Module 4 - Financial Statements

Why is Financial Information Important?

  • Financial information is crucial for managing a business and making informed decisions about its future.
  • Well-organized financial information allows for quick evaluation of a business.
  • Stakeholders can analyze the business easily and compare it to past years and other businesses.

Topics and Learning Objectives

  • Topics:
    • Financial statements and their uses and standard formats
  • Learning Objectives:
    • Explain how financial statement accounts differ from business activities
    • Understand how the four financial statements are interconnected
    • Produce accurate financial statements in approved accounting style and format
    • Categorize accounts into their correct elements and activities into their correct functions

Module Activities

  • Complete Blast from the Past (BFTP) questions listed in the Problems and Solutions file on D2L.
  • Study the material presented, paying attention to the LawnKare examples and the account activities described.
  • Complete Check Your Understanding (CYU) challenges.
  • Review any associated materials such as videos, reference documents, and websites.
  • Complete any assessments listed in the module.

Why Produce Financial Statements?

  • Financial statements tell a business’s story, describing its activities and performance.
  • They provide information on financial performance, current financial position, and cash flows.
  • Internal and external stakeholders use financial statements to analyze a business and make decisions.

Standard Financial Statements

  • There are four standard financial statements:
    • Income Statement
    • Statement of Retained Earnings
    • Balance Sheet
    • Statement of Cash Flows
  • Three of these statements (Income Statement, Statement of Retained Earnings, and Balance Sheet) are created using financial reporting elements.

Equations and Interconnections

  • Revenues – Expenses = Profit (Income Statement)
  • Profit – Dividends = Retained Earnings (Statement of Retained Earnings)
  • Retained Earnings + Owners’ Capital = Equity (Balance Sheet)
  • Assets = Liabilities + Equity (Balance Sheet)
  • The statement of cash flows is created differently and will be introduced later in the module.

Order of Producing Financial Statements

  • Income statement calculates profit.
  • Statement of retained earnings calculates ending retained earnings, using the profit from the income statement.
  • Balance sheet shows assets = liabilities + equity, using the ending retained earnings from the statement of retained earnings.

Statement of Cash Flows

  • The statement of cash flows stands alone, describing the inflows and outflows of cash during the period.
  • It ONLY uses the cash balance from the balance sheet.
  • It EXPLAINS something rather than producing a number used in another statement.

Order of Statement Production

  1. Income Statement
  2. Statement of Retained Earnings
  3. Balance Sheet
  4. Statement of Cash Flows

Income Statement

  • The income statement shows the business’s profitability by comparing revenues and expenses.
  • Answers questions such as:
    • Was the business profitable in the current year?
    • Was the profit high enough in comparison to the revenues earned?
    • Is there enough profit to repay loans plus interest?
    • Is the business generating enough profit to continue into the future?
  • The long-term survival of any business is dependent on its profit.

Profit vs. Cash

  • Profit on the income statement is NEVER equal to the cash balance.
  • Cash can increase due to borrowing or capital contributions, which do not affect revenue or profit.
  • Profit includes revenues not yet collected (receivables) and expenses not yet paid (payables).
  • Cash includes items that are not revenues or expenses (deferred revenue and prepaid expenses).

Income Statement Summary

  • The income statement measures profitability.
  • Does NOT answer questions about the cash balance.
  • Cash flow questions are answered by the statement of cash flows.
  • The Cash account is affected by all cash transactions, not just revenue-related ones.

Statement of Retained Earnings

  • The statement of retained earnings shows how much of the profit is kept in the business and how much is paid out to the owners.
  • Answers questions such as:
    • Did the business pay dividends to the owners?
    • Were the dividend payments high enough (or too high)?
    • How much of the profit was retained for future growth and expansion?
    • Could the business pay out additional dividends in the future?

Components of the Statement of Retained Earnings

  • Shows how retained earnings increased or decreased from the beginning to the end of the year.
  • Includes the company name, statement name, and period of time covered in the title.
  • Opening retained earnings is the same as the ending retained earnings from the previous year.
  • Dividends are distributions of profit to the company’s owners, not retained in the business.
  • Closing retained earnings is transferred to the equity section of the balance sheet.

Balance Sheet

  • The balance sheet shows the financial position of the business.
  • Also known as the statement of financial position.
  • Details the assets (owned), liabilities (owed to third parties), and equity (owed to the owners).
  • Used to assess the business's financial position.
  • Answers questions such as:
    • What is the breakdown of the assets?
    • Are the assets liquid enough to pay debts when due?
    • If the business closed now, would there be enough liquid assets to pay off the debts?
    • What is the breakdown of the liabilities?
    • How much debt is there in relation to the assets?
    • How much of the business is funded through debt and how much through owner’s contributions?

Balance Sheet Title

  • The date is a specific date (the end of the accounting period) because the balance sheet is a ‘snapshot’ of the company’s financial position on that date.
  • Assets are subdivided into current and long-term assets.
  • Current assets will be used up or converted to cash within one year, listed in order of liquidity.
  • Long-term assets include investments, property, plant, and equipment, and intangible assets.
  • Liabilities are divided into current and long-term liabilities.
  • Current liabilities will be paid or satisfied within one year.
  • Equity includes owner’s capital and retained earnings.
  • Owner’s capital is listed first.

Statement of Cash Flows

  • The statement of cash flows shows the cash inflows and outflows over the period, as well as the cash position at the end of the period.
  • Answers the basic question: Where did the business get and spend its cash?
  • Answers specific questions such as:
    • Was the business able to generate cash from its day to day operations?
    • Is there enough cash to pay dividends?
    • Is there cash available to pay the business's debts as they come due?
    • Will the business be able to fund future purchases from its own cash or will it have to borrow from creditors (the bank)?
    • Given the cash flows in the past what can be said (predicted) about future cash flows?
  • Focuses ONLY on cash transactions.

Categorization of Cash Flows

  • The statement of cash flows is divided into three activities: operating, investing, and financing.
  • Operating activities arise from day-to-day operations, affecting current assets, current liabilities, revenues, and expenses.
    • Collecting accounts receivable is an operating cash inflow.
    • Paying accounts payable is an operating cash outflow.
  • Investing activities involve purchasing and selling long term assets.
    • Sales of long term asset is an investing cash inflow.
    • Purchasing a long-term asset is an investing cash outflow.
  • Financing activities involve long term liabilities and owner’s equity.
    • Borrowing from the bank and receiving contributions from owners are financing cash inflows.
    • Repaying the loan (the principal, not the interest) and paying dividends are financing cash outflows.
  • Operating activities are the ‘lifeblood’ of the business because they are persistent.
  • Investing activities are oriented to the long term.
  • Financing activities show where the cash comes from to operate and invest in the business.

Format of the Statement of Cash Flows

  • Calculates the change in the company’s cash during the period.
  • Shows how much cash has been provided by, or used in, the three types of activities (operating, investing, and financing) during the period.
  • Transactions are recorded only when cash is received or paid (cash basis of accounting).
  • Accounting equations:
    Revenues–Expenses=ProfitRevenues – Expenses = Profit
    Income statement.
    Profit–Dividends=RetainedEarningsProfit – Dividends = Retained Earnings
    Statement of retained earnings.
    RetainedEarnings+Owners’capital=EquityRetained Earnings + Owners’ capital = Equity
    Assets=Liabilities+EquityAssets = Liabilities + Equity
    Balance sheet.

LawnKare Example

  • List of accounts:
    • Cash - 1714.00</li><li>AccountsReceivable−1714.00</li> <li>Accounts Receivable -55.00
    • Prepaid Expenses - 19.20</li><li>PrepaidInsurance−19.20</li> <li>Prepaid Insurance -410.00
    • Website Design - 300.00</li><li>BusinessLicence−300.00</li> <li>Business Licence -60.00
    • Accounts Payable - 122.81</li><li>DeferredRevenue−122.81</li> <li>Deferred Revenue -399.00
    • Loan Payable - 1500.00</li><li>Owner′sCapital−1500.00</li> <li>Owner's Capital -500.00
    • Service Revenue - 100.00</li><li>RentExpenses−100.00</li> <li>Rent Expenses -20.00
    • Advertising Expense - 19.78
    • Gas & Oil Expenses - 14.80
    • Website Expenses - 9.03</li></ul></li></ul><h3id="lawnkareincomestatement">LawnKareIncomeStatement</h3><ul><li>PeriodendingMay18,Year1<ul><li>Revenues<ul><li>ServiceRevenue−9.03</li></ul></li> </ul> <h3 id="lawnkareincomestatement">LawnKare Income Statement</h3> <ul> <li>Period ending May 18, Year 1<ul> <li>Revenues<ul> <li>Service Revenue -100.00
  • Operating Expenses
    • Rent - 20.00</li><li>Advertising−20.00</li> <li>Advertising -19.78
    • Gas & Oil - 14.80</li><li>Website−14.80</li> <li>Website -9.03
    • Total operating expenses - 63.61</li></ul></li><li>Profitbeforeincometax−63.61</li></ul></li> <li>Profit before income tax -36.39
    • Income tax - 0</li><li>Profit−0</li> <li>Profit -36.39

LawnKare Statement of Retained Earnings

  • Period ending May 18, Year 1
    • Opening retained earnings - 0</li><li>AddProfit−0</li> <li>Add Profit -36.39
    • Deduct Dividends - 0</li><li>Closingretainedearnings−0</li> <li>Closing retained earnings -36.39

LawnKare Balance Sheet

  • May 18, Year 1
    • Assets
      • Current Assets
        • Cash - 1,714.00</li><li>Accountsreceivable−1,714.00</li> <li>Accounts receivable -55.00
        • Prepaid expenses - 19.20</li><li>Prepaidinsurance−19.20</li> <li>Prepaid insurance -410.00
        • Total current assets - 2,198.20</li></ul></li><li>Intangibles<ul><li>Websitedesign−2,198.20</li></ul></li> <li>Intangibles<ul> <li>Website design -300.00
        • Business licence - 60.00</li><li>Totalintangibles−60.00</li> <li>Total intangibles -360.00
      • Total assets - 2,558.20</li></ul></li><li>Liabilities<ul><li>Currentliabilities<ul><li>Accountspayable−2,558.20</li></ul></li> <li>Liabilities<ul> <li>Current liabilities<ul> <li>Accounts payable -122.81
      • Deferred revenue - 399.00</li><li>Totalcurrentliabilities−399.00</li> <li>Total current liabilities -521.81
    • Long term liabilities
      • Loan payable - 1,500.00</li><li>Totalliabilities−1,500.00</li> <li>Total liabilities -2,021.81
  • Equity
    • Owner’s capital - 500.00</li><li>Closingretainedearnings−500.00</li> <li>Closing retained earnings -36.39
    • Total equity - 536.39</li></ul></li><li>Totalliabilitiesandequity−536.39</li></ul></li> <li>Total liabilities and equity -2,558.20

LawnKare Statement of Cash Flows

  • Period ending May 18, 2017
    • Cash flows from operating activities
      • Cash receipts from customers - 444</li><li>Cashpaymentstosuppliers−444</li> <li>Cash payments to suppliers -(430)
      • Cash provided by operating activities - 14</li></ul></li><li>Cashflowsfrominvestingactivities<ul><li>Purchaseofintangibles−14</li></ul></li> <li>Cash flows from investing activities<ul> <li>Purchase of intangibles -(300)
      • Cash used in investing activities - (300)</li></ul></li><li>Cashflowsfromfinancingactivities<ul><li>Capitalcontributionsbyowners−(300)</li></ul></li> <li>Cash flows from financing activities<ul> <li>Capital contributions by owners -500
      • Cash received from debt - 1,500</li><li>Cashprovidedbyfinancingactivities−1,500</li> <li>Cash provided by financing activities -2,000
    • Net inflow of cash - 1,714</li><li>Beginningcash,May1−1,714</li> <li>Beginning cash, May 1 -0
    • Ending cash, May 18 - $$1,714

GAAP and Financial Statement Objectives

  • The overall objective of GAAP is to provide financial information about a business that is useful to stakeholders for decision making.
  • Financial statements tell a business’s story, describing its activities and performance.
  • They provide information on financial performance, current financial position, and cash flows.
  • Both internal and external stakeholders can use the financial statements to analyze a business and answer questions, which allow them to make decisions and meet their objectives.

Steps to Solve Financial Statement Problems

  1. Identify whether the item is an account or an activity.
  2. If it is an account, identify the element the account belongs to.
  3. Subdivide the elements into the different categories of assets and liabilities (current assets, intangibles, current liabilities, long term liabilities).
  4. Indicate for each element what financial statement the account will appear on.
  5. Group the cash flow items into their activities.
  6. Starting with the income statement, create all four statements.

Module 5 - Merchandising Businesses

  • Focus will shift to merchandising businesses, which sell goods (inventory).
  • Accounting for inventory is complicated and requires understanding how to account for both purchases and sales.