This session introduced you to the fundamental concepts of financial statements.

The objectives for this session were to:

● Explain the role of financial statements in financial decision-making
● Describe the basic structure of the income statement
● Describe the basic structure of the balance sheet statement
● Describe the basic structure of the cash flow statement

Financial accounting is an information system that provides information to stakeholders about the economic
activities and condition of a business. Companies prepare financial statements to convey their business
activities and financial performance to the public.

The information contained in these statements is used mainly by the following entities:
● Shareholders, who have a vested interest in knowing about a company’s performance and profitability
● Creditors, who may be interested in understanding whether a company will be able to repay its loans
● Government regulators and tax agencies, who look at financial statements to check for company’s
compliance with government regulations

Next, you learnt about three types of business organizations, as listed below:
1. Sole proprietorship
a. It refers to a business owned by a single individual.
b. An individual’s tax return is the same as that of the company.
c. As a sole person is involved, it is easy to form and dissolve.
2. Partnership
a. It refers to a business owned by two or more individuals.
b. An upside of partnership is cooperative work, and a downside of partnership is that liabilities
are shared.
c. Each partner has to pay tax based on their share in the earnings of the partnership.
3. Corporation
a. It refers to a business organized under state or federal statutes as a unique legal entity.
b. Numerous legal documents and attorneys are needed to incorporate and dissolve a
corporation.
c. As an equity owner, the decision-making power is proportional to company ownership.
d. Liability is also limited in proportion with company ownership.
e. A corporation is considered to be a separate entity having an unlimited life, and its liability
depends on the percentage ownership of the corporation.

The key foundational principle in financial accounting is the matching principle, which requires expenses of a
period to be matched with the revenue generated during that period.

You also learnt about the difference between cash accounting and accrual accounting.
Individuals and partnerships tend to use the cash basis of accounting for financial statements. Here, revenues
and expenses are reflected whenever cash flows in or out of the business. In contrast, corporations generally
use the accrual basis of accounting. Here, revenues and expenses are shown when they are incurred and not
when cash flows in or out.

An income statement captures all of the financial activities happening in a company in a particular financial
year. It is also known as the profit or loss statement.

It is the first financial statement that is prepared. and it forms the basis for the statement of retained earnings,
the balance sheet and the cash flow statement.

You also learnt how to calculate net income:

Net income (profit/loss) = Revenue - Expenses

To calculate net retained earnings, the beginning retained earnings and the net income must be added, and the
dividends must be subtracted from the sum. The formula is as follows.

Net retained earnings = Beginning retained earnings + Net income - Dividends

If the net revenue of a company is higher than its expenses, then it has a net income; similarly, if expenses are
higher, net losses are incurred.

You then learnt certain points related to dividends, which are listed below:
1. It represents a return of the retained earnings and must not be conflated with expenses.
2. Companies pay dividends only if they have a positive retained earnings balance.
3. It is important to note that start-ups do not pay dividends; however, dividends are paid by established
companies when they want to return cash to their shareholders.
The income statement summarizes the revenue and expenses of a company for a specific period, such as a
month or a year. In addition to this, it indicates whether a company has a net income or net loss.

You learnt that revenue refers to the income received from selling products or services to customers; for
example, sales revenue, service revenue, interest income, and rental income.

You also learnt that expenses refer to the costs incurred in order to earn revenue; for example, COGS (Cost of
Goods Sold), wage expense, utility expense, transportation expense, advertising expense, rent expense,
interest expense, supplies expense, depreciation expense, etc. Expenses can be either fixed or variable.

The difference between revenue and COGS is called the gross margin or gross profit percentage. The primary
way to increase the gross margin is to either increase the selling price of goods or services or cut costs within
the company. The formula for this is as follows.
Gross margin = (Total revenue - Cost of goods sold) / Total revenue

Operating leverage refers to the degree to which a company can use the fixed cost base to generate more
revenue. A company that has a lot of invested capital (for instance, it owns its building) is not liable to have a
lot of fixed expenses (in this instance, it won’t have to pay rent). This company has a high operating leverage
because a lot of its revenue gets converted to net income.

Income statements are usually prepared on an annual basis, but if required, they can also be prepared on a
quarterly basis.

Statement of Retained Earnings

The net income, which is the value at the bottom line of the income statement, is used in another statement
called the statement of retained earnings. The formula for this is as follows.
Net retained earnings = Beginning period retained earnings + Net income - Dividends
The retained earnings are then carried over to the balance sheet. The equation used here is as follows.
Assets = Liabilities + Equity

The flow of information from one statement to another is illustrated below.

At the end, the final statement is created, which is called the cash flow statement. This will be covered in
detail in an upcoming segment.

A company that pays its dividends on time is attractive to investors, as it is considered to be stable.

Statement of Stockholders’ Equity

The statement of stockholders’ equity shows the changes in the value of a company over time. Equity includes
both the retained earnings and the stock.

Treasury stock is the stock bought back by the company from its shareholders.

Note that a company’s earnings per share (EPS) can be calculated using the following formula.

You also learnt that if a stock is undervalued, the issuing company can repurchase some of its shares at the
reduced price and then reissue them once the market has corrected, thereby increasing its equity capital
without issuing any additional shares.

A balance sheet provides a still photograph of the finances of a company at the end of a year. The readers of a
balance sheet may learn what a company’s financial standing is at that point in time and make decisions based
on their inference. It represents the closing balances in the various company accounts.

The left side and the right side of the following equation must be balanced.
Assets = Liabilities + Equity

There are two types of assets:

1. Short-term (current) assets
a. Short-term assets are in the form of cash, or they can be converted into cash in less than a year,
or will be used up in less than a year.
b. For example, inventory, marketable securities, and accounts receivable.
2. Long-term (non-current) assets
a. Long-term assets cannot be easily converted into cash.
b. For example, land and machinery.

Long-term assets can be further classified into the following:

a. Tangible assets
i. Tangible assets are those that have a physical form, like land and factory equipment.
ii. Accumulated depreciation is the sum of all recorded depreciation on an asset to a specific date.
b. Intangible assets
i. Intangible assets are those that lack physical substance.
ii. These assets are not depreciated but are amortized over their useful or legal life. So,
accumulated amortization is the total cost of intangible assets that have not yet been charged
to expense.
 iii. Examples include copyrights, patents, and goodwill.
iv. Goodwill is an intangible asset that accounts for the excess purchase price that a company pays
when acquiring another company. It is reevaluated on a periodic basis to determine its value.

You further learnt about liability, which is a financial obligation that a company must pay.

Liabilities are of broadly two types:

1. Short-term or current liabilities: Short-term liabilities are due and payable within one year, like bills
payable and accounts payable.
2. Long-term or non-current liabilities: Long-term liabilities are payable after a year or more.

A shareholder equity represents ownership in a company. It is mainly of two types:

1. Stocks
2. Retained earnings

Retained earnings are calculated by subtracting dividends from profits. The formula is as follows.
Retained earnings = Profits - Dividends

When transactions are made, debits and credits must always be balanced, and T-diagrams are used to help
with this equation. A T-diagram is illustrated below.

The terms debit and credit have different meanings on the two sides of the equation. For assets, a debt would
be an increase in cash, and a credit signifies a decrease. This is reversed on the right side, i.e., for liabilities and
equity, where a debit signifies a decrease in cash, and a credit signifies an increase.

An accrual occurs when the financial activity has taken place in advance of the cash exchanging hands. For
example, wages that have been earned during the period but have not yet been paid.

A deferral means that cash exchanges hands before the financial activity takes place. All corporations are
required to use the accrual basis of accounting.

A cash flow statement helps understand the balance sheet figures clearly. It explains where the cash comes
from and where it is spent.
A cash flow statement has three major sections:
● Operating cash flow
○ It includes any cash inflow and outflow that occurs on account of the day-to-day operating
activities of a company. It is a company's net income (in cash) and includes any changes in the
current assets and current liabilities, such as changes in cash, inventory, accounts receivable,
and accounts payable.
○ If current assets increase, the cash with the company decreases, whereas if current liabilities
increase, the cash increases.
○ The direct method of creating a cash flow statement records and totals all operating
transactions, whereas the indirect method starts with net income and adds back non-cash
items and changes in working capital. The indirect method is most commonly used for
preparing a cash flow statement.
● Investing cash flow
○ It includes any cash inflow or outflow that is related to the sale or purchase of the non-current
assets of a company.
○ Any purchase of non-current assets will lead to a cash outflow, whereas any sale of
non-current assets will lead to a cash inflow.
● Financing cash flow
○ It includes any cash inflow or outflow that occurs on account of obtaining or repaying capital.
○ Any borrowing, loan, or fresh capital is considered a cash inflow, whereas any repayment of
loans, payment of dividends, etc., is considered a cash outflow.

The operating cash flow section starts with net income and adds back non-cash adjustments. Those
adjustments can be found by subtracting the change in the balance sheet line items, as mentioned below:
● Increase in depreciation and amortization
● Change in inventory
● Change in accounts payable
● Change in accounts receivable

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