Third Year Accounting Major

Chapter three: Financial Statements

1. What is Financial Statements?
Financial Statements are formal, structured reports that summarize a company's financial
activities and position over a specific period of time. They are essential tools used by managers,
investors, creditors, and regulators to assess a company's performance and health.

The Four Core Financial Statements:

Statement Purpose What It Shows

Assets (what it owns), Liabilities

Shows a company's financial position
1. Balance Sheet (what it owes), and Owner's Equity
at a single point in time.
(owner's claim).

Revenues earned and Expenses

2. Income Shows a company's financial
incurred, resulting in Net Income
Statement performance over a period of time.
(profit) or Net Loss.

Shows the details of changes in the

3. Statement of How Net Income and Dividends
owner's investment (equity) over a
Changes in Equity affect Retained Earnings.
period of time.

Shows the movement of cash both

4. Statement of Cash generated from Operating,
into and out of the company over a
Cash Flows (SCF) Investing, and Financing activities.
period of time.

The Balance Sheet, or Statement of Financial Position, is one of the four core financial
statements. It provides a snapshot of a company's financial health at a specific point in time. The
primary section covered here is Assets, along with the related accounting concept of
Depreciation.

2. The Balance Sheet: Assets

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The Balance Sheet is governed by the fundamental Accounting Equation:

Assets=Liabilities+Owner’s Equity

Assets are resources controlled by the company as a result of past transactions and from which
future economic benefits are expected to flow to the entity.

Assets are generally categorized by liquidity (how quickly they can be converted to cash):

 Current Assets

These are expected to be converted into cash, sold, or consumed within one year or one
operating cycle, whichever is longer.

o Examples: Cash, Accounts Receivable (money owed by customers), Inventory,

and Prepaid Expenses.
 Non-Current (Long-Term) Assets

These are resources held for more than one year and are used in the operation of the
business.

o Examples: Property, Plant, and Equipment (PP&E), Long-Term Investments, and

Intangible Assets (e.g., patents, goodwill).

Depreciation Methods
Depreciation is the accounting process of allocating the cost of a tangible non-current asset
(like machinery, buildings, or vehicles) over its estimated useful life. This process is required by
the Matching Principle because the expense of using the asset must be matched with the revenue
the asset helps generate.

Depreciation applies to PP&E; it does not apply to land, which is not considered to be consumed
over time.

Key Terms

 Cost: The original purchase price plus all costs necessary to get the asset ready for its
intended use.
 Salvage (or Residual) Value: The estimated market value of the asset at the end of its
useful life.
 Useful Life: The expected period over which the asset will be used by the company.

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 Third Year Accounting Major

 Book Value: The asset's original cost minus its accumulated depreciation (the total
depreciation recorded up to a specific date).

Common Depreciation Methods

Method Description Formula (Annual Depreciation)

Spreads the cost evenly over

1. Straight-Line the asset's useful life. This is /
(Cost−Salvage Value) Useful Life in Years
the most common method.

Records more depreciation

2. Double-
Declining Balance
expense in the early years of
an asset's life and less in later
2× Book Value (Beginning of Year) /
(Accelerated) Useful Life
years.

Depreciates the asset based on (Cost−Salvage Value×Actual Units Produced )

3. Units-of- its actual usage (e.g., miles
Production driven, hours run) rather than /
Total Estimated Production
time.

2. The Balance Sheet (Liabilities/ the Owners' Equity) :

The Balance Sheet, or Statement of Financial Position, presents what a company owes
(Liabilities) and the residual claim held by its owners (Owners' Equity) at a specific point in
time.

The relationship between these two components and the company's assets is defined by the
fundamental Accounting Equation:

Assets= Liabilities+ Owners’ Equity

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Liabilities (What the Company Owes)

Liabilities are obligations of the company to outside parties (creditors, suppliers, or the
government) that result from past transactions and require a future outflow of economic benefits
(usually cash).

Liabilities are categorized based on their due date:

 Current Liabilities

These are obligations that are expected to be paid or settled within one year or one
operating cycle, whichever is longer.

o Examples: Accounts Payable (money owed to suppliers), Salaries Payable

(unpaid wages), Unearned Revenue (cash received for goods/services not yet
delivered), and the Current Portion of Long-Term Debt.
 Non-Current (Long-Term) Liabilities

These are obligations that are not due for more than one year.

o Examples: Notes Payable (long-term bank loans), Bonds Payable, and long-term
deferred tax liabilities.

Owners' Equity (The Owners' Claim)

Owners' Equity represents the residual claim on the assets of the company after deducting its
liabilities. In other words, it is the amount that would be left for the owners if all assets were sold
and all debts were paid.

For corporations, this section is called Stockholders' Equity and generally consists of two main
parts:

1. Contributed Capital

This is the amount of funds directly invested into the company by its owners
(shareholders) in exchange for stock.

o Key Account: Common Stock and Additional Paid-in Capital.

2. Retained Earnings

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This represents the cumulative net income that the company has earned since its
inception, minus all the dividends that have been paid out to shareholders.

o Formula: Beginning Retained Earnings

+Net Income−Dividends=Ending Retained Earnings.
o The Internal Link

Retained Earnings acts as a critical link between the Income Statement (which calculates Net
Income) and the Balance Sheet. The final balance of Equity is transferred to the Balance Sheet to
ensure the Accounting Equation remains in balance.

3. What is Income Statement?

The Income Statement, also known as the Profit and Loss (P&L) Statement or Statement of
Operations, is a financial statement that reports a company's financial performance over a
specific period of time (e.g., a month, quarter, or year). Its primary purpose is to show how
effectively a company generates profit by comparing its revenues and expenses. The result, or
"bottom line," is the company's Net Income or Net Loss.

The Basic Structure

The Income Statement follows a specific structure based on the formula:

Revenue−Expenses=Net Income (or Net Loss)

1. Revenue

This represents the inflows of assets (usually cash or accounts receivable) from delivering goods
or services, or from other business activities.

2. Expenses

These are the costs incurred by the company to generate revenue. Key expenses include:

 Cost of Goods Sold (COGS): The direct cost of producing the goods sold by a company.
 Operating Expenses: Costs related to the company's main operations, such as salaries,
rent, utilities, and marketing.
 Depreciation and Amortization: Non-cash expenses that allocate the cost of long-term
assets over time.

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3. Net Income (or Net Loss)

This is the final result when all expenses and losses are subtracted from all revenues and gains. 6
Net Income represents the increase in owner's equity resulting from profitable operations during
the period.

Key Measures of Profitability

The Income Statement often separates profitability into several key stages:

 Gross Profit: Sales Revenue minus Cost of Goods Sold (Revenue−COGS). This shows
the profit before operating expenses.

 Operating Income: Gross Profit minus Operating Expenses. This measures the profit
generated solely from the company's core business activities.
 Net Income: The final profit after all non-operating items (like interest expense and
taxes) have been deducted.

Net Income is a critical figure because it is transferred to the Statement of Changes in Equity,
specifically impacting the Retained Earnings balance on the Balance Sheet, demonstrating the
essential interconnectedness of the financial statements.

4. The Statement of Changes in Equity

The Statement of Changes in Equity (or Statement of Stockholders' Equity) is a financial
statement that provides a detailed reconciliation of the balance of a company's equity accounts
from the beginning to the end of a specific reporting period.

Its primary purpose is to show how and why the owners' (shareholders') stake in the company
changed during that time.

Key Components :The statement tracks changes across the main equity accounts, but focuses heavily
on Retained Earnings.

1. Retained Earnings (RE)

Retained Earnings is the cumulative total of a company's profits (net income) that have been kept
and reinvested in the business, rather than paid out as dividends.

The basic flow for Retained Earnings is:

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Beginning RE Balance+Net Income (or−Net Loss)−Dividends Paid=Ending RE Balance

2. Contributed Capital

This includes accounts like Common Stock and Additional Paid-in Capital, which reflect the
funds raised directly from investors (owners) when the company issues new shares.

3. Treasury Stock

This records shares that the company has bought back from the open market. This reduces total
equity.

The Essential Link

The Statement of Changes in Equity is crucial because it acts as the primary link between the
Income Statement and the Balance Sheet:

 Input from the Income Statement: The Net Income (or Net Loss) figure calculated on
the Income Statement is added to (or subtracted from) the Retained Earnings on this
statement.
 Output to the Balance Sheet: The resulting Ending Balance of Equity (specifically the
ending Retained Earnings balance) is carried directly to the Balance Sheet to satisfy the
Accounting Equation : Assets= Liabilities + Equity.

5. The Statement of Cash Flows: Tracking the movement of Cash

The Statement of Cash Flows (SCF) is a vital financial statement that reports the actual cash
inflows (receipts) and cash outflows (payments) of a company over a specific period of time.

Its primary purpose is to explain the change in the company's cash balance from the beginning of
the period to the end, focusing on liquidity and solvency, rather than just profitability (which is
measured by the Income Statement's Net Income).

The Three Core Activities

The Statement of Cash Flows is structured around the three main categories of business activity,
as every cash transaction must fall into one of these buckets:

1. Operating Activities (CFO)

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These cash flows are derived from the company's normal, day-to-day revenue-producing
activities. It essentially shows the cash generated from selling goods and services.

 Inflows: Cash received from customers, cash received from interest and dividends.
 Outflows: Cash paid to suppliers, cash paid for salaries and operating expenses, cash paid
for taxes.

2. Investing Activities (CFI)

These cash flows result from the purchase and sale of long-term assets (resources needed to
operate the business), such as property, plant, and equipment (PP&E).

 Inflows: Cash received from selling PP&E, cash received from selling long-term
investments.
 Outflows: Cash used to buy PP&E, cash used to buy long-term investments.

3. Financing Activities (CFF)

These cash flows involve transactions with the company's owners (equity) and lenders (debt).

 Inflows: Cash received from issuing new stock, cash received from taking out long-term
loans.
 Outflows: Cash paid to repay loans, cash paid to repurchase stock (Treasury Stock), cash
paid for dividends to shareholders.

The Cash Flow Formula

The final line of the Statement of Cash Flows confirms the total movement of cash:

Net Change in Cash=CFO+CFI+CFF

The total Net Change in Cash added to the cash balance at the beginning of the period must
equal the cash balance reported on the Balance Sheet at the end of the period, demonstrating the
interconnectedness of all the financial statements.

6. Conclusion
In conclusion, the four primary financial statements—the Balance Sheet, the Income Statement,
the Statement of Changes in Equity, and the Statement of Cash Flows—are indispensable tools

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for assessing a company's financial position and performance. We have established that these
reports are interdependent and must be analyzed together. By understanding the components of
Assets, Liabilities, and Equity, the calculation of Net Income, and the classification of Cash
Flows into operating, investing, and financing activities, you are now well-equipped to interpret
the true story behind any company's numbers.

References:
 Financial Statement Analysis by Dr. Jitendra Sonar - (English): SBPD
Publications. (2020). (n.p.): SBPD Publications.PP47
 Spurga, R. C. (2004). Balance Sheet Basics: Financial Management for Nonfinancial
Managers. United States: Penguin Publishing Group.
 Income Statements. (2025). Norway: Publifye AS.
 Epstein, B. J., Jermakowicz, E. K. (2008). Wiley IFRS 2008: Interpretation and Application of
International Accounting and Financial Reporting Standards 2008. Spain: Wiley.
 Berkau, C. (2022). Financial Statements: International Accounting (IFRS). Germany: UVK Verlag.
 Financial Accounting: Concepts Standards and Analysis. (2025). (n.p.): Chyren Publication.

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