Conveying Accounting Information

Introduction to the Balance Sheet

The balance sheet is a summary of the financial balances of a company and reflects the company’s solvency and financial position.

Learning Objectives

Name the two types of balance sheets and identify which accounts are listed on the balance sheet

Key Takeaways

Key Points

  • The balance sheet captures the financial position of a company at a particular point in time.
  • The balance sheet lists a company’s assets, liabilities, and stockholders’ equity (including dollar amounts) at a specific moment in time.
  • There are two types of balance sheets, classified and unclassified.
  • A balance sheet is used externally and internally.

Key Terms

  • classified balance sheet: a summary of a company’s assets, liabilities, and equity
  • asset: Items of ownership convertible into cash; total resources of a person or business, as cash, notes and accounts receivable; securities and accounts receivable, securities, inventories, goodwill, fixtures, machinery, or real estate (as opposed to liabilities).
  • liabilities: An amount of money in a company that is owed to someone and has to be paid in the future, such as tax, debt, interest, and mortgage payments.
  • equity: Ownership interest in a company, as determined by subtracting liabilities from assets.

Introduction to the Balance Sheet

The balance sheet is one of the four basic financial statements companies prepare each accounting cycle. The balance sheet is a summary of the financial balances of a sole proprietorship, a business partnership, a corporation, or other business organization, such as an LLC or an LLP. The balance sheet is also referred to as a statement of financial position because it reflects a company’s solvency and financial position. The International Accounting Standards Board, along with country specific organizations and companies set the guidelines for the appearance of the balance sheets.

What Period Does the Balance Sheet Cover

A balance sheet is like a photograph in that it captures the financial position of a company at a particular point in time. More specifically, it captures the financial position at the end of business on the day the balance sheet is run.

The Balance Sheet: If an error is found on a previous year’s financial statement, a correction must be made and the financials reissued.

What Items Appear On the Balance Sheet

The balance sheet lists a company’s assets, liabilities, and stockholders’ equity (including dollar amounts) as of a specific moment in time. Assets are the total resources of the business including cash, notes and accounts receivable, while liabilities are anything the company owes to someone, such as debt, mortgage or interest payments. The stockholder’s equity or just equity refers to the ownership interest in a company. The stockholder’s equity is determined by subtracting liabilities from assets.

There are two types of balance sheets, classified and unclassified.

Unclassified balance sheets have three major categories: assets, liabilities, and stockholder’s equity. The main categories of assets are usually listed first, and typically in order of liquidity (for example, cash on hand appears above accounts receivable). Liabilities are listed after assets. The difference between assets and liabilities is referred to as equity. According to the accounting equation, equity must equal assets minus liabilities. Equity is either calculated as proprietary or residual. For residual equity dividends to preferred shareholders are deducted from net income before calculating residual equity holders’ dividend per share.

A classified balance sheet has the same three major categories of assets, liabilities, and stockholder’s equity, but it breaks those categories down further to give a better idea of the profitability and strength of the company.

Who Uses a Balance Sheet

Both internal and external users use the balance sheet. The balance sheet is valuable because it shows the magnitude of the company’s financial obligations. If its debts are too high, for instance, a business may not be able to grow. The balance sheet also demonstrates how liquid the business is. An investor or business may want to ensure that the company’s resources are not overly invested in assets that cannot be easily converted into cash in case of an unexpected expense. Finally, the balance sheet shows the book value of the owners’ stake in the business. For an outside investor, this information can be especially useful in determining an appropriate price for an ownership share in the business.

Introduction to the Income Statement

The income statement shows revenues and expenses for a specific period.

Learning Objectives

Name the two types of income statements and their purposes

Key Takeaways

Key Points

  • The income statement is also referred to as a profit and loss statement (P&L), revenue statement, statement of financial performance, earnings statement, operating statement and statement of operations.
  • The income statement reflects the operating performance of a business and the changes in its assets and obligations.
  • The income statement represents a period of time, in contrast to the balance sheet which represents one moment in time.
  • The purpose of the income statement is to show managers and investors whether the company made or lost money during the period being reported.
  • The income statement is prepared on the accrual basis.

Key Terms

  • revenue: Income that a company receives from its normal business activities, usually from the sale of goods and services to customers.
  • profit: Total income or cash flow minus expenditures. The money or other benefit a non-governmental organization or individual receives in exchange for products and services sold at an advertised price.
  • expense: In accounting, an expense is money spent or costs incurred in an businesses efforts to generate revenue

Overview of the Income Statement

The income statement is one of the four basic financial statements that a company prepares each accounting cycle. The income statement reflects a company’s operating performance. The income statement also shows changes in the company’s assets and obligations. The important thing to remember about an income statement is that it represents a period of time. This contrasts with the balance sheet, which represents a single moment in time. The income statement is prepared on an accrual basis.

The income statement displays the revenues recognized for a specific period, and the cost and expenses charged against these revenues, including write offs (e.g., depreciation and amortization of various assets) and taxes.

The income statement is also referred to as a “profit and loss statement” (P&L), revenue statement, statement of financial performance, earnings statement, operating statement and statement of operations.

A Sample Income Statement: Expenses are listed on a company’s income statement.

Purpose of the Income Statement

The purpose of the income statement is to show managers and investors whether the company made or lost money during the period being reported.

The income statement explains how the revenue, which is money received from the sale of products and services before expenses are taken out, is transformed into the net income. Net income is what is left after all the revenues and expenses have been accounted for, it is also known as “Net Profit. ”

Types of Income Statement

There are two types of income statement, a single-step income statement and a multi-step income statement. The single-step income statement takes a simpler approach, totaling revenues and subtracting expenses to find the bottom line.

The multi-step income statement is more complex. It takes several steps to find the bottom line, starting with the gross profit. It then calculates operating expenses and, when deducted from the gross profit, yields income from operations. Adding to income from operations is the difference of other revenues and other expenses. When combined with income from operations, this yields income before taxes. The final step is to deduct taxes, which finally produces the net income for the period measured.

Operating vs. Non-operating Activities

Operating income occurs from any activity that is a direct result of its primary business, such as sales of goods and services.

Non-operating income, in accounting and finance, is gains or losses from sources not related to the typical activities of the business or organization. Non-operating income can include gains or losses from investments, property or asset sales, currency exchange, and other atypical gains or losses. Non-operating income is generally not recurring and is therefore usually excluded or considered separately when evaluating performance over a period of time (e.g. a quarter or year).

Introduction to the Retained Earning Statement

The statement of retained earnings explains the changes in a company’s retained earnings over the reporting period.

Learning Objectives

Review the items contained on the statement of shareholder’s equity

Key Takeaways

Key Points

  • Retained earnings are the accumulated net income of the corporation (proprietorship or partnership) minus dividends distributed to stockholders.
  • The U.S. Generally Accepted Accounting Principles require a statement of retained earnings to be prepared whenever comparative balance sheets and income statements are presented.
  • The retained earnings statement may appear in the balance sheet, in a combined income statement and changes in retained earnings statement, or as a separate schedule.
  • The statement of retained earnings uses information from the income statement and provides information to the balance sheet.

Key Terms

  • equity: Ownership, especially in terms of net monetary value of some business.
  • earnings: Business profits.
  • partnership: an association of two or more people to conduct a business
  • retained earnings statement: a financial statement that breaks down changes in the owners’ interest in the organization, and in the application of retained profit or surplus from one accounting period to the next
  • retained earnings restrictions: limits on how a company may allocate net income not paid out as dividends

The Statement of Shareholder ‘s Equity

The Statement of Shareholder’s Equity is one of the four main financial statements prepared during a company’s accounting cycle. The Statement of Shareholder’s Equity is also known as the Equity Statement, Statement of Owner’s Equity (single proprietorship), Statement of Partner’s Equity (partnership), and Statement of Retained Earnings and Stockholders’ Equity (corporation). The U.S. Generally Accepted Accounting Principles (U.S. GAAP) requires a statement of retained earnings to be prepared whenever comparative balance sheets and income statements are presented.

What are Retained Earnings?

Generally, retained earnings are the accumulated net income of the corporation (proprietorship or partnership) minus dividends distributed to stockholders.

What Does a Statement of Shareholder’s Equity Show?

The retained earnings statement explains the changes in a company’s retained earnings over the reporting period. The statement breaks down changes in the owner’s interest in the organization, and in the application of retained profit or surplus from one accounting period to the next. Line items for the retained earnings statement typically include profits or losses from operations, dividends paid, issue or redemption of stock, and any other items charged or credited to retained earnings.. The Statement of Shareholder’s Equity shows the inflows and outflows of capital, including treasury stock purchases, employee stock options and secondary equity issuance.

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The Statement of Retained Earnings and Stockholders’ Equity: The statement of retained earnings uses information from the income statement and provides information to the balance sheet.

The statement of retained earnings also shows any adjustments that were made to financial statements from prior financial periods in the current period. Adjustments are corrections or abnormal nonrecurring errors that may have been caused by an improper use of an accounting principle or by mathematical mistakes. Normal recurring corrections and adjustments that follow inevitably from the use of estimates in accounting practice, are not prior period adjustments and are not included in the retained earning statement.

Comprehensive income is the sum of net income and other items that must bypass the income statement because they have not been realized, including items like an unrealized holding gain or loss from available for sale securities and foreign currency translation gains or losses. These items are not part of net income, yet are important enough to be included in comprehensive income, giving the user a bigger, more comprehensive picture of the organization as a whole.Items included in comprehensive income, but not net income are reported under the accumulated other comprehensive income section of shareholder’s equity.

Where Does the Shareholder’s Equity Statement Appear?

The retained earnings statement may appear in the balance sheet, in a combined income statement and changes in retained earnings statement, or as a separate schedule. The statement of shareholder’s equity uses information from the income statement and provides information to the balance sheet. Retained earnings are part of the balance sheet under Stockholders Equity (Shareholders Equity) and are mostly affected by net income earned by the company during a specified period, less any dividends paid to the company’s owners/stockholders. The retained earnings account on the balance sheet represents an accumulation of earnings since net profits and losses are added/subtracted from the account from period to period. Retained Earnings are part of the Statement of Changes in Equity and are a component of shareholder’s equity.

The general equation can be expressed as follows:

Ending Retained Earnings = Beginning Retained Earnings − Dividends Paid + Net Income.

Introduction to the Statement of Cash Flows

The cash flow statement provides information on a firm’s liquidity and solvency.

Learning Objectives

Describe the effect operating, investing and financing activities have on the statement of cash flows, and how that statement differs from the income statement

Key Takeaways

Key Points

  • The cash flow statement is intended to provide information on a firm’s liquidity and solvency.
  • The money coming into the business is called cash inflow, and money going out from the business is called cash outflow. To show the affects on the inflows and outflows on a company, a statement of cash flow is used.
  • The cash flow statement includes only inflows and outflows of cash and cash equivalents.
  • Potential lenders or creditors use the statement of cash flows to determine a company’s ability to repay the funds.

Key Terms

  • solvency ratio: the size of a company’s capital relative to net premium written
  • statement of cash flows: a financial document that shows how changes in balance sheet accounts and income affect cash and cash equivalents, and breaks the analysis down to operating, investing, and financing activities
  • non-current asset: Another term for fixed asset; term used in accounting for assets and property which cannot easily be converted into cash.
  • write-off: The cancellation of an item; the amount cancelled or lost.
  • solvency: The state of having enough funds or liquid assets to pay all of one’s debts; the state of being solvent.

Overview of a Statement of Cash Flows

The money coming into the business is called cash inflow, and money going out from the business is called cash outflow. To show the affects on the inflows and outflows on a company, a statement of cash flow is used. The statement of cash flows is a cash basis report on three types of financial activities: operating activities, investing activities, and financing activities. Any non-cash activities are usually reported in footnotes.

Purpose of a Statement of Cash Flows

The cash flow statement is intended to provide information on a firm’s liquidity and solvency. The statement of cash flows show the company’s ability to change cash flows in future circumstances. The statement of cash flows also reconciles the cash balance from one balance sheet to the next. It provides additional information for evaluating changes in assets, liabilities and equity. The statement of cash flows makes it easier to compare different companies, because it eliminates allocations (such as depreciation ). In essence, it helps assess how well the expected payments are being realized as cash.

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Statement of Cash Flows: The statement of cash flows shows the liquidity of a company.

Contrasting Income Statement to the Statement of Cash Flows

The income statement is accrual based. It shows net income, which is calculated as follows: revenues earned minus the expenses incurred in order to earn those revenues. For example, a company earns revenues in April, but allows customers 30 days to pay, so the cash from April sales will not be received until May.The same for expenses, while inventory bought in April might not sell until May, the inventory was bought and paid for in April.

The statement of cash flows is cash based and it shows the actual inflows and outflows of cash for the given month.

Items on the Statement of Cash Flows

The cash flow statement includes only inflows and outflows of cash and cash equivalents. The statement of cash flows excludes transactions that do not directly affect cash receipts and payments. These non-cash transactions include depreciation or write-offs on bad debts or credit losses. The Statement of Cash Flows is composed of three sections:

  • Operating Activities. These include the cash inflows and outflows of all transactions related to core activities of the business.
  • Investing Activities. Investing activities include all transactions related to the acquisition or disposal of non-current assets. Non-current assets is another term for fixed assets, which includes all property that cannot be easily converted to cash. It also can refer to investments in other companies.
  • Financing Activities. Financing activities includes all transactions related to changes in the amount of a business’s equity available for sale or the amount of the business’s outstanding debt, with the exception of interest payments.

Users of a Statement of Cash Flows

  • Accounting personnel, who need to know whether the organization will be able to cover payroll and other immediate expenses
  • Potential investors, who need to judge whether the company is financially sound
  • Potential employees or contractors, who need to know whether the company will be able to afford compensation
  • Shareholder ‘s of the business

Relationships Between Statements

The four main financial statements provide relevant financial information for internal and external users.

Learning Objectives

Recognize the difference between the four common financial statements and explain their relationship to one another

Key Takeaways

Key Points

  • Each statement has a specific purpose. The balance sheet reflects a company’s solvency and financial position, and the statement of cash flows shows the cash inflows and outflows for a company over a period of time.
  • The income statement reflects a company’s profitability and specifically, net income reconciles the beginning (prior ending period) balance sheet to the current balance sheet.
  • The statement of shareholder ‘s equity shows the change in retained earnings between the beginning and end of a period (e.g., a month or a year) and it reconciles changes in the equity accounts (contributed capital, other capital, treasury stock) from the beginning to the ending balance sheet.
  • The balance sheet reflects a company’s solvency and financial position.
  • The statement of cash flows shows the cash inflows and outflows for a company over a period of time.

Key Terms

  • profitability: The capacity to make a profit.
  • retained earnings: Retained earnings are the portion of net income that is retained by the corporation rather than distributed to its owners as dividends.
  • earnings: Business profits.

The Purpose of Financial Statements

At the end of each accounting cycle, a company prepares financial statements. The purpose is to provide relevant financial information for both internal and external users.

The four most common financial statements are the balance sheet, income statement, statement of cash flows and the statement of stockholder’s equity.

Each statement has a specific purpose; the income statement reflects a company’s profitability, while the statement of retained earnings shows the change in retained earnings between the beginning and end of a period (e.g., a month or a year). The balance sheet reflects a company’s solvency and financial position and the statement of cash flows shows the cash inflows and outflows for a company over a period of time.

Together these four statements show the profitability and strength of a company.

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Financial Statements: The financials statements show a company’s profitability.

How the Statements Are Interconnected

The income statement reports the profitability of a business by comparing the revenues earned with the expenses incurred to produce these revenues. If revenue exceeds expenses for the period then a net income occurs. If expenses exceed revenue then a net loss is the result. The income statement, specifically, net income reconciles the beginning (prior ending period) balance sheet to the current balance sheet.

The statement of shareholder’s equity connects the income statement and the balance sheet. The statement of shareholder’s equity explains the changes in retained earnings between two balance sheet dates. These changes usually consist of the addition of net income (or deduction of net loss) and the deduction of dividends. The statement of shareholder’s equity reconciles changes in the equity accounts (contributed capital, other capital, treasury stock) from the beginning to the ending balance sheet.

The balance sheet, sometimes called the “statement of financial position,” lists the company’s assets, liabilities, and stockholders’ equity (including dollar amounts) as of a specific moment in time (usually the close of business on the date of the balance sheet).

The balance sheet is like a photograph; it captures the financial position of a company at a particular point in time, which is different from the other two statements, which show changes for a period of time.

Management is interested in the cash inflows to the company and cash outflows from the company, because these determine the cash the company has available to pay its bills when they are due.

The statement of cash flows shows the cash inflows and cash outflows from operating, investing, and financing activities. The statement of cash flows reconciles changes in the cash account from the beginning to the ending balance sheet. Operating activities generally include the cash effects of transactions and other events that enter into the determination of net income.

Clean Surplus vs. Dirty Surplus

A clean surplus occurs when all changes in the balance sheet are reconciled by the income statement. US GAAP doesn’t have a clean surplus because some items that affect balance sheet accounts don’t come through the income statement. Instead, there is said to be a dirty surplus. That is, the net change in the balance sheet accounts will not equal net income. The difference is comprehensive income. Comprehensive income is reported on the statement of changes in shareholder’s equity.

Financial Statement Notes

Financial statement notes explain specific items in the financial statements.

Learning Objectives

Describe why a company would use financial statement notes

Key Takeaways

Key Points

  • Notes to financial statements can include information on debt, going concern criteria, accounts, contingent liabilities, or contextual information explaining the financial numbers (for example, if the company is facing a lawsuit).
  • These notes help explain specific items in the financial statements. They also provide a more comprehensive assessment of a company’s financial condition.
  • The notes clarify individual statement line-items.

Key Terms

  • disclosure: The act of revealing something.
  • contingent: An event which may or may not happen; that which is unforeseen, undetermined, or dependent on something future; a contingency.

Financial Statement Notes

The goal of the financial statements is to convey the financial information about a company in an easy to understand format. While the Income Statement, Balance Sheet, Cash Flow Statement, and Statement of Retained Earning contain all numeric information about the company, these numbers often require a better explanation. So, additional supporting financial data is added in the Financial Statement Notes section.. Including notes to the financial statement is not optional, it is a reporting requirement.

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GE Financial Statement: Notes on the financial statements convey specific information about the line-items on the statement.

Where the Notes are Located

Notes to financial statements are added to the end of financial statements. These notes help explain specific items in the financial statements. They also provide a more comprehensive assessment of a company’s financial condition.

Items Included in the Financial Statement Notes

Notes to financial statements can include information and supporting data on debt, going concern criteria, accounts, contingent liabilities, or contextual information explaining the financial numbers (for example, if the company is facing a lawsuit).

The Purpose of Financial Statement Notes

The notes clarify individual line items on the various statements. For example, if a company lists a loss on a fixed asset impairment line in their income statement, notes could corroborate the reason for the impairment by describing how the asset became impaired. Notes can also explain the accounting methods used to prepare the statements. The notes support valuations for how particular accounts have been computed. In consolidated financial statements, all subsidiaries are listed as well as the amount of ownership (controlling interest) that the parent company has in the subsidiaries. Any items within the financial statements that are valuated by estimation are part of the notes if a substantial difference exists between the amount of the estimate previously reported and the actual result. Full disclosure of the effects of the differences between the estimate and actual results should be included.

Additional Items: Auditor and Management Reports

When an audit is performed on a company, the auditor issues a formal opinion in the form of an auditor report.

Learning Objectives

State how qualified opinion, unqualified opinion, adverse and disclaimer opinion reports differ from one another

Key Takeaways

Key Points

  • The auditor report helps readers make a more informed decision about the company based on its results.
  • There are four types of auditor reports: qualified opinion reports, unqualified opinion reports, adverse opinion reports, and disclaimer of opinion reports.
  • An adverse opinion is issued when the auditor determines that the financial statements of an auditee are materially misstated and, when considered as a whole, do not conform with GAAP.
  • An opinion is unqualified when the auditor concludes that the financial statements give a true and fair view in accordance with the financial reporting framework used for their preparation and presentation.
  • A qualified opinion report is issued when the auditor encounters one of two types of situations. While these specific situations do not comply with generally accepted accounting principles, the rest of the financial statements are fairly presented.
  • A disclaimer of opinion, also referred to as a disclaimer, occurs when the auditor could not form, and consequently refuses to present, an opinion on the financial statements.

Key Terms

  • unqualified: Not elaborated upon, undescribed.
  • auditor: One who audits bookkeeping accounts.

Auditor Reports

If a company has an audit performed, whether by an internal auditor or an outside auditor, the auditor issues a formal opinion. This opinion takes the form on an auditor report. The auditor report is available for use by any individual, group, company, or government to review. The auditor report helps readers make a more informed decision about the company based on its results. Please note that the Securities and Exchange Commission requires an audit by an outside auditor. The notes to the financials statement must include a reference to this report.

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Auditor and Management Reports: Auditor reports stem from an internal or external audit of the company’s financial statements.

The Purpose Of the Auditor Reports

In business, the auditor report is consider an essential component of the financial statements. Since many third-party users prefer, or even require financial information to be certified by an independent external auditor, many companies rely on auditor reports to certify their information to attract investors, obtain loans, and improve public appearance.

Types Of Auditor Reports

There are four types of auditor reports:

  • Qualified opinion report
  • Unqualified opinion report
  • Adverse opinion report
  • Disclaimer of opinion report

Qualified Opinion Report

A qualified opinion report is issued when the auditor encounters one of two types of situations. While these specific situations do not comply with generally accepted accounting principles, the rest of the financial statements are fairly presented. The two types of situations that result in a qualified opinion report are a single deviation from generally accepted accounting principles (GAAP) and limitation of scope.

A deviation from generally accepted accounting principles occurs when one or more areas of the financial statements do not conform to GAAP. These misstated items do not affect the rest of the financial statements from being fairly presented when taken as a whole. An example of GAAP is incorrectly calculating depreciation.

Limitation of scope occurs when the auditor could not audit one or more areas of the financial statements, and although they could not be verified, the rest of the financial statements were audited and they conform to GAAP. For example, if the auditor cannot observe and test the company’s inventory, but audited the rest of the statements and found them in accordance with GAAP, then the report is said to be limited in scope.

Unqualified Report

An opinion is unqualified when the auditor concludes that the financial statements give a true and fair view in accordance with the financial reporting framework used for their preparation and presentation. An auditor issues this report when the financial statements presented are free of material misstatements and are represented fairly in accordance with GAAP. An unqualified report is the best type of report a company can receive from an external auditor.

Adverse Opinion Report

An adverse opinion is issued when the auditor determines that the financial statements of an auditee are materially misstated and, when considered as a whole, do not conform to GAAP.

It is considered the opposite of an unqualified or clean opinion, essentially stating that the information contained is materially incorrect, unreliable, and inaccurate.

Disclaimer Of Opinion Report

A disclaimer of opinion, also referred to as a disclaimer, occurs when the auditor could not form, and consequently refuses to present, an opinion on the financial statements. This type of report is issued when the auditor tried to audit an entity but could not complete the work due to various reasons. Although this type of opinion is rarely used, they may be used when the auditee willfully hides or refuses to provide evidence and information to the auditor in significant areas of the financial statements.