As our discussion of Overnight Auto Service indicates, the statement of financial position (balance sheet), the income statement, and the statement of cash flows are all bused on the same underlying transaction information, but they present different “views” of the company. They should not be thought of as alternatives to each other; rather, all arc important in terms of presenting key financial information about the company. The following diagram explains how the three financial statements relate to the period of time they cover. The horizontaf line represents time (for example. a month or a year). At the beginning and ending points in time, the company prepares a statement of financial position (balance sheet) that gives a static look in financial terms of where the company stands. The other two financial statements-the income statement and the statement of cash flows-cover the interveningpericd of time between the two balance sheets and help explain important changes that occurred during the period.
If we understand where a company stands financially at two points in time. and if we, understand the changes that occurred during the intervening period in terms of the company’s profit-seeking activities (income statement) and its cash (statement of cash flows), we know a great deal about the company that is of value in assessing. the future cash flows of the company-information that is useful to investors, creditors, management. and others .
While these three key financial statements include a wealth of important information, they do not include all possible information that might be presented about a company. ‘ For example, look again at Overnight’s activities during the month of November. We could have prepared a separate financial statement on how liabilities changed or how the Tools and Equipment asset account changed. There is also important non financial information that underlies the statement of financial position, the income statement, and. the statement of cash flows that could be presented and that users of the statements would benefit from knowing. Accountants have developed methods of dealing with these other types of information, which we will learn about later in this text. At this point, we have focused our attention on the three primary financial statements that companies most often use to describe the activities that are capable of being captured in financial terms •.
We have used the word “cash” extensively In’ Introducing the primary financial statements. As we learned In Chapter 1, ultimately the flow of cash to Investors and creditors Is very Important. These
users of flilanclal statements are Interested In the cash activities of the enterprise In which they havEilrivested’ or to which theX have made loans or-sold on credit. All enterprises are Involved in continuous ‘cash-to-casn cycles that vary with the nature of the underlying business. For example, Overnight Auto Service Invests in a cash cycle in which i~ purchased land and a building necessary
for Its business. These assets,’ in turn, .are used to provlqe services for customers that result in cash flows back ‘into the company. Another .cash cycle is much shorter in terms of time, namely the payment of wages to employees. The underlying purpose, however, is the. same as the purchase of land and buildings-namely, to acquire what Is necessary to provide auto repair services that will ultimately result In positive cash flows for Overnight Auto Service. Sometimes the enterprise is able to delay a negative cash flow until it has a pos,ltlve cash flow to prqvlde the cash for payment.
For example, Overnight partially purchased its building on credit,. thereby allowing it to use the building to operate-and generate positive cash flows, some of which will be used to repay the. loan on the building. In other instances, cash payment is required before the positive cash flows from the .use of the asset can take. place (for example, OVernight’s purchase of land for casm. In the final analysis, managing a company’s cash flows Is an important responsibility of management and may ultimately determine the success or failure of a business
FORMS OF BUSINESS ORGANIZATIONS
In the United States, most business enterprises are organized as a sole proprietorship, a partnership, or a corporation. Generally accepted accounting principles can be applied to the financial statements of all three forms of organization,
An ‘unincorporated business owned by one person is called a sole proprietorship. Often the owner also acts as. the manager. Overnight Auto Service, the company used in our illustration, is a sole proprietorship owned by Michael McBryan. This .fonn of business organization is common for small retail stores; farms, service businesses, and professional practices in law, medicine, and accounting. In fact; the sole proprietorship is. by far the most common fonn of business organization in our economy.
From an accounting viewpoint, a sole proprietorship is regarded as a business entity separate from the other affairs of its owner. From a legal viewpoint, however, the business and its owner rife not regarded as separate entities. Thus, the owner is personally
A corporatlon is the only type of business organization recognized under the law as-an entity separate from its owners. Therefore, the owners of a corporation are not personally liable for the debts of the business. These owners can lose no more than the amounts they have invested in the business-a concept known as limited liability. This concept is the principal reason that corporations are the most attractive form of business organization to many investors.
Ownership of a corporation is divided into transferable shares of capital stock, arid the owners are called stockholders. Stock certificates are issued by the coeporation to each stockholder showing the number of shares that he or she owns. The stockholders are free to sell some or all of these shares to other investors at anytime. This transferability of ownership adds to the attractiveness of the corporate form of organization, because investors can more easily get their money out of the business. Corporations offer an even greater opportunity to bring together large amounts of capital from multiple owners.
There are many more sole proprietorships and partnerships than corporations, but most large businesses are organized as corporations. Thus corporations are the dominant form of business organization in terms of the dollar volume of their business activities. In addition, it is primarily corporatio .s that distribute their financial statements to investors and other outsiders.
represents the amount that the stockholders originally invested in the business in exchange for shares of the company’s stock. Retained earnings, in contrast, represents the. increase in stockholders’ equity that has accumulated over the years as : suit of profitable operations.