Chapter 2:

The Financial Statements

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Flow of Capital

2
 Business Activities
 Business activities are reflected in financial
statements; business activities include:
– Operating activities – production and
selling goods and services.
– Investing activities – acquisition and sale
of productive assets.
– Financing activities – issue and
retirement/repayment of liabilities and
equity.

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 Financial Statements
 Financial statements report the
company activity during the year and
the financial condition of the company at
the end of the year.
 The required financial statements are:
– Balance Sheet
– Income Statement
– Statement of Stockholders’ Equity
– Statement of Cash Flows
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 The Balance Sheet
 The balance sheet reports the financial
position at a point in time (end of the
quarter or year).
 The balance sheet is divided into three
major categories:
– Assets
– Liabilities
– Stockholders’ equity

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Balance Sheet

6
 The Balance Sheet
 The balance sheet is represented by the
fundamental accounting equation:
Assets = Liabilities + Stockholders’ Equity
A = L + SE
 The effects of all described business
transactions may be represented in this
formula.
 Asset and Liability accounts are typically
grouped into more detailed classifications
leading to the Classified Balance Sheet
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 The Balance Sheet (B/S)
 Assets - represent future benefit to the
company, and are classified in order of
liquidity (current assets; property, plant and
equipment; long-term investments)
 Liabilities - represent obligations of the
company, and are classified according to
payment date (current liabilities, long-term
liabilities)
 Stockholders’ equity - represents the residual
claims of the owners, and is classified based
on source (contributed capital and retained
earnings)
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 B/S Assets: Current Assets
 Current assets include
– Cash: checking and savings accounts;
petty cash.
– Short-term investments: investments in
stocks and bonds of other companies.
– Accounts receivable: amounts owed to a
company from its customers.
– Inventory: products on hand designated
for sale to customers.
– Prepaid expenses: amounts paid for
future expenses.
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 B/S Assets:
Property, Plant and Equipment
 Property, plant, and equipment are assets
that are used in the production of goods and
services. These productive assets are long-
term in nature, and include the following:
– Land: property upon which the productive
facilities are located.
– Building: the physical structure of the
company’s operations.
– Machinery and Equipment: include
operating machinery, vehicles, computers,
copy machines, etc.
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B/S Assets: Long-term Investments
 Long-term investments are assets acquired by
the company to provide long-term benefits to the
company. Long-term investments include:
– Long-term notes receivable owed to the
company (from customers or others).
– Investments in stock of other companies:
held for expectation of dividends and/or stock
price increase.
– Investment in bonds of other companies: held
for expectation of dividends and/or stock price
increase.
– Other assets, like land, held for the long term.

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 B/S Assets: Intangible Assets
 Intangible assets are long-lived assets that
have no physical substance. Examples
include:
– Patents: legal claim to produce and sell a
product.
– Copyrights: legal claims to books, art,
music and other created works.
– Goodwill: recognized when one company
buys another company, and the purchase
price is greater than the fair value of the
identifiable net assets.

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B/S Liabilities: Current Liabilities
 Current liabilities are obligations expected to
be paid (or services expected to be
performed) within the next year or operating
cycle. The elimination of the current liabilities
requires the use of current assets (most
commonly cash). Examples include:
– Accounts payable
– Wages payable
– Interest payable
– Short-term notes payable
– Current maturities of long-term debt
– Deferred (unearned) revenues

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B/S Liabilities: Long-term Liabilities
 Long-term liabilities are obligations expected to
require payments beyond the current year.
Examples of long-term liabilities include:
– Notes payable: amounts owed to banks and
other creditors beyond the current year.
– Mortgage payable: amounts owed to
mortgage company beyond the current year.
– Bonds payable: amounts owed to investors
holding bond investments issued by the
company, where payments of principal and
interest are beyond the current year.

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 B/S Stockholders’ Equity:
Contributed Capital
 Contributed capital is generated when owners
(shareholders) of the company contribute
cash and other assets into the company.
Components of contributed capital include
– Common stock: shares of stock issued to
owners to reflect ownership.
– Additional paid in capital (Paid-in capital in
excess of par value): excess amounts
contributed by shareholders for various
activities.
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 The Income Statement (I/S)
 The income statement shows the
components of net income in detail.
 Revenues represent the inflow of assets
(or decrease in liabilities) due to a
company’s operating activities.
 Expenses represent the outflow of assets
(or increases in liabilities) due to a
company’s operating activities.
 The general formula for the I/S is:
Revenues - Expenses = Net Income

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The Income Statement Format
Operating revenues
Sales
Fees earned
Other revenues
Less: Operating expenses
Cost of goods sold
Wage expense
Rent expense
Selling expense
Depreciation expense
Other expenses
Net Income
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Income Statement
 B/S Stockholders’ Equity:
Retained Earnings
 Retained earnings represent the excess
earnings retained in the company after
dividends have been paid to shareholders.
This represents the equity generated by
the company for the shareholders.

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 The Statement
of Stockholders’ Equity (SSE)
The following formula represents the
basic SSE:
Beginning stockholders’ equity
Plus: Issuance of stock
Plus: Net income
Less: Dividends
Ending stockholders’ equity
SEBegin + Issue + NI - D = SEEnd
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 The Statement
of Retained Earnings
The statement of retained earnings is a
subset of the SSE, and calculates the
changes in the retained earnings component.
Beginning retained earnings
Plus: Net income
Less: Dividends
Ending retained earnings
REBegin + NI - Div = REEnd
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Statement of Shareholders’ Equity

Harbour Island Company

Statement of Shareholders’ Equity
For the Year Ended December 31, 2019

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22
 The Statement of Cash Flows
 Cash flows from operating activities:
– Collections from sales, rent, interest, etc.
– Cash paid to suppliers and employees, and for
rent, selling activities, interest, and taxes etc.
 Cash flow from investing activities:
– Proceeds from sale of investment securities,
land, buildings, equipment, etc.
– Purchase of investment securities, land,
buildings, equipment, etc.
 Cash flow from financing activities:
– Proceeds from issuance of notes, debt, sale of
equity, etc.
– Payments on notes, debt, dividends, etc.
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Statement of Cash Flows

24
 Relationships Among the
Financial Statements
Beginning
Balance Sheet Ending
Balance Sheet
Assets Statement of Assets
(Cash) Cash Flows (Cash)

Income
Statement
= =
Liabilities Liabilities
+ +
Equity Statement of Equity
Stockholders’ Equity
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Income Statement
Statement of Shareholders’ Equity

Harbour Island Company

Statement of Shareholders’ Equity
For the Year Ended December 31, 2019

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27
Balance Sheet

28
Statement of Cash Flows

29
International Perspective – Balance Sheet
• Many non-U.S. firms that publish IFRS-based balance
sheets add shareholders’ equity to non-current liabilities,
referring to the total as capital employed. Consequently,
the balance sheet format looks like:
Non-current assets + Current assets - Current
liabilities = Non-current liabilities + Shareholders’
equity

• Under U.S. GAAP balance sheet accounts are listed in

order of liquidity. Many non-U.S. firms that publish IFRS-
based balance sheets list their assets in the opposite
order, starting with non-current assets, followed by
current assets.

• Many non-U.S. companies, especially in Europe, use the

term “turnover” instead of revenue.
 Exercise 2-3
Balance Sheet (B) or Income Statement (I)
a. Equipment
b. Fees Earned
c. Retained Earnings
d. Wage Expense
e. Patent
f. Cost of Goods Sold
g. Common Stock
h. Dividend Payable
i. Accumulated Depreciation
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 Exercise 2-3
Balance Sheet (B) or Income Statement (I)
j. Prepaid Expense
k. Gain on Sale of Short-term Investment
l. Rent Revenue
m. Supplies Inventory
n. Accounts Receivable
o. Land
p. Insurance Expense
q. Interest Payable
r. Unearned Revenue
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 Exercise
Given (in billions): 2020 2019 2018
Beginning RE ? 1.3 1.2
Revenues 4.4 4.1 3.9
Expenses 3.9 ? 3.5
Div. declared .3 .3 ?
Ending RE 1.6 ? ?
Now, using the following formulas and
relationships, solve for the other missing items:
(1) Rev - Exp = NI
(2) RE(B) + NI - Div = RE(E)
(3) RE(E) becomes RE(B) in the next year
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 Exercise
Solve for RE(B) using:
RE(B) + NI - Div = RE(E)
2020
NI = 4.4 – 3.9
RE(B) + (4.4 - 3.9) - .3 = 1.6
RE(B) = 1.4

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 Exercise
2019
First, find RE(E):
RE(E) 2014 = RE(B) 2015 = 1.4

Now find Expenses:

RE(B) + NI - Div = RE(E)
1.3 + (4.1 - Exp) - .3 = 1.4
5.1 - Exp = 1.4
Exp = 3.7
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 Exercise
2018
First, find RE(E):
RE(E) 2013 = RE(B) 2014 = 1.3

Now find Div:

RE(B) + NI - Div = RE(E)
1.2 + (3.9 - 3.5) - Div = 1.3
1.6 - Div = 1.3
Div = 0.3
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