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Fundamentals of Financial Statements

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Essay title: Fundamentals of Financial Statements

To the wise business owner, the company is much like a human being. Just as people make sure they see their doctors on a regular basis to ensure their physical health, so too business owners check the health of their business on a regular basis. This can be done through a series of financial statements, which, when correctly maintained, represents how profitably the business is functioning. Accounting, defined by Marshall (2003) as, "the process of identifying, measuring, and communicating economic information about an organization for the purpose of making decisions and informed judgments," provides the business owner with the framework for properly accumulating and recording that information.

This paper will discuss the impact of different business transactions on each of the financial statements, analyze and answer a hypothetical question based upon the statements, and identify and explain the optimal answers for the simulation.

Transactions and Their Impact

The report used to provide a "snapshot of [an] organization's financial position, frozen at a specific point in time" (Marshall) is the balance sheet, which shows assets, liabilities, and owner's equity in a balanced report. This means that the total of a company's assets will always equal their liabilities plus the owner's equity. Every business transaction will affect the balance sheet, but must affect both sides of the sheet equally.

Before Connie Rocha began her operation, she funded the business, purchased equipment and supplies, and rented her facility. Her balance sheet showed an increase in cash to fund the business; with no liabilities against that money, the owner's equity increased by the same amount. As she purchased supplies and equipment with cash, her net cash dropped, but she gained assets of equal value in equipment and supplies. When she purchased office equipment on credit, she gained an asset, but also added a liability to the income statement of the same amount. This transaction increased her total assets, but did not change her equity in the company. Therefore, what Connie would see at this point would be a balance sheet showing a large amount of available cash, as well as equipment and supplies necessary to start business.

Beginning operations added new impacts. While the balance sheet still remains vital to seeing the overall health of the business, other reports also are key indicators of how effectively Connie is doing business, by detailing more specific aspects of the Assets = Liabilities + Owner's Equity equation. These are the Income Statement, the Statement of Changes in Owner's Equity, and the Statement of Cash Flows. In a simple transaction, such as the cash purchase by a customer, the cash asset rises, as does the revenue column, which is an owner's equity element. In a case of a credit sale, the Accounts Payable is increased by the sale amount, as is revenue, keeping both sides equal. When payment is made on the account, Cash, an asset is increased, while the asset Accounts Payable is decreased by the same amount. The income statement will reflect sales that have been completed, less the cost of selling the goods, e.g. supplies, salaries, utilities, etc. This report will show Connie how much money she is making from her sales each month. She can use this information to determine whether her prices are accurate, and to determine whether the costs of goods sold is too high or too low in comparison. This number will also directly affect the Statement of Changes in Owner's Equity, as Connie's equity will be increased by the net income, and decreased by any withdrawal she makes. The remaining balance after those two factors, called retained earnings, is added to the previous Owner's equity to get the current amount.

The Statement of Cash Flows is a report that will enable Connie to determine whether she is gaining or losing actual cash from the business. This is vital, especially in a business of Connie's size, because no matter how strong the balance sheet, without cash, there is no way to transact for supplies and equipment necessary to fill the orders. As a business owner, the author has learned this firsthand. At the start of business operations, the author's print shop was busily fulfilling orders written by the previous owner, but his contract entitled the previous owner to all of the accounts receivable up to the date of purchase of the business. As a result, for the first 30 days, most of the cash received was being sent directly to the previous owner, with none coming to the new owner. This negative cash flow was nearly fatal for the business. Two years later, there are still repercussions felt due to that initial negative cash flow. Had the owner been more versed in the

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