Statement (IS), Balance Sheet (BS) & Statement of Owner’s Equity (OE) in the worksheet were created using the account balances from the columns labeled (3) Adjusted Trial Balance.
The purple rows labeled (5) are net income/loss and totals for the IS, BS, and Statement of OE
Review: Accounting Cycle Step 7 – Prepare Statements
Recall from the previous lecture –for step 7 – Prepare statements, we use the adjusted trial balance to prepare the financial statements. When using the adjusted trial balance in the worksheet to prepare financial statements, those statements within the worksheet are only draft formats (see the worksheet above). Official financial statements for reporting to external users must be presented separately.
The videos below demonstrate how to prepare the draft financial statements within the 10-column worksheet (the income statement, balance sheet, and statement of owner’s equity):
Example 1 – Draft Financial Statements (Click to view video)
Example 2 – Draft Financial Statements – A comprehensive example (Click to view video)
The following videos demonstrate how to prepare the three financial statements:
Balance Sheet (Click to view video)
Income Statement — Single step (Click to view video)
Income Statement — Multi-step (Click to view video)
Statement of Owner’s Equity (Click to view video)
The 3 financial statements below were prepared using FastForward’s 10-column worksheet presented earlier:
(Wild, Shaw, & Chiappetta, 2017)
We can also prepare the income statement, balance sheet, and statement of owner’s equity without using the 10-column worksheet, by following the four steps below:
Step 1— Prepare the income statement using revenue and expense accounts from the trial balance.
Step 2—Prepare the statement of owner’s equity using capital and withdrawals accounts from the trial
balance — and pull net income from step 1.
Step 3—Prepare balance sheet using asset and liability accounts from the trial balance — and pull the
updated capital balance.
Step 4—Prepare statement of cash flows from changes in cash flows for the period (see the next lecture).
The Classified Balance Sheet
A classified balance sheet organizes assets and liabilities into important subgroups that provide more information to decision makers. A classified balance sheet is the most popular format used by companies.
On the asset (left) side of the balance sheet, we group assets as current or noncurrent. A current asset is one that is expected to be converted into cash in one year or the company’s normal operating cycle, whichever is longer (Wild, Shaw, & Chiappetta, 2017).
The operating cycle of a company is the time it takes to acquire inventory, sell the inventory, and collect cash. For many companies, the operating cycle is less than one year. These companies would classify an asset as current if that asset is expected to be converted into cash within one year (Wild, Shaw, & Chiappetta, 2017).
On the liabilities plus equity (right) side of the balance sheet, we divide liabilities between current and noncurrent. A current liability is one we expect to be paid out of the company’s current assets within the longer of one year or the normal operating cycle (Wild, Shaw, & Chiappetta, 2017).
Classified Balance Sheet Format
Assets = Liabilities + Equity
(Wild, Shaw, & Chiappetta, 2017)
Notice that the classified balance sheet is presented in the accounting equation format:
Assets = Liabilities + Equity
The graphics below present examples of FastForward’s report form balance sheet and classified balance sheet formats.
Report Form – Balance Sheet
(Wild, Shaw, & Chiappetta, 2017)
Classified Balance Sheet Format
(Wild, Shaw, & Chiappetta, 2017)
Links Between the Three Financial Statements
Link 2: Ending capital balance of $33,585 from the Statement of Owner’s Equity flows to the Balance Sheet
Link 2: Ending capital balance of $33,585 from the Statement of Owner’s Equity flows to the Balance Sheet
Link 1: Net income of $3,785 from the Income Statement flows to the Statement of Owner’s Equity
Link 1: Net income of $3,785 from the Income Statement flows to the Statement of Owner’s Equity
(Wild, Shaw, & Chiappetta, 2017)
Prepare the Statement of Cash Flows
The purpose of the statement of cash flows is to report cash receipts (inflows) and cash payments (outflows) during a period. This includes separately identifying the cash flows related to operating, investing, and financing activities. It is the detailed disclosure of individual sources and uses of cash that makes this statement useful. The statement of cash flows helps users answer questions such as:
Where does a company spend its cash?
Why do income and cash flows differ?
Is there a cash shortage?
The following video explains the purpose of Statement of Cash Flows (Click to view video)
Information about cash flows influences decisions. Information about cash flows helps users decide whether a company has enough cash to pay its debts. It also helps evaluate a company’s ability to pay unexpected obligations and pursue unexpected opportunities. Managers use cash flow information to plan day-to-day operations and make long-term investment decisions.
Cash receipts and cash payments are classified on the statement of cash flows in one of the following three categories:
Operating activities — Transactions and events that determine net income. Examples include production and purchase of inventory, sale of goods and services to customers, or expenditures to operate the business.
Investing activities — Transactions and events that affect long-term assets. Examples are the purchase and sale of long-term assets.
Financing activities — Transactions and events that affect long-term liabilities and equity. Examples include obtaining cash from issuing debt or repaying amounts borrowed, or receiving cash from or distributing cash to owners. These activities involve transactions with a company’s owners and creditors.
The following video explains methods of reporting Statement of Cash Flows (Click to view video)
The next videos explain the three activities used to prepare the Statement of Cash Flows:
Operating activities (Click to view video)
Investing activities (Click to view video)
Financing activities (Click to view video)
Links Between the Four Financial Statements
Link 1: Net income of $4,400 from the Income Statement flows to the Statement of Owner’s Equity
Link 1: Net income of $4,400 from the Income Statement flows to the Statement of Owner’s Equity
Link 3: Total cash of $4,800 from the Balance Sheet is verified as the correct ending cash balance in the Statement of Cash Flows
Link 3: Total cash of $4,800 from the Balance Sheet is verified as the correct ending cash balance in the Statement of Cash Flows
Link 2: Ending capital balance of $34,200 from the Statement of Owner’s Equity flows to the Balance Sheet
Link 2: Ending capital balance of $34,200 from the Statement of Owner’s Equity flows to the Balance Sheet
(Wild, Shaw, & Chiappetta, 2017)
Review: Accounting Cycle Step 8 – Close
Reminder: After all financial statements are prepared, we complete step 8 – Close, to journalize and post entries to close temporary accounts, which transfers the end-of-period balances in revenue, expense, and withdrawals accounts to the permanent capital account. The closing process is a critical step at the end of an accounting period. Closing entries are necessary at the end of each period after financial statements are prepared for the following reasons:
Revenue, expense, and withdrawals accounts must begin each period with zero balances
Owner’s capital must reflect prior periods’ revenues, expenses, and withdrawals.
To close revenue and expense accounts, we transfer their balances to a temporary account called Income Summary. This account is temporary because it is only used to complete the closing process. Once all revenues and expenses are closed, Income Summary is also closed, but to the capital account.
We can use either the adjusted trial balance or the financial statements (Income statement and balance sheet) to make the closing entries.
For more details on preparing the post-closing trial balance, review the week 4 lecture.
This video presents a comprehensive example for The Closing Process (Click to view video)
This video explains the purpose of Income Summary (Click to view video)
Review: Accounting Cycle Step 9 – Prepare Post-Closing Trial Balance
Reminder: After all closing entries are completed, the last step of the accounting cycle (and closing process) is to prepare a post-closing trial balance. This step should be completed after all four closing entries have been journalized and posted.
The purpose of the post-closing trial balance is to verify that:
All temporary accounts were closed (income statement accounts and income summary account).
Total debits equal total credits for permanent accounts (balance sheet accounts)
There are four steps we must always follow for the closing process. To prevent confusion for the closing process, when you first try to make closing entries, it is an excellent idea to follow these four steps exactly:
Step 1: Close Credit Balances in Revenue Accounts to Income Summary
Step 2: Close Debit Balances in Expense Accounts to Income Summary
Step 3: Close Income Summary to Owner’s Capital
Step 4: Close Withdrawals Account to Owner’s Capital
This video explains and demonstrates Preparing the Post-Closing Trial Balance (Click to view video)
For more details on preparing the post-closing trial balance, review the week 4 lecture.
Ratios – Building Blocks of Analysis
Financial statement analysis focuses on one or more elements of a company’s financial condition or performance. Ratio analysis provides clues to and symptoms of underlying conditions of a business. When properly interpreted, ratios can identify areas requiring further investigation. A ratio expresses a relationship between two quantities such as a percent, rate, or proportion. Ratios can be organized into the building blocks of analysis: (1) liquidity and efficiency, (2) solvency, (3) profitability, and (4) market prospects (Wild, Shaw, & Chiappetta, 2017).
For purposes of this lecture, the following is a brief overview of the first 3 ratios. There are many ratios for each building block, but for this lecture, we will focus on current ratio, debt ratio, profit margin, and return on assets (ROA).
The 4 building blocks of analysis are discussed in more detail in an advanced accounting course.
Liquidity and Efficiency Ratio – Current Ratio
Liquidity and efficiency ratios indicate a company’s ability to meet its short-term obligations and to efficiently generate revenues.
Current ratio. Defined as current assets divided by current liabilities. When compared to a company’s prior year current ratios and the industry’s current ratios, a high current ratio suggests a strong liquidity position and a company’s ability to meet current obligations. An excessively high current ratio means that the company has invested too much in current assets compared to its current obligations. An excessive investment in current assets is not an efficient use of funds because current assets normally generate a low return on investment (compared with long-term assets) (Wild, Shaw, & Chiappetta, 2017).
Solvency Ratio – Debt Ratio
A company’s solvency is its ability to generate future revenues and meet long-term obligations.
Debt ratio. Calculated as total liabilities to total assets. This calculation expresses total liabilities as a percentage of total assets. The debt ratio reflects risk associated with a company’s debts and is used to analyze a company’s financial condition. Note: This ratio is usually used with the equity ratio and debt-to-equity ratio to assess a company’s solvency – since debt can have the effect of increasing or decreasing the return (dividends, etc.) to stockholders (Wild, Shaw, & Chiappetta, 2017).
Profitability Ratios – Profit Margin & Return on Assets
Profitability ratios indicate a company’s ability to provide positive financial returns to attract and maintain financing. A company’s operating efficiency and profitability can be expressed by two ratios (1) profit margin, and (2) return on assets.
Profit Margin. This ratio is a useful measure of a company’s operating results calculated as net income to net sales. It is measured by expressing net income as a percentage of sales (reflects the percentage of profits in each dollar of sales). Profit margin indicates a company’s ability to earn net income from sales – compared to competitors in the industry. Note: Sales and revenues are similar terms used interchangeably – for example, sales, sales revenue, or revenue (Wild, Shaw, & Chiappetta, 2017).
Return on assets (ROA). This ratio is used to calculate a company’s net income to average total assets. ROA is useful in evaluating management, analyzing and forecasting profits, and planning activities (Wild, Shaw, & Chiappetta, 2017). Note: This ratio is sometimes referred to as return on total assets.
Reference
Wild, J., Shaw, K., & Chiappetta, B. (2017). Principles of Financial Accounting, Chapters 1-17 w/ Connect
Access. (23rd ed.). New York, NY: McGraw-Hill Education.