2.3: Prepare an Income Statement, Statement of Owner’s Equity, and Balance Sheet (2024)

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One of the key factors for success for those beginning the studyof accounting is to understand how the elements of the financialstatements relate to each of the financial statements. That is,once the transactions are categorized into the elements, knowingwhat to do next is vital. This is the beginning of the process tocreate the financial statements. It is important to note thatfinancial statements are discussed in the order in which thestatements are presented.

Elements of the Financial Statements

When thinking of the relationship between the elements and thefinancial statements, we might think of a baking analogy: theelements represent the ingredients, and the financial statementsrepresent the finished product. As with baking a cake (see Figure 2.5), knowing the ingredients (elements) and how eachingredient relates to the final product (financial statements) isvital to the study of accounting.

2.3: Prepare an Income Statement, Statement of Owner’s Equity, and Balance Sheet (2)

To help accountants prepare and users better understandfinancial statements, the profession has outlined what is referredto as elements of the financial statements, whichare those categories or accounts that accountants use to recordtransactions and prepare financial statements. There are tenelements of the financial statements, and we have already discussedmost of them.

Revenue—value of goods and services theorganization sold or provided.
Expenses—costs of providing the goods orservices for which the organization earns revenue.
Gains—gains are similar to revenue but relateto “incidental or peripheral” activities of the organization.
Losses—losses are similar to expenses butrelated to “incidental or peripheral” activities of theorganization.
Assets—items the organization owns, controls,or has a claim to.
Liabilities—amounts the organization owes toothers (also called creditors).
Equity—the net worth (or net assets) of theorganization.
Investment by owners—cash or other assetsprovided to the organization in exchange for an ownershipinterest.
Distribution to owners—cash, other assets, orownership interest (equity) provided to owners.
Comprehensive income—definedas the “change in equity of a business enterprise during a periodfrom transactions and other events and circ*mstances from nonownersources” (SFAC No. 6, p. 21). While further discussion ofcomprehensive income is reserved for intermediate and advancedstudies in accounting, it is worth noting that comprehensive incomehas four components, focusing on activities related to foreigncurrency, derivatives, investments, and pensions.

Financial Statements for a Sample Company

Now it is time to bake the cake (i.e., prepare the financialstatements). We have all of the ingredients (elements of thefinancial statements) ready, so let’s now return to the financialstatements themselves. Let’s use as an example a fictitious companynamed Cheesy Chuck’s Classic Corn. This company is a small retailstore that makes and sells a variety of gourmet popcorn treats. Itis an exciting time because the store opened in the current month,June.

Assume that as part of your summer job with Cheesy Chuck’s, theowner—you guessed it, Chuck—has asked you to take over for a formeremployee who graduated college and will be taking an accounting jobin New York City. In addition to your duties involving making andselling popcorn at Cheesy Chuck’s, part of your responsibility willbe doing the accounting for the business. The owner, Chuck, heardthat you are studying accounting and could really use the help,because he spends most of his time developing new popcornflavors.

The former employee has done a nice job of keeping track of theaccounting records, so you can focus on your first task of creatingthe June financial statements, which Chuck is eager to see.Figure 2.6 shows the financial information (as of June 30) forCheesy Chuck’s.

2.3: Prepare an Income Statement, Statement of Owner’s Equity, and Balance Sheet (3)

We should note that we are oversimplifying some of the things inthis example. First, the amounts in the accounting records weregiven. We did not explain how the amounts would be derived. Thisprocess is explained starting in Analyzing and Recording Transactions. Second, we areignoring the timing of certain cash flows such as hiring,purchases, and other startup costs. In reality, businesses mustinvest cash to prepare the store, train employees, and obtain theequipment and inventory necessary to open. These costs will precedethe selling of goods and services. In the example to follow, forinstance, we use Lease payments of $24,000, which represents leasepayments for the building ($20,000) and equipment ($4,000). Inpractice, when companies lease items, the accountants mustdetermine, based on accounting rules, whether or not the business“owns” the item. If it is determined the business “owns” thebuilding or equipment, the item is listed on the balance sheet atthe original cost. Accountants also take into account the buildingor equipment’s value when the item is worn out. The difference inthese two values (the original cost and the ending value) will beallocated over a relevant period of time. As an example, assume abusiness purchased equipment for $18,000 and the equipment will beworth $2,000 after four years, giving an estimated decline in value(due to usage) of $16,000 ($18,000 − $2,000). The business willallocate $4,000 of the equipment cost over each of the four years($18,000 minus $2,000 over four years). This is calleddepreciation and is one of thetopics that is covered in Long-Term Assets.

Also, the Equipment with a value of $12,500 in the financialinformation provided was purchased at the end of the firstaccounting period. It is an asset that will be depreciated in thefuture, but no depreciation expense is allocated in ourexample.

Income Statement

Let’s prepare the income statement so we can inform how CheesyChuck’s performed for the month of June (remember, an incomestatement is for a period of time).Our first step is to determine the value of goods and services thatthe organization sold or provided for a given period of time. Theseare the inflows to the business, and because the inflows relate tothe primary purpose of the business (making and selling popcorn),we classify those items as Revenues, Sales, or Fees Earned. Forthis example, we use Revenue. The revenue for Cheesy Chuck’s forthe month of June is $85,000.

Next, we need to show the total expenses for Cheesy Chuck’s.Because Cheesy Chuck’s tracks different types of expenses, we needto add the amounts to calculate total expenses. If you addedcorrectly, you get total expenses for the month of June of $79,200.The final step to create the income statement is to determine theamount of net income or net loss for Cheesy Chuck’s. Since revenues($85,000) are greater than expenses ($79,200), Cheesy Chuck’s has anet income of $5,800 for the month of June.

Figure 2.7 displays the June income statement for CheesyChuck’s Classic Corn.

2.3: Prepare an Income Statement, Statement of Owner’s Equity, and Balance Sheet (4)

Financial statements are created using numerous standardconventions or practices. The standard conventions provideconsistency and help assure financial statement users theinformation is presented in a similar manner, regardless of theorganization issuing the financial statement. Let’s look at thestandard conventions shown in the Cheesy Chuck’s incomestatement:

The heading of the income statement includes three lines.
- The first line lists the business name.
- The middle line indicates the financial statement that is beingpresented.
- The last line indicates the time frame of the financialstatement. Do not forget the income statement is for a period of time (the month of June in ourexample).
There are three columns.
- Going from left to right, the first column is the categoryheading or account.
- The second column is used when there are numerous accounts in aparticular category (Expenses, in our example).
- The third column is a total column. In this illustration, it isthe column where subtotals are listed and net income is determined(subtracting Expenses from Revenues).
Subtotals are indicated by a single underline, while totals areindicated by a double underline. Notice the amount of MiscellaneousExpense ($300) is formatted with a single underline to indicatethat a subtotal will follow. Similarly, the amount of “Net Income”($5,800) is formatted with a double underline to indicate that itis the final value/total of the financial statement.
There are no gains or losses for Cheesy Chuck’s. Gains andlosses are not unusual transactions for businesses, but gains andlosses may be infrequent for some, especially small,businesses.

CONCEPTS IN PRACTICE

McDonald’s

For the year ended December 31, 2016,McDonald’s had sales of $24.6billion.¹¹The amount of sales is often used by the business as the startingpoint for planning the next year. No doubt, there are a lot ofpeople involved in the planning for a business the size ofMcDonald’s. Two key people atMcDonald’s are the purchasingmanager and the sales manager (although they might have differenttitles). Let’s look at howMcDonald’s 2016 sales amountmight be used by each of these individuals. In each case, do notforget that McDonald’s is aglobal company.

Statement of Owner’s Equity

Let’s create the statement of owner’s equity for Cheesy Chuck’sfor the month of June. Since Cheesy Chuck’s is a brand-newbusiness, there is no beginning balance of Owner’s Equity. Thefirst items to account for are the increases in value/equity, whichare investments by owners and net income. As you look at theaccounting information you were provided, you recognize the amountinvested by the owner, Chuck, was $12,500. Next, we account for theincrease in value as a result of net income, which was determinedin the income statement to be $5,800. Next, we determine if therewere any activities that decreased the value of the business. Morespecifically, we are accounting for the value of distributions tothe owners and net loss, if any.

It is important to note that an organization will have eithernet income or net loss for the period, but not both. Also, smallbusinesses in particular may have periods where there are noinvestments by, or distributions to, the owner(s). For the month ofJune, Chuck withdrew $1,450 from the business. This is a good timeto recall the terminology used by accountants based on the legalstructure of the particular business. Since the account was titled“Drawings by Owner” and because Chuck is the only owner, we canassume this is a sole proprietorship. If the business wasstructured as a corporation, this activity would be calledsomething like “Dividends Paid to Owners.”

At this stage, remember that since we are working with a soleproprietorship to help simplify the examples, we have addressed theowner’s value in the firm as capitalor owner’s equity. However, later weswitch the structure of the business to a corporation, and insteadof owner’s equity, we begin using such account titles ascommon stock and retained earnings to represent the owner’sinterests. The corporate treatment is more complicated, becausecorporations may have a few owners up to potentially thousands ofowners (stockholders). The details of accounting for the interestsof corporations are covered in Corporation Accounting.

So how much did the value of Cheesy Chuck’s change during themonth of June? You are correct if you answered $16,850. Since thisis a brand-new store, the beginning value of the business is zero.During the month, the owner invested $12,500 and the business hadprofitable operations (net income) of $5,800. Also, during themonth the owner withdrew $1,450, resulting in a net change (andending balance) to owner’s equity of $16,850. Shown in aformula:

Beginning Balance + Investments by Owners ± Net Income (NetLoss) – Distributions, or

$0+$12,500+$5,800–$1,450=$16,850$0+$12,500+$5,800–$1,450=$16,850

Figure 2.8 shows what the statement of owner’s equity forCheesy Chuck’s Classic Corn would look like.

2.3: Prepare an Income Statement, Statement of Owner’s Equity, and Balance Sheet (5)

Notice the following about the statement of owner’s equity forCheesy Chuck’s:

The format is similar to the format of the income statement(three lines for the heading, three columns).
The statement follows a chronological order, starting with thefirst day of the month, accounting for the changes that occurredthroughout the month, and ending with the final day of themonth.

The statement uses the final number from the financial statementpreviously completed. In this case, the statement of owner’s equityuses the net income (or net loss) amount from the income statement(Net Income, $5,800).

Balance Sheet

Let’s create a balance sheet for Cheesy Chuck’s for June 30. Tobegin, we look at the accounting records and determine what assetsthe business owns and the value of each. Cheesy Chuck’s has twoassets: Cash ($6,200) and Equipment ($12,500). Adding the amount ofassets gives a total asset value of $18,700. As discussedpreviously, the equipment that was recently purchased will bedepreciated in the future, beginning with the next accountingperiod.

Next, we determine the amount of money that Cheesy Chuck’s owes(liabilities). There are also two liabilities for Cheesy Chuck’s.The first account listed in the records is Accounts Payable for$650. Accounts Payable is the amount that Cheesy Chuck’s must payin the future to vendors (alsocalled suppliers) for the ingredients to make the gourmet popcorn.The other liability is Wages Payable for $1,200. This is the amountthat Cheesy Chuck’s must pay in the future to employees for workthat has been performed. Adding the two amounts gives us totalliabilities of $1,850. (Here’s a hint as you develop yourunderstanding of accounting: Liabilities often include the word“payable.” So, when you see “payable” in the account title, knowthese are amounts owed in the future—liabilities.)

Finally, we determine the amount of equity the owner, CheesyChuck, has in the business. The amount of owner’s equity wasdetermined on the statement of owner’s equity in the previous step($16,850). Can you think of another way to confirm the amount ofowner’s equity? Recall that equity is also called net assets(assets minus liabilities). If you take the total assets of CheesyChuck’s of $18,700 and subtract the total liabilities of $1,850,you get owner’s equity of $16,850. Using the basic accountingequation, the balance sheet for Cheesy Chuck’s as of June 30 isshown in Figure 2.9.

2.3: Prepare an Income Statement, Statement of Owner’s Equity, and Balance Sheet (6)

Connecting the Income Statement and the Balance Sheet

Another way to think of the connection between the incomestatement and balance sheet (which is aided by the statement ofowner’s equity) is by using a sports analogy. The income statementsummarizes the financial performanceof the business for a given period of time. The income statementreports how the business performed financially each month—the firmearned either net income or net loss. This is similar to theoutcome of a particular game—the team either won or lost.

The balance sheet summarizes the financial position of the business on a given date. Meaning,because of the financial performanceover the past twelve months, for example, this is the financialposition of the business as ofDecember 31. Think of the balance sheet as being similar to ateam’s overall win/loss record—to a certain extent a team’sstrength can be perceived by its win/loss record.

Statement of Cash Flows

In Describe the Income Statement, Statement of Owner’s Equity, BalanceSheet, and Statement of Cash Flows, and How TheyInterrelate, we discussed the function of and the basiccharacteristics of the statement of cash flows. This fourth andfinal financial statement lists the cash inflows and cash outflowsfor the business for a period oftime. It was created to fill in some informational gaps thatexisted in the other three statements (income statement, owner’sequity/retained earnings statement, and the balance sheet). A fulldemonstration of the creation of the statement of cash flows ispresented in Statement of Cash Flows.

Creating Financial Statements: A Summary

In this example using a fictitious company, Cheesy Chuck’s, webegan with the account balances and demonstrated how to prepare thefinancial statements for the month of June, the first month ofoperations for the business. It will be helpful to revisit theprocess by summarizing the information we started with and how thatinformation was used to create the four financial statements:income statement, statement of owner’s equity, balance sheet, andstatement of cash flows.

We started with the account balances shown in Figure 2.10.

2.3: Prepare an Income Statement, Statement of Owner’s Equity, and Balance Sheet (7)

The next step was to create the income statement, which showsthe financial performance of thebusiness. The income statement is shown in Figure 2.11.

2.3: Prepare an Income Statement, Statement of Owner’s Equity, and Balance Sheet (8)

Next, we created the statement of owner’s equity, shown inFigure 2.12. The statement of owner’s equity demonstrates howthe equity (or net worth) of the business changed for the month ofJune. Do not forget that the Net Income (or Net Loss) is carriedforward to the statement of owner’s equity.

2.3: Prepare an Income Statement, Statement of Owner’s Equity, and Balance Sheet (9)

The third financial statement created is the balance sheet,which shows the company’s financial position on a given date. Cheesy Chuck’s balancesheet is shown in Figure 2.13.

2.3: Prepare an Income Statement, Statement of Owner’s Equity, and Balance Sheet (10)

THINK IT THROUGH

Financial Statement Analysis

In Why It Matters, we pointed out that accounting informationfrom the financial statements can be useful to business owners. Thefinancial statements provide feedback to the owners regarding thefinancial performance and financial position of the business,helping the owners to make decisions about the business.

Using the June financial statements, analyze Cheesy Chuck’s andprepare a brief presentation. Consider this from the perspective ofthe owner, Chuck. Describe the financial performance of andfinancial position of the business. What areas of the businesswould you want to analyze further to get additional information?What changes would you consider making to the business, if any, andwhy or why not?

ETHICAL CONSIDERATIONS

Financial Statement Manipulation at Waste Management Inc.

Accountants have an ethical duty to accurately report thefinancial results of their company and to ensure that the company’sannual reports communicate relevant information to stakeholders. Ifaccountants and company management fail to do so, they may incurheavy penalties.

For example, in 2002 the Securities and Exchange Commission(SEC) charged the top management of WasteManagement, Inc. with inflating profits by $1.7billion to meet earnings targets in the period 1992–1997. An SECpress release alleged “that defendants fraudulently manipulated thecompany’s financial results to meet predetermined earnings targets.. . . They employed a multitude of improper accounting practices toachieve this objective.”¹³The defendants in the case manipulated reports to defer oreliminate expenses, which fraudulently inflated their earnings.Because they failed to accurately report the financial results oftheir company, the top accountants and management ofWaste Management, Inc. facecharges.

Thomas C. Newkirk, the associate director of the SEC’s Divisionof Enforcement, stated, “For years, these defendants cooked thebooks, enriched themselves, preserved their jobs, and dupedunsuspecting shareholders”¹⁴The defendants, who included members of the company board andexecutives, benefited personally from their fraud in the millionsof dollars through performance-based bonuses, charitable giving,and sale of company stock. The company’s accounting form,Arthur Andersen, abetted thefraud by identifying the improper practices but doing little tostop them.

Liquidity Ratios

In addition to reviewing the financial statements in order tomake decisions, owners and other stakeholders may also utilizefinancial ratios to assess the financial health of theorganization. While a more in-depth discussion of financial ratiosoccurs in Appendix A: Financial Statement Analysis, here we introduceliquidity ratios, a common, easy,and useful way to analyze the financial statements.

Liquidity refers to the business’s ability toconvert assets into cash in order to meet short-term cash needs.Examples of the most liquid assets include accounts receivable andinventory for merchandising or manufacturing businesses). Thereason these are among the most liquid assets is that these assetswill be turned into cash more quickly than land or buildings, forexample. Accounts receivable represents goods or services that havealready been sold and will typically be paid/collected withinthirty to forty-five days. Inventory is less liquid than accountsreceivable because the product must first be sold before itgenerates cash (either through a cash sale or sale on account).Inventory is, however, more liquid than land or buildings because,under most circ*mstances, it is easier and quicker for a businessto find someone to purchase its goods than it is to find a buyerfor land or buildings.

Working Capital

The starting point for understanding liquidity ratios is todefine working capital—current assets minuscurrent liabilities. Recall that current assets and currentliabilities are amounts generally settled in one year or less.Working capital (current assets minus current liabilities) is usedto assess the dollar amount of assets a business has available tomeet its short-term liabilities. A positive working capital amountis desirable and indicates the business has sufficient currentassets to meet short-term obligations (liabilities) and still hasfinancial flexibility. A negative amount is undesirable andindicates the business should pay particular attention to thecomposition of the current assets (that is, how liquid the currentassets are) and to the timing of the current liabilities. It isunlikely that all of the current liabilities will be due at thesame time, but the amount of working capital gives stakeholders ofboth small and large businesses an indication of the firm’s abilityto meet its short-term obligations.

One limitation of working capital is that it is a dollar amount,which can be misleading because business sizes vary. Recall fromthe discussion on materiality that $1,000, for example, is morematerial to a small business (like an independent local movietheater) than it is to a large business (like a movie theaterchain). Using percentages or ratios allows financial statementusers to more easily compare small and large businesses.

Current Ratio

The current ratio is closely related to workingcapital; it represents the current assets divided by currentliabilities. The current ratio utilizes the same amounts as workingcapital (current assets and current liabilities) but presents theamount in ratio, rather than dollar, form. That is, the currentratio is defined as current assets/current liabilities. Theinterpretation of the current ratio is similar to working capital.A ratio of greater than one indicates that the firm has the abilityto meet short-term obligations with a buffer, while a ratio of lessthan one indicates that the firm should pay close attention to thecomposition of its current assets as well as the timing of thecurrent liabilities.

Sample Working Capital and Current Ratio Calculations

Assume that Chuck, the owner of Cheesy Chuck’s, wants to assessthe liquidity of the business. Figure 2.14 shows the June 30, 2018, balance sheet. Assume theEquipment listed on the balance sheet is a noncurrent asset. Thisis a reasonable assumption as this is the first month of operationand the equipment is expected to last several years. We also assumethe Accounts Payable and Wages Payable will be paid within one yearand are, therefore, classified as current liabilities.

2.3: Prepare an Income Statement, Statement of Owner’s Equity, and Balance Sheet (11)

Working capital is calculated as current assets minus currentliabilities. Cheesy Chuck’s has only two assets, and one of theassets, Equipment, is a noncurrent asset, so the value of currentassets is the cash amount of $6,200. The working capital of CheesyChuck’s is $6,200 – $1,850 or $4,350. Since this amount is over $0(it is well over $0 in this case), Chuck is confident he hasnothing to worry about regarding the liquidity of his business.

Let’s further assume that Chuck, while attending a popcornconference for store owners, has a conversation with the owner of amuch larger popcorn store—Captain Caramel’s. The owner of CaptainCaramel’s happens to share the working capital for his store is$52,500. At first Chuck feels his business is not doing so well.But then he realizes that Captain Caramel’s is located in a muchbigger city (with more customers) and has been around for manyyears, which has allowed them to build a solid business, whichChuck aspires to do. How would Chuck compare the liquidity of hisnew business, opened just one month, with the liquidity of a largerand more-established business in another market? The answer is bycalculating the current ratio, which removes the size differences(materiality) of the two businesses.

The current ratio is calculated as current assets/currentliabilities. We use the same amounts that we used in the workingcapital calculation, but this time we divide the amounts ratherthan subtract the amounts. So Cheesy Chuck’s current ratio is$6,200 (current assets)/$1,850 (current liabilities), or 3.35. Thismeans that for every dollar of current liabilities, Cheesy Chuck’shas $3.35 of current assets. Chuck is pleased with the ratio butdoes not know how this compares to another popcorn store, so heasked his new friend from Captain Caramel’s. The owner of CaptainCaramel’s shares that his store has a current ratio of 4.25. Whileit is still better than Cheesy Chuck’s, Chuck is encouraged tolearn that his store is performing at a more competitive level thanhe previously thought by comparing the dollar amounts of workingcapital.

IFRS CONNECTION

IFRS and US GAAP in Financial Statements

Understanding the elements that make up financial statements,the organization of those elements within the financial statements,and what information each statement relays is important, whetheranalyzing the financial statements of a US company or one fromHonduras. Since most US companies apply generally acceptedaccounting principles (GAAP)¹⁵as prescribed by the Financial Accounting Standards Board (FASB),and most international companies apply some version of theInternational Financial Reporting Standards (IFRS),¹⁶knowing how these two sets of accounting standards are similar ordifferent regarding the elements of the financial statements willfacilitate analysis and decision-making.

Both IFRS and US GAAP have the same elements as components offinancial statements: assets, liabilities, equity, income, andexpenses. Equity, income, and expenses have similarsubcategorization between the two types of GAAP (US GAAP and IFRS)as described. For example, income can be in the form of earnedincome (a lawyer providing legal services) or in the form of gains(interest earned on an investment account). The definition of eachof these elements is similar between IFRS and US GAAP, but thereare some differences that can influence the value of the account orthe placement of the account on the financial statements. Many ofthese differences are discussed in detail later in this course whenthat element—for example, the nuances of accounting forliabilities—is discussed. Here is an example to illustrate howthese minor differences in definition can impact placement withinthe financial statements when using US GAAP versus IFRS. ACME CarRental Company typically rents its cars for a time of two years or60,000 miles. At the end of whichever of these two measures occursfirst, the cars are sold. Under both US GAAP and IFRS, the cars arenoncurrent assets during the period when they are rented. Once thecars are being “held for sale,” under IFRS rules, the cars becomecurrent assets. However, under US GAAP, there is no specific ruleas to where to list those “held for sale” cars; thus, they couldstill list the cars as noncurrent assets. As you learn more aboutthe analysis of companies and financial information, thisdifference in placement on the financial statements will becomemore meaningful. At this point, simply know that financial analysiscan include ratios, which is the comparison of two numbers, andthus any time you change the denominator or the numerator, theratio result will change.

There are many similarities and some differences in the actualpresentation of the various financial statements, but these arediscussed in The Adjustment Process at which point these similaritiesand differences will be more meaningful and easier to follow.

Footnotes

11 McDonald’s Corporation. U.S. Securities and ExchangeCommission 10-K Filing. March 1, 2017. http://d18rn0p25nwr6d.cloudfront.net...ed454e3b88.pdf
12 McDonald’s. “Our Food. Your Questions. Breakfast.” n.d.https://www.mcdonalds.com/us/en-us/a...breakfast.html
13 U.S. Securities and Exchange Commission. “WasteManagement Founder, Five Other Former Top Officers Sued for MassiveFraud.” March 26, 2002. https://www.sec.gov/news/headlines/wastemgmt6.htm
14 U.S. Securities and Exchange Commission. “WasteManagement Founder, Five Other Former Top Officers Sued for MassiveFraud.” March 26, 2002. https://www.sec.gov/news/headlines/wastemgmt6.htm
15 Publicly traded companies in the United States must filetheir financial statements with the SEC, and those statements mustbe compiled using US GAAP. However, in some states, privatecompanies can apply IFRS for SMEs (small and medium entities).
16 The following site identifies which countries requireIFRS, which use a modified version of IFRS, and which countriesprohibit the use of IFRS. https://www.iasplus.com/en/resources...cs/use-of-ifrs