UNIT 7: FINANCIAL STATEMENTS AND ADDITIONAL DISCLOSURE

7.1 INTRODUCTION

In the previous chapters we have stressed that the measurement of the resource and
obligations of a business enterprise is fundamental to the accounting process. The on-
going recording of transactions and events and the preparation of end-of-period adjusting
entries may be described as a process measuring assets and liabilities. The result of this
process is summarized in general-purpose financial statements that provide decision
makers with useful information.

To supplement the basic financial statements, additional disclosures may be included in

notes to the financial statements and in other sections of the annual report to share
holders.

7.2 INCOME STATEMENT

The income statement presents revenues, gains, expense and losses recognized by the
firm for a specified period of time. The income statement is an important financial
statement because it provides investors and creditors with information that helps them
predict the amount, timing, and uncertainly of future cash flows. Through use of the
income statement, investors and creditors are able to evaluate the past performance of an
enterprise and determine the risk of achieving particular cash flows.

7.2.1 Alternative Forms of Income Statement

The manner in which accounting information is displayed in an income statement can
influence the reader’s interpretation of the information.

Except for three specific items (extra ordinary items, discontinued operations, and effects
of changes in accounting principles), GAAP does not require a standard format for
organizing and presenting the firms revenues, expenses, gains, and losses. These income
statement elements are organized in one of two general ways: a single-step format and a
multiple-step format.
Single-Step Format

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The single-step format uses only two broad section classifications: (1) a revenue and
gains section, and (2) an expenses and losses section. It is a single step statement because
only one step is involved in computing and displaying operating income.

The single-step form of income statement is presented below:

NICE Corporation
Income Statement
For the Year ended Dec. 31, 1990.

Revenue:
Net sales --------------------------------------------------------Br. 18,108
Investment income ----------------------------------------------------420
Gain on disposal of equipment -------------------------------------- 50
Total revenue ------------------------------------------------------18,578
Costs and Expenses:
Cost of goods sold ------------------------------------------Br. 11,988
Selling Expenses --------------------------------------------------2640
General and administrative Expense ---------------------------1620
Interest Expense ----------------------------------------------------230
Income taxes expense -------------------------------------------1,043
-------------------------------------------1,043
Total costs and expenses ----------------------------------------------17,521
----------------------------------------------17,521
Net income -------------------------------------------------------------------------Br. 1,057

Multiple-Step Format
The multiple-step format provides for several classifications and intermediate subtotal
measures of income. It typically distinguishes among various operations and activities
that affect income. The multiple-step form is more likely to be found in more detailed
income statements prepared for the use of management bankers and other creditors.

The multiple-step form of income statement is presented below:

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 NICE Corporation
Income Statement
For the year ended December 31, 1990
(In thousands of birrs)

Sales (net of discounts, returns, and allowances) ------------------------------------Br. 18,108

Cost of goods sold:
Inventories Jan 1, 1990 -------------------------------------------Br. 1,000
Purchases (net of discounts, returns, and allowances) 10,302
Freight-in ----------------------------------------------------1,266
----------------------------------------------------1,266 11,568
Cost of goods available for sale ------------------------------------12,568
------------------------------------12,568
Less: Inventories Dec. 31, 1990 ---------------------------------------580
Cost of goods sold -------------------------------------------------------------------11,988
-------------------------------------------------------------------11,988
Gross profit on sales ------------------------------------------------------------------6,120
Operating expenses:
Selling expenses:
Sales salaries ------------------------------------Br. 1260
Advertising and promotion -------------------------880
Building occupancy (including depreciation
and property taxes on building) -------------------420
Other ----------------------------------------------------80
----------------------------------------------------80 Br. 2,640
General and administrative expenses:
Salaries ------------------------------------------------------1,160
Property tax ---------------------------------------------------308
Depreciation on equipment ----------------------------------80
Other ------------------------------------------------------------72
------------------------------------------------------------72 1620
Total operating expenses ------------------------------------------------------------------Br. 4260
Income from operation --------------------------------------------------------------------Br. 1,860

Other revenue (Expenses):

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 Investment income-------------------------------------------Br. 420
Gain on disposal of equipment -----------------------------------50
Interest expense --------------------------------------------------(230)
--------------------------------------------------(230) 240
Income before income taxes --------------------------------------------------------------Br. 2,100
Income taxes expense (including Br. 20 differed) -----------------------------------------1,043
-----------------------------------------1,043
Net income ----------------------------------------------------------------------------------Br. 1057
Earning per share of common stock ------------------------------------------------------Br. 1.25

7.2.2 Classification of Revenue

The major source of revenue for most business enterprises is the production and sale of
goods and services. Examples of secondary sources are dividends, loyalties, interest,
rents, investment income from affiliated companies, and gains on the disposal of assets.

Revenue offsets should be distinguished from expenses; they are deducted from gross
revenue in the income statement. Such items as sales discounts and sales returns and
allowances are not expenses, but rather revenue that is never realized.

7.2.3 Classification of Costs and Expenses

Costs and expenses are classified in the income statement to help users understand the
operating cost relationships of the business enterprise. Classifications may be according
to the nature of expenses (natural classification), business functions, (functional
classification), areas of responsibility, or any other useful basis.

In many income statements, costs and express are reported in single-step form, classified
according to the nature of expenses i.e. in categories that reflect the kind of resources
used during the accounting period. Examples are merchandise and supplies, salaries and
fringe benefits, purchased services, depreciation etc.

Expenses may be classified on a functional basis as cost of goods sold, selling expenses,
general and administrative expenses, income tax expense etc.

Check your progress – 1

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 i. What is generally included in the heading of a financial statement?
__________________________________________________________________
___________________________________________________.
ii. Explain the difference between the single-step form and the multiple-step form of
the income statement?
__________________________________________________________________
______________________________________________________.

7.3 STATEMENT OF RETAINED EARNINGS

A statement of retained earnings often presented as a supplement to the financial

statements. The purpose of statements of retained earnings is to reconcile the beginning
and ending balances of retained earnings, showing all changes in retained earnings,
during the accounting period, and to provide connecting ink between the income
statement and the balance sheet.

The ending balance of retained earnings is reported on the balance sheet as one element
of owners’ equity. Major components of a statement of retained earnings are:
1. Prior period adjustments
2. Net income or loss for the period
3. Dividends – both stock dividends and cash dividends
4. On special accounting changes, retroactive effects of accounting principle change.

Disclosure of cash dividends per share also is made in the statement of retained earnings.

7.3.1 Prior Period Adjustments

Prior period adjustments are correction of errors in the financial statements from a prior
period that affect retained earnings. Material errors in the financial statements might
include arithmetical mistakes, the misuse or omissions of information, mistakes in the
application of accounting principles and failure to interpret properly the accounting
aspects of transactions.

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In the financial statements for the current accounting period, a prior period adjustment is
reported as a correction to the beginning balance of retained earnings.

The format of the statement of retained earning is presented below:

NICE Corporation
Statement of Retained Earnings
For the year ended December 31, 1990

Retained earnings, beginning of the year, as originally reported --------------------Br. 2,800

Less: Prior period adjustment (correction of error), net of income tax
effect of Br. 240 ----------------------------------------------------------------------------------360
----------------------------------------------------------------------------------360
Retained Earnings, beginning of year, as restated -------------------------------------Br. 2,440
Add: Net income -------------------------------------------------------------------------------1,057
-------------------------------------------------------------------------------1,057
Subtotal -----------------------------------------------------------------------------------------3, 497
Less: Cash dividends on preferred stock -------------------------------------Br. 57
Cash dividends on common stock -----------------------------------------400
-----------------------------------------400 457
Retained Earnings, end of year -------------------------------------------------------------3,040
-------------------------------------------------------------3,040

Check your progress – 2

i. Define prior period adjustments and indicate how these are reported in financial
statements.
__________________________________________________________________
_____________________________________________________.

7.4 BALANCE SHEET

The balance sheet provides economic information about an entity’s resources (assets),
claims against those resources (liabilities) and the remaining claim accruing to the owners
(owners’ equity).

If a balance sheet is examined carefully, users can gain a considerable amount of

information related to enterprise liquidity and financial flexibility. Balance sheet is

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basically a historical statement, because it shows the cumulative effect of past
transactions and events.

7.4.1 Uses and Limitations of the Balance Sheet

A balance sheet in comparative form provides valuable information to creditors,
stockholders, management, prospective investor, and the public.

Individuals with the ability to interpret comparative balance sheets may learn much as to
the short-run solvency of a business enterprise, favorable or unfavorable trends in
liquidity, commitments that must be met in the future, and the relative positions of
creditors and stockholders.

The major limitation of the traditional balance sheet lies in the inability of accountants to
measure the “current fair value” of an enterprise’s net assets. The inability of accountants
to foresee future economic events necessitates the preparation of balance sheets on a
different basis. Further more, accountants are unable to identify and provide a valuation
for many factors that have a material effect on the financial position of an enterprise. The
quality, morale, and character of management and other personnel, the market position of
an enterprise and the regulation of its products are subjective and intangible factors of
great importance in the evaluation of the financial position of an enterprise. None of these
factors is reported directly in the birr and cents framework of the accounting process that
leads to a balance sheet.

7.4.2 Balance Sheet Classifications

The classifications, group headings, and number of items on a balance sheet vary
considerably depending on the size of the enterprise, the nature of its operations, and
whether the financial statements are intended for wide distribution or for the use of a few
owners and creditors.

As a generalization subject to many exceptions, the following classification of balance

sheet items is suggested as representative:

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Assets
Current assets
Investment (held for control or not readily marketable)
Plant assets
Intangible assets
Other non current assets (including deferred charges)
Liabilities
Current liabilities
Long-term debt (including deferred income tax credits & deferred revenue)
Stockholders’ equity
Capital stock (preferred and common stock)
Additional paid-in capital
Retained earnings

Working Capital
The working capital of a business enterprise is the excess of current assets over current
liabilities. This amount always has been considerable interest to creditors as a measure of
short-run solvency. The ability to finance currents operations and to pay obligations as
they mature.

Current assets include cash and other assets that are reasonably expected to be realized in
cash or sold or consumed during the normal operating cycle of the business or within one
year from the balance sheet date.

The normal operating cycle of a business is the average length of time from the
expenditure of cash to inventory, to sale, to accounts receivable, and finally back to cash.
Most companies use one year as the time period for classifying items as current or long-
term because either the operating cycle is less than one year or the operating cycle may
be difficult to measure reliably.

Five general types of assets generally are included in the current assets classification:
1. Cash – Money in any form-cash and checks a waiting deposit, balances in checking
accounts, and expendable cash funds.

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2. Secondary cash resources – Various short-term investments that are readily
marketable. Any such resources whose availability
for current use is restricted by contract are excluded
3. Short-term receivables – Trade accounts receivable (including installment receivables
collected during the enterprises operating cycle) and notes
receivable with short-term maturities.
4. Inventories – Material, supplies, goods in process, finished goods. This category
includes items held for sale in the ordinary course of operation, items
in process of production of goods or services. Goods held on
consignment from others are not included because title is not held to
such goods.
5.Short-tem prepayments – The cost of various services, such as insurance, taxes, and
rent, which have been paid for in advance of use. Short-
term prepayments sometimes are referred to as prepaid
expenses.

Current liabilities: are obligations whose liquidation is expected to require the use of
current assets or the creation of other current liabilities. Three main classes of current
liabilities fall within this definition.

1. Obligations for the acquisition of goods and services that have entered the operating
cycle.
This includes trade payables (including notes and accounts payable to suppliers) and
accrued liabilities such as wages, commissions, income taxes, property taxes etc.
2. Other debts that may be expected to required payment within the operating cycle or
one year.
This includes short-term notes payable to banks and the currently maturing portions of
long-term debt.
3. Collections received in advance of the delivery of goods or the performance of
services.

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These advances often are described as “deferred revenue” but it is the obligation to
furnish the goods or services or to refund the payment that requires them to be classified
in the current liabilities section of the balance sheet.

Some liabilities that will be paid shortly after the balance sheet date are excluded from
current liabilities, because of the requirements that a current liability must involve the use
of current assets or the issuance of new short-term debt for its extinction.

Examples are (1) obligations due at an early date that will be retired by the issuance of
new-long-term debts, for example, bonds that will be refunded or a loan secured by the
cash surrender value of life insurance policies (the amount of cash that would be received
if the policies were canceled) that will be renewed, and (2) obligations that will be paid
from a fund included among non current assets, for example, a life insurance policy loan
that will be liquidated by offset against the cash surrender value of the policy, or by
deduction from the proceeds of the life insurance policy at maturity.

7.2.2 Non current Resources and Obligations

The definition of Noncurrent assets determines by exclusion those assets that are reported
as non-current. There are four categories of non current assets:

1. Long-term funds, investments, and receivables:

Many long-term commitments of funds do not qualify as secondary cash resources.
Investments in the common stock of investees made for the purpose of influence
orcontrol are included in this category. Also included are non-current receivable (such as
long-term advances to affiliated companies), the cash surrender value of life insurance
policies, and funds established for such purposes as the payment of pensions, retirement
of preferred stock, or repayment of long-term debt. Assets, such as land held for
speculative purposes and future plant sites also are included in this category.

2. Long-tem tangible resources used in operations

These are tangible (have physical substance) and are held for productive use in business
operations. Land, natural resources subject to depletion, buildings, equipment, machines,
tools, leased assets under capital leases, leasehold improvements, and plant assets under
construction are included. Long-term prepayments for the use of physical assets, such as

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leaseholds, easements, or rights of way, also may be included in this category, though
some accountants group these in the next category.

3. Long-term intangible resources

Long-term property rights of an intangible nature may be of greater importance to a
business enterprise than its tangible assets. Examples of such asserts are patents,
goodwill, trademarks, copyrights, organization costs, and franchise.

4. Other non-current assets /Deferred charges/

Included in this category are items such as plant assets no longer used in operations and
held for disposal costs incurred in the issuance of long-term debts, deferred start-up and
moving costs, and any other non current assets that is not included in one of the first three
categories.
Contingent assets: Assets, as well as liabilities, may be contingent. A contingent asset is a
property right whose existence is conditional on the happening of some future event (gain
contingency). Generally, it is not appropriate to include contingent assets in the
accounting records, because to do so would violate the principle of revenue realization
and reliability.

Non-current liabilities
A non-current liability is an obligation that will not require the use of current assets or the
issuance of short-term debt within the next year or operating cycle, whichever is longer.
They may be classified into the following

1. Long-term debt based on security issues or related contractual arrangements

Included in this category are notes and bonds, reported net of unamortized discount and
including any unamortized premium. The distinguishing characteristic is that there is a
borrowing transaction supported by a contractual obligation to pay principal and interest.

2. Other non-current liabilities

This includes all long-term liabilities that do not belong in the first category. An amount
received in advance on a long-term commitment to furnish goods or services deferred
revenue, differed income tax credits, liabilities under capital leases and non current
amount payable under pension plans are examples.

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Contingent liabilities
Liabilities that may or may not come into existence as a result of transactions or events
that have not yet been finalized usually are not reported in birr amount in the balance
sheet. Some examples, of contingent liabilities are possible additional income tax
assessments and pending lawsuits that may result in the payment of damages.

Check your progress – 3

i. How is the definition of a current liability related to the definition of current
assets?
__________________________________________________________________
______________________________.
ii. Indicate circumstances under which liabilities payable within a few months after
the balance sheet date might be excluded from current liabilities.
__________________________________________________________________
_____________________________________________________.

7.2.3 Owner’s Equity

The owners’ equity in a business enterprise is the residual interest in assets, after
liabilities have been deducted. The amount of owners’ equity thus is directly dependent
on the values assigned to assets and liabilities.

Owners’ equity for a corporation is called stockholders’ equity, that for a partnership,
partners’ equity, and that for a sole proprietorship, proprietors’ equity. Owners’ equity
includes contributed (or paid-in) capital and retained earnings.

Because of legal requirements, owners’ equity is sub classified to reflect detailed sources.
For corporations, the most commonly reported sources are:

 Capital Stock
It is the firm’s stated or legal capital. It is the par value of the issued or outstanding
preferred and common stock of the corporation and represents the amount that is not
available for dividend declarations. Legal capital is specified by state law and the articles
of incorporation (the charter) of the corporation.

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  Contributed capital in excess of par (or stated value)
If reports the value of assets received by the corporation above the par (or stated value) of
the capital stock given in exchange. These amounts usually arise when the corporation
sells its stock above par (or the stated amount per share) or issues stock dividends.
Sometimes called additional paid-in capital or premium on stock, it is considered legal
capital in most instances.

 Other contributed capital

It arises from such transactions as the sale of treasury stock above its acquisition cost and
capital arising from recapitalizatons. For balance sheet presentation, there is generally
only one additional contributed capital account, which includes contributed capital in
excess of par. The specific underlying sub accounts are maintained in a subsidiary ledger.

 Retained Earnings
It is essentially a corporations accumulated net earnings, less dividends paid out, since
the company’s inception. In many corporations, retained earnings are the largest amount
in the owners’ equity section. A negative balance in retained earnings is called a deficit
and usually arises when a company experiences operating losses.

 Treasury Stock
Shares that have been issued and then required by the company, but not retired, are called
treasury stock. Treasury stock is not an asset of the issuing firm. Companies repurchase
their own stock for several reasons:
1. To meet employee stock purchase or option plan needs
2. To increase reported earnings per share
3. To stabilize the stock’s price
4. To reduce the outstanding shares, perhaps to discourage a hostile takeover attempt
5. To contract the firms operations
6. To indicate that management believes the stock is under valued

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Check your progress – 4
i. Discuss how treasury stock is reported in the balance sheet
___________________________________________________________________
___________________________________________________.

7.5 STATEMENT OF STOCKHOLDERS’ EQUITY

A financial statement that lists the beginning and ending balances of each equity account
and describes all the changes that occurred during the year.

MODEL CORPORATION
Statement of Stockholders’ Equity
For the year ended Dec. 31,1990 and 1991
Common stock at Br. 10 par Additional Retained Total
No. of shares Amount Paid-in capital Earnings
Balances, Jan, 1, 1990 ----------1,250 Br. 12,500 Br. 137,858 Br. 306,535 Br.
456,893
Net income in 1990 68,066 68,066
Cash dividend (Br. 11 a share) _____ _______ _______ (13,750) (13,750)
Balance, Dec. 31, 1990 ----------1250 Br. 12,500 Br. 137,858 Br. 360,851 Br. 511,209
Net income, 1991 79,685 79,685
Cash dividends (Br. 16 a share) (31,200) (31,200)
Issuance of common stock -------283 2,830 24,332 27,162
Conversion of Bonds
Payable to common stock --------417 4,170 30,315 34,485
50% stock dividend distributed --975
--975 9.750 (9750)
Balances, Dec. 31, 1991 2925 Br. 29,250 Br. 192,505 Br. 399,586 Br. 621,341

Check your progress – 5

i. What is the function of a statement of stockholders’ equity?
__________________________________________________________________
______________________________________________.

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7.6 STATEMENT OF CASH FLOWS

Along with an income statements and balance sheet, a statement of cash flows is included
in an annual reports to stockholders of publicity owned companies and is covered by the
auditors’ opinion. The objective of this statement are:

1. To summarize the financing, operating, and investing activities of a business

enterprise during an accounting period, including the amount of cash equivalent
obtained from operations, and
2. To complete the disclosure for changes in financial position during an accounting
period that are not readily apparent in comparative balance sheets.

The statement of cash flows discloses transactions that affect cash directly, as well as
significant investing and financing transactions that do not affect cash.

The statement of cash flows is prepared in three sections.

1. Operating cash flows: includes cash transaction that enter into the determination
of net income. Reported under this classification are both the cash inflows and the
cash outflows that are related to net income. The usual cash flows identified are:
Inflows – cash received from Outflows-cash paid for
- Customers – Purchase of goods for sale
- Interest on receivables – interest on liabilities
- Dividends from investment – income taxes, duties, & fines
- Refunds from suppliers – salaries and wages

2. Investing cash flows:

This classification includes cash inflows and cash outflows related to the disposing of or
acquiring operating facilities (plant, property, equipment), the sale or purchase of
investments, and other non-operating (investment) assets. Outflows are investments of
cash by the entity to acquire non-cash assets. Inflows under this classification occur only
when cash is received from the sale or disposal of prior investments.

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The following are typical cash flows under investing activities:
Inflows – cash received from Outflows – cash paid for
- Disposal / sale of property – Acquision / purchase of property
- Disposal / sale of investment securities – Long-term investment in debt
- Collection of a loan (excluding and equity securities.
interest which is an operating activity) – Loans to other parties
- Acquisition of intangible assets

3. Financing cash flows

This classification includes both cash inflows and outflows related to the financing
activities (borrowing or issuing stock) used to obtain cash for the business. Outflows
occur when principle amounts are returned to the owners and creditors for their earlier
investments. The usual cash flows under these classifications are:
Inflows – cash received from Outflows – cash paid to
- Owners from issuing equity securities – Owners for dividends &
- Creditors from issuing debt securities other cash distributions
- Owners for retiring stock
or treasury stock purchased
- Creditors for repayment
of amounts borrowed
(excluding interest, which is
included in operating activities).

A complete discussion of the statement of cash flows is found in other accounting books.
In this chapter we illustrate the statement without further explanation.

The statement of cash flows for NICE Corporation is presented below:

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 NICE CORPORATION
Statement of cash flows
For the year ended Dec 31, 1990.
Cash flows from operating activities:
Net income ------------------------------------------------------------Br. 1,057
Items reconciling net income to net cash flow from operation:
Depreciation Expense ---------------------------------------------186
Amortization of goodwill, patents, and bond discount ---------64
Retirement benefits payable in future years ----------------------40
Increase in deferred taxes -------------------------------------------20
Equity in income of subsidiaries ---------------------------------(110)
Increase in short-term investments --------------------------------(60)
Increase in notes and interest receivable ------------------------(125)
Increase in trade accounts receivables ---------------------------(312)
Decrease in short-term prepayments ------------------------------(40)
Decrease in trade notes and payables ----------------------------(330)
Decrease in income taxes payable -------------------------------(150)
Decrease in advances from customers ---------------------------(88)
Decrease in accrued liabilities ------------------------------------(50)
Increase in retirements benefits payable currently ---------------5
---------------5
Net cash provided by operating activities -------------------------------------------------Br.
-------------------------------------------------Br. 527
Cash flow from investing activities:
Disposal of equipment ------------------------------------------Br. 100
Increase in cash surrender value of life insurance--------------- (10)
Acquisition of patents ----------------------------------------------(120)
Net cash used by investing activities ------------------------------------------------------Br.
------------------------------------------------------Br. (30)
Cash flow from financing activities:
Issuance of preferred stock -------------------------------------Br. 250
Dividends paid on preferred & common stock -----------------(432)

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 Increase in fund for retirement of preferred stock --------------(30)
--------------(30)
Net cash used by financing activities ----------------------------------------------------Br. (212)
Net increase in cash and cash equivalents ------------------------------------------------Br. 285
Cash and cash equivalent at beginning of year -----------------------------------------------200
-----------------------------------------------200
Cash and cash equivalent at end of year ------------------------------------------------------485
------------------------------------------------------485

7.7 ADDITIONAL DISCLOSURES

The disclosure principle requires that financial statements include all significant
information needed by users of the statements. If the omission of certain information
would cause the financial statements to be misleading, disclosure of such information is
essential. The financial statements included in annual reports to shareholders are
accompanied by detailed notes to the statements. However, disclosure is not to
supplement the information in the body of the financial statements, not to correct or
justify improper presentations in the statements.

Some examples of information disclosed in notes to the financial statements included in

annual reports of publicity owned companies include the following:
1. A summary of significant accounting policies
2. Description of stock option, pension, and employee stock ownership plans
3. Litigation in which the company is a party, loss and gain contingencies, and
unusual commitments.
4. Terms of proposed business combinations and a description of any unusual events
or transactions, such as related party transactions.
5. The amounts of depreciation expense and research and development costs.
6. An analysis of the composition of income taxes expense, including a
reconciliation of the company’s effective income tax rate with the statutory
federal income tax rate.
7. Detailed description or summary of receivables, inventories, investments, plant
assets, intangible assets, borrowing arrangements, with banks, long-term debts,
and stockholders equity.

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This partial list of the type of information that may be disclosed in notes to the financial
statements suggests that such notes may be both numerous and complex.

Disclosure in a note to the financial statements is appropriate when subsequent events

provide evidence with respect to conditions that did not exist on the balance sheet date.
For example, a material write-off of trade receivables as a result of a major catastrophe,
such as an earthquake after the balance sheet date, is not indicative of a condition that
existed on that date. Therefore, the financial statements would not be adjusted but the
amount of write-off would be disclosed in a note to the statements.

Check your progress – 7

i. Describe the type of disclosures that are made in a note to the financial statements
entitled “Summary of significant Accounting policies.”
__________________________________________________________________
____________________________________________.

7.8 SUMMARY

Business enterprises report their financial progress and financial position using different
types of financial statements. Income statement, Balance sheet, Retained Earnings and
cash flow statements.

The income statement measures the success of business operations for a given period of
time. This statement assists the business community in determining profitability,
investment value, and credit worthiness of a particular business enterprise. The income
statement may be presented in the single-step format or the multiple-step format.

The statement of retained earnings serves to reconcile the balance of the retained earnings
account from the beginning to the end of the year. The importance information
communicated by the statement of retained earnings includes:

a) Prior period adjustments (income or loss related to the corrections of errors in the
financial statements of a prior period), (b) the relationship of dividend distributions to net
income for the period, and (c) any transfers to and from retained earnings.

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For many years financial statement users generally considered the income statement to be
superior to the balance sheet as a basis for judging the economic well-being of an
enterprise. However, the balance sheet can be a very useful financial statement. If a
balance sheet is examined carefully, users can gain a considerable amount of information
related to enterprise liquidity and financial flexibility.

The primary purpose of the statement of cash flows is to provide relevant information
about the cash receipts and cash payments of an enterprise during a period.

7.9 ANSWERS TO CHECK YOUR PROGRESS

1. i. The heading of a financial statement includes the name of the business enterprise, the
title of the statement, and the date or dates of the statement, such as “For Three
months ended March 31, 1996”).
ii. In a multiple-step form various intermediate amounts, such as gross profit on sales,
income from operations, and income before income taxes, are presented as separate
line items. The single-step form presents all revenue in one category, all costs and
expenses in another and derives net income as the final amount.
2. Prior period adjustment is correction of a material error related to a prior period or
periods.

In the financial statements for the current accounting period, a prior period adjustment is
reported as a correction to the beginning balance or retained earnings. When a correction
of an error is made as a prior period adjustments, the issuance of comparative financial
statements requires the restatement of prior periods financial statements to reflect the
correction.
3. i. Current liabilities are obligations whose liquidation is expected to require the use of
current assets.
ii. Some liabilities that will be paid shortly after the balance sheet date are excluded
from current liabilities, because of the requirement that a current liability must
involve the use of current assets or the issuance of new short-term debt for its
extinction.

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4. The balance of treasury stock is reported in the balance sheet as a deduction from the
balance sheet of stockholders’ equity.
5. The statement of stockholders’ equity lists the beginning and ending balances of each
equity account & describes all the changes during the year.
6. Net cash flows refers to the inflows of cash minus the outflows of cash
7. The types of disclosures by a business enterprise in a separate section entitled
“summary of significant Accounting policies” includes:
A. Basis for preparation of consolidated financial statements (principles of
consolidation)
B. Method or methods used to compute deprecation, depletion, and amortization
C. Inventory pricing
D. Method of revenue recognition
E. Any changes in accounting principles during the most recent accounting period

7.10 MODEL EXAMINATION QUESTIONS

I. True / False
_________ 1. The multiple-step income statement recognized a separation of operating
transactions from non-operating transactions and matches costs and
expenses with related revenues.
_________ 2. The statement of retained earnings shows the total change in stockholders’
equity for a specified period.
_________ 3. Proper presentation of inventories for a manufacturing concern includes
disclosure of the basis of valuation, the methods of pricing, and the stages
of production
_________ 4. Determination of cash flows from operating activities requires predicting
the amount of cash the entity will collect form customers who purchase
the entity’s product on account.
_________ 5. When the balance sheet is prepared using the report form, a special section
is included that presents a narrative explanation of the balance sheet
classifications.

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II. Multiple Choice
_________ 1. Which of the following items should never be included in the current
section of the balance sheet?
A. Receivable from a customer outstanding for more that a year
B. Deferred income taxes resulting from inter period tax allocation
C. Three-year premium for fire insurance on plant and equipment
D. A pension fund
_________ 2. Which of the following balance sheet classification would normally require
the greatest amount of supplementary disclosure?
A. Current assets
B. Current liabilities
C. Plant assets
D. Long-term liabilities
_________ 3. The statement of cash flows provides answers to all of the following
questions except,
A. Where did the cash come form during the period?
B. What was the cash used for during the period?
C. What is the impact of inflation on the c ash balance at the end of the year?
D. What was the change in the cash balance during the period?
__________ 4. The preparation of notes to the financial statements complies with the:
A. Business entity principle
B. Continuity principle
C. Matching principle
D. Disclosure principle
_________ 5. The following expenses and loss were among those incurred by KK
Company during 1990.
Accounting and legal fees -------------------------Br. 160,000
Interest ------------------------------------------------------60,000
Loss on disposal of office equipment -------------------25,000

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 Rent for office space -------------------------------------200,000

One-quarter of the rented premises is occupied by the sales department. How much
of the items listed above is included in KK’s general and administrative expenses
for 1990
A. Br. 310,000
B. Br. 335,000
C. Br. 360,000
D. Br. 370,000
E. Some other amount
III. Exercise
Selected information for Root Company for the year ended December 31, 1990 follows:
Total assets ---------------------------------------------------------------------Br. 2,255,000
Total liabilities -----------------------------------------------------------------------600,000
Preferred stock, $ 10 par -----------------------------------------------------------100,000
Common stock $ 1, par ------------------------------------------------------------300,000
Additional paid-in-capital ---------------------------------------------------------600,000
Prior period adjustment – overstatement of
net income in 1989 as a result of an
accounting error, net of income tax of $ 57,600 --------------------------------70,400
Net income ---------------------------------------------------------------------------75,000
Dividends declared on common stock ($ 0.20 a share) ------------------------60,000
Dividends declared on preferred stock ($ 1.50 a share) -----------------------15,000
Prepare Root company’s statement of retained earnings for the years ended December 31,
1990

2. Edmund corporation had inventories at the beginning and of 1992 as follows:

Jan 1 Dec 31
Raw material Br. 22,000 Br. 30,000
Goods in process 40,000 48,000
Finished goods 25,000 18,000
Totals Br. 87,000 Br. 96,000

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During 1992 the following costs and expense were incurred by Edmund
Raw material purchased -------------------------------------------------------Br. 300,000
Direct labor --------------------------------------------------------------------------120,000
Indirect labor -------------------------------------------------------------------------60,000
Property taxes and deprecation of factory building -----------------------------20,000
Property taxes and deprecation of sales room and office -----------------------15,000
Sales salaries -------------------------------------------------------------------------40,000
Office salaries ------------------------------------------------------------------------24,000
Utilities (60% applicable to factory 20% to sales room, and 20% to office) 60,000

Compute Edmund Corporation’s cost of good sold for the year ended December 31,
1992.

3. The stockholders’ equity of valentine corporation on June 30,1991 was as follows:

Common stock, $ 10par -----------------------------------200,000
Additional paid-in-capital --------------------------------225,000
Retained earnings ------------------------------------------610,000
------------------------------------------610,000
Total stockholders’ equity -------------------------Br. 1,035,000
The transactions affecting stockholders’ equity for the year ended June 30,1992 were:
1) An additional 7,500 shares of common stock were issued on May 1,1992 at Br.
30 a share.
2) Dividends declared June 2,1992, amounted to Br. 100,000
3) Net income amounted to Br. 195,000
Prepare a statement of stockholder’s equity for valentine corporation for the
year ended June 30,1992.
4. From the following list of ledger account balances for LIFE Company, compute (a) the
amount of working capital and (b) the equity (book value) per share of common
stock:
Investment in affiliated companies (at equity)------------------------------------ Br. 100,000
Cash surrender value of life insurance policies -----------------------------------------10,000
Organization costs ----------------------------------------------------------------------------5,000

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 Interest receivable -----------------------------------------------------------------------------
2,000

Reserve for loss contingencies (recorded by a debit to

retained earnings) ----------------------------------------------------------------------------
50,000
Retained earnings-un appropriated ------------------------------------------------------170,000
Common stock, $ 5par --------------------------------------------------------------------400,000
Additional paid-in capital -----------------------------------------------------------------200,000
Deferred income tax credits ----------------------------------------------------------------40,000
Cost of (construction) contracts in progress (for customers) ------------------------150,000
Bond sinking fund ---------------------------------------------------------------------------80,000
Liability under product warranty -----------------------------------------------------------6,000
Creditors accounts with debit balance -----------------------------------------------------4,500
Plant assets (met) --------------------------------------------------------------------------426,500
Other current assets ------------------------------------------------------------------------198,000
Other current liabilities --------------------------------------------------------------------108,000

5. A condensed income statement prepared by Leventhal corporation for the year ended
March 31, year 2, follows:

LEVENTHAL CORPORATION
Income statement
For year Ended March 31, 1992
Sales (net) -----------------------------------------------------------------Br. 900,000
Costs and Expenses:
Cost of goods sold ------------------------------Br. 620,000
Deprecation -------------------------------------------28,000
Amortization of intangible asset --------------------7,000
Other operating expenses ------------------------112,000
Income tax (including deferred
Income taxes of Br. 10,000) 45,000 812,000

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 Net income Br. 88,000
Earnings per share of common stock Br. 4,40

Additional information
1) Dividends of Br. 50,000 were declared can paid
2) Equipment of Br. 40,000 was acquired in exchange for common
stock
3) Equipment was sold for Br. 14,500 its carrying amount
4) The common stock was split 2 for 1
5) Long-term investments were acquired for Br. 60,000 cash
6) Treasury stock (common) was acquired for Br. 8,500 cash
7) Cash received as proceeds from long-term borrowing was 100,000
8) The working capital at the beginning of the year was Br. 425,400;
working capital at the end of the year was Br. 554,400. Cash at the
beginning of the year was Br. 120,000. Cash at the end of the year
was Br. 150,000
Instructions
Prepare a statement of cash flows for Leventhal Corporation for the year ended March
31, 1992

7.11 GLOSSARY

1. Cash flows: - the inflows and outflows of cash for a firm.

2. Cash flow from financing activities: - the section of the statement of cash flows in
which is reported the transactions involving
cash receipts form the issuance of equity and
debt securities and cash payments for
dividends, repurchase of equity securities, and
redemption of debt securities.
3. Cash flows from investing activities: - the section of the statement of cash flows in
which is reported the activities involving cash

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 receipts form the sale of investments, plant
assets and other non-current assets; and cash
payments for the acquisition of investments,
plant assets, and other non current assets.
4. Cash flows from operating activities: - the section of the statement of cash flows in
which is reported the cash transactions that
entered into the determination of net income
5. Deferred charge: - long-term prepayments
6. Multiple-step income statement: - an income statement with numerous sections and
subsections with several intermediate balances
before net income.
7. Prior period adjustments: - correction of a material error related to a prior period or
periods, excluded from the determination of net income
8. Single-step income statement: - an income statement with the total of all expenses
deducted form the total of all revenues
9. Treasury stock: - a corporation’s own outstanding stock that has been reacquired
10. Working capital: - current assets less current liabilities

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