Chapter 7.

Main Accounts and relationships

among financial statements
María José García López
FINANCIAL STATEMENTS

„ THEY ARE:
‰ INCOME STATEMENT
‰ STATEMENT OF RETAINED EARNINGS
‰ BALANCE SHEET
‰ STATEMENT OF CASH FLOWS

„ EACH OF THEM PROVIDES A DIFFERENT

INFORMATION ABOUT THE COMPANY

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 Question Answer Financial Statement
1. How well did the Revenues Income statement
company perform -Expenses (Statement of
during the period? Net income (loss) operations or
Statement of
earnings)

2. Why did the Beginning R.E. Statement of retained

company’s retained +Net income (-loss) earnings (Statement
earnings change -Dividends of stockholders’
during the period? Ending R.E. equity)

3. What is the Assets = Liabilities + Balance sheet

company’s financial Owners’ (Statement of
position at the end of Equity financial position)
the period?

4. How much cash did Operating cash flows Statement of cash

the company + Investing cash flow flows
generate and spend +Financing cash flow
during the period? Increase (decrease)
in cash during the
period
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Income Statement
How well did the company perform during the
month?

Revenues
– Expenses
Net Income (Loss)

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 INCOME STATEMENT
„ It is also known as Statement of Operations

„ It reports the company’s revenues, expenses,

and net income or net loss for the period

„ It is referred to one fiscal year (12 months)

‰ It may be different from the calendar year

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Income Statement
„ Two main categories of items on the Income
Statement:
‰ Revenues and Gains
‰ Expenses and Losses

Net Income = Revenues and Gains - Expenses and Losses

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María José García López
FINANCIAL STATEMENTS OF AIR & SEA TRAVEL, INC.

AIR & SEA TRAVEL, INC.

Income Statement
Month Ended April 30, 2001

Revenue:
Service revenue $8,500

Expenses:
Salary expense $1,200
Rent expense 1,100
Utilities 400
Total expenses 2,700
Net Income $5,800

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María José García López
 INCOME STATEMENT
„ Revenues are
‰ Increases in retained earnings from delivering
goods or services to customers or clients
‰ Its main source are the company’s sales
„ Expenses are
‰ Decreases in retained earnings that result from
operations
‰ Company incurs in them in order to operate

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 INCOME STATEMENT
„ REMEMBER: REVENUE RECOGNITION PRINCIPLE

„ The revenue recognition principle dictates that

revenue should be recognized in the accounting period
in which it is earned. But applying this general principle
in practice can be difficult. Some companies improperly
recognize revenue on goods that have not been shipped
to customers. Similarly, until recently, financial
institutions immediately recorded a large portion of their
loan fees as revenue rather than spreading those fees
over the life of the loan

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María José García López
 INCOME STATEMENT
„ When a sale is involved, revenue is recognized at the
point of sale. This sales basis involves an exchange
transaction between the seller and the buyer. The sales
price is an objective measure of the amount of revenue
realized. However, two exceptions to the sales basis for
revenue recognition have become generally accepted—
the percentage-of-completion method and the
installment method. These methods are left for more
advanced courses

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 INCOME STATEMENT
„ REMEMBER MATCHING PRINCIPLE

„ Expense recognition traditionally is tied to revenue

recognition: “Let the expense follow the revenue.” This
practice is referred to as the matching principle. It
dictates that expenses be matched with revenues in the
period in which efforts are made to generate revenues.
Expenses are not recognized when cash is paid, or
when the work is performed, or when the product is
produced. Rather, they are recognized when the labor
(service) or the product actually makes its contribution to
revenue.
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 INCOME STATEMENT
„ But, it is sometimes difficult to determine the
accounting period in which the expense
contributed to revenues. Several approaches
have therefore been devised for matching
expenses and revenues on the income
statement.

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 INCOME STATEMENT
„ To understand these approaches, you need to
understand the nature of expenses. Costs are the source
of expenses. Costs that will generate revenues only in
the current accounting period are expensed immediately.
They are reported as operating expenses in the income
statement. Examples include costs for advertising, sales
salaries, and repairs. These expenses are often called
expired costs

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 INCOME STATEMENT
„ Costs that will generate revenues in future
accounting periods are recognized as assets.
Examples include merchandise inventory,
prepaid expenses, and plant assets. These
costs represent unexpired costs. Unexpired
costs become expenses in two ways:

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 INCOME STATEMENT
„ Expenses include
‰ Cost of goods sold (cost of sales)
„ The cost of the goods that a company sold to its
customers
‰ Operating expenses
„ The costs of operating the business

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 INCOME STATEMENT
„ Operating expenses
‰ Advertising
„ The cost to promote the company’s products
‰ Depreciation
„ The expense of using company-owned buildings,
equipment, and furniture
‰ Other operating expenses
„ The costs of salaries, utilities, rent, and supplies
‰ Interest expense
„ The cost of borrowed money

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INCOME STATEMENT

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Balance Sheet

What is the company’s financial position at the

end of a period?

Assets = Liabilities + Owner’s Equity

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FINANCIAL STATEMENTS OF AIR & SEA TRAVEL, INC.

AIR & SEA TRAVEL, INC.

Statement of Retained Earnings
Month Ended April 30, 2001

Retained earnings, April 1, 2001 $ 0

Add: Net income for the month 5,800
$5,800
Less: Dividends (2,100)
Retained Earnings, April 30, 2001 $3,700

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 BALANCE SHEET
„ It reports the company’s assets, liabilities,
and owners’ equity.
„ This reflects the company’s financial position
at a specific moment in time.
„ It is dated as of the last day of the period
‰ e.g.: 31-December

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Balance Sheet
„ Items are listed within each category in order
by liquidity, with the most liquid listed first.
„ Assets
‰ Current Assets
‰ Property, Plant and, Equipment
‰ Other Assets

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Balance Sheet (cont.)
„ Liabilities
‰ Current Liabilities
‰ Long Term Liabilities
„ Shareholders’ Equity
‰ Paid-in Capital
‰ Retained Earnings

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FINANCIAL STATEMENTS OF AIR & SEA TRAVEL, INC.
AIR & SEA TRAVEL, INC.
Balance Sheet
April 30, 2001

Assets Liabilities

Cash $33,300 Accounts payable $ 100

Accounts receivable 2,000
Office supplies 500 Stockholders’ Equity
Land 18,000 Common stock 50,000
Retained earnings 3,700
Total stockholders’ equity 53,700
_______ Total liabilities and
Total assets $53,800 stockholders’ equity $53,800

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 ASSETS
„ Current assets are
‰ Those assets which the company expects to convert to
cash, sell, or consume during the next 12 months or within
the business's normal operating cycle if longer than a year
„ Current assets include:
‰ Cash
‰ Accounts receivable
„ Amount to be collected from customers who bought
merchandise on credit
‰ Merchandise inventory
„ The stock of goods the company has for selling to its
customers
‰ Prepaid expenses
„ Amounts paid but not yet used (e.g. rent, insurance, …)
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 ASSETS
„ Long-term assets are
‰ Those assets which the company expects to hold
longer than the next 12 months or the business’s
normal operating cycle if longer than one year
„ Long-term assets include
‰ Property: e.g. buildings
‰ Plant: e.g. land
‰ Equipment: e.g. machinery, vehicles,…
„ These are Tangible assets

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 ASSETS
„ Intangible assets are
‰ Those with no physical form, e.g.:
„ Trademarks
„ Patents
„ Other assets are
‰ Those with small values which do not fall within
any other standard asset category

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 LIABILITIES
„ Current liabilities are
‰ Debts payable within one year or within the business’s normal
operating cycle if longer than a year
„ Current liabilities include
‰ Notes payable:
„ Amounts borrowed that the company promises to pay back within
the year
‰ Accounts payable
„ Amounts owed for goods and services purchased but not yet paid
‰ Short-term expenses payable
„ Amounts owed to employees, to the government and interest
‰ Income taxes payable
„ Amounts owed to the government for income taxes
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 LIABILITIES
„ Long-term liabilities are
‰ Debts not payable within one year or within the
business’s normal operating cycle if longer than a
year
„ Long-term liabilities include
‰ Notes payable, long term
‰ Bonds payable

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 OWNERS’ EQUITY
„ Owners’ equity
‰ Represents the shareholders’ ownership of the
assets of the business
„ Owners’ equity of a corporation consists of
‰ Common stock
„ Amount that owners have paid into the company
‰ Retained earnings

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 Statement of Cash Flows
How much cash did the company generate and
spend during the year?

Operating cash flows

+ Investing cash flows
+ Financing cash flows
Increase (decrease) in cash

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María José García López
 STATEMENT OF CASH FLOWS
„ The Statement of Cash Flows reports the
company’s cash inflows and outflows from its
major activities as a business:
‰ operating
‰ investing
‰ financing activities

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Statement of Cash Flows
„ Three Basic Types of Activities
‰ Cash flows from Operating Activities
„ Cash earned from the company’s business, buying
goods and services and selling them to customers
‰ Cash flows from Investing Activities
„ Buying and selling long term assets and investments
‰ Cash flows from Financing Activities
„ It refers to the way the company acquires funds used in
its investing and operating activities. For example:
‰ Borrowing and repaying loans from banks or other lenders
‰ Selling or issuing stock
‰ Paying dividends
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 AIR & SEA TRAVEL, INC.
Statement of Cash Flows
Month Ended April 30, 2001

Cash flows from operating activities:

Collections from customers $ 6,500
Payments to suppliers and employees (3,100)
Net cash inflow from operating activities 3,400
Cash flows from investing activities:
Acquisition of land $(40,000)
Sale of land 22,000
Net cash outflow from investing activities (18,000)
Cash flows from financing activities:
Issuance (sale) of stock $ 50,000
Payment of dividends (2,100)
Net cash inflow from financing activities 47,900
Net increase in cash $ 33,300
Cash balance, April 1, 2001 0
Cash balance, April 30, 2001 $ 33,300
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Relationships Among Financial Statements
„ Income Statement is completed first
„ Statement of Retained Earnings requires Net
Income to calculate an ending balance
„ Balance Sheet requires the ending balance of
retained earnings to balance.
„ Statement of Cash Flows reports increases
and decreases in cash and must agree with
the Cash balance on the balance sheet

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Relationships Among the Financial Statements

ABC Company
Income Statement –
Year Ended December 31, 2006
Revenues $700,000
Expenses 670,000
Net income $ 30,000

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Relationships Among the Financial Statements
ABC Company
Statement of Retained Earnings
Year Ended December 31, 2006
Beginning retained earnings $180,000
Net income 30,000
Cash dividends (10,000)
Ending retained earnings $200,000

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Relationships Among the Financial Statements
ABC Company
Balance Sheet
December 31, 2006
Assets
Cash $ 25,000
All other assets 275,000
Total assets $300,000
Liabilities
Total liabilities $120,000
Stockholders’ equity
Common stock 40,000
Retained earnings 200,000
Other equity (60,000)
Total liabilities and stockholders’ equity $300,000
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Relationships Among the Financial Statements
ABC Company
Statement of Cash Flows
Year Ended December 31, 2006
Net cash provided by operating activities$ 90,000
Net cash used for investing activities (110,000)
Net cash provided by financing activities 40,000
Net increase in cash 20,000
Beginning cash balance 5,000
Ending cash balance $ 25,000

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 AIR & SEA TRAVEL, INC.
Statement of Cash Flows AIR & SEA TRAVEL, INC.
Month Ended April 30, 2001 Income Statement
Month Ended April 30, 2001
Cash flows from operating activities:
Collections from customers $ 6,500 Revenue:
Payments to suppliers and employees (3,100)
Net cash inflow from operating activities 3,400
Service revenue $8,500
Cash flows from investing activities:
Acquisition of land $(40,000) Expenses:
Sale of land 22,000 Salary expense $1,200
Net cash outflow from investing activities (18,000) Rent expense 1,100
Cash flows from financing activities: Utilities 400
Issuance (sale) of stock $ 50,000 Total expenses 2,700
Payment of dividends (2,100)
Net Income $5,800
Net cash inflow from financing activities 47,900
Net increase in cash $ 33,300
Cash balance, April 1, 2001 0
Cash balance, April 30, 2001 $ 33,300
AIR & SEA TRAVEL, INC.
Balance Sheet
AIR & SEA TRAVEL, INC. April 30, 2001
Statement of Retained Earnings Assets Liabilities
Month Ended April 30, 2001
Cash $33,300 Accounts payable $ 100
Accounts receivable 2,000
Retained earnings, April 1, 2001 $ 0 Office supplies 500 Stockholders’ Equity
Land 18,000 Common stock 50,000
Add: Net income for the month 5,800
Retained earnings 3,700
$5,800 Total stockholders’ equity 53,700
Less: Dividends (2,100) _______ Total liabilities and _______
Retained Earnings, April 30, 2001 $3,700 Total assets $53,800 stockholders’ equity $53,800

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