One of the key factors for success for those beginning the study of accounting is to understand how the elements of the financial statements relate to each of the financial statements. That is, once the transactions are categorized into the elements, knowing what to do next is vital. This is the beginning of the process to create the financial statements. It is important to note that financial statements are discussed in the order in which the statements are presented.
When thinking of the relationship between the elements and the financial statements, we might think of a baking analogy: the elements represent the ingredients, and the financial statements represent the finished product. As with baking a cake (see Figure 2.5), knowing the ingredients (elements) and how each ingredient relates to the final product (financial statements) is vital to the study of accounting.
Figure 2.5 Baking requires an understanding of the different ingredients, how the ingredients are used, and how the ingredients will impact the final product (a). If used correctly, the final product will be beautiful and, more importantly, delicious, like the cake shown in (b). In a similar manner, the study of accounting requires an understanding of how the accounting elements relate to the final product—the financial statements. (credit (a): modification of “U.S. Navy Culinary Specialist Seaman Robert Fritschie mixes cake batter aboard the amphibious command ship USS Blue Ridge (LCC 19) Aug. 7, 2013, while underway in the Solomon Sea 130807-N-NN332-044” by MC3 Jarred Harral/Wikimedia Commons, Public Domain; credit (b): modification of “Easter Cake with Colorful Topping” by Kaboompics .com/Pexels, CC0)
To help accountants prepare and users better understand financial statements, the profession has outlined what is referred to as elements of the financial statements , which are those categories or accounts that accountants use to record transactions and prepare financial statements. There are ten elements of the financial statements, and we have already discussed most of them.
Now it is time to bake the cake (i.e., prepare the financial statements). We have all of the ingredients (elements of the financial statements) ready, so let’s now return to the financial statements themselves. Let’s use as an example a fictitious company named Cheesy Chuck’s Classic Corn. This company is a small retail store that makes and sells a variety of gourmet popcorn treats. It is an exciting time because the store opened in the current month, June.
Assume that as part of your summer job with Cheesy Chuck’s, the owner—you guessed it, Chuck—has asked you to take over for a former employee who graduated college and will be taking an accounting job in New York City. In addition to your duties involving making and selling popcorn at Cheesy Chuck’s, part of your responsibility will be doing the accounting for the business. The owner, Chuck, heard that you are studying accounting and could really use the help, because he spends most of his time developing new popcorn flavors.
The former employee has done a nice job of keeping track of the accounting records, so you can focus on your first task of creating the June financial statements, which Chuck is eager to see. Figure 2.6 shows the financial information (as of June 30) for Cheesy Chuck’s.
Figure 2.6 Trial Balance for Cheesy Chuck’s Classic Corn. Accountants record and summarize accounting information into accounts, which help to track, summarize, and prepare accounting information. This table is a variation of what accountants call a “trial balance.” A trial balance is a summary of accounts and aids accountants in creating financial statements. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)
We should note that we are oversimplifying some of the things in this example. First, the amounts in the accounting records were given. We did not explain how the amounts would be derived. This process is explained starting in Analyzing and Recording Transactions. Second, we are ignoring the timing of certain cash flows such as hiring, purchases, and other startup costs. In reality, businesses must invest cash to prepare the store, train employees, and obtain the equipment and inventory necessary to open. These costs will precede the selling of goods and services. In the example to follow, for instance, we use Lease payments of $24,000, which represents lease payments for the building ($20,000) and equipment ($4,000). In practice, when companies lease items, the accountants must determine, based on accounting rules, whether or not the business “owns” the item. If it is determined the business “owns” the building or equipment, the item is listed on the balance sheet at the original cost. Accountants also take into account the building or equipment’s value when the item is worn out. The difference in these two values (the original cost and the ending value) will be allocated over a relevant period of time. As an example, assume a business purchased equipment for $18,000 and the equipment will be worth $2,000 after four years, giving an estimated decline in value (due to usage) of $16,000 ($18,000 − $2,000). The business will allocate $4,000 of the equipment cost over each of the four years ($18,000 minus $2,000 over four years). This is called depreciation and is one of the topics that is covered in Long-Term Assets.
Also, the Equipment with a value of $12,500 in the financial information provided was purchased at the end of the first accounting period. It is an asset that will be depreciated in the future, but no depreciation expense is allocated in our example.
Let’s prepare the income statement so we can inform how Cheesy Chuck’s performed for the month of June (remember, an income statement is for a period of time). Our first step is to determine the value of goods and services that the organization sold or provided for a given period of time. These are the inflows to the business, and because the inflows relate to the primary purpose of the business (making and selling popcorn), we classify those items as Revenues, Sales, or Fees Earned. For this example, we use Revenue. The revenue for Cheesy Chuck’s for the month of June is $85,000.
Next, we need to show the total expenses for Cheesy Chuck’s. Because Cheesy Chuck’s tracks different types of expenses, we need to add the amounts to calculate total expenses. If you added correctly, you get total expenses for the month of June of $79,200. The final step to create the income statement is to determine the amount of net income or net loss for Cheesy Chuck’s. Since revenues ($85,000) are greater than expenses ($79,200), Cheesy Chuck’s has a net income of $5,800 for the month of June.
Figure 2.7 displays the June income statement for Cheesy Chuck’s Classic Corn.
Figure 2.7 Income Statement for Cheesy Chuck’s Classic Corn. The income statement for Cheesy Chuck’s shows the business had Net Income of $5,800 for the month ended June 30. This amount will be used to prepare the next financial statement, the statement of owner’s equity. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)
Financial statements are created using numerous standard conventions or practices. The standard conventions provide consistency and help assure financial statement users the information is presented in a similar manner, regardless of the organization issuing the financial statement. Let’s look at the standard conventions shown in the Cheesy Chuck’s income statement:
For the year ended December 31, 2016, McDonald’s had sales of $24.6 billion. 11 The amount of sales is often used by the business as the starting point for planning the next year. No doubt, there are a lot of people involved in the planning for a business the size of McDonald’s . Two key people at McDonald’s are the purchasing manager and the sales manager (although they might have different titles). Let’s look at how McDonald’s 2016 sales amount might be used by each of these individuals. In each case, do not forget that McDonald’s is a global company.
A purchasing manager at McDonald’s , for example, is responsible for finding suppliers, negotiating costs, arranging for delivery, and many other functions necessary to have the ingredients ready for the stores to prepare the food for their customers. Expecting that McDonald’s will have over $24 billion of sales during 2017, how many eggs do you think the purchasing manager at McDonald’s would need to purchase for the year? According to the McDonald’s website, the company uses over two billion eggs a year. 12 Take a moment to list the details that would have to be coordinated in order to purchase and deliver over two billion eggs to the many McDonald’s restaurants around the world.
A sales manager is responsible for establishing and attaining sales goals within the company. Assume that McDonald’s 2017 sales are expected to exceed the amount of sales in 2016. What conclusions would you make based on this information? What do you think might be influencing these amounts? What factors do you think would be important to the sales manager in deciding what action, if any, to take? Now assume that McDonald’s 2017 sales are expected to be below the 2016 sales level. What conclusions would you make based on this information? What do you think might be influencing these amounts? What factors do you think would be important to the sales manager in deciding what action, if any, to take?
Let’s create the statement of owner’s equity for Cheesy Chuck’s for the month of June. Since Cheesy Chuck’s is a brand-new business, there is no beginning balance of Owner’s Equity. The first items to account for are the increases in value/equity, which are investments by owners and net income. As you look at the accounting information you were provided, you recognize the amount invested by the owner, Chuck, was $12,500. Next, we account for the increase in value as a result of net income, which was determined in the income statement to be $5,800. Next, we determine if there were any activities that decreased the value of the business. More specifically, we are accounting for the value of distributions to the owners and net loss, if any.
It is important to note that an organization will have either net income or net loss for the period, but not both. Also, small businesses in particular may have periods where there are no investments by, or distributions to, the owner(s). For the month of June, Chuck withdrew $1,450 from the business. This is a good time to recall the terminology used by accountants based on the legal structure of the particular business. Since the account was titled “Drawings by Owner” and because Chuck is the only owner, we can assume this is a sole proprietorship. If the business was structured as a corporation, this activity would be called something like “Dividends Paid to Owners.”
At this stage, remember that since we are working with a sole proprietorship to help simplify the examples, we have addressed the owner’s value in the firm as capital or owner’s equity. However, later we switch the structure of the business to a corporation, and instead of owner’s equity, we begin using such account titles as common stock and retained earnings to represent the owner’s interests. The corporate treatment is more complicated, because corporations may have a few owners up to potentially thousands of owners (stockholders). The details of accounting for the interests of corporations are covered in Corporation Accounting.
So how much did the value of Cheesy Chuck’s change during the month of June? You are correct if you answered $16,850. Since this is a brand-new store, the beginning value of the business is zero. During the month, the owner invested $12,500 and the business had profitable operations (net income) of $5,800. Also, during the month the owner withdrew $1,450, resulting in a net change (and ending balance) to owner’s equity of $16,850. Shown in a formula:
Beginning Balance + Investments by Owners ± Net Income (Net Loss) – Distributions, or
$0 + $12,500 + $5,800 – $1,450 = $16,850 $0 + $12,500 + $5,800 – $1,450 = $16,850Figure 2.8 shows what the statement of owner’s equity for Cheesy Chuck’s Classic Corn would look like.
Figure 2.8 Statement of Owner’s Equity for Cheesy Chuck’s Classic Corn. The statement of owner’s equity demonstrates how the net worth (also called equity) of the business changed over the period of time (the month of June in this case). Notice the amount of net income (or net loss) is brought from the income statement. In a similar manner, the ending equity balance (Capital for Cheesy Chuck’s because it is a sole proprietorship) is carried forward to the balance sheet. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)
Notice the following about the statement of owner’s equity for Cheesy Chuck’s:
The statement uses the final number from the financial statement previously completed. In this case, the statement of owner’s equity uses the net income (or net loss) amount from the income statement (Net Income, $5,800).
Let’s create a balance sheet for Cheesy Chuck’s for June 30. To begin, we look at the accounting records and determine what assets the business owns and the value of each. Cheesy Chuck’s has two assets: Cash ($6,200) and Equipment ($12,500). Adding the amount of assets gives a total asset value of $18,700. As discussed previously, the equipment that was recently purchased will be depreciated in the future, beginning with the next accounting period.
Next, we determine the amount of money that Cheesy Chuck’s owes (liabilities). There are also two liabilities for Cheesy Chuck’s. The first account listed in the records is Accounts Payable for $650. Accounts Payable is the amount that Cheesy Chuck’s must pay in the future to vendors (also called suppliers) for the ingredients to make the gourmet popcorn. The other liability is Wages Payable for $1,200. This is the amount that Cheesy Chuck’s must pay in the future to employees for work that has been performed. Adding the two amounts gives us total liabilities of $1,850. (Here’s a hint as you develop your understanding of accounting: Liabilities often include the word “payable.” So, when you see “payable” in the account title, know these are amounts owed in the future—liabilities.)
Finally, we determine the amount of equity the owner, Cheesy Chuck, has in the business. The amount of owner’s equity was determined on the statement of owner’s equity in the previous step ($16,850). Can you think of another way to confirm the amount of owner’s equity? Recall that equity is also called net assets (assets minus liabilities). If you take the total assets of Cheesy Chuck’s of $18,700 and subtract the total liabilities of $1,850, you get owner’s equity of $16,850. Using the basic accounting equation, the balance sheet for Cheesy Chuck’s as of June 30 is shown in Figure 2.9.
Figure 2.9 Balance Sheet for Cheesy Chuck’s Classic Corn. The balance sheet shows what the business owns (Assets), owes (Liabilities), and is worth (equity) on a given date. Notice the amount of Owner’s Equity (Capital for Cheesy Chuck’s) was brought forward from the statement of owner’s equity. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)
Another way to think of the connection between the income statement and balance sheet (which is aided by the statement of owner’s equity) is by using a sports analogy. The income statement summarizes the financial performance of the business for a given period of time. The income statement reports how the business performed financially each month—the firm earned either net income or net loss. This is similar to the outcome of a particular game—the team either won or lost.
The balance sheet summarizes the financial position of the business on a given date. Meaning, because of the financial performance over the past twelve months, for example, this is the financial position of the business as of December 31. Think of the balance sheet as being similar to a team’s overall win/loss record—to a certain extent a team’s strength can be perceived by its win/loss record.
However, because different companies have different sizes, you do not necessarily want to compare the balance sheets of two different companies. For example, you would not want to compare a local retail store with Walmart. In most cases you want to compare a company with its past balance sheet information.
In Describe the Income Statement, Statement of Owner’s Equity, Balance Sheet, and Statement of Cash Flows, and How They Interrelate, we discussed the function of and the basic characteristics of the statement of cash flows. This fourth and final financial statement lists the cash inflows and cash outflows for the business for a period of time. It was created to fill in some informational gaps that existed in the other three statements (income statement, owner’s equity/retained earnings statement, and the balance sheet). A full demonstration of the creation of the statement of cash flows is presented in Statement of Cash Flows.
In this example using a fictitious company, Cheesy Chuck’s, we began with the account balances and demonstrated how to prepare the financial statements for the month of June, the first month of operations for the business. It will be helpful to revisit the process by summarizing the information we started with and how that information was used to create the four financial statements: income statement, statement of owner’s equity, balance sheet, and statement of cash flows.
We started with the account balances shown in Figure 2.10.
Figure 2.10 Account Balances for Cheesy Chuck’s Classic Corn. Obtaining the account balances is the starting point for preparing financial statements. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)
The next step was to create the income statement, which shows the financial performance of the business. The income statement is shown in Figure 2.11.
Figure 2.11 Income Statement for Cheesy Chuck’s Classic Corn. The income statement uses information from the trial balance, which lists the accounts and account totals. The income statement shows the financial performance of a business for a period of time. The net income or net loss will be carried forward to the statement of owner’s equity. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)
Next, we created the statement of owner’s equity, shown in Figure 2.12. The statement of owner’s equity demonstrates how the equity (or net worth) of the business changed for the month of June. Do not forget that the Net Income (or Net Loss) is carried forward to the statement of owner’s equity.
Figure 2.12 Statement of Owner’s Equity for Cheesy Chuck’s Classic Corn. The statement of owner’s equity shows how the net worth/value (or equity) of business changed for the period of time. This statement includes Net Income (or Net Loss), which was brought forward from the income statement. The ending balance is carried forward to the balance sheet. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)
The third financial statement created is the balance sheet, which shows the company’s financial position on a given date. Cheesy Chuck’s balance sheet is shown in Figure 2.13.
Figure 2.13 Balance Sheet for Cheesy Chuck’s Classic Corn. The balance sheet shows the assets, liabilities, and owner’s equity of a business on a given date. Notice the balance sheet is the accounting equation in financial statement form: Assets = Liabilities + Owner’s Equity. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)
In Why It Matters, we pointed out that accounting information from the financial statements can be useful to business owners. The financial statements provide feedback to the owners regarding the financial performance and financial position of the business, helping the owners to make decisions about the business.
Using the June financial statements, analyze Cheesy Chuck’s and prepare a brief presentation. Consider this from the perspective of the owner, Chuck. Describe the financial performance of and financial position of the business. What areas of the business would you want to analyze further to get additional information? What changes would you consider making to the business, if any, and why or why not?
Accountants have an ethical duty to accurately report the financial results of their company and to ensure that the company’s annual reports communicate relevant information to stakeholders. If accountants and company management fail to do so, they may incur heavy penalties.
For example, in 2002 the Securities and Exchange Commission (SEC) charged the top management of Waste Management, Inc. with inflating profits by $1.7 billion to meet earnings targets in the period 1992–1997. An SEC press release alleged “that defendants fraudulently manipulated the company’s financial results to meet predetermined earnings targets. . . . They employed a multitude of improper accounting practices to achieve this objective.” 13 The defendants in the case manipulated reports to defer or eliminate expenses, which fraudulently inflated their earnings. Because they failed to accurately report the financial results of their company, the top accountants and management of Waste Management, Inc. face charges.
Thomas C. Newkirk, the associate director of the SEC’s Division of Enforcement, stated, “For years, these defendants cooked the books, enriched themselves, preserved their jobs, and duped unsuspecting shareholders” 14 The defendants, who included members of the company board and executives, benefited personally from their fraud in the millions of dollars through performance-based bonuses, charitable giving, and sale of company stock. The company’s accounting firm, Arthur Andersen , abetted the fraud by identifying the improper practices but doing little to stop them.
In addition to reviewing the financial statements in order to make decisions, owners and other stakeholders may also utilize financial ratios to assess the financial health of the organization. While a more in-depth discussion of financial ratios occurs in Appendix A: Financial Statement Analysis, here we introduce liquidity ratios, a common, easy, and useful way to analyze the financial statements.
Liquidity refers to the business’s ability to convert assets into cash in order to meet short-term cash needs. Examples of the most liquid assets include accounts receivable and inventory for merchandising or manufacturing businesses. The reason these are among the most liquid assets is that these assets will be turned into cash more quickly than land or buildings, for example. Accounts receivable represents goods or services that have already been sold and will typically be paid/collected within thirty to forty-five days. Inventory is less liquid than accounts receivable because the product must first be sold before it generates cash (either through a cash sale or sale on account). Inventory is, however, more liquid than land or buildings because, under most circumstances, it is easier and quicker for a business to find someone to purchase its goods than it is to find a buyer for land or buildings.
The starting point for understanding liquidity ratios is to define working capital —current assets minus current liabilities. Recall that current assets and current liabilities are amounts generally settled in one year or less. Working capital (current assets minus current liabilities) is used to assess the dollar amount of assets a business has available to meet its short-term liabilities. A positive working capital amount is desirable and indicates the business has sufficient current assets to meet short-term obligations (liabilities) and still has financial flexibility. A negative amount is undesirable and indicates the business should pay particular attention to the composition of the current assets (that is, how liquid the current assets are) and to the timing of the current liabilities. It is unlikely that all of the current liabilities will be due at the same time, but the amount of working capital gives stakeholders of both small and large businesses an indication of the firm’s ability to meet its short-term obligations.
One limitation of working capital is that it is a dollar amount, which can be misleading because business sizes vary. Recall from the discussion on materiality that $1,000, for example, is more material to a small business (like an independent local movie theater) than it is to a large business (like a movie theater chain). Using percentages or ratios allows financial statement users to more easily compare small and large businesses.
The current ratio is closely related to working capital; it represents the current assets divided by current liabilities. The current ratio utilizes the same amounts as working capital (current assets and current liabilities) but presents the amount in ratio, rather than dollar, form. That is, the current ratio is defined as current assets/current liabilities. The interpretation of the current ratio is similar to working capital. A ratio of greater than one indicates that the firm has the ability to meet short-term obligations with a buffer, while a ratio of less than one indicates that the firm should pay close attention to the composition of its current assets as well as the timing of the current liabilities.
Assume that Chuck, the owner of Cheesy Chuck’s, wants to assess the liquidity of the business. Figure 2.14 shows the June 30, 2018, balance sheet. Assume the Equipment listed on the balance sheet is a noncurrent asset. This is a reasonable assumption as this is the first month of operation and the equipment is expected to last several years. We also assume the Accounts Payable and Wages Payable will be paid within one year and are, therefore, classified as current liabilities.
Figure 2.14 Balance Sheet for Cheesy Chuck’s Classic Corn. The balance sheet provides a snapshot of the company’s financial position. By showing the total assets, total liabilities, and total equity of the business, the balance sheet provides information that is useful for decision-making. In addition, using ratios can give stakeholders another view of the company, allowing for comparisons to prior periods and to other businesses. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)
Working capital is calculated as current assets minus current liabilities. Cheesy Chuck’s has only two assets, and one of the assets, Equipment, is a noncurrent asset, so the value of current assets is the cash amount of $6,200. The working capital of Cheesy Chuck’s is $6,200 – $1,850 or $4,350. Since this amount is over $0 (it is well over $0 in this case), Chuck is confident he has nothing to worry about regarding the liquidity of his business.
Let’s further assume that Chuck, while attending a popcorn conference for store owners, has a conversation with the owner of a much larger popcorn store—Captain Caramel’s. The owner of Captain Caramel’s happens to share the working capital for his store is $52,500. At first Chuck feels his business is not doing so well. But then he realizes that Captain Caramel’s is located in a much bigger city (with more customers) and has been around for many years, which has allowed them to build a solid business, which Chuck aspires to do. How would Chuck compare the liquidity of his new business, opened just one month, with the liquidity of a larger and more-established business in another market? The answer is by calculating the current ratio, which removes the size differences (materiality) of the two businesses.
The current ratio is calculated as current assets/current liabilities. We use the same amounts that we used in the working capital calculation, but this time we divide the amounts rather than subtract the amounts. So Cheesy Chuck’s current ratio is $6,200 (current assets)/$1,850 (current liabilities), or 3.35. This means that for every dollar of current liabilities, Cheesy Chuck’s has $3.35 of current assets. Chuck is pleased with the ratio but does not know how this compares to another popcorn store, so he asked his new friend from Captain Caramel’s. The owner of Captain Caramel’s shares that his store has a current ratio of 4.25. While it is still better than Cheesy Chuck’s, Chuck is encouraged to learn that his store is performing at a more competitive level than he previously thought by comparing the dollar amounts of working capital.
Understanding the elements that make up financial statements, the organization of those elements within the financial statements, and what information each statement relays is important, whether analyzing the financial statements of a US company or one from Honduras. Since most US companies apply generally accepted accounting principles (GAAP) 15 as prescribed by the Financial Accounting Standards Board (FASB), and most international companies apply some version of the International Financial Reporting Standards (IFRS), 16 knowing how these two sets of accounting standards are similar or different regarding the elements of the financial statements will facilitate analysis and decision-making.
Both IFRS and US GAAP have the same elements as components of financial statements: assets, liabilities, equity, income, and expenses. Equity, income, and expenses have similar subcategorization between the two types of GAAP (US GAAP and IFRS) as described. For example, income can be in the form of earned income (a lawyer providing legal services) or in the form of gains (interest earned on an investment account). The definition of each of these elements is similar between IFRS and US GAAP, but there are some differences that can influence the value of the account or the placement of the account on the financial statements. Many of these differences are discussed in detail later in this course when that element—for example, the nuances of accounting for liabilities—is discussed. Here is an example to illustrate how these minor differences in definition can impact placement within the financial statements when using US GAAP versus IFRS. ACME Car Rental Company typically rents its cars for a time of two years or 60,000 miles. At the end of whichever of these two measures occurs first, the cars are sold. Under both US GAAP and IFRS, the cars are noncurrent assets during the period when they are rented. Once the cars are being “held for sale,” under IFRS rules, the cars become current assets. However, under US GAAP, there is no specific rule as to where to list those “held for sale” cars; thus, they could still list the cars as noncurrent assets. As you learn more about the analysis of companies and financial information, this difference in placement on the financial statements will become more meaningful. At this point, simply know that financial analysis can include ratios, which is the comparison of two numbers, and thus any time you change the denominator or the numerator, the ratio result will change.
There are many similarities and some differences in the actual presentation of the various financial statements, but these are discussed in The Adjustment Process at which point these similarities and differences will be more meaningful and easier to follow.
