The Four Financial Statements

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Modifying conventions: Materiality, cost-benefit, conservatism convention,

industry practices convention.

Financial Statements
Businesses have two primary objectives:

Earn a profit

Remain solvent

Solvency represents the ability of the business to pay its bills and service its debt.
The Four Financial Statements are reports that allow interested parties to evaluate the
profitability and solvency of a business. These reports include the following financial
statements:

Balance Sheet

Income Statement

Statement of Owner's Equity

Statement of Cash Flows

These four financial statements are the final product of the accountant's analysis of the
transactions of a business. A large amount of effort goes into the preparation of the
financial statements. The process begins with bookkeeping, which is just one step in the
accounting process. Bookkeeping is the actual recording of the company's transactions,
without any analysis of the information. Accountants evaluate and analyze the
information, making sense out of the numbers.

For the reports to be useful, they must be:

Understandable

Timely

Relevant

Fair and Objective (free from bias)

Fundamental Accounting Model


The balance sheet is based on the following fundamental accounting equation:

Assets = Liabilities + Equity


This model has been used since the 18th century. It essentially states that a business
owes all of its assets to either creditors or owners, where the assets of a business are
its resources, and the creditors and owners are the sources of those resources.

Transactions

To record transactions, one must:

1. Identify an event that affects the entity financially.

2. Measure the event in monetary terms.

3. Determine which accounts the transaction affects.

4. Determine whether the transaction increases or decreases the balances in those


accounts.

5. Record the transaction in the ledgers.

Most larger business accounting systems utilize the double entry method. Under double
entry, instead of recording a transaction in only a single account, the transaction is
recorded in two accounts.

To illustrate this concept, take the following example. Mike Peddler decides to open a
bicycle repair shop. To get started he rents a shop, purchases an initial inventory of bike
parts, and opens for business. Here are the transactions for the first month:

Date Transaction
Sep 1 Owner contributes $7500 in cash to capitalize the business.
Sep 8 Purchased $2500 in bike parts on account, payable in 30 days.
Sep 15 Paid first month's shop rent of $1000.
Sep 17 Repaired bikes for $1100; collected $400 cash; billed customers for the $700
balance.
Sep 18 $275 in bike parts were used.
Sep 25 Collected $425 from customer accounts.
Sep 28 Paid $500 to suppliers for parts purchased earlier in the month.
These transactions affect the accounting equation as shown below.

Assets = Liabilities + Owner's Equity


Bike Accounts Accounts Peddler, Revenue
Cash + Parts + Receivable = Payable + Capital + (Expenses)
Sep 1 7500 = 7500

Sep 8 2500 = 2500


Sep 15 (1000) = (1000)

Sep 17 400 700 = 1100

Sep 18 (275) = (275)

Sep 25 425 (425) =


Sep 28 (500) = (500)
Totals: 6825 + 2225 + 275 = 2000 + 7500 + (175)

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