Chapter 3 Financial Statements
CHAPTER OUTLINE
Learning Objectives
Financial Statements
Personal Cash Flow Statement
Income Statement
Statement of Financial Position
Balance Sheet
Sole Proprietorship
REVIEW AND DISCUSSION QUESTIONS
1. How are financial statements used by business? They are used by the business for internal control of finance.
Data from statements are used to track the company’s record, present status, and future financial direction.
2. Compare variable and fixed expenses. Variable expenses are expenses that we have control over as
3. Describe the basic format of an income statement, listing all its sections. The income statement has a
4. What is the primary difference between the income statement of a sole proprietorship or partnership and
the income statement of a corporation? The primary difference is that the income statement for a sole
5. What is a personal statement of financial position? It is a personal balance sheet that lists all items that are
6. What is the difference between the time periods listed on an income statement and on a balance sheet? An
7. What is the importance of liquidity? Liquidity is a measure of how fast an asset can be converted to cash. If a
8. List the categories that are on the balance sheet for a business. Current assets, fixed assets, current
liabilities, long term debt, and owner’s equity.
9. What is the accounting equation for the balance sheet?
10. What is the difference between a current asset and a fixed asset? A current asset is an asset that has a useful
life of one year or less. A fixed asset is one that has an expected life in excess of one year. Fixed assets may be
depreciated, current assets cannot be.
11. Compare owner’s equity in a sole proprietorship, partner’s equity in a partnership, and stockholder’s
equity in a corporation. Owner’s equity in a sole proprietorship is the total value of the business that results
12. What is the purpose of the statement of cash flows? The purpose is to show how cash flowed into and out of
the business during the year. The reason is that the income statement and balance sheet do not actually show
cash flow during the accounting period.
13. List the components of the statement of cash flows. The components include cash flows from operating
14. Why are fixed assets carried on the balance sheet at a price that may not reflect the true value of the
assets? The balance sheet reflects the historical costs of assets and includes depreciation (wearing value) for
15. Compare free cash flow to net increase in cash on the statement of cash flows. Using the Internet find one
company that has a positive free cash flow and one in the same industry that has a negative free cash
flow. Which of these companies do you consider to be the better investment? Why? Typically a company
with a positive free cash flow is a better investment and the student research should verify this.
EXERCISES AND PROBLEMS
1. Given the personal cash flow statement in Table 3-2, use your own data to determine your disposable
income at the end of the current year. Please include income from all sources, fixed expenses, and
variable expenses. There are no actual answers to this question but use the format of income, fixed
2. Given the statement of financial position in Table 3-4, use your own data to determine your net
worth. Make sure that student loans are included in liabilities, if applicable. This is similar to
3. The Happy Auto Shop has the following annual information: Gross Sales, $700,000; Net Sales,
$696,000; Gross Profit, $448,000. What are the shop’s returns and allowances and cost of goods
4. Construct a personal income statement for the Humperdink family using the following information:
salaries, $42,000; mortgage payment, $7,980; food, $2,400; interest income, $150; transportation,
$1,200; dividend income, $190; automobile payment, $3,060; clothes and personal, $2,000; student
loan payment, $1,700; property taxes, $1,100; utilities, $3,000; insurance, $2,100; income taxes
$9,700; and recreation and vacation, $2,000. What is the family‘s disposable income?
Humperdink Family
Personal Income Statement
(Cash Flow Statement)
(No time frame in problem)
Income
Salaries
$ 42,000
Dividend Income
190
Utilities
3,000
Income Taxes
9,700
TOTAL FIXED EXPENSES
$ 28,640
Variable Expenses
Food
$ 2,400
Transportation
1,200
5. Construct a statement of financial position (balance sheet) for the Humperdink family using the following
information: cash, $50; checking account, $2,500; student loan balance, $6,000; stocks and bonds, $2,600;
savings account, $5,850; residence, $110,000; automobile, $12,000; savings account, $5,800; automobile loan
balance, $12,000; 401K retirement account, $15,000; furniture, clothing, jewelry, $8,000; credit card balance,
$4,000; and mortgage loan balance, $99,000.
Humperdink Family
Statement of Financial Position
(No date given)
Assets
Cash and Cash Equivalents
Cash and Checking Account
$ 2,550
Savings Account
11,650
Total Cash and Cash Equivalents
$ 14,200
Invested Assets
Stocks and Bonds
2,600
401K Retirement Account
15,000
Total Invested Assets
$ 17,600
Use Assets
Residence
110,000
Automobile
12,000
Furniture, Clothing and Jewelry
8,000
Total Use Assets
$ 130,000
Total Assets
$ 161,800
Liabilities and Net Worth
Liabilities
Student Loan Balance
Credit Card Balance
4,000
Automobile Loan Balance
12,000
Mortgage Loan Balance
99,000
Total Liabilities
$ 121,000
Net Worth
Total Liabilities and Net Worth
$ 161,800
6. Construct an income statement using the following information: net sales, $500,000; salaries, $100,000; rent,
$24,000; COGS, $250,000; utilities, $25,000; payroll taxes, $25,000; insurance, $12,000; and interest expense,
$5,450. Make sure that you include gross profit, operating expenses, and net profit.
Sample Income Statement
Net Sales
$ 500,000
Cost of Goods Sold
250,000
Gross Profit
$ 250,000
Operating Expenses
Salaries
Rent
Utilities
Payroll Taxes
Insurance
Total Operating Expenses
$ 186,000
Operating Income
Interest Expenses
7. George’s Pizzeria has the following information as of December 31,2012: cash, $2,000; pizza ovens, $25,000;
furniture, $12,500; accounts payable, $3,500; notes payable, $12,500; accumulated depreciation, $10,000;
wages payable, $1,500; taxes payable, $2,500; equipment loan, $18,000. Construct a balance sheet for
George. Do you think he has a problem with his current balance sheet? If so, what is it? Yes, he has a
negative equity of $8,500.
George’s Pizzeria
Balance Sheet
as of December 31, 2012
Assets
Current Assets
Cash
$ 2,000
Total Current Assets
$ 2,000
Fixed Assets
Pizza Ovens
$ 25,000
Furniture
12,500
Less: Accumulated Depreciation
$ 27,500
Total Fixed Assets
Total Assets
$ 29,500
Liabilities and Owner’s Equity
Current Liabilities
Accounts Payable
$ 3,500
Notes Payable
12,500
Wages Payable
1,500
Taxes Payable
2,500
Total Current Liabilities
$ 20,000
Long Term Debt
Equipment Loan
18,000
Total Long Term Debt
$ 18,000
Total Liabilities
Owner’s Equity
8. State the stockholder’s equity of the Alphabet Corporation if it has a current net profit of $1,500,000,
beginning-of-the-period retained earnings of $3,675,000, 1 million shares of common stock issued at a par
value of $1 per share, and paid-in capital in excess of par of $12.50 per share?
$1,500,000 net profit + $3,675,000 retained earnings = $5,175,000 Total Retained Earnings.
9. State your current cash balance if you have the following information: total cash receipts of $624,000; a cash
balance at the end of last year of $60,000; total cash payments of $540,000; cash outflow from investing
activities of $100,000; and cash inflows from financial activities of $172,000.
Statement of Cash Flows
Total Cash Receipts
$ 624,000
Cash Payments
(540,000)
Net Cash Flow From Operating Activity
$ 84,000
Cash Outflow from Investing Activity
Cash Inflow from Financial Activity
Net Increase in Cash
$ 156,000
Cash Balance at the end of Last Year
Cash Balance at the end of This Year
RECOMMENDED TEAM ASSIGNMENT
The team assignment requires current research and an understanding of financial statements. We recommend teams
of 3 to four members. Depending on the detail that the instructor requires, you may want to use the 10k from the
SEC rather than the statements found in the annual report or on an internet search engine such as Yahoo! Finance.
1. Compare and contrast the financial statements of at least two companies within the same
industry.
CASE STUDY QUESTIONS
1. Develop a financial income statement and balance sheet by combining the chart of account items on the
DPSystems income statement and balance sheet in Tables 3–9 and 3–10.
Assets
Gross Revenue 64,250.00$ Current Assets
Operating Expenses Checking/Savings 13355.21
Office Supplies 552.95 Undeposited Funds 410
Computer Accesseried 560.35 Accounts Receivable -50
Software 206.91 Net Fixed Assets 4039.94
Hardware 108.09 Other Assets 310
Bank Charges 322.90 Total Assets 18065.15
As of December 31, 2007
Cash Basis
DPSystems Income Statement
January 1 through December 31, 2007
Cash Basis
DPSystems Balance Sheet
2. List the chart of account numbers and major categories used in DPSystems’ accounting system. Balance
Sheet: Assets 1000 to 1999. Current assets are 1000, fixed assets are 1400 & 1500, other assets are 1700. Liabilities
4999, expenses 5000 to 6999.
3. How would a hotel chain use a property management system to incorporate items from individual hotels into
their corporate financial statements? The system would simply consolidate all revenue by importing the room