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The Purpose and Use of Financial Statements CHAPTER 1 THE PURPOSE AND USE OF FINANCIAL STATEMENTS SUMMARY OF QUESTION TYPES BY LEARNING OBJECTIVE, LEVEL OF DIFFICULTY, BLOOM’S TAXONOMY, CPA CODES, AND AACSB CODES CHAPTER LEARNING OBJECTIVES 1.Identify the uses and users of accounting information. The purpose of accounting is to provide useful information for decision-making. There are two types of decision makers who use accounting information: internal users and external users. The primary internal users are managers, who work for the business and need internal accounting information to manage and run its operations. The primary external users are investors and lenders and other creditors. Investors (existing and potential shareholders) use accounting information to help decide whether to buy, hold, or sell shares. Lenders (such as bankers) and other creditors (such as suppliers) use accounting information to evaluate the risk of lending money or granting credit to a business. Other external users include non-management employees, customers, regulators, and taxing authorities. 2. Describe the primary forms of business organization. There are three types of business organizations: proprietorships, partnerships, and corporations. A proprietorship is a business owned by one person. A partnership is a business owned by two or more people. A corporation is a separate legal entity whose shares provide evidence of ownership. Corporations can be public, which means their shares trade on a stock exchange, or private, which means their shares are closely held and do not trade on a stock exchange. Generally accepted accounting principles are a common set of guidelines that are used to record and report economic events. These can differ depending on the form of business organization. Public corporations follow International Financial Reporting Standards (IFRS) and private corporations have the choice of using IFRS or Accounting Standards for Private Enterprises (ASPE). Proprietorships and partnerships generally use ASPE. 3. Explain the three main types of business activity. Financing activities involve collecting the necessary funds (through the issue of equity or the assumption of debt) to support the business. Repayments of debt, the declaration and payment of dividends, and share repurchases are also financing activities. Investing activities primarily involve purchasing the long-term assets (such as property, plant, and equipment) that are needed to run the business, but also include the disposition of these items. Operating activities involve putting the resources of the business into action to generate net income. These involve the day-to- day activities of the business as it earns revenues and incurs expenses doing so. 4. Describe the purpose and content of each of the financial statements. The income statement presents the revenues and expenses of a company for a specific period of time. The statement of changes in equity summarizes the changes in shareholders’ equity that Copyright © 2017 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission of this page is prohibited 1 - 1
Balance sheets and income statements are important tools to help you understand the health and prospects of your business, but the two differ in key ways. This guide will give you a comprehensive overview of both financial statements. The balance sheet and income statement represent important information regarding the financial performance and health of a business. An income statement assesses the profit or loss of a business over a period of time, whereas a balance sheet shows the financial position of the business at a specific point in time. Editor’s note: Looking for the right accounting software for your business? Fill out the below questionnaire to have our vendor partners contact you about your needs. The balance sheet and income statement complement each other in providing a complete picture of a company’s financial position and future prospects. Both are crucial for decision-makers, investors and financial institutions. If you don’t have a background in accounting or finance, these terms may seem daunting at first, but reading and analyzing financial statements remains a requisite skill for business owners and executives. What is a balance sheet?The balance sheet is the cornerstone of a company’s financial statements, providing a snapshot of its financial position at a certain point in time. It includes what the company owns (its assets), what it owes (its liabilities), and owner’s equity, which includes money initially invested in the company, along with any retained earnings attributable to the owners or shareholders. This statement is divided into two columns, based on the following equation:
This equation forms the foundation of a balance sheet, with assets in one column, equal to the liabilities and the owner’s equity in the other. The balance sheet reflects the company’s performance since its inception, encompassing every single transaction, the amounts raised, the debts accumulated, the assets acquired, and their present valuations, all presented in a single statement. This provides insight into the operations, finances and future prospects of the company using financial ratios such as debt-to-equity, which reflects the company’s ability to pay its debts using equity, or the current ratio, which divides current assets by current liabilities to determine the company’s ability to meet its obligations over the next 12 months. Did you know? The acid-test ratio adds further clarity to the current ratio by only considering easy-to-liquidate assets, providing a more accurate picture of a company’s ability to meet obligations.What’s included in a balance sheet?The balance sheet comprises assets, liabilities and owner’s equity toward the end of the accounting period. Assets
Liabilities
Owner’s or shareholder’s equityIn simple terms, owner’s or shareholder’s equity is equal to the total assets attributable to owners or shareholders in the event of the company’s liquidation, after paying all debts or liabilities. This segment of the balance sheet includes return of equity (ROE), calculated by dividing net income by shareholder’s equity. ROE measures management’s effectiveness in employing and driving returns based on equity. Shareholder’s equity also includes retained earnings – the portion of the net income that hasn’t been distributed to shareholders as dividends – to be used for funding further growth and expansion of the business. What is an income statement?Also known as the profit and loss (P&L) statement, the income statement summarizes the financial performance of a business during a specific period, reporting revenues, cost of goods sold, overheads, and the net profit attributable to shareholders. The P&L statement is one of three key financial statements a business releases, either quarterly, annually, or both if it’s a public company. It keeps track of profitability, income sources, expenses and budgets, allowing the company to take action against variances from projections. Investors and lenders pay attention to the P&L statement, especially when comparing different periods to determine the long-term trajectory of the company. To a skilled analyst, the data presented in a profit and loss statement can provide deep insights with the use of ratios. These include the gross and operating margin ratio, which highlights the company’s profitability in relation to the sales and expenses incurred; the price-earning and return-of-equity ratios to assess efficiency in capital allocation; and the times-interest-earned (TIE) ratio to measure the margin of safety a company has to meet its debt payments. What’s included in an income statement?The income statement focuses on four key items: sales revenues, expenses, gains and losses. It does not concern itself with cash or non-cash sales, or anything regarding cash flow.
What are the differences between a balance sheet and income statement?Here is a quick reference for the key differences between the balance sheet and income statement, summarizing what we’ve discussed above.
What are the similarities between an income statement and a balance sheet?The balance sheet and income statements complement one another in painting a clear picture of a company’s financial position and prospects, so they have similarities. Along with the cash flow statement, they comprise the core of financial reporting. Errors or omissions in either of them create inaccurate results across all of them. The income statement and balance sheet follow the same accounting cycle, with the balance sheet created right after the income statement. If the company reports profits worth $10,000 during a period, and there are no drawings or dividends, that amount is added to the shareholder’s equity in the balance sheet. These and other similarities keep them reliant on each other and make them both essential in providing a clear and complete picture of accounts. Can accounting software help you manage income statements and balance sheets?Given the importance of income statements and balance sheets in financial reporting, accounting software is invaluable. It can reduce mistakes or omissions that would result in flawed or inaccurate financial statements. There are many accounting tools and solutions, which you can read about in our review of QuickBooks accounting software or our FreshBooks accounting software review. There are accounting tools that cater to organizations of all types and sizes. Here are some of the best accounting software solutions, with budget pricing and intuitive user interfaces that can make accounting less daunting. Which financial statement helps users determine a company's policy toward dividends and growth?Retained earnings are profits held by a company in reserve in order to invest in future projects rather than distribute as dividends to shareholders. Analysts can look at the retained earnings statement to understand how a company intends to deploy its profits for growth.
What does a balance sheet determine?A balance sheet is a financial statement that reports a company's assets, liabilities, and shareholder equity. The balance sheet is one of the three core financial statements that are used to evaluate a business. It provides a snapshot of a company's finances (what it owns and owes) as of the date of publication.
What can the statement of changes in equity be used to determine?The purpose of a statement of changes in equity is to furnish shareholders with information that can further inform their investment strategy. It can be used to identify the par value of common or treasury stocks, clarify retained earnings and strengthen investor trust in your company.
Which financial statement would indicate whether a company has made a profit or loss during the reporting period?An income statement is a financial statement that shows you the company's income and expenditures. It also shows whether a company is making profit or loss for a given period. The income statement, along with balance sheet and cash flow statement, helps you understand the financial health of your business.
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