4. Overview of Financial Statements and the Income Statement

Question 1

Name some internal users of the financial statements and briefly discuss why each party uses them.

Answer 1

• Managers: Use financial statements to determine whether the organization is utilizing resources in the most cost-effective manner and to make key investment and financing decisions.
• Employees: Analyze the statements for their own job security and to determine the impact of profit-based compensation.

Question 2

List some external users of the financial statements and briefly discuss why each party uses them.

Answer 2

• Shareholders and prospective investors: To determine their return on investment.
• Financial institutions: Assess the ability to pay on loans and keep debt covenants.
• Suppliers: Assess the ability of their customers to pay bills on time.
• Customers: Assess whether the suppliers will remain in business.
• Competitors: Compare their performance to others in the industry.
• Regulators: Assess whether public organizations have adhered to accounting and reporting requirements.

Question 3

When looking at the financial statements, what are some inherent limitations that must be considered?

Answer 3

• Periodicity: The monthly, quarterly, and annual statement periods are generally not good indicators of the natural business cycle.
• Historical information: The information is historical and should be considered with current knowledge of the company.
• Valuation: Some items use historical cost, others use estimates, and other items are reported at fair value.
• Accounting Methods: Differences between methods might make it difficult to compare two organizations.
• Omissions: Several relevant items are omitted from the financial statements.

Question 4

Describe the purposes of the income statement and the balance sheet.

Answer 4

• Income Statement: Shows the sources of revenues, gains, expenses, and losses for a reporting period. Elements on the income statement are recorded on an accrual basis. The income statement is often combined with a presentation of Other Comprehensive Income. The income statement may be presented using either the single-step or multi-step method.
• Balance Sheet: Shows the assets, liabilities, and owners’ equity of the organization as of the end of a reporting period.

Question 5

Describe the purposes of the Statement of Changes in Equity and the Statement of Cash Flows.

Answer 5

• Statement of Changes in Equity: Presents the detailed changes in each equity account over the course of the reporting period. The accounts typically included in equity include: Preferred Stock, Common Stock, Additional Paid-In Capital, Treasury Stock, Retained Earnings, and Accumulated Other Comprehensive Income.
• Statement of Cash Flows: Explains the overall change in the cash position over the reporting period. The change is broken down into three categories of cash flows: Operating, Investing, and Financing.