CHAPTER 2

BASIC FINANCIAL
STATEMENTS
 Introduction to Financial Statements
 What is financial statement?

 Financial statement is a structured representation of the

financial position (Balance Sheet), financial performance
(Income Statement) of an entity and the inflow and outflow
of cash (cash flow statement).

 The objective of financial statements is to provide

information about
 the financial position,

 financial performance and

 cash flows of an entity

 Financial statements is also help to assess the probability

that an enterprise will be able to make future cash.
 Three Basic Financial Statements are
Balance Sheet Describes where the
Depicts the enterprise stands at a
revenue and Income Statement specific date.
expenses for Statement of Cash Flows
a designated Depicts the ways
period of cash has changed
time. during a
designated period
of time.

 These financial statements are windows to a company's

performance and health.
 THE BALANCE SHEET
What is Balance sheet?
 The balance sheet represents a record of a company's assets,
liabilities and equity at a particular point in time. Balance
sheet is named by the fact that a business’s financial structure
balances in the following manner:
 Assets = Liabilities + Shareholders' Equity
 Assets represent the resources that the business owns or
controls at a given point in time. This includes items such as
cash, inventory, machinery, buildings etc.
 The other side of the equation represents the total value of the
financing the company has used to acquire those assets.
Liabilities represent debt, while equity represents the total
value of money that the owners have contributed to the
business – including retained earnings, which is the profit
made in previous years.
 The Balance Sheet
ASSETS LIABILITIES EQUITY
Cash Accts Payable Pref Stock
Inventory Wages Payable Common Stk
Land/Bldgs = Taxes Payable + Retained
Earnings
Equipment Notes Payable
Accts Rcvbl Short term
Securities Long Term
 Why do we need Balance sheet?

 Because
 Balance sheet provides investors with a snapshot of a company's
health as of the date provided on the financial statement.
 If a company assets are large relative to liabilities, it's in
good shape. Conversely, if a company with a large amount of
liabilities relative to assets has risk to creditors.
 The higher the debt ratio, the greater risk will be associated
with the firm's operation. In addition, high debt to assets ratio
may indicate low borrowing capacity of a firm, which in turn
will lower the firm's financial flexibility.
 THE INCOME STATEMENT
What is Income Statement?
 The income statement shows an information about the
revenues, expenses and profit that was generated as a result
of the business' operations for that period and it measures a
company's performance over a specific time frame.

 The components of income Statement are:

 Revenue (how much the company earned)

 Expenses (how much the company has spent)

 Net Income before and after Tax (the profits of the

company)
Why do we need an Income Statement ?
 Because
 Income statement answers the question, "How well
is the company's business?
 “Does it performing well?
 Basically, the question is "Is it making money?"

 Firms with low expenses and high profits relative

to revenues are typically more desirable for
investment because it brings more money directly
to a shareholder.
 THE STATEMENT OF CASH FLOWS
What is statement of cash flow?
 The statement of cash flows represents a record of a
business' cash inflows and outflows over a period of time.
 It is the most sensitive statement and it focuses on the
following cash-related activities:
 Operating Cash Flow: Cash generated from day-to-day

business operations.
 Cash from Investing: Cash used for investing in assets,

as well as the proceeds from the sale of other

businesses, equipment or long-term assets
 Cash from financing: Cash paid or received from the

issuing and borrowing of funds

Why do we need Statement of Cash Flows ?
 Statement of cash flows is very important to investors, because
 It shows how much actual cash a company has generated.
 It shows the ability of firms to generate cash. Many
companies have shown “profits” on the income statement
but struggled later because of insufficient cash flows.
Because, the income statement includes non-cash revenues
or expenses, which the statement of cash flows excludes.
 It shows correct figures of firms, because cash flow
statement is very difficult for a business to manipulate its
cash situation. Earnings can be manipulated, but it's tough to
“fake” cash in the bank. For this reason some investors use
the cash flow statement as a more conservative measure of
a company's performance.
 Bringing the financial statements All Together
 The three financial statements (Balance sheet, Income
statement and cash flow statement) are all related.
 The changes of assets and liabilities that is indicated on
the balance sheet are also reflected in the revenues and
expenses which are stated on the income statement,
which shows the company’s gains or losses.
 Cash flows provide more information about cash assets
listed on a balance sheet and are related, but not
equivalent, to net income shown on the income
statement.
 Therefore, no one financial statement tells the
complete story of firms.
 ACCOUNTING PRINCIPLES

Certain accounting principles that are

important for an understanding of
financial statements and how professional
judgment by accountants may affect the
application of those principles are shown in
the next slides
The concept of business entity
ABC Company

A business entity is separated from

the personal affairs of its owner.
 The cost principle tells us that

Assets accounting information is based

upon actual cost incurred.
We refer to this as historical cost.
The stable-dollar assumption
tells us that we will only record
accounting information that can
be expressed in monetary units,
usually dollars in the United
Cost Principle The going-concern assumption states
the business entity is assumed to
States and the dollar will remain continue operations into the future.
constant across fiscal periods.

These accounting
Stable-Dollar principles support Going-Concern
Assumption cost as the basis Assumption
for asset valuation.

Objectivity The objectivity principle states that

accounting information must be
unbiased and based upon
Principle independent evidence.
 Statement of Financial Position: A Starting Point
ABC Company
Balance Sheet
January 1, 2007
Assets Liabilities & Owners' Equity
Cash $ 22,500 Liabilities:
Notes receivable 10,000 Notes payable $ 41,000
Accounts receivable 60,500 Accounts payable 36,000
Supplies 2,000 Salaries payable 3,000
Land 100,000 Total liabilities $ 80,000
Building 90,000 Owners' Equity:
Office equipment 15,000 Capital stock 150,000
Retained earnings 70,000
Total $ 300,000 Total $ 300,000
 ABC Company
Balance Sheet
January 1, 2007
Assets Liabilities & Owners' Equity
Cash $ 22,500 Liabilities:
Notes receivable 10,000 Notes payable $ 41,000
Accounts receivable 60,500 Accounts payable 36,000
Supplies 2,000 Salaries payable 3,000
Land 100,000 Total liabilities $ 80,000
Building 90,000 Owners' Equity
Office equipment 15,000 Capital stock 150,000
Retained earnings 70,000
Total $ 300,000 Total $ 300,000

Assets = Liabilities + Owners’ Equity

$300,000 = $80,000 + $220,000
 Business transactions affect the elements
of the accounting equation:

Assets = Liabilities + Owners’ Equity

In the next slides will demonstrate how certain business

transactions affect the elements of the accounting equation

EXAMPLE TRANSACTION.ppt
 Let’s analyze some transactions for Abeba’s Care Service company

On May 1, Abeba and her family invested $8,000 in her Care Service company
and received 800 shares of stock.

Abeba’s Care Service company

Balance Sheet
May 1, 2007
Assets Owners' Equity
Cash $ 8,000 Capital Stock $ 8,000

Total $ 8,000 Total $ 8,000

 On May 2, Abeba’s purchased an office
equipment for $2,500 cash.
Abeba’s Care Service Company
Balance Sheet
May 2, 2007
Assets Owners' Equity
Cash $ 5,500 Capital Stock $ 8,000
Tools & Equipment 2,500

Total $ 8,000 Total $ 8,000

 To explain how the statement of financial position, often referred to as the
balance sheet, is an expansion of the basic accounting equation.

Assets = Liabilities + Owners' Equity

Accts. Tools & Notes Accts. Capital Retained
Cash + Rec. + Equip. + Truck = Payable + Pay. + Stock + Earnings
May 1 $ 8,000 $ 8,000
Balances $ 8,000 $ 8,000
May 2 (2,500) $ 2,500
Balances $ 5,500 $ 2,500 $ 8,000
May 8 (2,000) $ 15,000 $ 13,000
Balances $ 3,500 $ 2,500 $ 15,000 $ 13,000 $ 8,000
May 11 300 $ 300
Balances $ 3,500 $ 2,800 $ 15,000 $ 13,000 $ 300 $ 8,000
May 18 $ 150 (150)
Balances $ 3,500 $ 150 $ 2,650 $ 15,000 $ 13,000 $ 300 $ 8,000
May 25 75 (75)
Balances $ 3,575 $ 75 $ 2,650 $ 15,000 $ 13,000 $ 300 $ 8,000
May 28 (150) (150)
Balances $ 3,425 $ 75 $ 2,650 $ 15,000 $ 13,000 $ 150 $ 8,000
May 29 750 750
Balances $ 4,175 $ 75 $ 2,650 $ 15,000 $ 13,000 $ 150 $ 8,000 $ 750
May 31 (50) (50)
Balances $ 4,125 $ 75 $ 2,650 $ 15,000 $ 13,000 $ 150 $ 8,000 $ 700
 Let’s prepare the Income Statement and Statement of Cash Flows
for Abeba’s Care Service company for the month ending May 31,
2007.
Assets = Liabilities + Owners' Equity

Cash +
Accts.
Rec. +
These
Tools &
Equip. + Truck
transactions
=
Notes
Payable +
Accts.
Pay. +
Capital
Stock
Retained
+ Earnings
May 1 $ 8,000 impact the $ 8,000
Balances $ 8,000 $ 8,000
May 2 (2,500) $ 2,500Statement of Cash
Balances $ 5,500 $ 2,500 $ 8,000
May 8 (2,000) $ Flows.
15,000 $ 13,000
Balances $ 3,500 $ 2,500 $ 15,000 $ 13,000 $ 8,000
May 11 300 $ 300
Balances $ 3,500 $ 2,800 $ 15,000 $ 13,000 $ 300 $ 8,000
May 18 $ 150 (150)
Balances $ 3,500 $ 150 $ 2,650 $ 15,000 $ 13,000 $ 300 $ 8,000
May 25 75 (75)
Balances $ 3,575 $ 75 $ 2,650 $ 15,000 $ 13,000 $ 300 $ 8,000
May 28 (150) These transactions (150)
Balances $ 3,425 $ 75 $ 2,650 $ 15,000 $ 13,000 $ 150 $ 8,000
May 29 750 impact the Income 750
Balances
May 31
$ 4,175
(50)
$ 75 $ 2,650 $
Statement.
15,000 $ 13,000 $ 150 $ 8,000 $ 750
(50)
Balances $ 4,125 $ 75 $ 2,650 $ 15,000 $ 13,000 $ 150 $ 8,000 $ 700
To explain how the income statement reports an enterprise’s financial
performance for a period of time in terms of the relationship of
revenues and expenses.

Abeba's Care Service

Income Statement
For the Month Ended May 31, 2007

Sales Revenue $ 750

Operating Expense:
Gasoline Expense 50
Net Income $ 700

Investments by and payments to the owners

are not included on the Income Statement.
To explain how the statement of cash flows presents the change in cash
for a period of time in terms of the company’s operating, investing, and
financing activities.

Abeba's Care Service

Statement of Cash Flows
For the Month Ended May 31, 2007
Cash flows from operating activities:
Cash received from revenue transactions $ 750
Cash paid for expenses (50)
Net cash provided by operating activities $ 700
Cash flows from investing activities:
Purchase of office equipment $ (2,500)
Purchase of truck (2,000)
Collection for sale of repair parts 75
Payment for repair parts (150)
Net cash used by investing activities (4,575)
Cash flows from financing activities:
Investment by owners 8,000
Increase in cash for month $ 4,125
Cash balance, May 1, 2007 -
Cash balance, May 31, 2007 $ 4,125
 Abeba’s Care Service
Statement of Cash Flows
For the Month Ended May 31, 2007
Cash flows from operating activities:
Cash received from revenue transactions $ 750
Cash paid for expenses (50)
Net cash provided by operating activities $ 700
Cash flows from investing activities:
Operating activities include
Purchase of office equipment $ (2,500)
Purchase of truck the cash effects of revenue
Collection for sale of repair parts
(2,000)
75
Payment for repair parts and expense transactions.
(150)
Net cash used by investing activities (4,575)
Cash flows from financing activities:
Investment by owners 8,000
Increase in cash for month $ 4,125
Cash balance, May 1, 2007 -
Cash balance, May 31, 2007 $ 4,125
 Abeba Care Service
Statement of Cash Flows
For the Month Ended May 31, 2007
Cash flows from operating activities:
Cash received from revenue transactions $ 750
Cash paid for expenses (50)
Net cash provided by operating activities $ 700
Cash flows from investing activities:
Purchase of office equipment $ (2,500)
Purchase of truck (2,000)
Collection for sale of repair parts 75
Payment for repair parts (150)
Net cash used by investing activities (4,575)
Cash flows from financing activities:
Investing activities include the
Investment by owners 8,000
cash effects of purchasing and
Increase in cash for month
Cash balance, May 1, 2007
$ 4,125
-
selling assets.
Cash balance, May 31, 2007 $ 4,125
 Abeba Care Service
Statement of Cash Flows
For the Month Ended May 31, 2007
Cash flows from operating activities:
Cash received from revenue transactions $ 750
Cash paid for expenses (50)
Net cash provided by operating activities $ 700
Financing activities include the cash
Cash flows from investing activities:
effects of transactions with the owners
Purchase of office equipment
Purchase of truck
$ (2,500)
(2,000)
and creditors.
Collection for sale of repair parts 75
Payment for repair parts (150)
Net cash used by investing activities (4,575)
Cash flows from financing activities:
Investment by owners 8,000
Increase in cash for month $ 4,125
Cash balance, May 1, 2007 -
Cash balance, May 31, 2007 $ 4,125
 Now, let’s prepare the Balance Sheet for Abeba’s
Care Service company for May 31, 2007.
Assets = Liabilities + Owners' Equity
Accts. Tools & Notes Accts. Capital Retained
Cash + Rec. + Equip. + Truck = Payable + Pay. + Stock + Earnings
May 1 $ 8,000 $ 8,000
Balances $ 8,000 $ 8,000
May 2 (2,500) $ 2,500
Balances $ 5,500 $ 2,500 $ 8,000
May 8 (2,000) $ 15,000 $ 13,000
Balances $ 3,500 $ 2,500 $ 15,000 $ 13,000 $ 8,000
May 11 300 $ 300
Balances $ 3,500 $ 2,800 $ 15,000 $ 13,000 $ 300 $ 8,000
May 18 $ 150 (150)
Balances $ 3,500 $ 150 These
$ 2,650 balances
$ 15,000 $ 13,000 will
$ 300 $ 8,000
May 25 75 (75)
Balances $ 3,575 $ 75 $ 2,650 appear
$ 15,000 on the $ 300
$ 13,000 $ 8,000
May 28
Balances
(150)
$ 3,425 $ 75 $ 2,650
Balance
$ 15,000
Sheet.
$ 13,000
(150)
$ 150 $ 8,000
May 29 750 750
Balances $ 4,175 $ 75 $ 2,650 $ 15,000 $ 13,000 $ 150 $ 8,000 $ 750
May 31 (50) (50
Balances $ 4,125 $ 75 $ 2,650 $ 15,000 $ 13,000 $ 150 $ 8,000 $ 700
 Abeba's Care Service Company
Balance Sheet
May 31, 2007
Assets Liabilities
Cash $ 4,125 Notes payable $ 13,000
Accounts receivable 75 Accounts payable 150
Tools & equipment 2,650 Owners' Equity
Truck 15,000 Capital stock 8,000
Retained earnings 700
Total assets $ 21,850 Total liabilities & equity $ 21,850

Assets = Liabilities + Owners’ Equity

$21,850 = $13,150 + $8,700

 To explain the important relationships among the statement of financial
position, income statement, and statement of cash flows, and how
these statements relate to each other.
Relationships Among Financial
Statements
Date at Date at
beginning end of
of period Time period

Balance Balance
Sheet Sheet

Income Statement
Statement of Cash Flows
 Financial Statement Articulation
Abeba's Car service company
Statement of Cash Flows
For the Month Ended May 31, 2007 Abeba's Car service company
Cash flows from operating activities: Income Statement
Cash received from revenue transactions $ 750
Cash paid for expenses (50)
For the Month Ended May 31, 2007
Net cash provided by operating activities $ 700
Cash flows from investing activities: Sales Revenue $ 750
Purchase of lawn mower $ (2,500)
Operating Expense:
Purchase of truck (2,000)
Collection for sale of repair parts 75 Gasoline Expense 50
Payment for repair parts (150) Net Income $ 700
Net cash used by investing activities (4,575)
Cash flows from financing activities:
Investment by owners 8,000
Increase in cash for month $ 4,125
Cash balance, May 1, 2007 -
Cash balance, May 31, 2007 $ 4,125
Abeba’s Care Service Company
Balance Sheet
May 31, 2007
Assets Liabilities
Cash $ 4,125 Notes payable $ 13,000
Accounts receivable 75 Accounts payable 150
Tools & equipment 2,650 Owners' Equity
Truck 15,000 Capital stock 8,000
Retained earnings 700
Total assets $ 21,850 Total liabilities & equity $ 21,850
 Forms of Business Organization

Sole
Proprietorships Partnerships Corporations
 Forms of Business Organization
Most business organizations are organized as a sole proprietorship, a
partnership or a corporation.
Sole proprietorship:- is unincorporated business owned by a
single person. It is separated from the other
affairs of its owner. It is common for small
retailer stores, farms, service business and
professional practices, like in law, medicine and
accounting.
Partnership: is unincorporated business owned by two or more
persons agree to act as partners (co-owners). It is widely
used for small business.
Corporation: is a type of business organization that is recognized
under the law as an entity separate from its owners.
GAAP can be applied to the financial statements of all three forms of
organization.
 Characteristics of Business organizations
Sole proprietorship Partnership Corporation

Owner Proprietor—only Partners—two or Stockholders—

one owner more owners generally many owners

Life of organization Limited by the owner’s Limited by the owner’s Indefinite

choice, or death choice, or death

Legal viewpoint Owner and business entity are not Owners and business entity Separate entity from owners
regarded as separate are not regarded as separate

Accounting viewpoint Business entity is separated from other Business entity is separated Business entity is separated
affairs of owner from other affairs of owners from other affairs of owners

Separate taxable entity from No No Yes

owner

Ease of formation Very easy Partnership agreement is Articles of corporation

helpful generally requires

Management Owner May be divided among Board of directors

partners

Personal liability Proprietor is Partners are Stockholders are not

of the owner(s) for personally liable personally liable personally liable
the business’s debts
Transferability of ownership Only by sale of entire business or Can sell all or a portion of Can easily transfer(sell) all or a
creation of different entity partnership interest portion of stock
 Reporting Ownership Equity in the
Statement of Financial Position

Sole Ow ner's equity:

Proprietorships Abeba, capital $ 8,000

Partners' equity
Alemu, capital $ 4,000
Partnerships Kebede, capital 4,000
Total partners' equity $ 8,000

Owners' equity
Capital stock $ 7,000
Corporations
Retained earnings 1,000
Total stockholders' equity $ 8,000