Lesson notes Lesson 9: Financial Statements Learning objectives Learn what financial statements are and how these accounting tools work in their future profession Be acquainted with the functions and formats of these financial statements Learn some details relating to preparation of these financial statements. Explain important relationships among the balance sheet, income statement, and cash flow statement, and how these statements relate to each other Teaching hours Students major in accounting: 9 hours Others: 6 hours Teaching contents: Opening Story The financial statement sits imposingly in front of you, a stream of numbers rolling endlessly down the page. You’re a new board member, studying the numbers, hoping to decipher their meaning. Then you’re hit with the accounting jargon: balance sheets and income statements; cash basis and accrual basis. You think you hear the financial statements quietly laugh at you, and you begin to wonder if the board should hire a psychiatrist instead of an accountant. Don’t despair. Financial statements may seem confusing initially, but they’re not as difficult as you think. Here’s a look at the basics. “Show me the money!” Cuba Gooding Jr. uttered an immortal line in the movie Jerry Maguire, “Show me the money!” Well, that is what financial statements do. They show you the money. The questions are: * Do they show you where a company’s money came from? * Do they show you where it went, and where it is now. * How accountants make all these ends satisfied? What Are the Financial Statements? Organizations report their accounting information to internal and external users in the form of financial statements. Statements reveal an organization’s financial health and performance. The financial statement is a picture of the company in financial terms. Each financial statement relates to a specific date or covers a particular period. Stock/ resources and obligations at a point in time: Balance sheet. Flow/activity over a period of time: Income statement, Statement of cash flows. The instructor might facilitate some discussion on the importance of financial statements to a company and its investors and creditors and why management may take steps to improve the appearance of the company in its financial statements. How Are Financial Statements Prepared? The first step in understanding financial statements is to determine whether they were prepared on a cash, accrual, or modified cash accounting basis. Why? Financial statements vary greatly depending on the accounting method. The reader must know which accounting method was used in order to accurately read the statement. The three methods are defined as follows: Cash Basis. Cash basis accounting is similar to a personal checkbook. Financial records track when cash is received or paid out. Income is recorded when a deposit is made to the bank. Expenses are recorded when a check is written to pay a bill. Cash basis financial statements are easy to understand and to prepare. The disadvantage, however, is they don’t give a full picture of the financial condition. The records omit information on unpaid bills or uncollected assessments. Accrual Basis. Accrual basis accounting tracks any and all transactions, even if cash is not received or paid out. For example, income is recorded when the dues are assessed, not necessarily when they are collected. The same is true for expenses. Expenses are recorded when they are incurred. For example, if the association buys new equipment, the purchase is recorded even if the bill has not been paid. Because it tracks all income and expenses, accrual basis accounting more accurately records the financial activity of a particular time period. Modified Cash Basis. Most associations use modified cash basis accounting for their record keeping. It is a compromise between the cash basis and accrual basis. With this method, most transactions are recorded on the cash basis, but some are logged on an accrual basis. For example, accounts receivable (amounts owners owe the association) and income commonly are recorded as they are billed (accrual basis). Expenses are recorded as the bills are paid (cash basis). Other accrual adjustments, such as prepaid expenses and income tax accruals, are not made. Modified cash basis is less complex than accrual basis financial statements. During the annual review or audit, however, a CPA often must convert the financial statements to accrual basis. What Are the Functions of Financial Statements? Accounting information is conveyed through a standardized set of reports.? The four fundamental financial statements are the income statement, statement of retained earnings, balance sheet, and statement of cash flows. Useful for investment decisions. (All financial statements) Comprehensible. (All financial statements) About economic resources and claims on resources (Balance Sheet). About financial performance during a period (Income Statement). About cash flows (Statement of Cash Flows). The financial statements can help you to better understand the performance and position of a business, so that the students can be directed to participate in the in-class discussion on the following topics: 1. How well did the company perform (or operate) during the period? 2. Why did the company’s retained earnings change during the period? 3. What is the company’s financial position at the end of the period? 4. How much cash did the company generate and spend during the period? What Financial Statements Are Required by the GAAPs? This section will explain certain accounting principles that are important for an understanding of financial statements and how professional judgment by accountants may affect the application of those principles. First of all, to make it clear to the students that some financial statements are required by the regulators, we review the concept of GAAP here. The rules that make acceptable accounting practices are referred to as Generally Accepted Accounting Principles (GAAP). Information presented using these principles is considered to be relevant, reliable, consistent and comparable. INCOME STATEMENT A summary of an entity's results of operation for a specified period of time is revealed in the income statement, as it provides information about revenues generated and expenses incurred.? The differences between the revenues and expenses are identified as the net income or net loss. This financial statement is use to explain how the income statement reports an enterprise's financial performance for a period of time in terms of the relationship of revenues and expenses. BALANCE SHEET The balance sheet focuses on the accounting equation by revealing the economic resources owned by an entity and the claims against those resources (liabilities and owners' equity). The balance sheet is prepared as of a specific date, whereas the income statement and statement of retained earnings cover a period of time. This financial statement demonstrates how certain business transactions affect the elements of the accounting equation: Assets = Liabilities + Shareholders' (Owners') Equity. After learning this, students are supposed to understand how the balance sheet is an expansion of the basic accounting equation. Assets: properties or economic resources owned by the business. Common characteristic is the ability to provide probable future economic benefits to the business. Liabilities: debts or obligations of a business or claims against assets. A common characteristic is capacity to reduce future assets or to require future services or products. Equity: is the owner’s claim to the assets or the residual interest in the assets of an entity after deducting liabilities; also called net assets. STATEMENT OF CASH FLOWS This financial statement is a bit more complex, detailing an enterprises cash flows, broken down according to operating, investing, and financing sources.? Its coverage is best deferred until you have had a chance to progress further in your study of accounting. This financial statement is used to explain how the cash flow statement presents the change in cash for a period of time in terms of the company's operating, investing, and financing activities. ILLUSTRATIVE STATEMENTS The following portrays sample final statements for Beauty Photo Store.? Additional examples (if there is some extra time): The following are three financial statements of Tony Blow Corporation. Please take time to review these statements, noting carefully how the net income on the income statement flows through to the statement of retained earnings, and how the ending retained earnings flows through to the balance sheet. Tony Blow Corporation Income Statement For the year ending December 31, 20X3 Revenues ? ?  Services to customers $750,000 ?  Interest income 15,000 ?  Total revenues ? $765,000  Expenses ? ?  Salaries $235,000 ?  Rent 115,000 ?  Other operating expenses 300,000 ?  Total expenses ? 650,000  ????? Net income ? $115,000   Quartz Corporation Statement of Retained Earnings For the year ending December 31, 20X3 Beginning retained earnings $400,000  Plus:? Net income 115,000  ? $515,000  Less: Dividends 35,000  Ending retained earnings $480,000   Quartz Corporation Balance Sheet December 31, 20X3 Assets ? ? Liabilities ? ?  Cash $192,000 ? Salaries payable $? 34,000 ?  Accounts receivable 248,000 ? Accounts payable 166,000 ?  ??? Land 450,000 ? Total liabilities ? $200,000  Other assets ?? 10,000 ? Stockholders' equity ? ?  ? ? ? Capital stock $220,000 ?  ? ? ? Retained earnings 480,000 ?  ? ? ? Total stockholders' equity ? 700,000  Total assets $900,000 ? Total Liabilities and equity ? $900,000   Summary There are two major types of financial statements-stock reports and flow reports; Financial statement can serve as an important device to disclose information to investors in order for them to make better decisions; Four major financial statements are compared, explained and illustrated in this lesson; In this section, the former case of The Beauty Photo Store is picked up again here, and its four major financial statements are illustrated to show its performance and financial positions. Case for Open Discussion You’re a new board member, studying the numbers, hoping to decipher their meaning. Then you’re hit with the accounting jargon: balance sheets and income statements; cash basis and accrual basis. You think you hear the financial statements quietly laugh at you, and you begin to wonder if the board should hire a psychiatrist instead of an accountant. Suggested Questions: 1) How are financial statements prepared? 2) Do they make things simpler? 3) What information can we infer from these statements? 4) How can we make use of them?