` EMILIO AGUINALDO COLLEGE ISO 9001:2015 CERTIFIED

QUALITY MANAGEMENT SYSTEM

[Link]

Chapter Outline
2.1 Describe the Income Statement, Statement of Owner’s Equity, Balance Sheet, and Statement of Cash
Flows, and How They Interrelate
2.2 Define, Explain, and Provide Examples of Current and Noncurrent Assets, Current and Noncurrent
Liabilities, Equity, Revenues, and Expenses
2.3 Prepare an Income Statement, Statement of Owner’s Equity, and Balance Sheet

Why It Matters
As a teenager, Derek loves computers. He also enjoys giving back to the community by helping others. Derek
understands that many senior citizens live far away from their families, resulting in infrequent visits and loneliness.
This summer he is considering combining both things he enjoys by working with the local retirement center. His idea
is to have workshops to show the senior citizens how to connect with their families through the use of technology.
The director of the retirement center is enthused about Derek’s idea and has agreed to pay him for the services.
During his visits, he will set up tablets and then show the seniors how to use them. Since he lives nearby, he will
also provide support on an as-needed basis.
While he is excited about this opportunity, he is also trying to save up money for college. Although the retirement
center will pay him for the workshops, he knows the investment in providing tablets will be expensive, and he wants
to ensure he can cover his costs. A neighbor who works in banking suggests that Derek get a small loan to cover the
costs of the tablets and use the income he earns to repay the loan. Derek is excited by the idea but is anxious when
his neighbor mentions he will have to provide the bank monthly financial information, such as checking account and
other financial statements. While he enjoys technology
` EMILIO AGUINALDO COLLEGE ISO 9001:2015 CERTIFIED
QUALITY MANAGEMENT SYSTEM

[Link]

and helping others, he is unfamiliar with financial statements. Derek decides to learn more about how
financial statements will help both him and the bank make sound financial decisions.

Describe the Income Statement, Statement of Owner’s Equity, Balance

Sheet, and Statement of Cash Flows, and How They Interrelate
The study of accounting requires an understanding of precise and sometimes complicated terminology, purposes,
principles, concepts, and organizational and legal structures. Typically, your introductory accounting courses will
familiarize you with the overall accounting environment, and for those of you who want greater detail, there is an
assortment of more advanced accounting courses available.
This chapter concentrates on the four major types of financial statements and their interactions, the major types of
business structures, and some of the major terms and concepts used in this course. Coverage here is somewhat
basic since these topics are accorded much greater detail in future chapters.

Types of Business Structure

As you learned in Role of Accounting in Society, virtually every activity that occurs in a business has an
associated cost or value. Part of an accountant’s role is to quantify these activities, or transactions.
Also, in business—and accounting in particular—it is necessary to distinguish the business entity from the
individual owner(s). The personal transactions of the owners, employees, and other parties connected to the
business should not be recorded in the organization’s records; this accounting principle is called the business
entity concept. Accountants should record only business transactions in business records.
This separation is also reflected in the legal structure of the business. There are several common types of legal
business structures. While the accounting concepts for the various types of businesses are essentially the same
regardless of the legal structure, the terminology will change slightly depending on the organization’s legal structure,
and it is important to understand the differences.
There are three broad categories for the legal structure of an organization: sole proprietorship, partnership, and
corporation. A sole proprietorship is a legal business structure consisting of a single individual. Benefits of this type
of structure include ease of formation, favorable tax treatment, and a high level of control over the business. The
risks involved with sole proprietorships include unlimited personal liability and a limited life for the business. Unless
the business is sold, the business ends when the owner retires or passes away. In addition, sole proprietorships
have a fairly limited ability to raise capital (funding), and often sole proprietors have limited expertise—they are
excellent at what they do but may have limited expertise in other important areas of business, such as accounting or
marketing. Partnership is a legal business structure consisting of an association of two or more people who
contribute money, property, or services to operate as co-owners of a business. Benefits of this type of structure
include favorable tax treatment, ease of formation of the business, and better access to capital and expertise. The
downsides to a partnership include unlimited personal liability (although there are other legal structures—a limited
liability partnership, for example—to help mitigate the risk); limited life of the partnership, similar to sole
proprietorships; and increased complexity to form the venture (decision-making authority, profit-sharing arrangement,
and other important issues need to be formally articulated in a written partnership agreement).Corporation is a legal
business structure involving one or more individuals (owners) who are legally distinct (separate) from the business. A
primary benefit of a corporate legal structure is the owners of the organization
` EMILIO AGUINALDO COLLEGE ISO 9001:2015 CERTIFIED
QUALITY MANAGEMENT SYSTEM

[Link]

have limited liability. That is, a corporation is “stand alone,” conducting business as an entity separate from its
owners. Under the corporate structure, owners delegate to others (called agents) the responsibility to make day-to-
day decisions regarding the operations of the business. Other benefits of the corporate legal structure include
relatively easy access to large amounts of capital by obtaining loans or selling ownership (stock), and since the stock
is easily sold or transferred to others, the business operates beyond the life of the shareholders. A major
disadvantage of a corporate legal structure is double taxation—the business pays income tax and the owners are
taxed when distributions (also called dividends) are received.

Types of Business Structures

Sole Proprietorship Partnership Corporation

Number of Owners Single individual Two or more individuals One or more owners

Ease of Formation Easier to form Harder to form Difficult to form

Ability to Raise Capital Difficult to raise capital Harder to raise capital Easier to raise capital

Liability Risk Unlimited liability Unlimited liability Limited liability

Taxation Consideration Single taxation Single taxation Double taxation

Table 2.1
The Four Financial Statements
Are you a fan of books, movies, or sports? If so, chances are you have heard or said the phrase “spoiler alert.” It is
used to forewarn readers, viewers, or fans that the ending of a movie or book or outcome of a game is about to be
revealed. Some people prefer knowing the end and skipping all of the details in the middle, while others prefer to
fully immerse themselves and then discover the outcome. People often do not know or understand what
accountants produce or provide. That is, they are not familiar with the “ending” of the accounting process, but that is
the best place to begin the study of accounting.
Accountants create what are known as financial statements. Financial statements are reports that
communicate the financial performance and financial position of the organization.
In essence, the overall purpose of financial statements is to evaluate the performance of a company, governmental
entity, or not-for-profit entity. This chapter illustrates this through a company, which is considered to be in business to
generate a profit. Each financial statement we examine has a unique function, and together they provide information
to determine whether a company generated a profit or loss for a given period (such as a month, quarter, or year); the
assets, which are resources of the company, and accompanying liabilities, which are obligations of the company, that
are used to generate the profit or loss; owner interest in profits or losses; and the cash position of the company at the
end of the period.
The four financial statements that perform these functions and the order in which we prepare them are:
Income Statement
Statement of Owner’s Equity
Balance Sheet
` EMILIO AGUINALDO COLLEGE ISO 9001:2015 CERTIFIED
QUALITY MANAGEMENT SYSTEM

[Link]

Statement of Cash Flows.

The order of preparation is important as it relates to the concept of how financial statements are interrelated. Before
explaining each in detail, let’s explore the purpose of each financial statement and its main components.

CONTINUING APPLICATION AT WORK

Introduction to the Gearhead Outfitters Story

Gearhead Outfitters, founded by Ted Herget in 1997 in Jonesboro, Arkansas, is a retail chain that sells
outdoor gear for men, women, and children. The company’s inventory includes clothing, footwear for hiking
and running, camping gear, backpacks, and accessories, by brands such as The North Face, Birkenstock,
Wolverine, Yeti, Altra, Mizuno, and Patagonia. Herget fell in love with the outdoor lifestyle while working as
a ski instructor in Colorado and wanted to bring that feeling back home to Arkansas. And so, Gearhead was
born in a small downtown location in Jonesboro. The company has had great success over the years,
expanding to numerous locations in Herget’s home state, as well as Louisiana, Oklahoma, and Missouri.

While Herget knew his industry when starting Gearhead, like many entrepreneurs he faced regulatory and
financial issues that were new to him. Several of these issues were related to accounting and the wealth of
decision-making information that accounting systems provide.
For example, measuring revenue and expenses, providing information about cash flow to potential lenders,
analyzing whether profit and positive cash flow is sustainable to allow for expansion, and managing
inventory levels. Accounting, or the preparation of financial statements (balance sheet, income statement,
and statement of cash flows), provides the mechanism for business owners such as Herget to make
fundamentally sound business decisions.

Purpose of Financial Statements

Before exploring the specific financial statements, it is important to know why these are important documents. To
understand this, you must first understand who the users of financial statements are. Users of the information found
in financial statements are called stakeholders. A stakeholder is someone affected by decisions made by a
company; this can include groups or individuals affected by the actions or policies of an organization, including
include investors, creditors, employees, managers, regulators, customers, and suppliers. The stakeholder’s interest
sometimes is not directly related to the entity’s financial performance. Examples of stakeholders include lenders,
investors/owners, vendors, employees and management, governmental agencies, and the communities in which the
businesses operate. Stakeholders are interested in the performance of an organization for various reasons, but the
common goal of using the financial statements is to understand the information each contains that is useful for
making financial decisions. For example, a banker may be interested in the financial statements to decide whether or
not to lend the organization money.
Likewise, small business owners may make decisions based on their familiarity with the business—they know if the
business is doing well or not based on their “gut feeling.” By preparing the financial statements,
` EMILIO AGUINALDO COLLEGE ISO 9001:2015 CERTIFIED
QUALITY MANAGEMENT SYSTEM

[Link]

accountants can help owners by providing clarity of the organization’s financial performance. It is important to
understand that, in the long term, every activity of the business has a financial impact, and financial statements are a
way that accountants report the activities of the business. Stakeholders must make many decisions, and the financial
statements provide information that is helpful in the decision-making process.
As described in Role of Accounting in Society , the complete set of financial statements acts as an X-ray of a
company’s financial health. By evaluating all of the financial statements together, someone with financial knowledge
can determine the overall health of a company. The accountant can use this information to advise outside (and
inside) stakeholders on decisions, and management can use this information as one tool to make strategic short- and
long-term decisions.

ETHICAL CONSIDERATIONS

Utilitarian View of Accounting Decisions and Stakeholder Well-Being

Utilitarianism is a well-known and influential moral theory commonly used as a framework to evaluate business
decisions. Utilitarianism suggests that an ethical action is one whose consequence achieves the greatest good
for the greatest number of people. So, if we want to make an ethical decision, we should ask ourselves who is
helped and who is harmed by it. Focusing on consequences in this way generally does not require us to take
into account the means of achieving that particular end, however. Put simply, the utilitarian view is an ethical
theory that the best action of a company is the one that maximizes utility of all stakeholders to the decision.
This view assumes that all individuals with an interest in the business are considered within the decision.

Financial statements are used to understand the financial performance of companies and to make long-and
short-term decisions. A utilitarian approach considers all stakeholders, and both the long- and short-term
effects of a business decision. This allows corporate decision makers to choose business actions with the
potential to produce the best outcomes for the majority of all stakeholders, not just shareholders, and therefore
maximize stakeholder happiness.

YOUR TURN
Accounting decisions can change the approach a stakeholder has in relation to a business. If a company
focuses on modifying operations and financial reporting to maximize short-term shareholder value, this could
indicate the prioritization of certain stakeholder interests above others. When a company pursues only short-
term profit for shareholders, it neglects the well-being of other stakeholders. Professional accountants should
be aware of the interdependent relationship between all stakeholders and consider whether the results of their
decisions are good for the majority of stakeholder interests.

Business Owners as Decision Makers

Think of a business owner in your family or community. Schedule some time to talk with the business
owner, and find out how he or she uses financial information to make decisions.
Solution
Business owners will use financial information for many decisions, such as comparing sales from one
period to another, determining trends in costs and other expenses, and identifying areas in which to
reduce or reallocate expenses. This information will be used to determine, for example, staffing and
inventory levels, streamlining of operations, and advertising or other investment decisions.
` EMILIO AGUINALDO COLLEGE ISO 9001:2015 CERTIFIED
QUALITY MANAGEMENT SYSTEM

[Link]

The Income Statement

The first financial statement prepared is the income statement, a statement that shows the organization’s financial
performance for a given period of time. Let’s illustrate the purpose of an income statement using a real-life example.
Assume your friend, Chris, who is a sole proprietor, started a summer landscaping business on August 1, 2020. It is
categorized as a service entity. To keep this example simple, assume that she is using her family’s tractor, and we
are using the cash basis method of accounting to demonstrate Chris’s initial operations for her business. The other
available basis method that is commonly used in accounting is the accrual basis method. She is responsible for
paying for fuel and any maintenance costs. She named the business Chris’ Landscaping. On August 31, Chris
checked the account balance and noticed there is only $250 in the checking account. This balance is lower than
expected because she thought she had been paid by some customers. Chris decides to do some research to
determine why the balance in the checking account is lower than expected. Her research shows that she earned a
total of $1,400 from her customers but had to pay $100 to fix the brakes on her tractor, $50 for fuel, and also made a
$1,000 payment to the insurance company for business insurance. The reason for the lower-than-expected balance
was due to the fact that she spent ($1,150 for brakes, fuel, and insurance) only slightly less than she earned ($1,400)
—a net increase of $250. While she would like the checking balance to grow each month, she realizes most of the
August expenses were infrequent (brakes and insurance) and the insurance, in particular, was an unusually large
expense. She is convinced the checking account balance will likely grow more in September because she will earn
money from some new customers; she also anticipates having fewer expenses.

The Income Statement can also be visualized by the formula: Revenue – Expenses = Net Income/(Loss).

Let’s change this example slightly and assume the $1,000 payment to the insurance company will be paid in
September, rather than in August. In this case, the ending balance in Chris’s checking account would be $1,250, a
result of earning $1,400 and only spending $100 for the brakes on her car and $50 for fuel. This stream of cash
flows is an example of cash basis accounting because it reflects when payments are received

This OpenStax book is available for free at [Link]

` EMILIO AGUINALDO COLLEGE ISO 9001:2015 CERTIFIED
QUALITY MANAGEMENT SYSTEM

[Link]

and made, not necessarily the time period that they affect. At the end of this section and in The Adjustment
Process you will address accrual accounting, which does reflect the time period that they affect.
In accounting, this example illustrates an income statement, a financial statement that is used to measure the
financial performance of an organization for a particular period of time. We use the simple landscaping account
example to discuss the elements of the income statement, which are revenues, expenses, gains, and losses.
Together, these determine whether the organization has net income (where revenues and gains are greater than
expenses and losses) or net loss (where expenses and losses are greater than revenues and gains). Revenues,
expenses, gains, and losses are further defined here.

Revenue
[1]
Revenue is the value of goods and services the organization sold or provided to customers for a given period of
time. In our current example, Chris’s landscaping business, the “revenue” earned for the month of August would be
$1,400. It is the value Chris received in exchange for the services provided to her clients. Likewise, when a business
provides goods or services to customers for cash at the time of the service or in the future, the business classifies
the amount(s) as revenue. Just as the $1,400 earned from a business made Chris’s checking account balance
increase, revenues increase the value of a business. In accounting, revenues are often also called sales or fees
earned. Just as earning wages from a business or summer job reflects the number of hours worked for a given rate
of pay or payments from clients for services rendered, revenues (and the other terms) are used to indicate the dollar
value of goods and services provided to customers for a given period of time.

YOUR TURN

Coffee Shop Products

Think about the coffee shop in your area. Identify items the coffee shop sells that would be classified as
revenues. Remember, revenues for the coffee shop are related to its primary purpose: selling coffee and
related items. Or, better yet, make a trip to the local coffee shop and get a first-hand experience.
Solution

Many coffee shops earn revenue through multiple revenue streams, including coffee and other specialty
drinks, food items, gift cards, and merchandise.

Expenses
An expense[2] is a cost associated with providing goods or services to customers. In our opening example, the
expenses that Chris incurred totaled $1,150 (consisting of $100 for brakes, $50 for fuel, and $1,000 for
` EMILIO AGUINALDO COLLEGE ISO 9001:2015 CERTIFIED
QUALITY MANAGEMENT SYSTEM

[Link]
insurance). You might think of expenses as the opposite of revenue in that expenses reduce Chris’s checking
account balance. Likewise, expenses decrease the value of the business and represent the dollar value of costs
incurred to provide goods and services to customers for a given period of time.

YOUR TURN

Coffee Shop Expenses

While thinking about or visiting the coffee shop in your area, look around (or visualize) and identify items or
activities that are the expenses of the coffee shop. Remember, expenses for the coffee shop are related to
resources consumed while generating revenue from selling coffee and related items. Do not forget about any
expenses that might not be so obvious—as a general rule, every activity in a business has an associated cost.

Solution

Costs of the coffee shop that might be readily observed would include rent; wages for the employees; and
the cost of the coffee, pastries, and other items/merchandise that may be sold. In addition, costs such as
utilities, equipment, and cleaning or other supplies might also be readily observable. More obscure costs of
the coffee shop would include insurance, regulatory costs such as health department licensing, point-of-
sale/credit card costs, advertising, donations, and payroll costs such as workers’ compensation,
unemployment, and so on.

Gains
gain[3] can result from selling ancillary business items for more than the items are worth. (Ancillary business items
are those that are used to support business operations.) To illustrate the concept of a gain, let’s return to our
example. However, this example and the accompanying losses example are not going to be part of our income
statement, balance sheet, or owner’s equity statement discussions. The gains and losses examples are only to be
used in demonstrating the concepts of gains and losses. Assume that Chris paid $1,500 for a small piece of property
to use for building a storage facility for her company. Further assume that Chris has an opportunity to sell the land for
$2,000. She subsequently found a better storage option and decided to sell the property. After doing so, Chris will
have a gain of $500 (a selling price of $2,000 and a cost of $1,500) and will also have $2,000 to deposit into her
checking account, which would increase the balance.
Thinking back to the proceeds ($1,400) Chris received from her landscaping business, we might ask the question:
how are gains similar to and different from revenues? The revenue of $1,400 that Chris earned from her business
and the $2,000 she received from selling the land are similar in that both increase her checking account balance
and make her business more valuable.
A difference, however, is evident if we consider how these funds were earned. Chris earned the $1,400 because she
provided services (her labor) to her clients. Chris’s primary objective is to earn revenue by working for her clients. In
addition, earning money by selling her land was an infrequent event for Chris, since her primary job was serving as a
landscaper. Her primary goal is to earn fees or revenue, not to earn money by selling land. In
` EMILIO AGUINALDO COLLEGE ISO 9001:2015 CERTIFIED
QUALITY MANAGEMENT SYSTEM

[Link]

fact, she cannot consider doing that again because she does not have additional land to sell.

The primary goal of a business is to earn revenue by providing goods and services to customers in exchange for
cash at that time or in the future. While selling other items for more than the value of the item does occur in
business, these transactions are classified as gains, because these sales are infrequent and not the primary
purpose of the business.

Losses
loss[4] results from selling ancillary business items for less than the items are worth. To illustrate, let’s now assume
that Chris sells her land that she purchased for $1,500 at a sales price of $1,200. In this case she would realize
(incur) a loss of $300 on the sale of the property ($1,200 sales price minus the $1,500 cost of purchasing the
property) and will also have $1,200 to deposit into her checking account, which would increase the balance.

You should not be confused by the fact that the checking account balance increased even though this transaction
resulted in a financial loss. Chris received $1,200 that she can deposit into her checking account and use for future
expenses. The $300 loss simply indicates that she received less for the land than she paid for it. These are two
aspects of the same transaction that communicate different things, and it is important to understand the differences.

As we saw when comparing gains and revenues, losses are similar to expenses in that both losses and
expenses decrease the value of the organization. In addition, just as Chris’s primary goal is to earn money from
her job rather than selling land, in business, losses refer to infrequent transactions involving ancillary items of the
business.

Net Income (Net Loss)

Net income (net loss) is determined by comparing revenues and expenses. Net income is a result of revenues
(inflows) being greater than expenses (outflows). A net loss occurs when expenses (outflows) are greater than
revenues (inflows). In accounting it is common to present net income in the following format:

Recall that revenue is the value of goods and services a business provides to its customers and increase the value
of the business. Expenses, on the other hand, are the costs of providing the goods and services and decrease the
value of the business. When revenues exceed expenses, companies have net income. This means the business has
been successful at earning revenues, containing expenses, or a combination of both. If, on the other hand, expenses
exceed revenues, companies experience a net loss. This means the business was unsuccessful in earning adequate
revenues, sufficiently containing expenses, or a combination of both. While businesses work hard to avoid net loss
situations, it is not uncommon for a company to sustain a net loss from time-to-time. It is difficult, however, for
businesses to remain viable while experiencing net losses over the long term.

Shown as a formula, the net income (loss) function is:

` EMILIO AGUINALDO COLLEGE ISO 9001:2015 CERTIFIED
QUALITY MANAGEMENT SYSTEM

[Link]
70 Chapter 2 Introduction to Financial Statements

To be complete, we must also consider the impact of gains and losses. While gains and losses are infrequent in a
business, it is not uncommon that a business would present a gain and/or loss in its financial statements. Recall that
gains are similar to revenue and losses are similar to expenses. Therefore, the traditional accounting format would
be:

Shown as a formula, the net income (loss) function, including gains and losses, is:

When assessing a company’s net income, it is important to understand the source of the net income. Businesses
strive to attain “high-quality” net income (earnings). High-quality earnings are based on sustainable earnings—also
called permanent earnings—while relying less on infrequent earnings—also called temporary earnings. Recall that
revenues represent the ongoing value of goods and services the business provides (sells) to its customers, while
gains are infrequent and involve items ancillary to the primary purpose of the business. We should use caution if a
business attains a significant portion of its net income as a result of gains, rather than revenues. Likewise, net losses
derived as a result of losses should be put into the proper perspective due to the infrequent nature of losses. While
net losses are undesirable for any reason, net losses that result from expenses related to ongoing operations, rather
than losses that are infrequent, are more concerning for the business.

Statement of Owner’s Equity

Equity is a term that is often confusing but is a concept with which you are probably already familiar. In short, equity
is the value of an item that remains after considering what is owed for that item. The following example may help
illustrate the concept of equity.
When thinking about the concept of equity, it is often helpful to think about an example many families are familiar
with: purchasing a home. Suppose a family purchases a home worth $200,000. After making a down payment of
$25,000, they secure a bank loan to pay the remaining $175,000. What is the value of the family’s equity in the
home? If you answered $25,000, you are correct. At the time of the purchase, the family owns a home worth
$200,000 (an asset), but they owe $175,000 (a liability), so the equity or net worth in the home is $25,000.
The statement of owner’s equity, which is the second financial statement created by accountants, is a statement
that shows how the equity (or value) of the organization has changed over time. Similar to the income statement,
the statement of owner’s equity is for a specific period of time, typically one year. Recall that another way to think
about equity is net worth, or value. So, the statement of owner’s equity is a financial
` EMILIO AGUINALDO COLLEGE ISO 9001:2015 CERTIFIED
QUALITY MANAGEMENT SYSTEM

[Link]

statement that shows how the net worth, or value, of the business has changed for a given period of time.

The elements of the financial statements shown on the statement of owner’s equity include investments by owners
as well as distributions to owners. Investments by owners and distributions to owners are two activities that impact
the value of the organization (increase and decrease, respectively). In addition, net income or net loss affects the
value of the organization (net income increases the value of the organization, and net loss decreases it). Net income
(or net loss) is also shown on the statement of owner’s equity; this is an example of how the statements are
interrelated. Note that the word owner’s (singular for a sole owner) changes to owners’ (plural, for a group of owners)
when preparing this statement for an entity with multiple owners versus a sole proprietorship.

In our example, to make it less complicated, we started with the first month of operations for Chris’s Landscaping. In
the first month of operations, the owner’s equity total begins the month of August 2020, at $0, since there have been
no transactions. During the month, the business received revenue of $1,400 and incurred expenses of $1,150, for net
income of $250. Since Chris did not contribute any investment or make any withdrawals, other than the $1,150 for
expenses, the ending balance in the owner’s equity account on August 31, 2020, would be $250, the net income
earned.
At this stage, it’s important to point out that 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 stockholder’s equity, which includes
account titles such as common stock and retained earnings to represent the owners’ interests.

The corporate treatment is more complicated because corporations may have a few owners up to potentially
thousands of owners (stockholders). More detail on this issue is provided in Define, Explain, and Provide Examples
of Current and Noncurrent Assets, Current and Noncurrent Liabilities, Equity, Revenues, and Expenses.

Investments by Owners
Generally, there are two ways by which organizations become more valuable: profitable operations (when revenues
exceed expenses) and investments by owners. Organizations often have long-term goals or projects that are very
expensive (for example, building a new manufacturing facility or purchasing another company).
While having profitable operations is a viable way to “fund” these goals and projects, organizations often want to
undertake these projects in a quicker time frame. Selling ownership is one way to quickly obtain the funding
necessary for these goals. Investments by owners represent an exchange of cash or other assets for which the
investor is given an ownership interest in the organization. This is a mutually beneficial arrangement: the organization
gets the funding it needs on a timely basis, and the investor gets an ownership interest in the organizatio
` EMILIO AGUINALDO COLLEGE ISO 9001:2015 CERTIFIED
QUALITY MANAGEMENT SYSTEM

[Link]

When organizations generate funding by selling ownership, the ownership interest usually takes the form of common
stock, which is the corporation’s primary class of stock issued, with each share representing a partial claim to
ownership or a share of the company’s business. When the organization issues common stock for the first time, it is
called an initial public offering (IPO). In Corporation Accounting, you learn more about the specifics of this type of
accounting. Once a company issues (or sells) common stock after an IPO, we describe the company as a publicly
traded company, which simply means the company’s stock can be purchased by the general public on a public
exchange like the New York Stock Exchange (NYSE). That is, investors can become owners of the particular
company. Companies that issue publicly traded common shares in the United States are regulated by the Securities
and Exchange Commission (SEC), a federal regulatory agency that, among other responsibilities, is charged with
oversight of financial investments such as common stock.
Distributions to Owners
There are basically two ways in which organizations become less valuable in terms of owners’ equity: from
unprofitable operations (when expenses or losses exceed revenues or gains) and by distributions to owners.
Owners (investors) of an organization want to see their investment appreciate (gain) in value. Over time, owners of
common stock can see the value of the stock increase in value—the share price increases—due to the success of
the organization. Organizations may also make distributions to owners, which are periodic rewards issued to the
owners in the form of cash or other assets. Distributions to owners represent some of the value (equity) of the
organization.
For investors who hold common stock in the organization, these periodic payments or distributions to owners are
called dividends. For sole proprietorships, distributions to owners are withdrawals or drawings. From the
organization’s perspective, dividends represent a portion of the net worth (equity) of the organization that is returned
to owners as a reward for their investment. While issuing dividends does, in fact, reduce the organization’s assets,
some argue that paying dividends increases the organization’s long-term value by making the stock more desirable.
(Note that this topic falls under the category of “dividend policy” and there is a significant stream of research
addressing this.)

Balance Sheet
Once the statement of owner’s equity is completed, accountants typically complete the balance sheet, a statement
that lists what the organization owns (assets), what it owes (liabilities), and what it is worth (equity) on a specific
date. Notice the change in timing of the report. The income statement and statement of owner’s equity report the
financial performance and equity change for a period of time. The balance sheet, however, lists the financial
position at the close of business on a specific date. (Refer to Figure 2.2 for the balance sheet as of August 31,
2020, for Chris’ Landscaping.)

Figure 2.2 “Balance Sheet for Chris’ Landscaping.” (attribution: Copyright, Rice University, OpenStax, under CC
BY-NC-SA 4.0 license)

Assets
` EMILIO AGUINALDO COLLEGE ISO 9001:2015 CERTIFIED
QUALITY MANAGEMENT SYSTEM

[Link]
If you recall our previous example involving Chris and her newly established landscaping business, you are probably
already familiar with the term asset[8]—these are resources used to generate revenue. In Chris’s business, to keep
the example relatively simple, the business ended the month with one asset, cash, assuming that the insurance was
for one month’s coverage.
However, as organizations become more complex, they often have dozens or more types of assets. An asset can
be categorized as a short-term asset or current asset (which is typically used up, sold, or converted to cash in
one year or less) or as a long-term asset or noncurrent asset (which is not expected to be converted into cash or
used up within one year). Long-term assets are often used in the production of products and services.

Examples of short-term assets that businesses own include cash, accounts receivable, and inventory, while
examples of long-term assets include land, machinery, office furniture, buildings, and vehicles. Several of the
chapters that you will study are dedicated to an in-depth coverage of the special characteristics of selected
assets. Examples include Merchandising Transactions, which are typically short term, and Long-Term Assets,
which are typically long term.
An asset can also be categorized as a tangible asset or an intangible asset. Tangible assets have a physical
nature, such as trucks or many inventory items, while intangible assets have value but often lack a physical
existence or corpus, such as insurance policies or trademarks.

Liabilities
You are also probably already familiar with the term liability[9]—these are amounts owed to others (called
creditors). A liability can also be categorized as a short-term liability (or current liability) or a long-term liability
(or noncurrent liability), similar to the treatment accorded assets. Short-term liabilities are typically expected to be
paid within one year or less, while long-term liabilities are typically expected to be due for payment more than one
year past the current balance sheet date.
Common short-term liabilities or amounts owed by businesses include amounts owed for items purchased on credit
(also called accounts payable), taxes, wages, and other business costs that will be paid in the future. Long-term
liabilities can include such liabilities as long-term notes payable, mortgages payable, or bonds payable.

Equity
In the Statement of Owner’s Equity discussion, you learned that equity (or net assets) refers to book value or net
worth. In our example, Chris’s Landscaping, we determined that Chris had $250 worth of equity in her company at
the end of the first month (see Figure 2.2).
At any point in time it is important for stakeholders to know the financial position of a business. Stated
differently, it is important for employees, managers, and other interested parties to understand what a
business owns, owes, and is worth at any given point. This provides stakeholders with valuable financial
information to make decisions related to the business.
` EMILIO AGUINALDO COLLEGE ISO 9001:2015 CERTIFIED
QUALITY MANAGEMENT SYSTEM

[Link]

Statement of Cash Flows

The fourth and final financial statement prepared is the statement of cash flows, which is a statement that lists the
cash inflows and cash outflows for the business for a period of time. At first glance, this may seem like a redundant
financial statement. We know the income statement also reports the inflows and outflows for the business for a
period of time. In addition, the statement of owner’s equity and the balance sheet help to show the other activities,
such as investments by and distributions to owners that are not included in the income statement. To understand why
the statement of cash flows is necessary, we must first understand the two bases of accounting used to prepare the
financial statements. The changes in cash within this statement are often referred to as sources and uses of cash. A
source of cash lets one see where cash is coming from. For example, is cash being generated from sales to
customers, or is the cash a result of an advance in a large loan. Use of cash looks at what cash is being used for. Is
cash being used to make an interest payment on a loan, or is cash being used to purchase a large piece of
machinery that will expand business capacity? The two bases of accounting are the cash basis and the accrual
basis, briefly introduced in Describe the Income Statement, Statement of Owner’s Equity, Balance Sheet, and
Statement of Cash Flows, and How They Interrelate.

Under cash basis accounting, transactions (i.e., a sale or a purchase) are not recorded in the financial
statements until there is an exchange of cash. This type of accounting is permitted for nonprofit entities and small
businesses that elect to use this type of accounting. Under accrual basis accounting, transactions are generally
recorded in the financial statement when the transactions occur, and not when paid, although in some situations
the two events could happen on the same day.
An example of the two methods (cash versus accrual accounting) would probably help clarify their differences.
Assume that a mechanic performs a tune-up on a client’s car on May 29, and the customer picks up her car and
pays the mechanic $100 on June 2. If the mechanic were using the cash method, the revenue would be recognized
on June 2, the date of payment, and any expenses would be recognized when paid.
If the accrual method were used, the mechanic would recognize the revenue and any related expenses on May 29,
the day the work was completed. The accrual method will be the basis for your studies here (except for our coverage
of the cash flow statement in Statement of Cash Flows). The accrual method is also discussed in greater detail in
Explain the Steps within the Accounting Cycle through the Unadjusted Trial Balance.
While the cash basis of accounting is suited well and is more efficient for small businesses and certain types of
businesses, such as farming, and those without inventory, like lawyers and doctors, the accrual basis of accounting
is theoretically preferable to the cash basis of accounting. Accrual accounting is advantageous because it
distinguishes between the timing of the transactions (when goods and services are provided) and when the cash
involved in the transactions is exchanged (which can be a significant amount of time after the initial transaction). This
allows accountants to provide, in a timely manner, relevant and complete information to stakeholders. The
Adjustment Process explores several common techniques involved in accrual accounting.
Two brief examples may help illustrate the difference between cash accounting and accrual accounting. Assume
that a business sells $200 worth of merchandise. In some businesses, there are two ways the customers pay: cash
and credit (also referred to as “on account”). Cash sales include checks and credit cards and are paid at the time of
the sale. Credit sales (not to be confused with credit card sales) allow the customer to take the merchandise but pay
within a specified period of time, usually up to forty-five days.
` EMILIO AGUINALDO COLLEGE ISO 9001:2015 CERTIFIED
QUALITY MANAGEMENT SYSTEM

[Link]

A cash sale would be recorded in the financial statements under both the cash basis and accrual basis of
accounting. It makes sense because the customer received the merchandise and paid the business at the
same time. It is considered two events that occur simultaneously (exchange of merchandise for cash).
Similar to the previous example for the mechanic, a credit sale, however, would be treated differently under each of
these types of accounting. Under the cash basis of accounting, a credit sale would not be recorded in the financial
statements until the cash is received, under terms stipulated by the seller. For example, assume on April 1 a
landscaping business provides $500 worth of services to one of its customers. The sale is made on account, with the
payment due forty-five days later. Under the cash basis of accounting, the revenue would not be recorded until May
16, when the cash was received. Under the accrual basis of accounting, this sale would be recorded in the financial
statements at the time the services were provided, April 1. The reason the sale would be recorded is, under accrual
accounting, the business reports that it provided $500 worth of services to its customer. The fact the customers will
pay later is viewed as a separate transaction under accrual accounting (Figure 2.3).
` EMILIO AGUINALDO COLLEGE ISO 9001:2015 CERTIFIED
QUALITY MANAGEMENT SYSTEM

[Link]

Figure 2.3 Credit versus Cash. On the left is a credit sale recorded under the cash basis of accounting. On the
right the same credit sale is recorded under the accrual basis of accounting. (attribution: Copyright Rice
University, OpenStax, under CC BY-NC-SA 4.0 license)

Let’s now explore the difference between the cash basis and accrual basis of accounting using an expense. Assume
a business purchases $160 worth of printing supplies from a supplier (vendor). Similar to a sale, a purchase of
merchandise can be paid for at the time of sale using cash (also a check or credit card) or at a later date (on
account). A purchase paid with cash at the time of the sale would be recorded in the financial statements under both
cash basis and accrual basis of accounting. It makes sense because the business received the printing supplies from
the supplier and paid the supplier at the same time. It is considered two events that occur simultaneously (exchange
of merchandise for cash).
If the purchase was made on account (also called a credit purchase), however, the transaction would be recorded
differently under each of these types of accounting. Under the cash basis of accounting, the $160 purchase on
account would not be recorded in the financial statements until the cash is paid, as stipulated by the seller’s terms.
For example, if the printing supplies were received on July 17 and the payment terms were fifteen days, no
transaction would be recorded until August 1, when the goods were paid for. Under the accrual basis of accounting,
this purchase would be recorded in the financial statements at the time the business received the printing supplies
from the supplier (July 17). The reason the purchase would be recorded is that the business reports that it bought
$160 worth of printing supplies from its vendors. The fact the business will pay later is viewed as a separate issue
under accrual accounting. Table 2.2 summarizes these examples under the different bases of accounting.

Transactions by Cash Basis versus Accrual Basis of Accounting

Transaction Under Cash Basis Accounting Under Accrual Basis Accounting

$200 sale for cash Recorded in financial statements at time Recorded in financial statements at
of sale time of sale

$200 sale on Not recorded in financial statements until Recorded in financial statements at
account cash is received time of sale

$160 purchase for Recorded in financial statements at time Recorded in financial statements at
cash of purchase time of purchase

Table 2.2 Businesses often sell items for cash as well as on account, where payment terms are extended for a
period of time (for example, thirty to forty-five days). Likewise, businesses often purchase items from suppliers (also
called vendors) for cash or, more likely, on account. Under the cash basis of accounting, these transactions would
not be recorded until the cash is exchanged. In contrast, under accrual accounting the transactions are recorded
when the transaction occurs, regardless of when the cash is received or paid.
` EMILIO AGUINALDO COLLEGE ISO 9001:2015 CERTIFIED
QUALITY MANAGEMENT SYSTEM

[Link]

Transactions by Cash Basis versus Accrual Basis of Accounting

Transaction Under Cash Basis Accounting Under Accrual Basis Accounting

$160 purchase on Not recorded in financial statements until Recorded in financial statements at
account cash is paid time of purchase

Table 2.2 Businesses often sell items for cash as well as on account, where payment terms are extended for a
period of time (for example, thirty to forty-five days). Likewise, businesses often purchase items from suppliers (also
called vendors) for cash or, more likely, on account. Under the cash basis of accounting, these transactions would
not be recorded until the cash is exchanged. In contrast, under accrual accounting the transactions are recorded
when the transaction occurs, regardless of when the cash is received or paid.
Knowing the difference between the cash basis and accrual basis of accounting is necessary to understand the need
for the statement of cash flows. Stakeholders need to know the financial performance (as measured by the income
statement—that is, net income or net loss) and financial position (as measured by the balance sheet—that is, assets,
liabilities, and owners’ equity) of the business. This information is provided in the income statement, statement of
owner’s equity, and balance sheet. However, since these financial statements are prepared using accrual
accounting, stakeholders do not have a clear picture of the business’s cash activities. The statement of cash flows
solves this inadequacy by specifically focusing on the cash inflows and cash outflows.

2.2 Define, Explain, and Provide Examples of Current and Noncurrent Assets,
Current and Noncurrent Liabilities, Equity, Revenues, and Expenses
In addition to what you’ve already learned about assets and liabilities, and their potential categories, there are a
couple of other points to understand about assets. Plus, given the importance of these concepts, it helps to have an
additional review of the material.
To help clarify these points, we return to our coffee shop example and now think of the coffee shop’s assets—items
the coffee shop owns or controls. Review the list of assets you created for the local coffee shop. Did you happen to
notice many of the items on your list have one thing in common: the items will be used over a long period of time? In
accounting, we classify assets based on whether or not the asset will be used or consumed within a certain period of
time, generally one year. If the asset will be used or consumed in one year or less, we classify the asset as a current
asset. If the asset will be used or consumed over more than one year, we classify the asset as a noncurrent asset.
Another thing you might have recognized when reviewing your list of coffee shop assets is that all of the items were
something you could touch or move, each of which is known as a tangible asset. However, as you also learned in
Describe the Income Statement, Statement of Owner’s Equity, Balance Sheet, and Statement of Cash Flows, and
How They Interrelate, not all assets are tangible. An asset could be an intangible asset, meaning the item lacks
physical substance—it cannot be touched or moved. Take a moment to think about your favorite type of shoe or a
popular type of farm tractor. Would you be able to recognize the maker of that shoe or the tractor by simply seeing
the logo? Chances are you would. These are examples of intangible assets, trademarks to be precise. A trademark
has value to the organization that created (or purchased) the trademark, and the trademark is something the
organization controls—others cannot use the trademark without permission.
` EMILIO AGUINALDO COLLEGE ISO 9001:2015 CERTIFIED
QUALITY MANAGEMENT SYSTEM

[Link]
78 Chapter 2 Introduction to Financial Statements

Similar to the accounting for assets, liabilities are classified based on the time frame in which the liabilities are
expected to be settled. A liability that will be settled in one year or less (generally) is classified as a current liability,
while a liability that is expected to be settled in more than one year is classified as a noncurrent liability.

Examples of current assets include accounts receivable, which is the outstanding customer debt on a credit sale;
inventory, which is the value of products to be sold or items to be converted into sellable products; and sometimes
a notes receivable, which is the value of amounts loaned that will be received in the future with interest, assuming
that it will be paid within a year.
Examples of current liabilities include accounts payable, which is the value of goods or services purchased that
will be paid for at a later date, and notes payable, which is the value of amounts borrowed (usually not inventory
purchases) that will be paid in the future with interest.
Examples of noncurrent assets include notes receivable (notice notes receivable can be either current or
noncurrent), land, buildings, equipment, and vehicles. An example of a noncurrent liability is notes payable
(notice notes payable can be either current or noncurrent).

Why Does Current versus Noncurrent Matter?

At this point, let’s take a break and explore why the distinction between current and noncurrent assets and liabilities
matters. It is a good question because, on the surface, it does not seem to be important to make such a distinction.
After all, assets are things owned or controlled by the organization, and liabilities are amounts owed by the
organization; listing those amounts in the financial statements provides valuable information to stakeholders. But
we have to dig a little deeper and remind ourselves that stakeholders are using this information to make decisions.
Providing the amounts of the assets and liabilities answers the “what” question for stakeholders (that is, it tells
stakeholders the value of assets), but it does not answer the “when” question for stakeholders. For example,
knowing that an organization has $1,000,000 worth of assets is valuable information, but knowing that $250,000 of
those assets are current and will be used or consumed within one year is more valuable to stakeholders. Likewise,
it is helpful to know the company owes $750,000 worth of liabilities, but knowing that $125,000 of those liabilities
will be paid within one year is even more valuable. In short, the timing of events is of particular interest to
stakeholders.

THINK IT THROUGH

Borrowing
When money is borrowed by an individual or family from a bank or other lending institution, the loan is
considered a personal or consumer loan. Typically, payments on these types of loans begin shortly after the
funds are borrowed. Student loans are a special type of consumer borrowing that has a different structure for
repayment of the debt. If you are not familiar with the special repayment arrangement for student loans, do a
brief internet search to find out when student loan payments are expected to begin.
Now, assume a college student has two loans—one for a car and one for a student loan. Assume the
person gets the flu, misses a week of work at his campus job, and does not get paid for the absence.
Which loan would the person be most concerned about paying? Why?
` EMILIO AGUINALDO COLLEGE ISO 9001:2015 CERTIFIED
QUALITY MANAGEMENT SYSTEM

[Link]

Equity and Legal Structure

Recall that equity can also be referred to as net worth—the value of the organization. The concept of equity does not
change depending on the legal structure of the business (sole proprietorship, partnership, and corporation). The
terminology does, however, change slightly based on the type of entity. For example, investments by owners are
considered “capital” transactions for sole proprietorships and partnerships but are considered “common stock”
transactions for corporations. Likewise, distributions to owners are considered “drawing” transactions for sole
proprietorships and partnerships but are considered “dividend” transactions for corporations.
As another example, in sole proprietorships and partnerships, the final amount of net income or net loss for the
business becomes “Owner(s), Capital.” In a corporation, net income or net loss for the business becomes retained
earnings, which is the cumulative, undistributed net income or net loss, less dividends paid for the business since
its inception.
The essence of these transactions remains the same: organizations become more valuable when owners make
investments in the business and the businesses earn a profit (net income), and organizations become less valuable
when owners receive distributions (dividends) from the organization and the businesses incur a loss (net loss).
Because accountants are providing information to stakeholders, it is important for accountants to fully understand the
specific terminology associated with the various legal structures of organizations.

The Accounting Equation

Recall the simple example of a home loan discussed in Describe the Income Statement, Statement of Owner’s
Equity, Balance Sheet, and Statement of Cash Flows, and How They Interrelate. In that example, we assumed a
family purchased a home valued at $200,000 and made a down payment of $25,000 while financing the remaining
balance with a $175,000 bank loan. This example demonstrates one of the most important concepts in the study of
accounting: the accounting equation, which is:

In our example, the accounting equation would look like this:

$200,000 = $175,000 + $25,000

As you continue your accounting studies and you consider the different major types of business entities available
(sole proprietorships, partnerships, and corporations), there is another important concept for you to remember. This
concept is that no matter which of the entity options that you choose, the accounting process for all of them will be
predicated on the accounting equation.
It may be helpful to think of the accounting equation from a “sources and claims” perspective. Under this approach,
the assets (items owned by the organization) were obtained by incurring liabilities or were provided by owners.
Stated differently, every asset has a claim against it—by creditors and/or owners.
` EMILIO AGUINALDO COLLEGE ISO 9001:2015 CERTIFIED
QUALITY MANAGEMENT SYSTEM

[Link]

YOUR TURN

The Accounting Equation

On a sheet of paper, use three columns to create your own accounting equation. In the first column, list all of
the things you own (assets). In the second column, list any amounts owed (liabilities). In the third column,
using the accounting equation, calculate, you guessed it, the net amount of the asset (equity).
When finished, total the columns to determine your net worth. Hint: do not forget to subtract the liability from
the value of the asset.
Here is something else to consider: is it possible to have negative equity? It sure is . . . ask any college
student who has taken out loans. At first glance there is no asset directly associated with the amount of the
loan. But is that, in fact, the case? You might ask yourself why make an investment in a college education—
what is the benefit (asset) to going to college? The answer lies in the difference in lifetime earnings with a
college degree versus without a college degree. This is influenced by many things, including the supply and
demand of jobs and employees. It is also influenced by the earnings for the type of college degree pursued.
(Where do you think accounting ranks?)
Solution

Answers will vary but may include vehicles, clothing, electronics (include cell phones and computer/ gaming
systems, and sports equipment). They may also include money owed on these assets, most likely vehicles and
perhaps cell phones. In the case of a student loan, there may be a liability with no corresponding asset (yet).
Responses should be able to evaluate the benefit of investing in college is the wage differential between
earnings with and without a college degree.

Expanding the Accounting Equation

Let’s continue our exploration of the accounting equation, focusing on the equity component, in particular. Recall
that we defined equity as the net worth of an organization. It is helpful to also think of net worth as the value of the
organization. Recall, too, that revenues (inflows as a result of providing goods and services) increase the value of
the organization. So, every dollar of revenue an organization generates increases the overall value of the
organization.
Likewise, expenses (outflows as a result of generating revenue) decrease the value of the organization. So,
each dollar of expenses an organization incurs decreases the overall value of the organization. The same
approach can be taken with the other elements of the financial statements:
Gains increase the value (equity) of the organization.
Losses decrease the value (equity) of the organization.
Investments by owners increase the value (equity) of the organization.
Distributions to owners decrease the value (equity) of the organization.
Changes in assets and liabilities can either increase or decrease the value (equity) of the organization
depending on the net result of the transaction.
A graphical representation of this concept is shown in Figure 2.4.
` EMILIO AGUINALDO COLLEGE ISO 9001:2015 CERTIFIED
QUALITY MANAGEMENT SYSTEM

[Link]

Figure 2.4 Graphical Representation of the Accounting Equation. Both assets and liabilities are categorized as
current and noncurrent. Also highlighted are the various activities that affect the equity (or net worth) of the
business. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

The format of this illustration is also intended to introduce you to a concept you will learn more about in your study
of accounting. Notice each account subcategory (Current Assets and Noncurrent Assets, for example) has an
“increase” side and a “decrease” side. These are called T-accounts and will be used to analyze transactions, which
is the beginning of the accounting process. See Analyzing and Recording Transactions for a more comprehensive
discussion of analyzing transactions and T-Accounts.

Not All Transactions Affect Equity

As you continue to develop your understanding of accounting, you will encounter many types of transactions
involving different elements of the financial statements. The previous examples highlighted elements that change the
equity of an organization. Not all transactions, however, ultimately impact equity. For example, the following do not
impact the equity or net worth of the organization:[10]
Exchanges of assets for assets
Exchanges of liabilities for liabilities
Acquisitions of assets by incurring liabilities
Settlements of liabilities by transferring assets

It is important to understand the inseparable connection between the elements of the financial statements and the
possible impact on organizational equity (value). We explore this connection in greater detail as we return to the
financial statements.

2.3 Prepare an Income Statement, Statement of Owner’s Equity, and

Balance Sheet
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.
` EMILIO AGUINALDO COLLEGE ISO 9001:2015 CERTIFIED
QUALITY MANAGEMENT SYSTEM

[Link]

Elements of the Financial Statements

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.
Revenue—value of goods and services the organization sold or provided.
Expenses—costs of providing the goods or services for which the organization earns revenue.
Gains—gains are similar to revenue but relate to “incidental or peripheral” activities of the organization.
Losses—losses are similar to expenses but related to “incidental or peripheral” activities of the
organization.
Assets—items the organization owns, controls, or has a claim to.
Liabilities—amounts the organization owes to others (also called creditors).
Equity—the net worth (or net assets) of the organization.
Investment by owners—cash or other assets provided to the organization in exchange for an ownership
interest.
` EMILIO AGUINALDO COLLEGE ISO 9001:2015 CERTIFIED
QUALITY MANAGEMENT SYSTEM

[Link]

Distribution to owners—cash, other assets, or ownership interest (equity) provided to owners.

Comprehensive income—defined as the “change in equity of a business enterprise during a period from
transactions and other events and circumstances from nonowner sources” (SFAC No. 6, p. 21). While further
discussion of comprehensive income is reserved for intermediate and advanced studies in accounting, it is
worth noting that comprehensive income has four components, focusing on activities related to foreign currency,
derivatives, investments, and pensions.

Financial Statements for a Sample Company

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)
` EMILIO AGUINALDO COLLEGE ISO 9001:2015 CERTIFIED
QUALITY MANAGEMENT SYSTEM

[Link]

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.

Income Statement
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.
` EMILIO AGUINALDO COLLEGE ISO 9001:2015 CERTIFIED
QUALITY MANAGEMENT SYSTEM

[Link]

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:
The heading of the income statement includes three lines.
The first line lists the business name.
The middle line indicates the financial statement that is being presented.
The last line indicates the time frame of the financial statement. Do not forget the income statement is for
a period of time (the month of June in our example).
There are three columns.
Going from left to right, the first column is the category heading or account.
The second column is used when there are numerous accounts in a particular category (Expenses, in our
example).
The third column is a total column. In this illustration, it is the column where subtotals are listed and net
income is determined (subtracting Expenses from Revenues).
Subtotals are indicated by a single underline, while totals are indicated by a double underline. Notice the
amount of Miscellaneous Expense ($300) is formatted with a single underline to indicate that a subtotal will
follow. Similarly, the amount of “Net Income” ($5,800) is formatted with a double underline to indicate that it is
the final value/total of the financial statement.
There are no gains or losses for Cheesy Chuck’s. Gains and losses are not unusual transactions for
businesses, but gains and losses may be infrequent for some, especially small, businesses.
` EMILIO AGUINALDO COLLEGE ISO 9001:2015 CERTIFIED
QUALITY MANAGEMENT SYSTEM

[Link]
86 Chapter 2 Introduction to Financial Statements

CONCEPTS IN PRACTICE

McDonald’s
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?

Statement of Owner’s Equity

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
` EMILIO AGUINALDO COLLEGE ISO 9001:2015 CERTIFIED
QUALITY MANAGEMENT SYSTEM

[Link]

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

Figure 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 format is similar to the format of the income statement (three lines for the heading, three columns).
The statement follows a chronological order, starting with the first day of the month, accounting for the
` EMILIO AGUINALDO COLLEGE ISO 9001:2015 CERTIFIED
QUALITY MANAGEMENT SYSTEM

[Link]
88 Chapter 2 Introduction to Financial Statements

changes that occurred throughout the month, and ending with the final day of the month.

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).

Balance Sheet
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)
Connecting the Income Statement and the Balance Sheet
Another way to think of the connection between the income statement and balance sheet (which is aided by
` EMILIO AGUINALDO COLLEGE ISO 9001:2015 CERTIFIED
QUALITY MANAGEMENT SYSTEM

[Link]

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.

Statement of Cash Flows

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.

Creating Financial Statements: A Summary

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
` EMILIO AGUINALDO COLLEGE ISO 9001:2015 CERTIFIED
QUALITY MANAGEMENT SYSTEM

[Link]

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.
` EMILIO AGUINALDO COLLEGE ISO 9001:2015 CERTIFIED
QUALITY MANAGEMENT SYSTEM

[Link]

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)
` EMILIO AGUINALDO COLLEGE ISO 9001:2015 CERTIFIED
QUALITY MANAGEMENT SYSTEM

[Link]

THINK IT THROUGH

Financial Statement Analysis

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?

ETHICAL CONSIDERATIONS

Financial Statement Manipulation at Waste Management Inc.

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 form, Arthur Andersen, abetted the fraud by identifying
the improper practices but doing little to stop them.
` EMILIO AGUINALDO COLLEGE ISO 9001:2015 CERTIFIED
QUALITY MANAGEMENT SYSTEM

[Link]

Liquidity Ratios
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.

Working Capital
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.

Current Ratio
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.

Sample Working Capital and Current Ratio Calculations

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
` EMILIO AGUINALDO COLLEGE ISO 9001:2015 CERTIFIED
QUALITY MANAGEMENT SYSTEM

[Link]
94 Chapter 2 Introduction to Financial Statements

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.
` EMILIO AGUINALDO COLLEGE ISO 9001:2015 CERTIFIED
QUALITY MANAGEMENT SYSTEM

[Link]

IFRS CONNECTION

IFRS and US GAAP in Financial Statements

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.
` EMILIO AGUINALDO COLLEGE ISO 9001:2015 CERTIFIED
QUALITY MANAGEMENT SYSTEM

[Link]

Key Terms
accounting equation assets = liabilities + owner’s equity
accounts payable value of goods or services purchased that will be paid for at a later date
accounts receivable outstanding customer debt on a credit sale, typically receivable within a short time
period
accrual basis accounting accounting system in which revenue is recorded or recognized when earned yet not
necessarily received, and in which expenses are recorded when legally incurred and not necessarily when
paid
asset tangible or intangible resource owned or controlled by a company, individual, or other entity with the intent
that it will provide economic value
balance sheet financial statement that lists what the organization owns (assets), owes (liabilities), and is worth
(equity) on a specific date
cash basis accounting method of accounting in which transactions are not recorded in the financial
statements until there is an exchange of cash
common stock corporation’s primary class of stock issued, with each share representing a partial claim to
ownership or a share of the company’s business
comprehensive income change in equity of a business enterprise during a period from transactions and other
events and circumstances from nonowner sources
corporation legal business structure involving one or more individuals (owners) who are legally distinct
(separate) from the business
current asset asset that will be used or consumed in one year or less
current liability debt or obligation due within one year or, in rare cases, a company’s standard operating cycle,
whichever is greater
current ratio current assets divided by current liabilities; used to determine a company’s liquidity (ability to meet
short-term obligations)
distribution to owner periodic “reward” distributed to owner of cash or other assets
dividend portion of the net worth (equity) that is returned to owners of a corporation as a reward for their
investment
elements of the financial statements categories or groupings used to record transactions and prepare
financial statements
equity residual interest in the assets of an entity that remains after deducting its liabilities
expense cost associated with providing goods or services
gain increase in organizational value from activities that are “incidental or peripheral” to the primary
purpose of the business
income statement financial statement that measures the organization’s financial performance for a given period
of time
initial public offering (IPO) when a company issues shares of its stock to the public for the first time intangible
asset asset with financial value but no physical presence; examples include copyrights, patents,
goodwill, and trademarks
inventory value of products to be sold or items to be converted into sellable products
investment by owner exchange of cash or other assets in exchange for an ownership interest in the
organization

liquidity ability to convert assets into cash in order to meet primarily short-term cash needs or emergencies long-
term asset asset used ongoing in the normal course of business for more than one year that is not
intended to be resold
` EMILIO AGUINALDO COLLEGE ISO 9001:2015 CERTIFIED
QUALITY MANAGEMENT SYSTEM

[Link]
long-term liability debt settled outside one year or one operating cycle, whichever is longer
loss decrease in organizational value from activities that are “incidental or peripheral” to the primary
purpose of the business
net income when revenues and gains are greater than expenses and losses net loss when
expenses and losses are greater than revenues and gains noncurrent asset asset that will be
used or consumed over more than one year noncurrent liability liability that is expected to be
settled in more than one year notes payable value of amounts borrowed that will be paid in the
future with interest notes receivable value of amounts loaned that will be received in the future
with interest
partnership legal business structure consisting of an association of two or more people who contribute
money, property, or services to operate as co-owners of a business
publicly traded company company whose stock is traded (bought and sold) on an organized stock
exchange
retained earnings cumulative, undistributed net income or net loss for the business since its inception
revenue inflows or other enhancements of assets of an entity or settlements of its liabilities (or a
combination of both) from delivering or producing goods, rendering services, or other activities that
constitute the entity’s ongoing major or central operations
Securities and Exchange Commission (SEC) federal regulatory agency that regulates corporations with
shares listed and traded on security exchanges through required periodic filings
short-term asset asset typically used up, sold, or converted to cash in one year or less
short-term liability liability typically expected to be paid within one year or less sole
proprietorship legal business structure consisting of a single individual
stakeholder someone affected by decisions made by a company; may include an investor, creditor,
employee, manager, regulator, customer, supplier, and layperson
statement of cash flows financial statement listing the cash inflows and cash outflows for the business for a period
of time
statement of owner’s equity financial statement showing how the equity of the organization changed for a period
of time
tangible asset asset that has physical substance
working capital current assets less current liabilities; sometimes used as a measure of liquidity