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Getting a Handle on Financial Statements
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Tracing changes in the balance sheet to the income and expense statement (profit and loss account) is more than just an exercise. It is the fastest way to get a handle on accounting. Sure, the first few times, it feels like you’re banging your head against a wall. But keep at it. A good manager will check over his or her financial statements every month or at least every quarter. Once you understand them, financial statements help you keep the pulse of your business. If you look at them regularly, they also help you see changes as they happen, so you can catch problems before they become too big to handle.
• Income and expense statements always have a period, from a beginning date to an ending date.
• Balance sheets have a single date, reporting the status of the company on that date.
• An income and expense statement shows the change in the balance sheet from the start date to the end date of the income and expense statement.
Income and expense statement (profit and loss account) is adocument that shows all of the gozintaand gozouta for a business during aparticular period of time. Sometimesit is just called an income statement. Revenue is a synonym for income, sothis can also be called a statement of revenue. The income statement is also knownas a profit and loss statement, an operating statement, or a statement of operations. The income statement may be defined as a summary of the revenue (income), expenses, and net income of a business entity for a specific periodof time.Let us review the meaningsof the elements entering into the income statement.
Revenue is the increase in capital resulting from the delivery of goods or rendering of services by the business. In amount, the revenue is equal to the cash and receivables gained in compensation for the goods delivered or services rendered. Revenue includes gross income from the sale of products or services. It may be designated as sales, income from fees, and so on, to indicate gross income. The gross amount is reduced by sales returns and by sales discounts to arrive at net sales.
Cost of Goods Sold. The inventory of a merchandising business consists of goods on hand at the beginning of the accounting period and those on hand at the end of the accounting period. The beginning inventory appears in the income statement and is added to purchases to arrive at the cost of goods available for sale. Ending inventory is deducted from the cost of goods available for sale to arrive at cost of goods sold.
Expenses is the decrease in capital caused by the business’s revenue-producing operations. In amount, the expense is equal to the value of goods and services used up or consumed in obtaining revenue.
Operating Expenses includes all expenses or resources consumed in obtaining revenue. Operating expenses are further divided into two groups. Selling expenses are related to the promotion and sale of the company’s product or service. Generally, one individual is held accountable for this function, and his or her performance is measured by the results in increasing sales and maintaining selling expenses at an established level. General and administrative expenses are those related to the overall activities of the business, such as the salaries of the president and other officers. When preparing income statements, list expenses from highest to lowest except Miscellaneous, which is always last, no matter how large the amount may be.
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Net income is the increase in capital resulting from profitable operation of a business; it is the excess of revenue over expenses for the accounting period.
It is important to note that a cash receipt qualifies as revenue only if it serves to increase capital. Similarly, a cash payment is an expense only if it decreases capital. Thus, for instance, borrowing cash from a bank does not contribute to revenue.
In many companies, there are hundreds and perhaps thousands of income and expense transactions in a month. To lump all these transactions under one account would be very cumbersome and would, in addition, make it impossible to show relationships among the various items. To solve this problem, we set up a temporary set of income and expense accounts. The net difference of these accounts, the net profit or net loss, is then transferred as one figure to the capital account.
Balance sheet is a financial statement that shows the financial position—that is, the assets, liabilities, and value (equity)—of a company on a particular day.
The financial condition or position of a business enterprise is represented by the relationship of assets to liabilities and capital.
Assets i s properties that are owned and have money value—for instance,
cash, inventory, buildings, equipment.
Current Assets is assets reasonably expected to be converted into cash or used in the current operation of the business (generally taken as one year). Examples are cash, notes receivable, accounts receivable, inventory, and prepaid expenses.
Other Assets is various assets other than current assets, fixed assets, or assets to which specific captions are given. For instance, the caption “Investments” would be used if significant sums were invested. Often companies show a caption for intangible assets such as patents or goodwill.
In other cases, there may be a separate caption for deferred charges. If, however, the amounts are not large in relation to total assets, the various items may be grouped under one caption, “Other Assets.”
Property, plant and equipment are long-lived assets used in the production of goods or services. These assets, sometimes called fixed assets or plant assets, are used in the operation of the business rather than being held for sale, as are inventory items.
Liabilities is amounts owed to outsiders, such as notes payable, accounts payable, bonds payable.
Current Liabilities is debts that must be satisfied from current assets within the next operating period, usually one year. Examples are accounts payable, notes payable, the current portion of long-term debt, and various accrued items such as salaries payable and taxes payable.
Long-term liabilities is liabilities that are payable beyond the next year.
The most common examples are bonds payable and mortgages payable.
These three basic elements are connected by a fundamental relationship called the accounting equation. This equation expresses the equality of the assets on one side with the claims of the creditors and owners on the other side:
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Assets= Liabilities + Owner’s Equity
All accounts placed on the balance sheet are assigned a type. These are the most basic types of accounts:
– income
– expense
– asset
– liability
– equity
The information needed for the balance sheet items are the net balances at the end of the period, rather than the total for the period as in the income statement. Thus, management wants to know the balance of cash in the bank and the balance of inventory, equipment, etc., on hand at the end of the period.
The balance sheet may then be defined as a statement showing the assets, liabilities, and capital of a business entity at a specific date. Thisstatement is also called a statement of financial position or statement offinancial condition.
Among the items of the balance sheet are the following:
Accounts receivable isthemoney due from customers for goods and services.
Marketable securities isstocks, bonds, or other financial instrument held by the company.
Inventor y is goods available for sale.
Fixed assets isthe property, plant, and equipment of the company.
Accounts payable is themoney the company owes to vendors for good or services rendered.
Notes payable is a loan or obligation to be paid, current portion of a long-term debt.
Income taxes payable istaxes due in the current year.
Accrued expenses is expenses that will be due but have not yet been paid.
Deferred income taxes is an estimate of the taxes that would be due if assets were sold at stated value.
There are some other accounts that have some inherent risk. The accounts receivable may not all collect. If the inventory is particularly high, that could be a sign that the product is not moving. The balance sheet consists of many accounts that are actually estimates that may or may not come true. Understanding the potential limitations helps when considering the balance sheet in conjunction with other financial statements.
Capital Statement
Instead of showing the details of the capital account in the balance sheet, we may show the changes in a separate form called the capital statement.
This is the more common treatment. The capital statement begins with the balance of the capital account on the first day of the period, adds increases in capital (example: net income) and subtracts decreases in capital (example: withdrawals) to reach the balance of the capital account at the end of the period.
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