Learning Outcomes
- Differentiate among common financial statements
General purpose financial statements provide much of the information needed by external users of financial accounting. These financial statements are formal reports providing information on a company’s financial position, cash inflows and outflows, and the results of operations.
Many companies publish these statements in annual reports, also known as a 10-K or a 10-Q (quarterly report). A company’s annual report contains an independent auditor’s opinion as to the fairness of the financial statements, as well as information about the company’s activities, products, and plans. Typically the best place to find these reports for a public company can be on their website under the Investor Relations section. Financial statements used by external entities are prepared using Generally Accepted Accounting Principles or GAAP. We will discuss the language of GAAP further in later sections.
There are four basic financial statements and they are prepared in the following order:
- Income Statement
- Statement of Owner’s Equity
- Balance Sheet
- Statement of Cash Flows
Income Statement
The income statement answers a business’s most important question: How much profit is it making? It is limited to a specific period of time (a month or a year) from beginning to end. The income statement relies on the matching principle in that it only reports revenue and expenses in a specified window of time. It does not include any revenue or expenses from before or after that block of time.
The income statement is a report that lists and summarizes revenue, expense, and net income information for a period of time, usually a month or a year. It is based on the following equation:
[latex]\text{Revenue}-\text{Expenses}=\text{Net income (or Net loss)}[/latex]
Revenue is shown first. A list of expenses follows, and their total is subtracted from revenue. If the difference is positive, there is a profit or net income. If the difference is negative, there is a net loss. This loss is typically presented in parentheses to represent a negative number.
neatniks
Let’s revisit Nick Frank and his cleaning business, NeatNiks. Here again is the completed spreadsheet we created to track Nick’s cash-based transactions for the month of October:
| Checking Account | = | Nick Frank, Capital | Nick Frank, Withdrawals | Service Revenue | Insurance Expense | Rent Expense | Supplies Expense | Contractor Expense | |
|---|---|---|---|---|---|---|---|---|---|
| 1-Oct | +20,000 | = | +20,000 | ||||||
| 4-Oct | (12,000) | = | (12,000) | ||||||
| 15-Oct | +1,500 | = | +1,500 | ||||||
| 25-Oct | (2,600) | = | (1,500) | (1,100) | |||||
| 26-Oct | (1,000) | = | (1,000) | ||||||
| 30-Oct | +1,600 | = | +1,600 | ||||||
| 31-Oct | (4,000) | = | (4,000) | ||||||
| Balance | +3,500 | = | +20,000 | (4,000) | +3,100 | (1,500) | (12,000) | (1,000) | (1,100) |
Using the information in the trial balance, we can create our income statement, which summarizes the company’s revenues and expenses.
The interactive activity below contains the last row of our spreadsheet (the “Balance” row with the totals for each category). See if you can figure out where the various column totals go in the income statement.
Here is the completed Income Statement for NeatNiks for October:
| Description | Amount | Total |
|---|---|---|
| Subcategory, Revenues: | ||
| Service Revenue | $3,100 | |
| Subcategory, Expenses: | ||
| Insurance | 1,500 | |
| Rent | 12,000 | |
| Supplies | 1,000 | |
| Contractors | 1,110 | |
| Total Expenses | 15,600 | |
| Net Income (loss) | Single Line $(12,500) Double line | |
The income statement is a report on operations for a period of time (often a full year, but in this case, we just reported for a month).
An income statement can also be called a statement of earnings or a profit and loss (P&L).
Statement of Owner’s Equity
The second statement, the statement of owner’s equity, summarizes the increases and decreases in the owner’s equity. According to our cash-basis income statement above, the business lost $12,500. We also know that the owner put in $20,000 at the beginning of the month and took out $4,000 at the end of the month.
| Checking Account | = | Nick Frank, Capital | Nick Frank, Withdrawals | Service Revenue | Insurance Expense | Rent Expense | Supplies Expense | Wage Expense |
|---|---|---|---|---|---|---|---|---|
| +3,500 | = | +20,000 | (4,000) | +3,100 | (1,500) | (12,000) | (1,000) | (1,100) |
Let’s use this information to create a statement of owner’s equity:
| Description | Amount |
|---|---|
| Nick Frank, Capital, October 1, 20XX | $0 |
| Owner contributions | 20,000 |
| Net income/(loss) for the month | (12,500) |
| Single Line7,500 | |
| Owner withdrawals | (4,000) |
| Nick Frank, Capital, October 31, 20XX | Single Line$3,500Double Line |
Like the income statement, the statement of owner’s equity also reports a period of time (in this case the month of October).
If there are multiple owners and investors, or if the company is publicly traded, this statement is likely to have a different name, such as the statement of stockholders’ equity.
Balance Sheet
The third statement is the balance sheet, which shows the total assets against total liabilities and owner’s equity. We haven’t recorded any liabilities (debt) yet, so our balance sheet is pretty simple:
| Description | Amount |
|---|---|
| Subcategory, Assets | |
| Cash | $3,500 |
| Total Assets | Single line $3,500Double line |
| Subcategory, Liabilities | |
| Total Liabilities | Single line$- |
| Subcategory, Owner’s Equity | |
| 3,500 | |
| Total Liabilities and Owner’s Equity | Single line $3,500 Double line |
Unlike the two previous statements, the balance sheet is a snapshot—a single moment in time—rather than the records of a period of time. It is the financial position of the business at the very end of the last day of the reporting period. In this case, it was at the end of October—so 11:59:59PM on October 31st.
Once business resumes on November 1st, all the numbers on the balance sheet will change as well, and we’ll start a new income statement and a new statement of owner’s equity to report November transactions.
The balance sheet can also be called the statement of financial position.
Statement of Cash Flows
Since this whole analysis was based on cash transactions, our statement of cash flows won’t be any different than our income statement above.
| Description | Amount | Total |
|---|---|---|
| Subcategory, Revenues: | ||
| Service Revenue | $ 3,100 | |
| Subcategory, Expenses | ||
| Insurance | 1,500 | |
| Rent | 12,000 | |
| Supplies | 1,000 | |
| Wages | 1,100 | |
| Total Expenses | Single Line | Single Line15,600 |
| Net Income (loss) | Single Line$(12,500)Double Line | |
When we start working with the accrual basis of accounting, we’ll revisit this topic and dive in deeper.
Like the income statement and the statement of owner’s equity, the statement of cash flows reports a period of time (in this case the month of October).
Practice Question
