Question

LO5. How do you prepare financial statements? a) What two types of accounts appear on the income statement? b) Included on the statement of owner's equity is the net income and which accounts? c) What does the balance sheet tell an investor? d) What are the three sections of the statement of cash flows?

Answer 1

Answer(a): There are two types of account, appear in the income statement:

1. Expenses and losses- Under this head, all the expenditures are written, these expenditures can be operating, selling & administrative, interest expense, income tax etc. Expenditures are recorded on the debit side of income statement. Examples of expenses: Salary, wages, rent, Insurance, Advertisement expense, interest and taxes.
2. Income and gains- These are the revenues and gains that are recorded on the right hand side of income statement. Examples: Sales, Interest income, Other income etc.

Income statement is prepared on the basis of nominal account rule in which debit all the expenditures and losses and credit all the incomes. After the accounting period end, expenditures are subtracted from the income to know the Net profit or loss. If income is greater than expenses, there is profit in the account.

(b): Owner's equity- It is the book value of the company that is calculated by subtracting liabilities from assets. These are the items included in owner's equity account:

1. Common stock
2. Preferred stock
3. Paid-in-capital access in Par
4. Retained earnings

Answer(c): Balance sheet contains asset, liabilities and shareholder's equity. It is very important financial statement that tells financial, liquidity and solvency position of a company. Balance sheet tells the investors that how a company is doing financially, investors take investing decision by analyzing balance sheet of the company on the other hand it is also useful to creditors and debtholders, they see whether company is having more debt or not and company is having enough assets to repay the loan.

Answer(d): Three sections of statement of cash flow:

1. Cash flow from Operating activities - This includes day to day cash activities. Net Income, non cash expense and working capital are the main elements.
2. Cash flow from Financing activities- This includes the activities to raise funds. Loan from creditors, issuing more stocks are included.
3. Cash flow from Investing activities- This include the activities in which company is investing money. Purchasing property, sale of asset etc. are included.