Study: How do the Financial Statements Articulate with Each Other?
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Slides 1-2 (1m:20s)
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Welcome to Introduction to Accounting Preparing for a User’s Perspective. How do the financial statements articulate with each other?
You’ve already been introduced to the general-purpose financial statements Links to an external site.. There are four of them. There are also footnote disclosures that help describe additional information that is not included on the face of these financial statements. You should also already know these equations. Now we haven’t dug into any of these equations in any detail yet, but as long as you know these equations, we are at a good starting point and we can work from there.
What we are going to do in this topic, is we are going to show you how these three financial statements, the statement of shareholder equity, income statement, statement of cash flows, explain how a company’s assets, liabilities and equity change from one year to the next. In other words, these three statements describe information that happens over a period of time and the balance sheet provides information as of a point in time.
The very next slide, it’s going to be kind of long. It’s fairly detailed, but if you will stick with it, you will gain an understanding that will pay off enormously through the rest of the course. Please stick with it, do your best and get ready.
Slides 3-5 (8m:54s)
Links to an external site. Financial Statement Articulation. Now this is a great topic. I am going to pack a ton into this video, I realize, it may feel a little bit overwhelming, but if you will stick with me and really concentrate for the next about 10 minutes, this is going to go a long way to helping you understand the big picture of financial accounting.
We’ve already introduced the four general-purpose financial statements so we are going to go in and focus first on the balance sheet and then describe how the other three statements help us understand how the balance sheet changed from one period to the next.
Let’s start off with the balance sheet. Every financial statement we prepare in this class, will always be labeled in a similar way. We will always name the company for which the financial statement exists, the name of the financial statements, in this case, the balance sheet and then we give the period to which it relates. Now this is as of a point in time. It’s like taking a photograph of the company’s financial resources (its assets) and then indicating who has claims against those resources in the company.
So let’s look at our assets Links to an external site..
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As of 12/31/X1 |
As of 12/31/X2 |
Cash. Cash, coin, your currency, and checks you have received from your customers, we consider that all cash.
Accounts receivable Links to an external site.. These are amounts that customers owe you because they bought something from you and have not paid yet. It’s receivable.
Inventory Links to an external site.. This is the product that you have purchased, or you have built and plan to sell as part of your normal operations of the business. It’s sitting in your warehouse waiting to be sold. It’s sitting in a retail location in a mall waiting to be sold to customers.
Vehicles. These are any of the vehicles you use to deliver goods and services to customers, or sometimes you have vehicles for your salespeople, your chief executive officer. These are vehicles that the company owns and uses to run the business.
Equipment. This equipment could be robots in a manufacturing plant, they could be computers that the accounting department uses.
Building. This is the structure in which you keep all this stuff.
Land. What the building sits on, for example, or if maybe you have vacant land. It’s the dirt that you own.
And if you take all of these assets and you add them up, it shows that you have $350 of assets. These are things that are going to provide you a future benefit somehow. If you have an asset that is not going to benefit you somehow in the future, it’s NOT an asset.
Let’s look at a candy bar. Let’s say you have a candy bar asset, but you ate it already, it’s not an asset anymore.
Now these assets were obtained somehow, you financed these somehow, and that financing, comes either through debt financing Links to an external site. (lenders and creditors) or equity financing Links to an external site., so let’s dig into the liabilities, the debt financing.
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As of 12/31/X2 |
Accounts payable
Links to an external site.. These are amounts that you as a company owe other companies or individuals for services you’ve already received from them. You haven’t paid yet. Maybe you bought some inventory and you haven’t paid for all of it yet. Maybe you paid some with cash, but the other portion you haven’t paid yet, so you still owe $10.
Notes payable. It’s a liability Links to an external site., but notes payable are a little more formalized, usually interest is involved, you will not only pay back the $90, but you will also be charged a fee called interest Links to an external site.for having borrowed it, it’s kind of like a rental fee, but we do call it interest.
If you take these liabilities and add them up, you get a$100 in liabilities. There are other liabilities, like wages payable when workers work for you, but you haven’t paid them yet. Utilities payable, you received electricity services but you haven’t paid it yet.
Any time you see the word “payable”, that is a liability, it shows that some other company or individual has a claim against your company on these assets.
Now, if your assets were not all funded by debt, as they are not in this case, they must have been funded by the owners.
Capital Contributions. So as you can see, we have owners that contributed $200, and then the company earned some income, but the owners chose to keep that, chose to “retain” that in the business.
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As of 12/31/X1 |
As of 12/31/X2 |
Retained Earnings
Links to an external site.. Retained Earnings represents all of the income that has ever been earned that has not been paid out to the owners in the form of a dividend.
You add those two together, you get total shareholder equity of $250. If you take your total liabilities (your debt financing) plus your equity financing $250 and you get $350 in total liabilities and shareholders’ equity.
Well that was at the end of 12/31/X1. If we were to jump ahead one year to the next year, X2, these account balances are going to change because it’s running a business. As you can see, almost every one of these account balances changed because things happen in business, you buy things, you sell things, you get paid, you don’t get paid, and you borrow money. All of these different things happen.
The question for an investor or creditor is “Wow! Why did these balances change?” And if you understand the “Why?” it changed, that might help you evaluate, whether this company, is successful, whether it’s healthy, and it might help you predict, what might happen between X2 and X3, and that’s where the real money is.
If you can predict successfully what the balance sheet Links to an external site. will look like one year later, you’ve got yourself a good skill that’s going to generate a lot of money for yourself and those who trust you and your ability.
Let’s look at the information that will help us understand why it changed from these numbers (X1) to these numbers (X2).
So the statement that helps us explain how cash changed from $10 to $30 is the Statement of Cash Flows. As you can see, we named it after the company, Statement of Cash Flows, for the year ended—Why? Because it is explaining how it goes from this year (X1) to this year (X2). This is not a photograph, it’s more like a motion picture. These things happened during the past year.
It starts off by saying “Hey what was our beginning cash?” Based on your bank reconciliation you already know what your ending cash is. We can see that cash changed $20. Cash went from $10 to $30, so the Statement of Cash Flows
Links to an external site. explains “What are the activities that caused it to go from $10 to $30?”
Operating activities. They are operating activities Links to an external site.. That’s from your income, your basic operations, the cash flows of cash received and cash paid in relation to your operations. That’s like you receive cash from your customers and you make payments to your suppliers, that’s in your operating activities.
Investing activities. Your investing activities. This is when you buy and sell long-term assets. When you bought this equipment it was a cash outflow. When you sell it, whatever cash you received, that’s an inflow.
Financing activities. This is the cash you received by borrowing usually with interest or by owners contributing. A cash outflow in the financing activities is when you pay dividends Links to an external site.out to your owners.
We see that our equity accounts changed from $200 to $220 (Capital Contributions) and from $50 to $90 (Retained Earnings). That is explained on the Statement of Shareholder Equity. For the year ended. Why? Because it is changing from this (X1 numbers) to that (X2 numbers). This prior year to the new year.
We are going to break it out into the two pieces, Capital Contributions and Retained Earnings. We have our beginning balances from the prior year and our ending balances from the current year and we are going to try to explain “Why did we go from $200 to $220 (for Capital Contributions) and from $50 to $90 (for Retained Earnings).
Capital Contributions. Let’s focus on the Capital Contributions. Maybe owners contributed $20 extra and obtained a little more ownership in the company. And, maybe the company did not buy back any ownership, so it wound up going up to $220.
Retained Earnings. Retained Earnings are all of the earnings they have retained in that they (the owners) kept it back. So, if you take the Net Income Links to an external site., which we will look at in a moment, that increases the earnings that the owners can possibly retain and then you deduct the Dividends which is the amount of the earnings that the company has paid out to the owners.
The net change here is a $40 increase causing us to go from $50 (X1 Ending Retained Earnings) to $90 (X2 Ending Retained Earnings).
The next thing the owners will want to know is “Well how did we get this Net Income?” Then you go into the next statement. Income Statement for the year ended. They brought in $500 of Revenues Links to an external site.deducted the Expenses $400 that matched those Revenues and got Net Income of $100.
So, in the middle here we have the three statements, the Statement of Cash Flows, the Statement of Shareholder Equity Links to an external site., and also specifically, Net Income.
The bottom line is that, we had certain balances, last year on our balance sheet. Things happen to them as described on these financial statements. These are our ending balances.
Creditors and investors analyze all these financial statements, that explain the old balances and the new and how they got there, so that they can not only understand how the company has done in the past, but predict how they think it will do in the future and that ability to predict the future successfully is where the real money is at when you are talking about financial statement analysis.
In the next topic, I will describe the expanded accounting equation, but if you got this, how the financial statements articulate, then the expanded accounting equation should slide right into that theoretical understanding and you’ll just do great.