Chapter 1: Introduction to Financial Statements

Types of businesses

Sole proprietorship: A business owned by one person. This is the simplest and most common
business set up. The advantage is that the owner retains full business control.

Partnership: A business owned by two or more people. This structure allows owners to pool
resources and even combine distinct strengths/skillsets.

Corporation: A business structure which creates a separate legal entity. A corporation is

owned by stockholders and may be traded on a stock exchange such as the TSX or NYSE.

Users of financial information

This group can be small or large depending on the nature and size of the business. Some
common users are:

• Managers (internal) – Individuals and managing groups rely on accurate, timely, and
relevant information in their decision-making.
• Creditors/suppliers (external)- Banks and other lenders analyze risk and business
viability prior to extending credit.
• Shareholders (external)- Investors rely on assets, business performance, etc as a
predictor of future profitability.

• Government/regulatory authorities (external)- taxation and regulation relies on

financial results.

Income Statement

The income statement reports a company’s revenues, expenses, and resulting net
income/loss over a specific period of time (ex. month, quarter, year). The income calculation
is as follows:

Revenue: Amount of money earned through business activity, such as sales, services, or
interest.

Expense: Amount of money spent through business activity, such as salary, rent, or supplies.

Let’s try some quick questions:

Question: If a business generated $50,000 in revenues and $40,000 in expenses last year,
what was the net profit?

______________________________________________
Question: If a business generated $30,000 in revenues and $40,000 in expenses last year,
what was the net profit/loss?

______________________________________________

And now, let’s take a look at an income statement:

UCW Bookstore
Income Statement
For the Years Ended December 31, 2021 and 2020

2021 2020
Revenues
Sales Revenue $472,500 $460,000
Service Revenue 253,500 210,000
Total Revenues _____ 670,000

Expenses
Operating expenses:
Cost of Goods Sold 200,000 175,000
Salary expense 300,000 275,000
Rent expense 100,000 100,000
Utilities expense 50,000 50,000
Amortization expense 16,000 20,000
Total operating expenses _____ 620,000
Operating profit 50,000
Interest expense 15,000 24,000
Net Income before taxes 26,000
Income tax expense 10,000 6,000
Net Income $ . $20,000

Note the proper format of the income statement. The company name is at the top, followed
by the nature of the document and the time period covered. Having multiple years side-by-
side allows the user to easily compare company performance. Let’s talk about where some
of the numbers come from:

Revenues

The bookstore’s primary business function is selling textbooks and office supplies. The
second, non-traditional, service offered by the bookstore is IT support which includes
computer repair and software installation services. As accountants, we would expect to see
two sources of revenue on the income statement.
Expenses

There are a bunch of expenses, so let’s touch on the major ones:

Cost of Goods Sold: To sell books and office supplies to students, the bookstore must first
buy them from its suppliers. This is a business expense which is recorded when the goods
are sold.

Salary expense: Payments to employees and contractors are recorded as an expense.

Rent expense: The bookstore is run from a physical location and rents a small space within
the UCW campus. The bookstore pays its own utilities expenses (heat, water, electricity).

Retained Earnings Statement

Like the income statement, the retained earnings statement covers a specific time period.
This statement shows changes in retained earnings. Let’s have a look at an example:

UCW Bookstore
Statement of Retained Earnings
For the Years Ended December 31, 2021 and 2020

Retained earnings: 2021 2020

Balance, beginning of year $130,000 $114,000
Net income 20,000
Less: dividends and other 7,000 4,000
distributions to shareholders
Balance, end of year $ . $130,000

Once again, note the lines at top (similar to the income statement). Another important point
is the ending retained earnings balance of the past year is the beginning retained earnings
balance of the current year. The net income number is carried in from the income
statement, but the retained earnings balance only increases by the net amount remaining
after dividends are paid out.

Balance Sheet

The balance sheet is best described as a statement which embodies the accounting
equation:

As the formula suggests, the total value of assets owned by a business MUST equal the value
of the liabilities and owner’s equity. Liabilities are often referred to as Debt and Owner’s
Equity can be shortened to Equity.

Assets: economic resources controlled by an entity that are expected to provide current/
future benefit to the business i.e., cash, office supplies, merchandise inventory, land,
machinery/equipment.
Liabilities/Debt: debts payable to outside parties such as creditors, suppliers, employees,
governments i.e., accounts payable, notes payable, salaries payable, taxes payable.

Owner’s equity/Equity: the amount of an entity’s assets which remain after the liabilities
are subtracted (can also be called net assets).

Question: If a business has $100,000 worth of assets and bank debt of $30,000, how much
equity does it have?

______________________________________________
To understand equity at a fundamental level, we should define two basic terms:

Owner investment: When an owner or investor adds funds or other assets into the business,
this results in an increase in equity.

Owner withdrawal: When an owner or investor takes funds or other assets out of the
business, this results in a decrease in equity.

Question: If the business owner withdraws $20,000 from the company for home repairs,
how much equity is now in the business?

______________________________________________
Question: If the business owner transfers her old vehicle (worth $5,000) to the business,
how much equity is now in the business? Assume there was $70,000 of equity before the
transfer.

______________________________________________
Let’s have a look at the UCW Bookstore’s balance sheet:

UCW Bookstore
Balance Sheet
December 31, 2021 and December 31, 2020

Assets
2021 2020
Current Assets:

Cash $200,000 $170,000

Accounts receivable 5,000 15,000
Inventory 440,000 430,000

Total current assets 615,000

 Fixed Assets
Furniture 30,000 30,000
Accumulated Depreciation- (10,000)
Furniture (8,000)
Furniture, net 22,000
Equipment 50,000 50,000
Accumulated Depreciation- Equipment (20,000) (6,000)
Equipment, net ________ 44,000
Total Assets $ .$ $681,000
Liabilities and
Shareholders' Equity
Current Liabilities:
Accounts Payable 5,000 5,000
Long-Term Debt
Bank Loan 232,000 246,000
Total Liabilities 251,000
Shareholders' Equity
Common Shares 300,000 300,000
Retained Earnings 158,000 130,000
Total Shareholders' Equity ___ ____ 430,000
$ .

$681,000 .

Total Liabilities and Shareholders' Equity .

Note that there is a significant difference between the balance sheet and the two previous
statements we looked at. The balance sheet doesn’t show a time period, but rather a single
day. This is because the balance sheet is a “snapshot” of the company’s financial position at
a given point in time.

The first part of the accounting equation, the assets, are summed up at the top of the
balance sheet, while liabilities and equity are summed up (to the same amount) at the
bottom. Note that the retained earnings number is brought in from the Statement of
Retained Earnings.

Looking at the balance sheet carefully raises some additional questions about the business,
so let’s analyze some more details about the business:

The bookstore has typical assets- some shelves to store books, some furniture to conduct
sales, and some specialized equipment for trouble shooting and fixing computers. There is
also inventory on hand so common books and office supplies can be offered for sale on site.
A bank loan was taken out to help fund operations as the money contributed by
shareholders wasn’t enough to cover all the start-up costs. The shareholders receive 20% of
net income as dividends each year. Extra cash is typically used to repay the bank loan.

The bookstore’s balance sheet paints an accurate picture of what is happening with the
business. In the assets section, we see equipment and furniture. In the liabilities and
shareholders’ equity section, we see the bank loan and common shares, which the company
is using for financing its operations. Note that we also saw dividends being paid out in the
Statement of Retained Earnings.

Cash Flow Statement

As its name suggests, the cash flow statement provides details about cash inflows and
outflows. This financial statement has three major sections:

Operating activities: These are cash items which are tied to the company’s core business
practices (operations). The calculation starts with the net income figure from the income
statement. Then, an adjustment is made for non-cash items that are in the net income
number. A good example of this is amortization expense, which doesn’t involve disbursing
cash like other expenses (salary, rent, etc). In this case, the $16,000 expense is added back
to the net income number.

Investing activities: The purchase of long-term/capital assets is considered to be an

investment by the company. Hence, buying equipment or furniture would result in a cash
outflow, while selling them would be a cash inflow. In this case, no capital assets were
bought or sold, so this section shows a net cash flow of $0.

Financing activities: This section tallies the cash inflows and outflows related to equity and
debt financing. In this case, we don’t have any new financing, but dividends were paid to
common shareholders and some debt was repaid this year.

Let’s have a look at the UCW’s Cash Flow Statement:

UCW Bookstore
Cash Flow Statement
For the Years Ended December 31, 2021 and 2020

2021 2020
Cash Flows- Operating Activities
Net Income $35,000 $20,000
Adjustments to reconcile net income to net cash provided by
16,000 20,000
operating activities
Net cash provided by operating activities ____ 40,000

Cash Flows- Investing Activities

Purchases of property, plant, and equipment 0 0
Sales of property, plant, and equipment 0 0
 Net cash used in investing activities __ 0

Cash Flows- Financing Activities

Issuance of common stock 0 0
Issuance of short and long-term debt 0 0
Repayment of short and long-term debt (14,000) (10,000)
Payment of dividends and other distributions to shareholders (7,000) (4,000)
Net cash used in financing activities ____ (14,000)

Net Increase in Cash and Cash Equivalents 26,000

Cash and Cash Equivalents- Beginning of Year ______ 144,000
Cash and Cash Equivalents- End of Year $ . $170,000

Note that the cash flow statement covers a period of time like the income statement. Also,
this statement relies on inputs from several financial statements. As mentioned, the net
income number is transferred from the income statement. The amortization expense, which
is also on the income statement, is deducted. Purchases of property, plant, and equipment
can be determined by analyzing year-to-year changes in the balance sheet, as can debt and
equity issues. Again, the sum of dividend payments are included in the statement of retained
earnings. Finally, the beginning cash balance is carried in from the balance sheet.

Some final points about the financial statements:

• This is an example of an extremely basic retail and service business model: As

accountants are asked to prepare financial statements for bigger and more complex
businesses, reporting tends to get tougher, and more judgement based. Often,
accountants must rely on their professional judgement over knowledge of the rules
since there cannot be clear rules for every single situation.

• There are common rules and practices which should be followed on all financial
statements: You will notice that some elements we just covered are staples of all
financial statements out there. As accountants, we should familiarize ourselves with
these concepts and practice them in our own work. Some common practices are:

• Organization of financial statement items in a readable and understandable format

• Use of appropriate headings which clearly state the financial statement type,
business name, and date/period being reported
• Dollar symbol ($) only shown with the first and last items of a financial statement
• A double underline beneath the major totals of a financial statement
• Negative numbers presented in brackets