CHAPTER 2

INTRODUCTION TO FINANCIAL STATEMENTS

Business entities may have many objectives & goals.
The two primary objectives of every business are
profitability and solvency.
Profitability is the ability to generate income.
Solvency is the ability to pay debts as they become due.
Unless a business can produce satisfactory income &
pay its debts as they become due, the business can’t
survive to realize its other objectives.
 Financial Statements
Financial Income Statement / Profit or loss statement – a statement that summarizes
statements are the revenues earned and expenses incurred to determine Net profit or Net
loss for a specific period of time such as a month or a year
reports
prepared by a Statement of Owners’ Equity / Capital Statement - is a summary of changes
business to (increases and decreases) in owner’s equity that have occurred during a
specific period of time such as a month or a year..
provide
financial Statement of Financial Position / Balance Sheet : - is used to provide
information information about amounts and types of assets a business owns and
amounts and types of resources contributed by its owner/s and creditor/s.
about its
economic Statement of Cash Flow: - is used to provide information about sources and
uses of cash over a specific period of time such as a month or a year
affairs to
users
 A Starting Point: Statement of Financial Position (Balance
Sheet)
 Is a list of balances in the assets, liability & owners’
( stockholders’) equity accounts.
 This “list depicts the position of assets, liabilities, &
owners’ (stockholders’) equity of a specific business
at a specific point of time.”
 It is prepared on a specified date because the figure
shown in the balance sheet is true on that date only.
 The totals of the assets should be equal to the totals
of liabilities & owners’ (stockholders’) equity. If it is
not so, it means that there is some error.
CHARACTERISTICS OF BALANCE
SHEET:
 It is a statement and not an account.
 It is always prepared on a particular date, & thus shows
the position at that date & not for a period.
 It has no debit side & credit side.
 It shows the financial position of the business concern.
 It shows what the firm owes to others & also what
others owe to the firm
 The totals of assets always are equal with the totals of
liabilities & owners’(SH) equity.
USES OF BALANCE SHEET
 The balance sheet is described as a
snapshot/photograph/picture of the financial position of a
business entity.
 The various groups interested in the company can draw
useful inferences from an analysis of the information
contained in the balance sheet.
 It proves that the accounting equation (Assets = Liabilities
+ Owner's Equity) is in balance.
 It shows the nature & value of the assets.
 It shows what the firm owes to others and also what others
owe to the firm.
 ELEMENTS OF THE BALANCE SHEET

Assets Examples
• building, land, vehicle, money, office machine such as
computer, stationery materials, fuel,
• Inventory (merchandise held for sale),
• Accounts Receivable (money claims against customers for
goods and services sold to them on credit),
• Rent Receivable (money claims against lessee/tenant/renter
for housing services rendered to them but not yet collected),
• Supplies (also called consumable - refer to assets that are
expected to be consumed within a very short period of time
and include such items as fuel, stationery materials, cleaning
materials, postage and postage stamps, etc),.
LIABILITIES Examples
Accounts Payable (liability arising from purchase of goods on credit),
Salary Payable (obligation for professional or technical services received from
employees),
obligations/debts
Utility Payable (obligation to utility companies for utility services such as
of a business that telephone, electricity and water services received but not yet paid),
arise as a result
Bank Loan Payable (money borrowed from banks),
of borrowing
and/or buying Interest Payable (interest accrued on loans not yet repaid),
goods and Sales Tax (VAT) Payable (amount collected from customers on behalf of and due to
services on credit government/tax authority) and
Unearned Rent (money collected from tenants promising to provide them housing
services in the future).
CAPITAL (EQUITY) Examples

also called  Capital (Equity) may include:

owner’s
equity/net  direct investment of resources by owner/s and
worth/net assets
refer to
 profit generated from business operations that
resources
contributed by or
that belong to the are accumulated over time or not withdrawn by
owner/s of a
business entity. the owner/s for personal use.
 VARIABLES THAT AFFECT CAPITAL

 Revenues - refer to money or other assets received in exchange for goods and
services sold to customers. Business organizations may sell goods and services
on cash and/or credit basis.
Capital  Expenses - refer to goods and services consumed/used in operating or carrying
(owners’ on day-to-day activities of a business.
equity) is  Drawing (withdrawal): - amount of cash or other assets taken by owners for
affected by personal use. It is also called Dividend for corporations
four major  Investment by Owners: - the amount of owners cash or other personal assets
variables
that is transferred to the business
Expanded Accounting Equation
 Business Transactions
Analysis

Each Business transaction affects at least two elements of

accounting equation. The effect could be a decrease or
increase in one or more elements of accounting equation.
Use the following illustration to analyze the effect of
transaction on accounting equation elements
 Illustration:
As a means of illustration, suppose Mr. Yitref, a graduate from
Maryland International College, established a sole
proprietorship to be known as “Matref Consulting”, a service
providing firm that provides consultancy service in management
and finance on January 1, 2021. During January, the business
engages in the following transactions:
 Transaction (1) - Owner’s investment: - Mr. Yitref starts business by depositing Br. 100,000 in a bank account opened in the name of
Yitref Consulting.

 Transaction (2) - Purchase of land for cash: - Materef Consulting bought land for Birr 20,000 in cash, to be used as a future site for
the business.

 Transaction (3) - Purchase of Supplies on credit (on account): - Mr. Yitref bought office supplies for birr 2,500 on credit, to be used
by the business.

 Transaction (4) – Payment of liability: - Matref Consulting paid Birr. 1,500 to creditors on account.

 Transaction 5 – Selling of service: - During the first month of operation, the firm earned service Fees of Birr 30,000 receiving the
amount in cash for the services it rendered.

 Transaction (6 )- Recording Expenses: - During the month of September, Matref Consulting paid Birr 15,000 for different types of
expenses (birr 10,000 to salary of employees, birr 3000 Telephone, birr 1,500 for rent, and birr 500 for advertisement).

 Transaction (7) – Owner’s Withdrawal: - Mr. Yitref, the owner, withdrew Birr 3000 for his personal from the business.

 Transaction (8) – Consumption of supplies: - Physical count of supplies at the end of the month revealed that supplies worth
Br.1500 are consumed

 Required: Show the effect of each of the above transactions on elements of accounting equation, and prepare the four basic financial
statements based on the summary of transactions
 Type of owner’s
Tra. Supplies + Land Accounts Dawit Gem. Capital Transaction
No Cash + Payable
1 +100,000 - - - + 100,000 Owners
Investment
Bal Birr 100,000 - - - Birr 100,000
2 -20,000 - + 20,000 - -
Bal Birr 80,000 - Birr 20,000 - Birr 100,000
3 - +2500 +2500
Bal Birr 80,000 Birr 2,500 Birr 20,000 Birr2500 Birr 100,000
4 -1,500 - -1500
Bal Birr 78,500 Birr 2,500 Birr 20,000 Birr1,000 Birr 100,000
5 + 30,000 - - - + 30,000 Service fee
Bal Birr 108,500 Birr 2,500 Birr 20,000 Birr1,000 Birr 100,000
6 -15,000 - - - -10,000 Salary Exp.
-3000 Teleph. Exp
- - - - -1500 Rent Exp.
-500 Adv. Exp.
Bal Birr 93,500 Birr 2500 Birr 20,000 Birr 1000 Birr 115,000
7 -3,000 - - - -3000 Owner’s
withdrowal
Bal Birr 90,500 Birr 2500 Birr 20,000 Birr 1,000 Birr 112,000
8 - -1500 - - -1500
Bal Br. 90,500 Br. 1000 Br. 20000 Br.1000 Br.110500
Total Assets =Birr 111,500 Total Liabilities and Owner’s Equity = Birr 111,500
 Financial Statement Elements

As we have discussed above elements of financial

statements are;

 Income Statement / Profit or loss

statement –

 Statement of Owners’ Equity / Capital

Statement

 Statement of Financial Position / Balance

 Matref Consulting
Income statement
For the Month Ended January 31,2021
Revenues:
Service Fee Birr 30,000.00
Expenses:
Salary Expense Birr 10,000.00
Telephone Expense 3,000.00
Rent Expense 1,500.00
Advertising Expense 500.00
Supplies Expense 1500.00

Total Expenses 16,500.00

Net Income Birr 13,500.00
 Matref Consulting
Statement of Owner’s Equity
For the Month ended January 31,2021
Dawit G. Capital, September 1……………………………………Birr -0-
Add: Investments………………………………… Birr 100,000.00
Net income…………………………………… 13,500.00

113,500.00
Less: Drawings………………………………………………………3,000.00
Dawit G. Capital, September 30…………………………… Birr 110,500.00
 Matref Consuling
Balance Sheet
January 31,2021

Assets Liability
Cash…………Birr 90,500.00 Accounts payable…… Birr 1,000.00
Supplies……………1,000.00 Owner’s Equity
Land………………20,000.00 Ato Dawit Gem., Capital Br110,500.00.
_________ Total Liabilities and
Total Assets……..111,500.00 Owner’s equity……...Birr 111,500.00
Statement of cash flows has 3 sections
1. Cash flows from the operating activities are the cash effects
of revenues & expense transactions that are included in the
income statements.
2. Cash flows from the investing activities are the cash effects of
purchasing & selling assets.
3. Cash flows from financing activities are the cash effects of
owners investing in the company, owners withdrawal from the
company & creditors loaning money to the co. & repayment of
either or both.
 Greener Landscape Group
Statement of Cash Flows
For the Year Ended on Dec.31,2009
Cash Flows from Operating Activities:
Cash from Customers $ 870
Cash to Employees (200)
Cash to Suppliers (1,265)
Cash Flow Used by Operating Activities (595)
Cash Flows from Investing Activities:
Purchases of Equipment (8,000)
Cash Flows from Financing Activities:
Investment by Owner 15,000
Withdrawal by Owner (50)
Cash Flow Provided by Financing Activities 14,950
Net Increase in Cash 6,355
Beginning Cash, Jan.1 0
 ?
•Explain how the statement of cash
flows presents the change in cash
for a period of time in terms of the
company’s operating, investing and
financing statements.
Forms of Business Organizations
 Accountants frequently refer to a business
organization as an accounting entity or a business
entity.
 For accounting purpose, each business
organization or entity has an existence separate
from its owner(s), creditors, employees, customers
& other business
 This separate existence of business organization is
called business entity concept.
Thus, in the accounting records of the business
entity, the activities of each business should be
kept separate from the activities of other
businesses & from the personal & financial
Forms of Business Organizations
In modern business world, most business
enterprises are organized as:

1. Sole proprietorships,

2. Partnerships, &

3. Corporations
 SOLE PROPRIETORSHIP
 Is unincorporated business owned by an individual &
often managed by that same person.
 No legal formalities are necessary to organize such
businesses, & usually business operations can begin with
only a limited investment.
 From an accounting view point, a sole proprietorship is
a business entity separate from the other affairs of its
owner.
 From the legal point of view, however, the business &
its owner are not regarded as separate entities.
 Thus, the owner is personally liable for the debts of the
business.
 PARTNERSHIP
Partnership: Is an unincorporated business owned by two or
more persons associated as partners.
 As in case of the sole proprietorship, the owners of a partnership
are personally responsible for all debts of the business.
 From an accounting stand point, a partnership is viewed as a
business entity separate from the personal affairs of its owners.
 A benefit of partnership form over sole proprietorship form is the
ability to bring together large amount of capital investment
from multiple owners.
 CORPORATION
A corporation is a business incorporated under the
law of a state and owned by a few stockholders or
thousands of stockholders.
 It is unique in that it is a separate legal business
entity.
 The owners of the corporation are stockholders or
shareholders.
 The corporate form of business protects the
personal assets of the owners from the creditors
of the corporation.
 Presentations of Owner’s Equity in Balance Sheet
 Sole proprietorship
 Owner’s Equity:
Mr. X, Capital…………………………….. xx
 Partnership
Partners’ Capital:
Partner A, Capital…………………….xx
Partner B, Capital……………………..xx
Total partners’ equity xxx
 Corporation
 Stockholders’ Equity:
Capital Stock……………………………………xx
Retained Earnings……………………………. xx
Total Stockholders’ Equity xxx
 Relationships among Financial
Statements
Beg._______________TIME_________________End
B/Sheet Income St’t
B/S
St’t of CF
At the beginning & ending point in time, a co. prepare a
st’t of financial position (B/S) that gives a static look in
financial terms of where the co. stands.
The other 2 FSs of IS & SCF cover the intervening
period of time b/n the two B/Ss & explain the important
changes that occurred during the period.
 ILLUSTRATION
1. United communications was organized on December 1 of
the current year and had the following account balances at
December 31, listed in tabular form.
Assets = Liabilities + Owners Equity
Cash + Land + Building + office equipment = Notes Payable + Accounts Payable + Capital
Stock

Balances $37000 95000 125000 51250 80000 28250 200000

Early in January, the following transactions were carried out by

United Communications;
2. Sold capital stock to owners for 35000
3. Purchased land and a small office building for a total price
of 90,000 of which 35000 was the value of the land and
55000 was the value of the building. Paid 22500 in cash
and signed a note payable for the remaining 67500
3. Brought several computer systems on credit for
9500(30 day open account)
4. Obtained a loan from Capital bank in the amount
of 20000 signed a note payable
5. Paid the 28,250 account payable as of January 31.
Instructions
a. Record the effects of each of the five transactions
in the format given above and show the totals for
all columns after each transaction.
b. Prepare a balance sheet at the end of the five
transactions (January 31)
Financial Statement
Connections