Assignment #02

(Accounting Fundamentals)

Submitted by : Muhammad Dawood

Roll No : CS-325
Class : BsCs-Sem#02-(A)
Submitted to : Ma’am Saba Iqbal

OCTOBER 24, 2024

National University of Modern Languages, Lahore

 Meaning of Financial Statements

Financial statements are basically reports that depict financial and accounting information
relating to businesses. A company’s management uses it to communicate with external
stakeholders. These include shareholders, tax authorities, regulatory bodies, investors, creditors,
etc.
These statements basically include the following reports:

 Balance sheet
 Profit and Loss statement
 Statement of cash flow
 Income sheet

Nature of Financial Statements:

Historical Records:
Financial statements capture the financial activities of a business for a past period. They record
what happened during a specific time frame.

Example: A company's income statement for 2023 will show its revenue, expenses, and
profit or loss for that year.
Monetary Representation: All information in financial statements is expressed in terms of
money, making it easier to assess the financial health of a business.

Example: Assets like machinery are recorded in terms of their purchase price or current
value, rather than their physical size or type.
Objectivity and Standardization: Financial statements are prepared based on established
accounting standards (like GAAP or IFRS), ensuring consistency and comparability.

Example: Two companies preparing their financials using the same accounting standards will
present information in a similar way, allowing for easy comparison by investors.
Accrual Basis: Financial statements are typically prepared on an accrual basis, meaning
transactions are recorded when they are incurred, not when cash is exchanged.

Example:
A company records revenue from a sale in November even if the payment will be received in
January.
Understanding The Accrual Basis Of Accounting:
The policy of recognizing revenue in the accounting records when it is earned and recognizing
expenses when the related goods or services are used is called the accrual basis of accounting.
The purpose of accrual accounting is to measure the profitability of the economic activities
conducted during the accounting period. The most important concept involved in accrual
accounting is the matching principle. Revenue is offset with all of the expenses incurred in
generating that revenue, thus providing a measure of the overall profitability of the economic
activity.

Cash Basis Accounting:

An alternative to the accrual basis is called cash basis accounting. Under cash basis accounting,
revenue is recognized when cash is collected from the customer, rather than when the company
sells goods or renders services. Expenses are recognized when payment is made, rather than
when the related goods or services are used in business operations. The cash basis of accounting
measures the amounts of cash received and paid out during the period, but it does not provide a
good measure of the profitability of activities undertaken during the period.

Purpose of Financial Statements:

Informed Decision-Making: Financial statements provide stakeholders (like investors,
management, and creditors) with critical financial information to make decisions.

Example: An investor uses a company's balance sheet and income statement to decide
whether to invest in the company.

Performance Evaluation: They help assess how well the business has performed over
a specific period.

Example: A company's income statement reveals its profit margins and whether it’s
generating more revenue than expenses, helping stakeholders evaluate its profitability.

Assess Financial Position: The balance sheet shows the financial position of the
company, including what it owns (assets) and what it owes (liabilities).

Example: A company with more assets than liabilities is in a strong financial position, which
is reassuring to investors and lenders.

Cash Flow Insight: The cash flow statement provides information on cash inflows and
outflows, highlighting how effectively a company manages its cash.

Example: A company may show a profit on the income statement but could have poor cash
flow, indicating problems in collecting payments from customers.
Example of a Real Business Scenario:
Imagine a small manufacturing business called "ABC Manufacturing" that produces furniture.
For the year 2023:

Income Statement: ABC Manufacturing shows a revenue of $500,000 and expenses of

$400,000, resulting in a net profit of $100,000. This helps management and investors understand
if the business is profitable.

Balance Sheet: As of December 31, 2023, ABC Manufacturing has assets (furniture-
making machines, raw materials, cash) worth $600,000 and liabilities (loans, payables) worth
$200,000. This shows the company’s overall financial position.

Cash Flow Statement: ABC’s cash flow statement reveals that while the company made
a profit of $100,000, it only has $50,000 in cash due to delayed payments from customers. This
shows how cash is moving within the business.

Explain Multi step Income statement?

A multi-step income statement is an income statement that segregates total revenue and expenses
into operating and non-operating heads. It offers an in-depth analysis of the business’s financial
performance in a specific reporting period. It lists items in different categories to make it
convenient for users of the income statement to better understand the core operations of the
business.
 Revenue:
The total amount earned from sales or services before deducting any costs or expenses.
Example: Sales Revenue = $500,000

Cost of Goods Sold (COGS):

The direct costs associated with producing the goods or providing services, such as raw materials
and labor.
Example: COGS = $300,000

Gross Profit:
Formula: Gross Profit = Revenue - COGS
This shows the profit a company makes after deducting the cost of production but before
operating expenses.
Example: Gross Profit = $500,000 - $300,000 = $200,000

Operating Expenses:
These are costs that the company incurs to run its core operations. They include:

Selling Expenses: Costs related to marketing, sales commissions, and distribution.

Administrative Expenses: General overhead costs like office supplies, utilities, and salaries.
Example: Total Operating Expenses = $120,000

Operating Income (Operating Profit):

Formula: Operating Income = Gross Profit - Operating Expenses
This reflects the profit from the company’s core operations, excluding non-operating activities
like interest or taxes.
Example: Operating Income = $200,000 - $120,000 = $80,000

Non-Operating Items:
These are revenues and expenses not related to core operations, such as:

Interest Expense: Costs of borrowed money (e.g., loans).

Interest Income: Money earned from investments.
Gains/Losses: From selling assets or other non-operating activities.
Example: Interest Expense = $10,000, Interest Income = $2,000
Income Before Taxes:
Formula: Income Before Taxes = Operating Income + Non-Operating Income - Non-Operating
Expenses
Example: Income Before Taxes = $80,000 + $2,000 - $10,000 = $72,000

Income Tax Expense:

The amount of tax the company must pay on its income.
Example: Income Tax = $15,000

Net Income:
Formula: Net Income = Income Before Taxes - Income Tax
This is the final profit or loss after accounting for all revenues, expenses, and taxes.
Example: Net Income = $72,000 - $15,000 = $57,000

ABC Manufacturing Co. For the Year Ended December 31, 2023
Revenue

Cost of Goods Sold $300,000

(COGS)

Gross
Profit
$200,000

Operating
Expenses

- Selling $60,000
Expenses

- Administrative $60,000
Expenses

Total Operating $120,000

Expenses

Operating Income $80,000

Non-Operating Items

- Interest Expense $10,000

- Interest Income $2,000

Income Before Taxes $72,000

Income Tax Expense $15,000

Net Income $57,000

 Relationships among the income statement , statement of
retained earning and Balance Sheet :
The Income Statement, Statement of Retained Earnings, and Balance Sheet are three
interconnected financial statements that provide a comprehensive picture of a company's
financial health.

Income Statement:
The income statement shows the company’s performance over a period, focusing on its revenues,
expenses, and net income (or loss). It calculates how much profit or loss the company generated
during the reporting period.

Key Elements:

Revenue: The income earned from the company's operations.

Expenses: The costs incurred to generate revenue.
Net Income: The profit or loss after all expenses are deducted from revenues.
Connection to Other Statements:
Net Income from the income statement is carried forward to the Statement of Retained Earnings.
It represents the earnings generated by the business during the period.

Statement of Retained Earnings:

The statement of retained earnings shows changes in the retained earnings balance over a period.
Retained earnings represent the cumulative profits that a company has decided to reinvest in the
business rather than distribute as dividends to shareholders.

Key Elements:
Beginning Retained Earnings: The retained earnings balance at the start of the
period.

Net Income: From the income statement, which is added to retained earnings.
Dividends: Payments made to shareholders, which are subtracted from retained earnings.
Ending Retained Earnings: This balance is carried forward to the equity section of
the balance sheet.

Connection to Other Statements:

Net Income from the income statement increases retained earnings.
Dividends paid reduce retained earnings.
The Ending Retained Earnings is reported in the equity section of the Balance Sheet.

Balance Sheet:

The balance sheet provides a snapshot of the company’s financial position at a specific point in
time. It lists the company’s assets, liabilities, and equity, showing what the company owns, owes,
and the owners' stake in the company.

Key Elements:

Assets: Resources owned by the company (e.g., cash, inventory, property).

Liabilities: Obligations the company owes to others (e.g., loans, accounts payable).

Equity: The residual interest in the company’s assets after deducting liabilities. This includes
common stock and retained earnings.

Connection to Other Statements:

Ending Retained Earnings from the statement of retained earnings is part of the equity section of
the balance sheet.
The balance sheet shows the accumulated retained earnings, which include past and current
profits that were reinvested into the business.
Flow of Information Among the Statements:

Income Statement:

Reports Net Income (or loss) for the period, which reflects the company's profitability.

Statement of Retained Earnings:

Takes Net Income from the income statement and adds it to the beginning retained earnings.
After subtracting any dividends, it reports Ending Retained Earnings, which reflects the portion
of profits retained by the company for reinvestment.

Balance Sheet:
Reports Ending Retained Earnings as part of the Equity section. The balance sheet also ensures
that the fundamental accounting equation (Assets = Liabilities + Equity) is in balance.

Sketch to illustrate the relationships among the Income Statement, Statement of

Retained Earnings, and Balance Sheet.