Accounting and Finance Foundations

Unit 7

Accounting and Finance Foundations Unit 7: Financial Statements 541

Financial Statements

Chapter 18

Student Guide

Businesses use financial statements to communicate financial information to the public. (Remember the

Disclosure Principle?). The four general purpose financial statements for companies are the:

1. Income Statement


2. Balance Sheet


3. Statement of Owner’s Equity


4. Statement of Cash Flows

The income statement is prepared from the revenue and expense accounts, while the balance sheet is cre-

ated using the assets and liability accounts. The net income from the income statement is combined with

the dividends on the statement of retained earnings or the statement of owner’s equity. Net income closes

into retained earnings in the Stockholder’s Equity section of the balance sheet.

The statement of cash flows explains the changes in cash and cash equivalents from one accounting period

to the next. It shows cash inflows and cash outflows from a company’s operating, investing, and financing

activities for a particular accounting period. Cash equivalents are short-term, highly liquid assets or invest-

ments.

The items reported in the financial statements are organized into classes or categories known as elements.

The FASB (Financial Accounting Standards Board) has identified ten elements of financial statements:

n    Assets

n    Liabilities

n    Equity

n    Common stock

n    Revenue

n    Expenses

n    Distributions

n    Net income

n    Gains

n    Losses

These elements represent broad classifications as opposed

to specific items. The subclassifications of these elements

are called accounts.

The information that financial statements contains is utilized

in many different ways. Financial statement information is

used to make investment and credit decisions; to assess

cash flow prospects; and to learn more about business

resources, claims to those resources, and changes to them.

The individuals who use this information may be members of

management, other individuals with direct financial inter-

est in the company (e.g., investors and creditors), or even

people with indirect financial interest in the company’s activi-

ties (e.g., tax authorities, regulators, labor unions, custom-

ers, and consultants).

Financial statements are commonly used to evaluate a company’s liquidity and profitability. Liquidity in-

volves having enough money on hand to pay bills when they are due and to take care of unexpected needs

for cash. Profitability is the ability of a company to earn income.