Chapter 2
Introducing Financial Statements
IN THIS CHAPTER
Chapter 1 presents a brief introduction to the three primary business financial statements: the income statement, the balance sheet, and the statement of cash flows. In this chapter, you get more tidbits about these three financials, as they’re sometimes called. Then, in Part 2, you really get the goods. Remember when you were learning to ride a bicycle? Chapter 1 is like getting on the bike and learning to keep your balance. In this chapter, you put on your training wheels and start riding. Then, when you’re ready, the chapters in Part 2 explain all 21 gears of the financial statements bicycle, and then some.
For each financial statement, we introduce its basic information components. The purpose of financial statements is to communicate information that is useful to the readers of the financial statements, to those who are entitled to the information. Financial statement readers include the managers of the business and its lenders and investors. These constitute the primary audience for financial statements. (Beyond this primary audience, others are also interested in a business’s financial statements, such as its labor union or someone considering buying the business.) Think of yourself as a shareholder in a business. What sort of information would you want to know about the business? The answer to this question should be the touchstone for the accountant in preparing the financial statements.
The financial statements explained in this chapter are for businesses. Business financial statements serve as a useful template for not-for-profit (NFP) entities and other organizations (social clubs, homeowners’ associations, retirement communities, and so on). In short, business financial statements are a good reference point for the financial statements of non-business entities. There are differences but not as many as you may think. As we go along in this and the following chapters, we point out the differences between business and non-business financial statements.
Toward the end of this chapter, we briefly discuss accounting standards and financial reporting standards. Notice here that we distinguish accounting from financial reporting:
Accounting standards deal primarily with how to record transactions for measuring profit and for putting values on assets, liabilities, and owners’ equity.
Financial reporting standards focus on additional aspects such as the structure and presentation of financial statements, disclosure in the financial statements and elsewhere in the report, and other matters.
We use the term financial accounting to include both types of standards.
Setting the Stage for Financial Statements
This chapter focuses on the basic information components of each financial statement reported by a business. The first step is to get a good idea of the information content reported in financial statements. The second step is to become familiar with more details about the “architecture,” rules of classification, and other features of financial statements (see Part 2).
Offering a few preliminary comments about financial statements
Realistic examples are needed to illustrate and explain financial statements. But this presents a slight problem. The information content of a business’s financial statements depends on whether it sells products, services, or both (for instance, Apple sells both products and services); invests in other businesses; and so on. For example, the financial statements of a movie theater chain are different from those of a bank, which are different from those of an airline, which are different from an automobile manufacturer’s, which are different from — well, you name it.
The classic example used to illustrate financial statements involves a business that sells both products and services, and sells on credit to its customers. Therefore, the assets in the example include receivables from the business’s sales on credit and inventory of products it has purchased or manufactured that are awaiting future sale. Keep in mind, however, that many businesses that sell products do not sell on credit to their customers. Many retail businesses sell only for cash (or accept credit or debit cards that are near cash). Such businesses do not have a receivables asset.
The illustrative financial statements that follow in this part and Part 2 do not include a historical narrative of the business. Nevertheless, whenever you see financial statements, we encourage you to think about the history of the business. To help you out in this regard, here are some particulars about the business example we use in this chapter:
It sells products and services to other businesses (not on the retail level).
It sells on credit, and its customers take approximately a month or so before they pay.
It holds a fairly large stock of products awaiting sale.
It
