1.3 Financial Statements

Users of accounting information can be divided into two major groups: internal users, such as managers and executives who actually work in the company, and external users, such as potential lenders and investors. The first half of this textbook focuses on financial accounting, which is the name given to accounting information provided for and used by external users. Managerial accounting is the name given to accounting systems designed for internal users. From an accounting standpoint, the crucial difference between internal users and external users is that internal users, because they work within the company, have the power to custom design accounting reports to meet their specific needs. External users typically must rely on general purpose financial information provided by the company.

The general purpose information provided by financial accounting is summarized in the financial statements: the balance sheet, income statement, and statement of cash flows.

Balance Sheet

The balance sheet reports the resources of a company (the assets), the company’s obligations (the liabilities), and the owners’ equity, which represents how much money has been invested in the company by its owners.

A condensed illustration of McDonald’s 2019 balance sheet is shown below. All numbers are in millions of U.S. dollars.1

McDonald’s reports total assets in excess of $47 billion. Notice that the total of the assets is exactly equal to the total of the liabilities and the equity. Is this exact equality a coincidence? You’ll find out later when we discuss the balance sheet in more detail. The $47 billion asset total is also interesting in light of the statement made earlier that the value of the McDonald’s brand name and reputation is over $45 billion, but accounting rules prohibit including that value in the balance sheet. Could it be true that roughly half of McDonald’s economic assets are actually not listed in its balance sheet ($47 billion listed and $45 billion not listed)? We’ll address that question later when we discuss long-term assets in detail.

Income Statement

The income statement reports the amount of net income earned by a company during a period, with annual and quarterly income statements being the most common. Net income is the excess of a company’s revenues over its expenses; if the expenses are more than the revenues, then the company has suffered a loss for the period. The income statement represents the accountant’s best effort at measuring the economic performance of a company.

A simplified version of McDonald’s 2019 income statement is given below (in millions of U.S. $):

Overall, during 2019 McDonald’s made over $6 billion. Later we will learn how to use detailed revenue and expense data, coupled with an understanding of how a franchise business like McDonald’s works, to estimate how much profit McDonald’s makes each time it sells you a Big Mac.

Statement of Cash Flows

The statement of cash flows reports the amount of cash collected and paid out by a company in the following three types of activities: operating, investing, and financing. The types of activities that fall in each of these three categories will be explained later when we discuss the financial statements in detail. The statement of cash flows is the most objective of the financial statements because, as you will see in subsequent chapters, it involves a minimum of accounting estimates and judgments.

A summary of McDonald’s 2019 statement of cash flows is given below (in millions of U.S. $):

McDonald’s cash balance increased by just $32.5 million (rounded to $33 million) during the year. Notice that no detail about cash from operations is given. The reason is that because of some traditional accounting reporting practices, companies are not required to report cash expenditures by category, such as cash paid to employees, cash paid for rent, and the like. You will have to wait until later to find out more about this.

The three primary financial statements will be more formally introduced in our “Overview of the Financial Statements.” We cover the basics of how to analyze the financial statements when we provide an “Introduction to Financial Statement Analysis.” The remainder of the text provides more detail about the preparation, use, and interpretation of financial statements. If you are eager to start looking at some real financial statements right now, the information in Business Context 1-1 in the next section tells you how to access financial reports for public companies.

Questions Exercises