Lesson 2: General Purpose Financial Statements -it is a distribution of income to owners rather than

Profitability Vs. Solvency an expense of doing business

1. Profitability -Dividends are the means by which a corporation
-is the ability to generate income. rewards its stockholders (owners) for providing it with
Companies can sometimes improve their investment funds.Corporations are not required to pay
profitability by borrowing from creditors and using the dividends and because dividends are not an expense,
funds effectively. they do not appear on the income statement.The effect
2. Solvency of a dividend is to reduce cash and retained earnings by
-is the ability to pay debts as they become due. the amount paid out.
The higher the proportion of assets provided by (5) Notes to Financial Statements
owners, the more solvent the company. The Balance Sheet
(3. Liquidity) Basic Accounting Equation
-is the ability to convert asset, or security into cash. Assets= Liabilities + Owners’ Equity
Required Financial Statements under GAAP Business Resources= Amount from Creditors + Amount from Owners

1. Balance Sheet or Statement of Financial Position Unclassified balance sheet has three major

-reflect resources and explain how those resources categories: assets, liabilities, and stockholders' equity.

were capitalized A classified balance sheet contains the same three

A balance sheet is like a photograph; it captures the major categories and subdivides them to provide useful

financial position of a company at a particular point in information for interpretation and analysis by users of

time. The other two statements are for a period of time. financial statements.

2. Income Statement or Statement of Operations 1. Assets

-seeks to represent the results of operation to know -property/rights that provide probable future

whether the company have profit or not. benefits.

-reflects a company’s profitability. *Current Assets

3. Statement of Cash Flows -cash and other assets that a business can convert

-designed to identify the major sources and uses of to cash or uses up in a relatively short period—one year

cash. or one operating cycle, whichever is longer.

-shows the cash inflows and cash outflows from An operating cycle is the time it takes to start with

operating, investing, and financing activities. cash, buy necessary items to produce revenues (such

*Operating activities as materials, supplies, labor, and/or finished goods), sell

-generally include the cash effects of transactions services or goods, and receive cash by collecting the

and other events that enter into the determination of net resulting receivables.

income. Companies in service industries and

*Investing activities merchandising industries generally have operating

-generally include business transactions involving cycles shorter than one year.

the acquisition or disposal of long-term assets Companies in some manufacturing industries, such

such as land, buildings, and equipment. as distilling and lumber, have operating cycles longer

*Financing activities than one year.

-generally include the cash effects of transactions A) Cash includes deposits in banks available for current

and other events involving creditors and owners operations at the balance sheet date plus cash on hand

(stockholders). consisting of currency, undeposited checks, drafts, and

(4) Statement of Retained Earnings money orders. Cash is the first current asset to appear

-shows the change in retained earnings between on a balance sheet. The term cash normally includes

the beginning and end of a period cash equivalents.

-one purpose of the statement of retained earnings B) Cash equivalents are highly liquid, short-term

is to connect the income statement and the balance investments acquired with temporarily idle cash and

sheet. easily convertible into a known cash amount. Examples

*Dividend are Treasury bills, short-term notes maturing within 90

-a payment (usually of cash) to the owners of the days, certificates of deposit, and money market funds.

business C) Marketable securities are temporary investments

such as short-term ownership of stocks and bonds of term purposes. We describe several types of
other companies. Such investments do not qualify as property, plant, and equipment next.
cash equivalents. These investments earn additional Land is ground the company uses for business
money on cash that the business does not need at operations; this includes ground on which the company
present but will probably need within one year. locates its business buildings and that is used for
D) Accounts receivable (also called trade accounts outside storage space or parking. Land owned for
receivable) are amounts owed to a business by investment is not a plant asset because it is a long-term
customers. An account receivable arises when a investment.
company performs a service or sells merchandise on Buildings are structures the company uses to carry
credit. Customers normally provide no written evidence on its business. Again, the buildings that a company
of indebtedness on sales invoices or delivery tickets owns as investments are not plant assets.
except their signatures. Office furniture includes file cabinets, desks, chairs,
E) Merchandise inventories are goods held for sale. and shelves.
Note: A company's inventory should not be recorded on Office equipment includes computers, copiers, FAX
its balance sheet at its cost if it is obsolete and has no machines, and phone answering machines.
resale value, meaning it is destined for the trash bin. Leasehold improvements are any physical
A note is an unconditional written promise to pay alterations made by the lessee to the leased property
another party the amount owed either when demanded when these benefits are expected to last beyond the
or at a certain specified date, usually with interest (a current accounting period. An example is when the
charge made for use of the money) at a specified rate. A lessee builds room partitions in a leased building. (The
note receivable appears on the balance sheet of the lessee is the one obtaining the rights to possess and
company to which the note is given. A note receivable use the property.)
arises (1) when a company makes a sale and receives a Construction in progress represents the partially
note from the customer, (2) when a customer gives a completed stores or other buildings that a company
note for an amount due on an account receivable, or (3) plans to occupy when completed.
when a company loans money and receives a note in Accumulated depreciation is a contra asset account
return. to depreciable assets such as buildings, machinery, and
F) Interest receivable arises when a company has equipment. This account shows the total depreciation
earned but not collected interest by the balance sheet taken for the depreciable assets. On the balance sheet,
date. Usually, the amount is not due until later. companies deduct the accumulated depreciation (as a
G) Prepaid expenses include rent, insurance, and contra asset) from its related asset.
supplies that have been paid for but all the benefits have B) Long-term investments A long-term investment
not yet been realized (or consumed) from these usually consists of securities of another company held
expenses. If prepaid expenses had not been paid for in with the intention of (1) obtaining control of another
advance, they would require the future disbursement of company, (2) securing a permanent source of income
cash. Furthermore, prepaid expenses are considered for the investor, or (3) establishing friendly business
assets because they have service potential. relations. The long-term investment classification in the
*Long-term assets balance sheet does not include those securities
-are assets that a business has on hand or uses for purchased for short-term purposes. For most
a relatively long time. Examples include property, plant, businesses, long-term investments may be stocks or
and equipment; long-term investments; and intangible bonds of other corporations. Occasionally, long-term
assets. investments include funds accumulated for specific
A) Property, plant, and equipment are assets with useful purposes, rental properties, and plant sites for future
lives of more than one year; a company acquires use.
them for use in the business rather than for resale.The C) Intangible assets Intangible assets consist of the
terms plant assets or fixed assets are also used for noncurrent, nonmonetary, nonphysical assets of a
property, plant, and equipment. To agree with the order business. Companies must charge the costs of
in the heading, balance sheets generally list property intangible assets to expense over the period benefited.
first, plant next, and equipment last. These items are Among the
fixed assets because the company uses them for long- intangible assets are rights granted by governmental
bodies, such as patents and copyrights. Other intangible due until later.
assets include leaseholds and goodwill. D) Sales taxes payable are the taxes a company has
A patent is a right granted by the federal collected from customers but not yet remitted to the
government; it gives the owner of an invention the taxing authority, usually the state.
authority to manufacture a product or to use a process Other accrued expenses might include taxes withheld
for a specified time. from employees, income taxes payable, and interest
A copyright granted by the federal government payable.
gives the owner the exclusive privilege of publishing Taxes withheld from employees include federal
written income taxes, state income taxes, and social security
material for a specified time. taxes withheld from employees' paychecks. The
Leaseholds are rights to use rented properties, company plans to pay these amounts to the proper
usually for several years. governmental agencies within a short period.
Goodwill is an intangible value attached to a Income taxes payable are the taxes paid to the
business, evidenced by the ability to earn larger net state and federal governments by a corporation on its
income per dollar of investment than that earned by income. Interest payable is interest that the company
competitors in the same industry. The ability to produce has accumulated on notes or bonds but has not paid by
superior profits is a valuable resource of a business. the balance sheet date because it is not due until later.
Normally, companies record goodwill only at the time of E) Dividends payable, or amounts the company has
purchase and then only at the price paid for it. declared payable to stockholders, represent a
Accumulated amortization is a contra asset account distribution of income. Since the corporation has not
to intangible assets. This account shows the total paid these declared dividends by the balance sheet
amortization taken on the intangible assets. date, they are a liability.
2. Liabilities F) Unearned revenues (revenues received in advance)
-probable future obligations/company’s debts. result when a company receives payment for goods or
Warranty Obligations - promise to provide future service under services before earning the revenue, such as payments
warranty
for subscriptions to a magazine. These unearned
*Current liabilities
revenues represent a liability to perform the agreed
-are debts due within one year or one operating
services or other contractual requirements or to return
cycle, whichever is longer. The payment of current
the assets received.
liabilities normally requires the use of current assets.
Companies report any current installment on long-
Balance sheets list current liabilities in the order they
term debt due within one year under current liabilities.
must be paid; the sooner a liability must be paid, the
The remaining portion continues to be reported as a
earlier it is listed. Examples of current liabilities follow.
long-term liability.
A) Accounts payable are amounts owed to suppliers for
*Long-term liabilities
goods or services purchased on credit. Accounts
-are debts such as a mortgage payable and bonds
payable are generally due in 30 or 60 days and do not
payable that are not due for more than one year.
bear interest. In the balance sheet, the accounts
Companies should show maturity dates in the balance
payable amount is the sum of the individual accounts
sheet for all long-term liabilities. Normally, the
payable to suppliers shown in a subsidiary ledger or file.
liabilities with the earliest due dates are listed first.
B) Notes payable are unconditional written promises by
A) Notes payable with maturity dates at least one year
the company to pay a specific sum of money at a certain
beyond the balance sheet date are long-term liabilities.
future date. The notes may arise from borrowing money
B) Bonds payable are long-term liabilities and are
from a bank, from the purchase of assets, or from the
evidenced by formal printed certificates sometimes
giving of a note in settlement of an account payable.
secured by liens (claims) on property, such as
Generally, only notes payable due in one year or less
mortgages. Maturity dates should appear on the balance
are
sheet for all major longterm liabilities.
included as current liabilities.
3. Owners’ Equity
C) Salaries payable are amounts owed to employees for
-the amount of assets minus the amount of liabilities
services rendered. The company has not paid these
equals the amount of owners’ equity
salaries by the balance sheet date because they are not
-the amount provided by the owners to the business
 -equal to the amount of Capital Stock plus the assets
amount of Retained Earnings A) Wage Expense - salary
-shows the owners' interest in the business. This B) Cost of Goods Sold - cost of inventory
interest is equal to the amount contributed plus the % Operating revenues are the revenues generated by
income left in the business. the major activities of the business—usually the sale of
A) Paid-in capital shows the capital paid into the products or services or both.
company as the owners' investment. % Cost of goods sold is the major expense in
B) Retained earnings shows the cumulative income of merchandising companies.
the company less the amounts distributed to the owners % Operating expenses for a merchandising company
in the form of dividends. are those expenses, other than cost of goods sold,
Owners Provide Assets in Two Possible Ways incurred in the normal business functions of a company.
A) Contributing money or other resources in exchange Usually, operating expenses are either selling expenses
for ownership evidenced by shares of stock or administrative expenses.
-called Contributed Capital / Capital Stock Selling expenses are expenses a company incurs
-the amount of assets contributed by owners in selling and marketing efforts. Examples include
for a stock. salaries and commissions of salespersons, expenses for
-shows the amount of the owners’ investment salespersons' travel, delivery, advertising, rent (or
in the corporation depreciation, if owned) and utilities on a sales building,
B) Allowing any increase in assets from profitable sales supplies used, and depreciation on delivery trucks
operations to be retained in the business rather than used in sales.
distributed to owners as a dividend. Administrative expenses are expenses a company
- called Retained Earnings incurs in the overall management of a business.
-the amount of assets created through profits Examples include administrative salaries, rent (or
and retained in the business. depreciation, if owned) and utilities on an administrative
-generally consists of the accumulated net building, insurance expense, administrative supplies
income of the corporation minus dividends used, and depreciation on office equipment.
distributed to stockholders Certain operating expenses may be shared by the
Income Statement selling and administrative functions. For example, a
Revenue - Expenses = NI / NL company might incur rent, taxes, and insurance on a
Revenue > Expenses = Net Income building for both sales and administrative purposes.
Revenue < Expenses = Net Loss
Expenses covering both the selling and administrative
An unclassified income statement has only two
functions must be analyzed and prorated between the
categories—revenues and expenses.
two functions on the income statement. For instance, if
In contrast, a classified income statement divides
USD 1,000 of depreciation expense relates 60 per cent
both revenues and expenses into operating and
to selling and 40 per cent to administrative based on the
nonoperating items. The statement also separates
square footage or number of employees, the income
operating expenses into selling and administrative
statement would show USD 600 as a selling expense
expenses. A classified income statement is also called a
and USD 400 as an administrative expense.
multiple-step income statement.
% Nonoperating revenues (other revenues) and
1. Revenues
nonoperating expenses (other expenses) are revenues
-amount of in-flowing assets from the sale or
and expenses not related to the sale of products or
providing services to customers.
services regularly offered for sale by a business. An
-”sales price”
example of a nonoperating revenue is interest that a
A) Sales Revenue - merchandising
business earns on notes receivable. An example of a
B) Consulting Fee Revenues - consultation
nonoperating expense is interest incurred on money
C) Interest Revenue - loaning money
borrowed by the company.
2. Expenses
To summarize the more important relationships in
-the amount of out-flowing assets that represents a
the income statement of a merchandising firm in
cost for providing goods or services.
equation form:
-incurring of liabilities requiring the future outflow of
A) Net sales = Gross sales - (Sales discounts + Sales
returns and allowances).
B) Net purchases = Purchases - (Purchase discounts +
Purchase returns and allowances).
C) Net cost of purchases = Net purchases +
Transportation-in.
D) Cost of goods sold = Beginning inventory + Net
cost of purchases - Ending inventory.
E) Gross margin = Net sales - Cost of goods sold.
F) Income from operations = Gross margin - Operating
(selling and administrative) expenses.
G) Net income = Income from operations +
Nonoperating revenues - Nonoperating expenses.
Each of these relationships is important because of
the way it relates to an overall measure of business
profitability. For example, a company may produce a
high gross margin on sales. However, because of large
sales commissions and delivery expenses, the owner
may realize only a very small percentage of the gross
margin as profit. The classifications in the income
statement allow a user to focus on the whole picture as
well as on how net income was derived (statement
relationships).