MBADM811:
Lesson 1: Introduction to Financial Statements
Lesson Overview
We're all familiar with many types of businesses: service businesses, such as attorney firms; retail businesses, such as department stores; manufacturing businesses, such as automakers; and financial businesses, such as credit card companies. Many companies combine activities—for example, providing services as well as making or selling products—as restaurants and beauty salons do. There is enormous variety in company activities. But one thing all types of businesses have in common is an accounting system: a consistent way to keep track of financial transactions and report the company’s financial condition to those who use this information.
The accounting system that U.S. companies typically use is based on Generally Accepted Accounting Principles, or GAAP, which have evolved over time—many centuries, in fact. GAAP does not dictate the exact accounting procedure for every business activity, but rather provides guidelines for company managers to use in tracking financial information. The common business transactions covered in this course are accounted for in a standard way, and a company’s financial information is collected and reported on four standard financial statements: the balance sheet, the income statement, the statement of changes in shareholders’ (owners’) equity, and the statement of cash flows.
In this lesson, you will consider the types of financial information generated by a business, and who uses that information. You will also be introduced to GAAP guidance and the conceptual framework underlying financial reporting. In addition, you will become familiar with the four basic financial statements and the information reported on each.
Learning Objectives
After completing this lesson, you should be able to do the following:
- Identify the internal and external stakeholders who are interested in a company’s financial information.
- Identify the general characteristics of financial information reported in accordance with GAAP, as outlined in the FASB’s conceptual framework.
- Name the four basic financial statements, and discuss the elements contained in each.
- Calculate retained earnings, and demonstrate how it relates to stockholders’ equity.
- Create a balance sheet, income statement, and statement of stockholders’ equity, given basic company financial data.
Lesson Readings & Activities
By the end of this lesson, make sure you have completed the readings and activities found in the Course Schedule.
Financial Information
Many pages in this lesson, and throughout the course, will instruct you to read certain pages from your textbook. The readings will be applicable to the lesson page on which they appear. In this lesson, the concepts from the textbook will be applied to a simple fictional business.
Suppose Andy and Nick are high school students who decide to start a lawn care business to earn money during the summer. Each of them has $500 to invest in the business, and at the end of the summer they'll split the profits from their work. They begin by listing the items they'll need:
- lawn mower,
- grass trimmer,
- vehicle with trailer, and
- various small tools and supplies: gasoline, rakes, gloves, ear protection, fertilizer.
With their total of $1,000 cash, they can purchase enough supplies to get started and all of the equipment except the vehicle and trailer. Nick’s dad is willing to lend them his small pickup truck and trailer as long as they pay for the gas and return the truck and trailer in the same condition, except for ordinary wear and tear. If the truck or trailer is damaged, they'll need to pay for any repairs not covered by insurance.
Think about the financial information Andy and Nick have already generated and will generate as they conduct their lawn care services:
- They're each contributing $500 and decide to open a checking account for the business. The bank account has a balance of $1,000 after their first deposit.
- They have a truck and trailer, but these items are borrowed; the business doesn't own them. They decide to look up the value of these items and note that they're currently worth $8,000.
- They purchase the lawn mower and trimmer for $310. They'll purchase the small tools and supplies as needed.
- They'll be collecting payment for their services, based on the size of each customer’s lawn and the level of service (mowing only; mowing and trimming; or mowing, trimming, and fertilizing).
Users of Financial Information
Now think about the stakeholders of Andy and Nick’s company—those who are interested in the company’s financial information.
Owners
Obviously, Andy and Nick are interested as the owners. They've invested in the company and expect a return on their investment. In other words, they expect that their initial $1,000, along with their hard work, will earn profits and provide them with more than $1,000 to split at the end of the summer.
Managers
Another reason Andy and Nick are interested in financial information is their roles as managers of the business. Although they trust each other, they decide to formally track amounts each takes from the bank account by using a debit card and matching their purchase receipts with online banking information on a weekly basis. Using a spreadsheet, they'll keep a list of each recurring expense, such as gas for the mower and truck. They'll also keep a log with customer names, hours spent for each job, amounts charged for their services, and payments received. Cash payments from customers will be promptly deposited in the bank account. Tracking these financial details will provide answers to the following questions, which will provide Andy and Nick with valuable insights about their business:
- What are their highest costs?
- Does their pricing structure correspond with the time spent on each job?
- Are they getting paid promptly?
- Who still owes them money for their work?
- Are they making a profit?
The formal record-keeping process also provides control over financial information and assets:
- Utilizing a bank account provides third-party verification of deposits and withdrawals.
- Making prompt deposits safeguards cash received from customers.
- Reconciling the bank statement with purchase receipts helps prevent errors and would uncover any nonbusiness use of funds.
- Documentation of their lawn care jobs helps ensure accuracy in billing and collecting from customers.
- When both owners are responsible for these control activities, they're accountable to each other and less likely to be tempted to cheat each other—in other words, less likely to commit fraud.
Creditors
What about Nick’s dad? Do you think he's interested in how the business is doing financially? He certainly should be. He's a creditor, because he lent Andy and Nick his truck and trailer and expects them to be returned in good condition. He would like to see that the business is profitable to ensure that Andy and Nick have the money to pay for any damages, as promised. (Of course, he also wants his son and his son's friend be successful!)
Government Entities
Andy and Nick will generate income as they conduct business, and the income may be taxed at the federal, state, and local levels. So government entities are also interested in collecting the financial information they need to levy taxes.
Internal Users
As you can see, owners, managers, creditors, and governments have different reasons for needing financial information. Managers are internal users of financial information. They typically need more detailed information pertaining to the day-to-day operations of the business in order to make managerial decisions about issues such as pricing, strategies to keep costs low, and how to encourage customers to pay promptly. The financial reports utilized by internal users are specific to the business and may be in any form beneficial for management use.
External Users
Owners, creditors, and governments are external users of financial information. In many companies, the owners are not involved in managing the business. For example, in public companies—those that have sold shares of ownership that can be traded in financial markets—the owners are investors that may keep their ownership rights for a limited period of time. They're interested in higher-level, less detailed information, including periodic profits, how the corporate resources are invested, the level of debt, and how cash is generated. Creditors and governments, too, need a more general idea of the company’s financial health. Creditors are interested in its ability to repay loans, while governments need limited detail concerning taxable income. Other external users include employees, labor unions, and major customers and suppliers.
| Internal | External | |
|---|---|---|
| User | Managers | Nonmanaging owners Creditors Government Employees Customers Suppliers Local community |
| How information is used | Use detailed financial information to run the business, reported in any convenient format | Use summarized financial information reported in the financial statements |
Four basic financial reports are utilized by most external users: the balance sheet, income statement, statement of changes in owners’ equity, and statement of cash flows. They're presented in a standardized format and, for public companies, must conform to GAAP guidelines. They provide a means for management to communicate the company’s financial information to outsiders. In addition, governments provide their own forms for managers to utilize in reporting the company’s taxable income. The focus in this course is on the communication provided by the four basic financial statements. A fifth report—the statement of comprehensive income—will be introduced later in the course.
GAAP Guidelines and Financial Reporting Standards
The financial statements are management’s communication to external users. Since management has knowledge of the company’s day-to-day transactions and external users do not, there's an inherent risk that management’s communication may be inaccurate, misleading, or presented in a way that makes it difficult for external users to compare the company’s financial condition to that of other companies. For this reason, standard-setting organizations provide standards and guidelines for management to follow in their accounting system and financial statement presentation. In the United States, the primary authority for accounting standards is the Securities and Exchange Commission (SEC), a government body. The SEC has the power to ensure that accounting standards are upheld and financial statement users’ interests are protected. However, the SEC delegates responsibility for setting specific accounting standards to the Financial Accounting Standards Board (FASB), made up of accounting and finance experts with backgrounds in industry, auditing, education, and investing.
Remember that GAAP stands for Generally Accepted Accounting Principles, and some of these accounting principles have been in use for centuries. The FASB has created formal written descriptions of already-existing GAAP and has organized the guidance by topic into a framework called Codification. New guidance and revisions to old guidance are added to the Codification after a period of public comment and deliberations.
The FASB has also created a conceptual framework describing (1) the characteristics of useful accounting information, (2) the elements comprising the financial statements, and (3) assumptions and principles used throughout the accounting system. Here, we’ll consider the important characteristics of accounting information, as defined in the conceptual framework:
- Relevance: The information should help financial statement users confirm their assessment of the company’s financial condition, as well as predict the company’s financial future. Also, the information reported should be material—large enough or important enough to influence the decisions of a financial statement user.
- Faithful representation: The information should be complete, error-free, and neutral (unbiased).
- Enhancing characteristics: The information should be consistent (to allow for comparisons), verifiable, timely, and understandable.
In the following sections, we will look at the four financial statements, highlighting their elements and structure. Throughout the rest of the course, some of the assumptions and principles in the conceptual framework will be covered.
The Balance Sheet
Andy and Nick have decided to name their lawn care company A & N Lawn Care. It's important to think about the company as an entity apart from its owners. Once Andy and Nick have provided their initial investment of $1,000, the money becomes a resource of A & N Lawn Care and will be used by the company. Likewise, it's the company that will earn money using its resources. Of course, the company accomplishes this through the work of its managers, Andy and Nick, but it's essential that they keep their personal finances separate from the transactions of the company. The financial information they're tracking for the company has the characteristics outlined in the FASB conceptual framework and can be summarized and presented using the four basic financial statements. First, we’ll consider the balance sheet.
The balance sheet contains information about a company’s financial position at a point in time—often the end of a year, quarter, or month. It's divided into three major sections, representing three of the elements in the conceptual framework:
- Assets: Resources that will benefit the company in the future. After the initial investment and purchases, A & N Lawn Care owns mowing and trimming equipment that cost $310 and a bank account with a balance of $690 (the original $1,000 deposit minus the $310 spent on the mower and trimmer). The company also has the use of the truck and trailer, worth $8,000. Although the company doesn't own the truck and trailer, they're still assets because they're resources that will benefit the company in the future.
- Liabilities: Obligations of the company. A & N Lawn Care has an obligation to return the truck and trailer to Nick’s dad in substantially the same condition, so the value of its liability is $8,000.
- Equity: The amount of financing provided by owners, plus amounts the company earns and keeps to financially sustain the business. Owners Andy and Nick provided $1,000 of financing, or contributed capital. So far the company has no earnings. Thus A & N Lawn Care’s equity section contains $1,000 of contributed capital.
On June 1, 20xx, after the initial investment and purchases of equipment and supplies, A & N’s balance sheet looks like Figure 1.1.
Please watch Video 1.1 to learn more about the balance sheet.
Here is A & N Lawn Care's balance sheet after they have set up the business, but just before they begin to mow lawns for their customers. The heading at the top includes the name of the company, the title of the financial statement, the balance sheet, and the date. Notice the date is at June 1st 20XX. Stating the date in this way indicates that this is the financial position of A & N Lawn Care on this particular date, which is often called the balance sheet date.
The balance sheet gives financial information about what the company owns, its assets, and what it owes, its liabilities as of the balance sheet date. Likewise, the equity section shows amounts contributed by owners as of the balance sheet date. The balance sheet is organized in a standard way, with assets listed first, then liabilities, then equity. Each of these elements represents a class of items, which are listed in the appropriate section.
For example A & N's assets include two items, cash, which they keep in their bank account, and the equipment they will use, the mower, the trimmer, the truck, and the trailer. The amount shown for equipment is $8,310, which includes the $310 cost of the mower and trimmer, plus the $8,000 value of the truck and trailer. These items are combined and shown in one line on the balance sheet.
Many companies call this category of assets, property, plant, and equipment, or PPE. Sometimes it's called fixed assets. They are long term assets that will be used over a period of time, typically more than one year. In contrast, assets that are used up and replaced in less than a year are considered short term, or current assets. So we have here that cash is a current asset, and equipment is a long term-- which I'll abbreviate LT, long term asset. We'll talk more about current assets later. So total assets equal $9,000.
The next section is the liabilities and equity section. Liabilities are listed first. The only liabilities that A & N Lawn Care has is a note payable, and this is for $8,000. This represents the obligation that Andy and Nick have to return that truck and trailer to Nick's father. A note payable is actually a formal legal agreement between a company and a creditor that states the amount borrowed and all terms of the agreement, including interest rate and timing of payments.
Andy and Nick have only an informal agreement with Nick's dad, but in the balance sheet we're showing it as a note payable. Both assets and liabilities are listed on the balance sheet in order of liquidity. Liquidity refers to how quickly an asset can be used or converted to cash, or how quickly a liability will be paid off. Under assets, cash is the most liquid asset, and it is listed first. The equipment helps the company earn money over time, so it converts the value of equipment into cash more slowly. When we look at the balance sheets of larger companies, we'll see that certain liabilities are paid off quickly, and others would be paid off over a longer period of time. The current liabilities will be shown first, and the long term liabilities would be shown underneath.
Lastly, we see the equity section. The only item that A & N Lawn Care has in the equity section right now is contributed capital. After Andy and Nick begin conducting business, the company will have earnings that will also be listed under equity. The amounts in the liability section and the equity section are added, for a total-- total liabilities in equity of $9,000. The amounts in liabilities and equity equal the amounts in assets. These two totals must always be in balance. And that is why we call it the balance sheet.
In the balance sheet, assets must always “balance with,” or equal, liabilities and equity. The relationship can be written as an equation (Figure 1.2):
This relationship is called the accounting equation. Later, you will learn how the accounting system records transactions to always keep the accounting equation—and the balance sheet—in balance. For now, it's important to be able to identify specific business items as assets, liabilities, or equity items. Click "Next" at the bottom of the page for a practice exercise.
The Income Statement
The income statement reports the operating results of the company for one period, such as a year, quarter, or month. A simple single-step income statement contains just two major elements:
- Revenues: amounts earned from selling goods or services during the period.
- Expenses: expenditures required to earn the revenues of the period.
The excess of revenues over expenses is the company’s net income. Net income is a measure of profit (or loss) for the period, so the income statement is sometimes referred to as a profit and loss (P&L) statement.
Suppose Andy and Nick earned $2,500 mowing, trimming, and fertilizing lawns during the month of June. Most of their customers paid in cash, but one customer still owes them $50. They spent $100 on rakes, gloves, and ear protectors, $500 on gasoline, $600 on fertilizer, and $30 on flyers advertising their business. For the month of June, the A & N Lawn Care income statement would look like Figure 1.3.
Please watch Video 1.2 to learn more about income statements.
Let's suppose Andy and Nick earned $2,500 mowing, trimming, and fertilizing lawns during the month of June. Most of their customers paid in cash, but one customer still owes them $50. They spent $100 on rakes, gloves, and ear protectors, which we're calling small tools and supplies. They spent $500 on gasoline purchases, $600 on fertilizer, and $30 on flyers advertising their business.
So for the month of June, the A & N Lawn Care income statement would look like this. Several things are important to notice. First of all, again we have the heading, which includes the name of the company and the title of the statement. For the date on the income statement, the date is stated differently than it is on the balance sheet. Notice that it says for the month ending June 30 20xx. This is because this income statement shows income for a particular period of time that has a beginning and an ending date. We started June 1, and we end at June 30. So the income statement covers a specific period of time.
The balance sheet, on the other hand, as we said before, indicates financial information at a particular point in time. And it is an accumulation of information. The income statement is only information from a beginning date to an ending date. On the income statement, we will see revenues and expenses. The specific revenues and expenses vary from one company to another.
A & N Lawn Care provides services. So our revenues in this company are called service revenues. And this is the $2,500 they earned from their customers during June. In contrast, a company that sells goods typically shows sales revenue instead of service revenue. So sales revenue is another type of revenue that you might see on another type of income statement. Also notice that A & N Lawn Care lists each of its expenses separately. We had the advertising flyers, which were $30; the small tools and supplies, which were the gloves, et cetera, for $100; their gasoline or fuel costs $500; and their fertilizer was $600.
Larger companies combine their expenses into general categories, such as selling expenses or general and administrative expenses. And you'll see that on some of the other financial statements that we'll cover in this course. Yeah, Andy and Nick provided this $2,500 worth of services to their customers during June. Under GAAP guidelines, the income statement reports all the revenues they earned. And it doesn't matter when they got paid.
So notice I said earlier that there was a $50 payment owed from a customer, but that $50 is included in this $2,500 because they actually earned the revenues. You'll also notice, after looking at the expenses that are listed, that income tax is not listed as an expense. Most companies that we're going to be talking about in this course do have income taxes because they will be corporations. For Andy and Nick, they do not need to list income tax as an expense because they're a partnership, and partnerships are taxed differently. So for Andy and Nick, no income tax.
The bottom line of the income statement, of course, is net income. And we have total net income of $1,270. That includes the revenues minus each of the four expenses that we list. Net income is called the bottom line because it is the last line on the income statement. It is a measure of the company's profit for the period, and it's an important metric for creditors and investors as they analyze the company's financial data.
Another frequently used term for net income is earnings. So net income, same thing as earnings. We'll use those terms interchangeably. This is called a single step income statement. Single step refers to-- and I'll abbreviate income statement IS. Single step refers to the fact that expenses are subtracted from revenues. And that's a one step calculation. So revenues minus expenses equals net income. And we will talk about multistep income statements at a later date.
The Statement of Changes in Stockholders’ (Owners’) Equity
The statement of changes in owners’ equity, as the name implies, reports any changes that have occurred in the components of equity. Often, it is called the statement of owners’ equity, or statement of stockholders’ equity if the company is a corporation. Three elements of FASB’s conceptual framework are found in this financial statement:
- Investments by owners: Transfers, usually cash, from owners to the company. A & N Lawn Care’s owners have invested $1,000, which we have called contributed capital. Owner investments increase equity.
- Net income: Amounts generated through transactions with nonowners. In our discussion of the income statement, we saw that A & N Lawn Care had transactions with customers to earn revenue, and with suppliers to purchase various items, resulting in net income of $1,270. Net income is an addition to equity each period. If there were a net loss, it would decrease equity.
- Distributions to owners: Transfers, usually cash, from the company to its owners. Suppose Andy and Nick were so pleased with their first month’s work that they decided to each take a distribution of $100 from the company, instead of waiting until the end of the summer to split all of the profits. Distributions to owners for the month would be $200. Distributions decrease equity.
The accumulation of net income over the years, minus any distributions to owners, is called retained earnings. A statement of owners' equity shows changes in retained earnings by adding net income and subtracting distributions.
Figure 1.4 is A & N Lawn Care’s statement of changes in owners’ equity for the month of June.
Please watch Video 1.3 to learn more about the statement of changes in owners' equity.
This is A and N Lawn Care's Statement of Changes in Owners' Equity for the month of June. The two main components of owners' equity are contributed capital and retained earnings.
We've already defined contributed capital. Since it is a new company, A and N Lawn Care began with a zero balance in contributed capital, and 1,000, here's your zero balance, 1,000 was added at the beginning of the month. By the end of June, the balance was still 1,000.
Retained earnings is the accumulation of net income or loss since the company began operations. Remember that another term for net income is earnings. The business may keep its earnings within the company and use the cash generated to make additional purchases or investments to grow the company. In other words, the earnings are retained within the company.
Net income or loss of each period is added to or subtracted from retained earnings. So added if it is positive net income and subtracted if it's a net loss, and it accumulates over time. When distributions are made to owners, retained earnings are decreased by the amount of the distribution.
Now as a new company, A and N Lawn Care's retained earnings started also with a zero balance. Net income for the month of June increased retained earnings by 1,270, the amount of net income, and distributions were $200, 100 for each of the owners. So this column shows changes in retained earnings from the beginning of the month to the end of the month. The end of the month ending balance in retained earnings is 1,070.
Finally, the owners' equity column shows, again, the beginning balance of zero, and then all of the changes from everything within owners' equity, contributed capital as well as retained earnings. So we've got the owner contributions of 1,000, the net income of 1,270, and the distributions of 200. The total, positive amounts added to equity minus the distribution to the owners, which is subtracted from equity, gives you a total of 2,070 for the month under owners' equity.
Another thing to notice about the Statement of Changes in Owners' Equity is that it again, is a statement that covers a particular period of time. The date is shown as for the month ending June 30, 20xx. Again, the statement covers from the beginning of June to the end of June.
At this point I'm going to erase what I have on the screen here because I wanted to highlight retained earnings. In this retained earnings column, you see the calculation for retained earnings. I talked through it a minute ago, but this is a really important calculation.
You've got to remember that retained earnings equals the beginning balance in retained earnings plus net income for the period, in this case one month, minus dividends that might have been paid out during the period. And that equals ending retained earnings. So you should probably call this ending retained earnings. That formula is really important because retained earnings is really an accumulation of all of the retained earnings in the company from the beginning when the company began operations. Every year net income will be added to retained earnings and any dividends will be subtracted.
Notice also that dividends are subtracted separately from the addition of net income. That's also an important point. Dividends are not part of net income. Dividends are not an expense, and you will never see them on the income statement. So net income increases retained earnings, but separately, dividends decrease retained earnings.
As noted, changes in retained earnings are shown in the statement of owners' equity. It is important to highlight the formula for retained earnings (Figure 1.5):
In a corporation, distributions to owners (shareholders) are called dividends. Always remember that distributions (dividends) are not reported in net income. In other words, distributions are not an expense and are not subtracted from revenues to arrive at net income. Rather, dividends are a direct reduction from retained earnings; they never pass through net income.
The Statement of Cash Flows
The statement of cash flows reports cash inflows and cash outflows from three types of business activities:
- Operating activities consist of the daily activities of the company related to earning income. However, revenues and expenses as reported on the income statement do not necessarily reflect cash flows from operating activities. Recall that A & N Lawn Care’s income statement reported $2,500 of earned revenues, but one customer still owes $50. Thus, only $2,450 was received in cash. The operating activities section of the cash flow statement shows only the cash amounts received and paid by the company to generate net income.
- Investing activities are transactions related to buying and selling long-term assets, such as property, plant, and equipment (PPE), or investments in securities, such as stocks and bonds.
- Financing activities include borrowing or paying off the principal amount of a loan, receiving capital contributions from owners, and paying cash distributions to owners.
A & N Lawn Care’s statement of cash flows for the month of June would look like Figure 1.6.
Please watch Video 1.4 to learn more about the statement of cash flows.
The statement of cash flows, again, begins with the heading, the title of the company, the title of the statement, Statement of Cash Flows, and a date. The statement of cash flows covers a period-- in this case, for the month ending June 30-- just like the income statement did and the owners' equity statement.
The cash flow statement is divided into three sections. Cash flows from operating activities, cash flows from investing activities, and cash flows from financing activities. Let's look at each section separately.
Cash flows from operating activities include all of the items that are reported in the income statement, but on a cash flow basis. For example, on our income statement, we see revenues reported. What we want to isolate for the cash flow statement is the cash received from customers to earn those revenues.
So the actual cash received from customers for A&N Lawn Care was $2,450. You might recall that revenues that they had during their first month of operations totaled $2,500. But one customer still owed them $50, so that $50 has not been received in cash. So the cash received from customers is only $2,450, and that's why we see the $2,450 on the cash flow statement.
Also reported on the income statement are all of the expenses. So again, we're going to focus on the cash flows that were paid out for those expenses in the operating section of the cash flow statement. So for A&N Lawn Care for June, we had cash paid for advertising, $30, and cash paid to suppliers for $1,200. And that included the $100 for small tools and supplies, the $500 for fuel, and the $600 for fertilizer.
Now both the cash paid for advertising and the cash paid to suppliers for the various other expenses are noted in parentheses. So we have parentheses around those numbers to indicate that is a cash outflow. The cash received from customers, of course, is a cash inflow, and that's shown as a positive number. Altogether, our total net cash from operating activities is $1,220, and that's a positive cash inflow.
The next section is the investing section. In that section of the cash flow statement, we would report all of the cash inflows and outflows to invest in assets. In the case of A&N Lawn Care, they purchased equipment for $310. That was a cash outflow. And that cash outflow included the purchase of their lawn mower and their trimmer. So $310 for that cash outflow as an investing activity.
Cash flows from financing activities include transactions with outside parties that they borrow money from. So it has to do with borrowing and also using contributed capital. So those are both financing-type activities.
Using contributed capital is one example of a transaction with an owner. So another type of transaction with an owner is paying distributions. So any transactions with owners, as well as any borrowing or paying off of loans, would be in the financing section. For A&N Lawn Care, we have the contributions from the owners, which is an inflow of $1,000, positive amount, and the distributions to owners, which is an outflow of cash. So $200 of cash was paid to the owners as a distribution. If they had borrowed money, that would be an inflow in financing activities. Companies who borrow money and then pay it back over time would count the payback of the principal amount of the loan as a cash outflow.
At the bottom of the statement of cash flows, you see a calculation, which is known as the reconciliation of cash. The reconciliation begins with the total net increase or decrease in cash from each of the three sections that we've just talked about. So here we have a $1,220 cash inflow from operating activities, we have the $310 outflow from investing activities, and we have the total inflow or positive amount of $800 from financing activities.
So those three numbers, the $1,200, the minus $310, and the $800 add up to $1,710 as the net increase in cash. We're going to add that to the cash balance at the beginning of the period, which in this case was zero, because A&N Lawn Care is a brand new business, and they didn't have any cash to begin with. So the net increase in cash of $1,710 is also the cash balance at the end of the period. And that cash balance should agree with the balance sheet amount. And we'll see when we look at the balance sheet for the period ending June 30, we'll see that that is the case, that this cash balance from the cash flow statement agrees with the ending cash balance on the balance sheet of A&N Lawn Care at the end of June.
Relationships Among the Financial Statements
The information on the financial statements all comes from the same accounting system, and the four basic financial statements are all related to one another. Recall that the income statement calculates net income for the accounting period (usually a month, quarter, or year). The same net income is shown on the statement of owners’ equity, in the calculation of retained earnings for the period. For A & N Lawn Care, June net income of $1,270 is added to retained earnings in the June statement of owners’ equity. Also, the $200 distribution is subtracted from retained earnings, separately from net income. Total retained earnings and total owners’ equity are then shown on the balance sheet.
Remember that the balance sheet shown earlier had a date of June 1, 20xx, before A & N Lawn Care conducted business for the month of June. At the end of June, the balance sheet would look like Figure 1.7.
Please watch Video 1.5 to learn more about A & N's balance sheet on June 30.
Remember that the balance sheet shown earlier had a date of June 1, 20xx. That was before A&N Lawn Care conducted business for the month of June. At the end of June, the balance sheet would look like this. You've got your heading again with the name of the company and the title of this statement. For a balance sheet, it is at a particular point in time and this is at June 30, not June 1.
Now that they've done a month's worth of work and the different assets in the statement are a little bit different than they were before. We've got a cash account that now has $1,710. Accounts receivable is $50. That represents the amount that one customer still owes them at the end of June. We put it in an account called accounts receivable, which is self-explanatory. They are waiting to receive that particular amount of money.
Accounts receivable is an asset and it is listed under cash, because it is a little bit less liquid than cash. And yet, they will receive that amount in a short amount of time, so it is a fairly liquid asset. Next, equipment is listed, because it is the least liquid asset that they have on their balance sheet. Their equipment is still $8,310.
So total assets now are up to $10,070. Their note payable remains the same at $8,000. Contributed capital remains the same at $1,000. And now they have retained earnings of $1,070, which includes their net income for the month minus the dividends that they distributed to themselves, the owners. Total equity now is $2,070. So total liabilities in equity is $10,070, the same as assets. Again, the balance sheet is in balance.
At this point, it's a good idea to look at how the different financial statements are related to each other. So I'm going to erase all my marks here and go back to the income statement. So this is the income statement for the month ending June 30.
We calculated net income and that was $1,270. Net income is calculated first of all of the financial statements, because that carries over to the next statement, which is the statement of changes in owners' equity. And here we see net income on the statement of changes in owners' equity. So income statement is related to the owners' equity statement and it carries right over.
On the owners' equity statement, we calculate retained earnings. And remember, I said that was a very important calculation, because it increases retained earnings in the owners' equity section of the balance sheet. So with retained earnings, we added the net income and then we subtracted the distributions to the owners. So the total in retained earnings at the end of the month was $1,070.
That $1,070 can be seen on the balance sheet as the amount in retained earnings. So we'll skip ahead over the cash flow statement to get to the balance sheet. And you can see retained earnings is $1,070 on the balance sheet.
Now notice that the cash account on the bank balance sheet is $1,710. That is a number that matches the bottom line of the statement of cash flows. Because when we calculated cash flows, remember we were talking about just the cash that came into the company or went out of the company regardless of when expenses were paid or when revenues were earned. So with just the cash ins and outs, if you will, the cash inflows and the cash outflows, we divided them into the different sections but the total at the end of the month added up to the cash balance that we would expect to see on the balance sheet in the cash account. And that's what we have on the balance sheet.
We now have a complete picture of A & N Lawn Care’s financial information for the month of June, in the form of the four basic financial statements. Details of operating revenues and expenses are shown on the income statement and summarized in net income. Net income carries over to the statement of owners’ equity in the calculation of retained earnings. The final balance in retained earnings then carries over to the balance sheet, along with the balances of the other equity accounts.
The relationships among the income statement, owners’ equity statement, and the balance sheet are summarized in Figure 1.8.
In addition, the reconciliation of cash in the statement of cash flows agrees with the balance in the Cash account on the balance sheet. The four financial statements will always tie together in this manner. Another illustration of the financial statement relationships is shown on page 16 of your textbook.
The financial statements alone don't present enough information to enable investors and creditors to make informed decisions, because they're presented in a summary format. They don't contain any information about the characteristics of the company, its choices of accounting methods, or details of complex transactions. For this reason, companies also present notes to the financial statements to provide a more complete communication of financial data. FASB guidelines strive to ensure that companies provide transparency in their financial statements, meaning that they do not hide or disguise information, which might mislead the users of the financial statements. In this course, we will sometimes refer to the financial statement notes and their contents when covering certain topics.
Lesson Summary
You are now familiar with types of financial information generated by a company and the stakeholders who are interested in that information: internal parties, such as managers, and external parties, such as owners and creditors. You've also learned about the elements and basic structure of four financial statements: the balance sheet, income statement, statement of changes in owners’ equity, and statement of cash flows, which comprise management’s communication to the public about the company’s financial condition. In the next lesson, you will learn how financial information is recorded in the company’s accounting system.