All three financial statements contain important information, but each includes different information. For that reason, it is important for you to understand all three financial statements and how they relate to each other. The way they relate is sometimes referred to as articulation. a term we will say more about later .

A logical starting point for understanding financial statements is the .statement of financial ‘position,. also called the balance sheet. The purpose of this statement is to”

demonstrate where the company stands, in financial terms, at a specific date. As we will see later in this chapter, the other financial statements relate to the statement of financial position and show how important aspects of a company’s financial position change over time. Beginning with the statement of financial position also allows us to understand certain basic accounting principles and terminology that are important for understanding all financial statements.

Every business prepares a balance sheet at the end.of the year, und muny compunics prepare one at the end of each month. It consists of a listing of the assets, the liabilities. and the owner’s equity of a business. The date is important, as the financial position of a business may change quickly. A balance sheet is most useful if it is relatively recent. The following statement shows the financial position of Vagabond Travel Agency at December 31, 2001.

A balance sheet shows financial position at a specific 'date

A balance sheet shows financial position at a specific ‘date

Let us briefly describe several features of this balance sheet. Fif’5t. the heading communicates three things: (1) the”name of the business entity. (2) the name of ~e financial statement, and (3) the date. The body of the balance sheet also consists of three distinct sections: assets, liabilities, and owner’s equity.

Notice that cash is listed first among the assets, followed by notes receivable. accounts receivable, supplies, aad any other assets that will .\”0011 he’ converted into C(fS” or used up in business operations. Following these relatively “liquid” assets are the more “permanent” assets, such as land, buildings, and equipment

Liabilities are shown before owner’s equity. Each major type of liability (such as notes’ payable, accounts payable, and salaries payable) is listed separately, followed by a figure for total liabilities.

Finally, notice that the amount of total assets ($300,000) is-equal to the total amount of liabilities and owner’s equity (also $300,(00). This relationship always exists-in fact, the equality of these totals is why this financial statement is frequently called a balance sheet


Assets are economic resources thai are owned by a business and are expected to benetit future operations. In most cases, the benefit to future operations comes in the form of positive future cash flows. The positive future cash flows may come directly as the asset is converted into cash (collection of a receivable) or indirectly as the asset is used in operating the business to create other’ assets that result in positive future cash flows (building and land used to manufacture a product for sale). Assets may have definite. physical form such as buildings, machinery, 01′ an inventory of merchandise, On the other hand, some assets exist not in physical o~ tangible form, but in the form of valuable legal claims or rights; examples are amounts due from customers, investments in government bonds, and patent rights,

One of the most basic and at the same time most controversial problems in accounting is determining the dollar amount for the various assets of a business.At present, generally accepted accounting principles call for the valuation of most assets in a balance sheet at cost, rather than at their current value, The specific accounting principles supporting cost as the basis for asset valuation are ‘discussed below

The Cost Principle

Assets such as land, buildings, merchandise, and equipment are typical of the many economic resources that will be used in producing revenue for the  The prevailing accounting view is that such assets should be recorded at their cost.  we say that an asset is shown in the balance sheet at its historical cost, we mean {h~ original cost of the asset to the business entity; this amount may be very different from the asset’s current market value

In reading a balance sheet, it is important to bear in mind that the dollar amounts listed do not indicate the prices at which the assets could be sold or the prices at which they could be repla:ced. Perhaps the greatest limitation of a balance sheet is that it does -not show how much the business currently is worth

The Objectivity Principle

Another reason for using cost rather than current market values in accounting for assets is the need for a definite, factual basis for’ valuation. The cost of land, buildings, and many other assets purchased for cash ~an be rather definitely determined. Accountants use the term objective to describe asset valuations that are factual and can be verified by independent experts. For example, if land is shown on the -balance sheet at cost, any CPA who performed an audit of the business would be able to find objective. evidence that the land was actually measured at the cost incurred in acquiring it. Estimated market values, on the other hand, for assets such as buildings and specialized machinery are not factual and objective. Market values are constantly changing and estimates of the prices’ at which assets could be sold are largely a matter of judgment.

At the date an asset is acquired, the cost and market value are usually the same. With the passage of time, however, the current- market value of assets is likely to differ considerably from the cost recorded in the owner’s accounting records

Posted on November 21, 2015 in Basic Financial Statements

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