Chapter2: Review of the Accounting Process
Preparing the Financial Statements
The Income Statement
The purpose of the income statement The income statement is a change statement that summarizes the profit-generating transactions that caused shareholders’ equity (retained earnings) to change during the period. is to summarize the profit-generating activities of a company that occurred during a particular period of time. It is a change statement in that it reports the changes in shareholders' equity (retained earnings) that occurred during the period as a result of revenues, expenses, gains, and losses. Illustration 2–9 shows the income statement for Dress Right Clothing Corporation for the month of July 2011.
The income statement indicates a profit for the month of July of $2,417. During the month, the company was able to increase its net assets (equity) from activities related to selling its product. Dress Right is a corporation and subject to the payment of income tax on its profits. We ignore this required accrual here and address income taxes in a later chapter.
The components of the income statement usually are classified, that is, grouped according to common characteristics. A common classification scheme is to separate operating items from nonoperating items, as we do in Dress Right's income statement. Operating items include revenues and expenses directly related to the principal revenue-generating activities of the company. For example, operating items for a manufacturing company include sales revenues from the sale of products and all expenses related to this activity. Companies that sell products like Dress Right often report a subtotal within operating income, sales less cost of goods sold, called gross profit. Nonoperating items include gains and losses and revenues and expenses from peripheral activities. For Dress Right Clothing, rent revenue and interest expense are nonoperating items because they do not relate to the principal revenue-generating activity of the company, selling clothes. In Chapter 4 we discuss the format and content of the income statement in more depth.
The Balance Sheet
The purpose of the balance sheet The balance sheet is a position statement that presents an organized list of assets, liabilities and equity at a particular point in time. is to present the financial position of the company on a particular date. Unlike the income statement, which is a change statement reporting events that occurred during a period of time, the balance sheet is a statement that presents an organized list of assets, liabilities, and shareholders' equity at a point in time. To provide a quick overview, Illustration 2–10 shows the balance sheet for Dress Right at July 31, 2011.
Examples of assets not classified as current include property and equipment and long-term receivables and investments. The only noncurrent asset that Dress Right has at July 31, 2011, is furniture and fixtures, which is classified under the property and equipment category.
All liabilities not classified as current are listed as long term. Dress Right's liabilities at July 31, 2011, include the $30,000 note payable due to be paid in 23 months. This liability is classified as long term.
Shareholders' equity lists the paid-in capital portion of equity—common stock—and retained earnings. Notice that the income statement we looked at in Illustration 2–9 ties in to the balance sheet through retained earnings. Specifically, the revenue, expense, gain, and loss transactions that make up net income in the income statement ($2,417) become the major components of retained earnings. Later in the chapter we discuss the closing process we use to transfer, or close, these temporary income statement accounts to the permanent retained earnings account.
During the month, retained earnings, which increased by the amount of net income, also decreased by the amount of the cash dividend paid to shareholders, $1,000. The net effect of these two changes is an increase in retained earnings from zero at the beginning of the period to $1,417 ($2,417 − 1,000) at the end of the period and is also reported in the statement of shareholders' equity in Illustration 2–12 on page 79.
The Statement of Cash Flows
Similar to the income statement, the statement of cash flows The purpose of the statement of cash flows is to summarize the transactions that caused cash to change during the period. also is a change statement, disclosing the events that caused cash to change during the period. The statement classifies all transactions affecting cash into one of three categories: (1) operating activities inflows and outflows of cash related to transactions entering into the determination of net income., (2) investing activities involve the acquisition and sale of long-term assets used in the business and non-operating investment assets., and (3) financing activities cash inflows and outflows from transactions with creditors and owners.. Operating activities are inflows and outflows of cash related to transactions entering into the determination of net income. Investing activities involve the acquisition and sale of (1) long-term assets used in the business and (2) nonoperating investment assets. Financing activities involve cash inflows and outflows from transactions with creditors and owners.
The statement of cash flows for Dress Right for the month of July 2011 is shown in Illustration 2–11. As this is the first period of operations for Dress Right, the cash balance at the beginning of the period is zero. The net increase in cash of $68,500, therefore, equals the ending balance of cash disclosed in the balance sheet.
There are two generally accepted formats that can be used to report operating activities, the direct method and the indirect method. In Illustration 2–11 we use the direct method. These two methods are discussed and illustrated in subsequent chapters.
The Statement of Shareholders' Equity
The final statement, the statement of shareholders' equity The statement of shareholders’ equity discloses the sources of changes in the permanent shareholders’ equity accounts., also is a change statement. It discloses the sources of the changes in the various permanent shareholders' equity accounts that occurred during the period. Illustration 2–12 shows the statement of shareholders' equity for Dress Right for the month of July 2011.6
The individual profit-generating transactions causing retained earnings to change are summarized in the income statement. Therefore, the statement of shareholders' equity only shows the net effect of these transactions on retained earnings, in this case an increase of $2,417. In addition, the company paid its shareholders a cash dividend that reduced retained earnings.
6Some companies choose to disclose the changes in the retained earnings component of shareholders' equity in a separate statement or in a combined statement of income and retained earnings.