Chapter 4 Pt2: Understanding Accounting Issues
Financial statements: any of several types of status; most often used in reference
to balance sheets, income statements and/or statements of cash flow.
o Balance Sheets—a type of financial statement that summarize a firm’s
financial position on a particular date in terms of its assets, liabilities and
• Current assets—cash and other assets that can be
converted into cash within a year; normally listed in order
of liquidity—the ease and speed with which an asset can
be converted to cash; cash is perfectly liquid. Business
debts can usually be satisfied only through payments of
cash. Market able securities as short term investments are
slightly less liquid but can be sold quickly if necessary.
These include stocks or bonds of other companies, gov’t
securities, and money market certificates. There are 3
important non-liquid assets held by many companies:
accounts receivable, merchandise inventory and prepaid
o Accounts receivable --amounts dues to the firm
customers who have purchased goods or services on
credit. Most businesses expect to receive payment
within 30 days of a sale. Read example. Total
accounts receivable assets are decreased
o Merchandise inventory—cost of merchandise that
has been acquired for sale to customers but is still
on hand. Assumptions must be made about which
ones were sold and which ones remain in storage.
o Prepaid expenses—includes supplies on hand and
rent paid for the period to come. They are assets b/c
they have are available to the company.
• Fixed assets—have long-term use or value to the firm
such as land, buildings, and machinery. But as buildings
and equipment wear out or become obsolete, their value
decreases depreciation—distributing the cost of a
major asset over the years in which it produces revenues;
calculated by each year subtracting the asset’s original
value divided by the number of years in its productive life.
• Intangible Assets—non-physical assets such as patents,
trademarks, copyright, and franchise fees that have
economic value but whose precise value is difficult to
calculate. Goodwill—the amount paid for an existing
business beyond the value of its other assets.
Liabilities • Current liabilities—any debts owed by the firm that must
be paid within one year. Include accounts payable—
amounts due from the firm to its suppliers for goods,
and/or services purchased on credit; a form of current
liability. Long-term liabilities—any debts owed by the
firm that are not due for at least one year.
• The final section of the balance sheet shows owner’s equity
broken down into stated capital, paid-in capital, and
retained earnings. Paid-in capital—any additional money
invested in the firm by the owners. Retained earnings –a
company’s net profits less any dividend payments to
o Income (profit-and-loss) statements –a type of financial statement
that describes a firm’s revenues and expenses and indicates whether
the firm has earned a profit or suffered a loss during a given period.
REVENUES – EXPENSES = PROFIT
Revenues—any monies received by a firm as a result of selling a
good or service or from other sources such as interest, rent, and
Cost of Goods Sold—any expenses directly involved in
producing or selling a good or service during a given time period.
• Gross Profit (gross margin)—a firm’s revenues (gross
sales) less its cost of goods sold.
Operating Expenses—costs incurred by a firms other than
those included in cost of goods sold. These are resources that
must flow out of a company for it to earn revenues. Selling
expenses result from activities related to selling the firm’s goods
or services. These many include salaries for the sales force,
delivery costs, and advertising expenses. General and
administrative expenses (e.g. management salaries, insurance
expenses, and maintenance costs) are expenses related to the
general management of the company.
• Operating Income and Net Income: managers must
determine operating income—compares the gross profit
from business operations against operating expenses.
Subtracting income taxes from operating income reveals
net income (net profit or net earnings)—a firm’s gross
profit less its operating expenses and income taxes.
o Statement of Cash Flows—a financial statement that describes a
firm’s generation and use of cash during a given period.
Cash flows from operations: is concerned with the firm’s main