Accounting and Financial

Reporting
Master of Business Administration Program

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Lecture Week 2
Financial Statements

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 Learning Objectives

1 Describe the four financial statements and how they are prepared.
2 Explain the meaning of return on assets as a measure of profitability.
3 Explain the trade-off between risk and return.

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Quick Test
Transactions made by Virmari SA, a public accounting firm, for the
month of August are shown below. Prepare a tabular analysis
which shows the effects of these transactions on the expanded
accounting equation.
1. The owner invested €25,000 cash in the business.
2. The company purchased €7,000 of office equipment on credit.
3. The company received €8,000 cash in exchange for services
performed.
4. The company paid €850 for this month’s rent.
5. The owner withdrew €1,000 cash for personal use.

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Transaction 1. The owner invested €25,000 cash in the business.

Assets Liabilities Owner’s Equity

Accounts Owner's Owner's
No. Cash + Equipment = Payable + Capital - Drawings + Revenue - Expense
1 +€25,000 +€25,000
2
3
4
5

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Transaction 2. The company purchased €7,000 of office equipment on credit.

Assets Liabilities Owner’s Equity

Accounts Owner's Owner's
No. Cash + Equipment = Payable + Capital - Drawings + Revenue - Expense
1 +€25,000 +€25,000
2 +€7,000 +€7,000
3
4
5

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Transaction 3. The company received €8,000 cash in exchange for services
performed.

Assets Liabilities Owner’s Equity

Accounts Owner's Owner's
No. Cash + Equipment = Payable + Capital - Drawings + Revenue - Expense
1 +€25,000 +€25,000
2 +€7,000 +€7,000
3 +8,000 Service Revenue +€8,000
4
5

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Transaction 4. The company paid €850 for this month’s rent.

Assets Liabilities Owner’s Equity

Accounts Owner's Owner's
No. Cash + Equipment = Payable + Capital - Drawings + Revenue - Expense
1 +€25,000 +€25,000
2 +€7,000 +€7,000
3 +8,000 +€8,000
4 -850 Rent Expense -€850
5

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Transaction 5. The owner withdrew €1,000 cash for personal use.

Assets Liabilities Owner’s Equity

Accounts Owner's Owner's
No. Cash + Equipment = Payable + Capital - Drawings + Revenue - Expense
1 +€25,000 +€25,000
2 +€7,000 +€7,000
3 +8,000 +€8,000
4 -850 -€850
5 -1,000 -€1,000
€ 31,150 + €7,000 = €7,000 + €25,000 - €1,000 + €8,000 - €850

€38,150 €38,150

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Financial Statements
Let’s prepare the financial statements reflecting the
transactions we have recorded.
Companies prepare four financial statements:

Income Owner's Statement Statement

Equity of Financial of Cash
Statement
Statement Position Flows

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Financial Statements
1. The income statement describes a company’s revenues and expenses along
with the resulting net income or loss over a period of time due to earnings
activities.
2. Statement of owner’s equity—explains changes in equity from net income (or
loss) and from any owner investments and withdrawals over a period of time.
3. Statement of financial Position—describes a company’s financial position
(types and amounts of assets, liabilities, and equity) at a point in time.
4. Statement of cash flows—identifies cash inflows (receipts) and cash outflows
(payments) over a period of time.

The first financial statement that we prepare is the income statement. Let’s get
started.
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Income Statement

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Income Statement
• Net income is defined as the difference between revenues and
expenses.
• If expenses exceed revenues, we have a net loss rather than net income.
• Financial statements have a three line title with the company name, the
name of the statement, and the period covered by the report.
• In our case, we had total revenues of $6,100 and total expenses of
$1,700, so net income for the month ended December 31, 2011, was
$4,400.
• After completing the income statement, we can prepare the statement
of owner's equity.
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STATEMENT OF OWNER’S EQUITY

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STATEMENT OF OWNER’S EQUITY
• In the statement of owner's equity, we start with the balance at the beginning of the
period, add new owner investments and net income earned during the period, and
deduct any withdrawals paid, resulting in the ending balance in owner's equity.
• FastForward was started this month, so the beginning balance in owner's equity was
zero.
• Chas Taylor invested $30,000 in the company at the beginning of the month.
• During December, net income of $4,400 was earned. Notice that the net income
flows from the income statement to the statement of owner’s equity. We must
complete the income statement before we can begin working on the statement of
owner’s equity.
• In addition, $200 withdrawal was made by Chas Taylor, so the ending balance in
owner's equity is $34,200. After we complete this statement, we can prepare the
statement of financial position (balance sheet).
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Statement of Financial Position
The statement of financial position (balance sheet)
describes a company’s financial position at a point in
time.

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Statement of Financial Position
• The statement of financial position is a summary of assets, liabilities and equity
at the end of the month. Our total assets are equal to $40,400. This includes
cash of $4,800, supplies of $9,600, and equipment of $26,000.
• Liabilities include accounts payable of $6,200.
• Equity is composed of C. Taylor, Capital of $34,200. The account C.Taylor, Capital
flows directly from the statement of owner’s equity. You can see that the books
are in balance because total assets are equal to total liabilities plus equity.
• Creditors have claims against our assets of $6,200. The owner has claims to
assets of $34,200.

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Statement of Cash Flows
• Information on cash receipts and payments for a specific period of
time
• Answers the following:
▪ Where did cash come from?
▪ What was cash used for?
▪ What was change in cash balance?
• The statement reconciles to the ending cash balance of $4,800. Recall
that the ending cash balance of $4,800 flows from the balance sheet
to the statement of cash flows.
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Statement of Cash Flows

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Statement of Cash Flows
• The three major types of activities in any organization can be defined as:
1. Financing Activities – Provide the means organizations use to pay for
resources such as land, buildings, and equipment to carry out plans.
2. Investing Activities - Are the acquiring and disposing of resources
(assets) that an organization uses to acquire and sell its products or
services.
3. Operating Activities – Involve using resources to research, develop,
purchase, produce, distribute, and market products and services.

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Statement of Cash Flows
• Investing (assets) and financing
(liabilities and equity) are set
opposite each other to stress their
balance.
• Operating activities are below
investing and financing activities to
show that operating activities are
the result of investing and financing.
• Planning is part of each activity and
gives them meaning and focus.
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 Statement of Cash Flows
Notice that the statement is divided into three major sections:
1. Cash flows from operating activities which report cash receipts and
payments from the primary business the company engages in (Net
Income Transactions).
2. Cash flows from investing activities which involve cash transactions
from buying and selling long-term assets (Non-current Assets).
3. Cash flows from financing activities which include long-term cash
borrowings and repayments to lenders (Liabilities) and the cash
investments from and withdrawals by the owner (Owner’s Equity).

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Quick Test
Which of the following financial statements is prepared as
of a specific date?
a. Statement of financial position
b. Income statement
c. Owner's equity statement
d. Statement of cash flows

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Quick Test
Presented below is selected information related to Li Fashions at
December 31, 2020. Li reports financial information monthly.
Equipment HK$10,000 Utilities Expense HK$4,000
Cash 8,000 Accounts Receivable 9,000
Service Revenue 36,000 Salaries and Wages Expense 7,000
Rent Expense 11,000 Notes Payable 16,500
Accounts Payable 2,000 Owner’s Drawings 10,000
a. Determine the total assets at December 31, 2020.
b. Determine the net income reported for December 2020.
c. Determine the owner’s equity at December 31, 2020.

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Quick Test
Li reports financial information monthly.
Equipment HK$10,000 Utilities Expense HK$4,000
Cash 8,000 Accounts Receivable 9,000
Service Revenue 36,000 Salaries and Wages Expense 7,000
Rent Expense 11,000 Notes Payable 16,500
Accounts Payable 2,000 Owner’s Drawings 10,000
a. Determine the total assets at December 31, 2020.

$
Cash 8,000
Accounts receivable 9,000
Equipment 10,000
$27,00
Total assets 0 25
Quick Test
Li reports financial information monthly.
Equipment HK$10,000 Utilities Expense HK$4,000
Cash 8,000 Accounts Receivable 9,000
Service Revenue 36,000 Salaries and Wages Expense 7,000
Rent Expense 11,000 Notes Payable 16,500
Accounts Payable 2,000 Owner’s Drawings 10,000
b. Determine the net income reported for December 2020.

Service revenue $36,000

Rent expense (11,000)
Salaries and wages expense (7,000)
Utilities expense (4,000)
Net income $14,000

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Quick Test
Li reports financial information monthly.
Equipment HK$10,000 Utilities Expense HK$4,000
Cash 8,000 Accounts Receivable 9,000
Service Revenue 36,000 Salaries and Wages Expense 7,000
Rent Expense 11,000 Notes Payable 16,500
Accounts Payable 2,000 Owner’s Drawings 10,000
c. Determine the owner’s equity at December 31, 2020.

Total assets $27,000

Less: Notes payable (16,500)
Less: Accounts payable (2,000)
Owner’s equity $ 8,500

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 Decision Analysis (Return on Assets)
• Return on assets is a useful profitability measure
used in evaluating management, analyzing and
forecasting profits, and planning activities.
Net income
• Return on assets (ROA), also called return on Return on assets =
Average total assets
investment (ROI) is stated in ratio form as income
divided by assets invested.
Here is a table to illustrate, showing the return on assets for Dell from 2009
through 2013, as well as the return on assets for the entire industry.

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Return on Assets (Example)
• Best Buy reports net income of $1,317 million for fiscal year 2010. At
the beginning of fiscal 2010, its total assets are $15,826 million and at
the end of fiscal 2010, they total $18,302 million. Best Buy’s return on
assets for fiscal 2010 is:
Return on assets = $1,317 million
= 7.7%
($15,826 million + $18,302 million)/2
• Is a 7.7% return on assets good or bad for Best Buy?
To help answer this question, we compare (benchmark) Best Buy’s
return with its prior performance, the returns of competitors (such as
RadioShack, Conn’s, and Rex Stores), and the returns from alternative
investments. 29
Return on Assets (Example)

• Best Buy shows a fairly stable pattern of

good returns that reflect its productive use
of assets.
• There is a decline in its 2009 return reflecting
the recessionary period.
• We compare Best Buy’s return to the normal
return for similar merchandisers of electronic
products (third column). When compared to
the industry, Best Buy performs well.

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Return and Risk Analysis
• The trade-off between
Many different return and risk is a
returns may be normal part of
reported. business.
• Higher risk implies
Risk is the higher, but riskier,
ROA uncertainty about expected returns.
Interest return on the return we will • To make better
savings accounts earn. decisions, we need to
consider both return
Interest return on and risk.
corporate bonds

Bonds are written

promises by organizations
to repay amounts loaned
with interest 31
 Return and Risk Analysis (Example)
• Banks report return from a savings account in the form of an interest return such as 4%. If we invest in
a savings account or in U.S. Treasury bonds, we expect a return of around 2% to 7%. How do we decide
among these investment options?
The answer depends on our trade-off between return and risk.
• All business investments involve risk, but some
investments involve more risk than others. The lower the
risk of an investment, the lower is our expected return.
The bar graph shows recent returns for 10-year bonds
with different risks.
• U.S. Treasury bonds provide a low expected return, but
they also offer low risk since they are backed by the U.S.
government. High-risk corporate bonds offer a much
larger potential return but with much higher risk.
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References
• Wild, J., Shaw, K., Chiappetta, B. and Samaha, K., 2017. Fundamental
Accounting Principles. 2nd ed. McGraw-Hill Education.
• Weygandt, J., Kimmel, P. and Kieso, D., 2019. Accounting Principles
IFRS Version. Global Edition. Wiley.

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