Introducing the Big Three
Gauging the Health of a Business through Its Financials
You may have heard accounting referred to as the “language of business.”
That’s because financial statements are the end result of the accounting pro- cess, and these written reports are used by many different people and enti- ties to make their own important investment and business decisions.
As I explain in Chapter 1, financial accounting is the process of classifying and recording all events that take place during the normal course of a company’s business. The results of these events are arranged on the correct financial statement and reported to the external users of the financial statements.
External users include investors, creditors, banks, and regulatory agencies such as the Internal Revenue Service (IRS) and the U.S. Securities and Exchange Commission (SEC).
External users of the financial statements differ from internal users in that the external user is generally less educated than the internal user. When I say less educated, I’m not referring to this person’s formal education; an exter- nal user may very well hold a PhD from an Ivy League school! What I mean is that the external user is less educated about the company’s operations.
The external user usually has no clue what is going on within the company because this person isn’t privy to the day-to-day operations.
In contrast, the internal users of the financial statements are employees, department heads, and other company management — all folks who work at the business.
The facts and figures shown on the financial statements give the people and businesses using them a bird’s-eye view of how well the business is perform- ing. For example, looking at the balance sheet, you can see how much debt the business owes and what resources it has to pay that debt. The income statement shows how much money the company is making, both before and after business expenses are deducted. Finally, the statement of cash flows shows how well the company is using its cash. A company can bring in a boat-load of cash, but if it’s spending that cash in an unwise manner, it’s not a healthy business.
This chapter provides only a brief look at each financial statement. While you prepare each statement using the same accounting facts (see Chapter 5), each one presents those facts in a slightly different way. I provide more detailed information about the three financial statements in other sections of this book: Look to Part III for balance sheet info, Chapter 10 for the lowdown
on the income statement, and Chapter 11 for a discussion of counting dollars and cents on the statement of cash flows.
Reporting Assets and Claims:
The Balance Sheet
The balance sheet shows the health of a business from the day the business started operations to the specific date of the balance sheet report. Therefore, it reflects the business’s financial position. Most accounting textbooks use the clichéd expression that the balance sheet is a “snapshot” of the com- pany’s financial position at a point in time. This expression means that when you look at the balance sheet as of December 31, 2012, you know the com- pany’s financial position as of that date.
Accounting is based upon a double-entry system: For every action, there must be an equal reaction. In accounting lingo, these actions and reactions are called debits and credits (see Chapter 5). The net effect of these actions and reactions is zero, which results in the balancing of the books.
The proof of this balancing act is shown in the balance sheet when the three balance sheet components perfectly interact with each other. This interac- tion is called the fundamental accounting equation and takes place when
Assets = Liabilities + Equity
The fundamental accounting equation is also called just the accounting equa- tion or the balance sheet equation.
Not sure what assets, liabilities, and equity are? No worries — you find out about each later in this section. But first, I explain the classification of the balance sheet. And nope, all you James Bond fans, it doesn’t have anything to do with having top-secret security clearance.
Realizing why the balance sheet is “classified”
A classified balance sheet groups similar accounts together. For example, all current assets (see Chapter 7) such as cash and accounts receivable show up in one grouping, and all current liabilities (see Chapter 8) such as accounts
payable and other short-term debt show up in another. This grouping is done for the ease of the balance sheet user so that person doesn’t have to go on a scavenger hunt to round up all similar accounts.
Also, people who aren’t accounting geeks (poor them!) may not even know which accounts are short-term versus long-term (continuing more than one year past the balance sheet date), or equity as opposed to assets. By clas- sifying accounts on the balance sheets, the financial accountant gives them information that is easy to use and more comparable.
Studying the balance sheet components
Three sections appear on the balance sheet: assets, liabilities, and equity.
Standing on their own, they contain valuable information about a company.
However, a user has to see all three interacting together on the balance sheet to form a reliable opinion about the company.
Assets
Assets are resources a company owns. Examples of assets are cash, accounts receivable, inventory, fixed assets, prepaid expenses, and other assets. I fully discuss each of these assets in other chapters in this book (starting with Chapter 7), but here’s a brief description of each to get you started:
✓ Cash: Cash includes accounts such as the company’s operating check- ing account, which the business uses to receive customer payments and pay business expenses, and imprest accounts, in which the company maintains a fixed amount of cash, such as petty cash.
Petty cash refers to any bills and coins the company keeps handy for insignificant daily expenses. For example, the business runs out of toilet paper in the staff bathroom and sends an employee to the grocery store down the block to buy enough to last until the regular shipment arrives.
✓ Accounts receivable: This account shows all money customers owe to a business for completed sales transactions. For example, Business A sells merchandise to Business B with the agreement that B pays for the mer- chandise within 30 business days. Business A includes the amount of the transaction in its accounts receivable.
✓ Inventory: For a merchandiser — a retail business that sells to the gen- eral public, like your neighborhood grocery store — any goods available for sale are included in its inventory. For a manufacturing company — a business that makes the items merchandisers sell — inventory also includes the raw materials used to make those items. See both Chapters 7 and 13 for more information about inventory.
✓ Fixed assets: The company’s property, plant, and equipment are all fixed assets. This category includes long-lived assets, such as the company-owned car, land, buildings, office equipment, and computers.
See Chapters 7 and 12 for more information about fixed assets.
✓ Prepaid expenses: Prepaids are expenses that the business pays for in advance, such as rent, insurance, office supplies, postage, travel expense, or advances to employees.
✓ Other assets: Any other resources owned by the company go into this catch-all category. Security deposits are a good example of other assets.
Say the company rents an office building, and as part of the lease it pays a $1,000 security deposit. That $1,000 deposit appears in the “other assets” section of the balance sheet until the property owner reimburses the business at the end of the lease.
Liabilities
Liabilities are claims against the company’s assets. Usually, they consist of money the company owes to others. For example, the debt can be owed to an unrelated third party, such as a bank, or to employees for wages earned but not yet paid. Some examples of liabilities are accounts payable, payroll liabilities payable, and notes payable. I fully discuss each of these liabilities in Chapter 8. For now, here’s a brief description of each:
✓ Accounts payable: This is a current liability reflecting the amount of money the company owes to its vendors. This category is the flip side of accounts receivable because an account receivable on one company’s balance sheet appears as an account payable on the other company’s balance sheet.
✓ Payroll liabilities: Most companies accrue payroll and related payroll taxes, which means a company owes its employees money but has not yet paid them. This process is easy to understand if you think about the way you’ve been paid by an employer in the past. Most companies have a built-in lag time between when employees earn their wages and when the paychecks are cut.
In addition to recording unpaid wages in this account, the company also has to add in any payroll taxes or benefits that will be deducted from the employee’s paycheck when the check is finally cut.
✓ Short-term notes payable: Notes payable that are due in full less than 12 months after the balance sheet date are short-term — or could be the short-term portion of a long-term note. For example, a business may need a brief influx of cash to pay mandatory expenses such as payroll.
A good example of this situation is a working capital loan, which a bank makes with the expectation that the loan will be paid back from the col- lection of the borrower’s accounts receivable.
✓ Long-term notes payable: If a short-term note has to be paid back within 12 months after the balance sheet date, you’ve probably guessed that a long-term note is paid back after that 12-month period! A good example of a long-term note is a mortgage. Mortgages are used to finance the pur- chase of real property assets (see Chapter 12).
Equity
Equity shows the owners’ total investment in the business, which is their claim to the corporate assets. As such, it shows the difference between assets and liabilities. It’s also known as net assets or net worth. Examples of equity are retained earnings and paid-in capital. I fully discuss both equity accounts in Chapter 9. For now, here’s a brief description of each:
✓ Retained earnings: This account shows the result of income and divi- dend transactions. For example, the business opens on March 1, 2012.
As of December 31, 2012, it has cleared $50,000 (woohoo!) but has also paid $10,000 in dividends to shareholders. The retained earnings number is $40,000 ($50,000 – $10,000).
Retained earnings accumulate year after year — therefore the “retained”
in the account name. So if in 2013 the same business makes $20,000 and pays no dividends, the retained earnings as of December 31, 2013, are
$60,000 ($40,000 + $20,000).
✓ Paid-in capital: This element of equity reflects stock and additional paid-in capital. Nope, you’re not seeing a typo! There is a paid-in capital account called “additional paid-in capital.” In brief, here’s what the two types of equity are:
• Stock: Corporations raise money by selling stock — pieces of the corporation — to interested investors. Stock sold to investors usu- ally comes in two different types: common and preferred. Each type of stock has its own characteristics and advantages, which I discuss fully in Chapter 9.
• Additional paid-in capital: This equity account reflects the amount of money the investors pay over the stock’s par value. Par value is the price printed on the face of the stock certificate and quite often is set at a random dollar amount. For example, if the par value of JMS, Inc. stock is $10 per share and you buy 100 shares at $15 per share, additional paid-in capital is $500 ($5 times 100 shares).
There is another stock account: Treasury stock is a company’s own stock that it buys back from its investors. While treasury stock is a part of equity, it is not a part of paid-in capital. It shows up on the balance sheet as a reduction in equity.
Seeing an example of a classified balance sheet
A classified balance sheet groups together similar accounts so the finan- cial statement user has an easier time reading it. In Chapter 7, I show you a blown-out balance sheet that is structured in accordance with generally accepted accounting principles (GAAP; see Chapter 4). In Figure 3-1, I give you a very abbreviated version of what a classified balance sheet looks like.
Figure 3-1:
An abbreviated classified balance sheet.
Classified Balance Sheet December 31, 2012
Assets Current assets
Property, plant & equipment Total assets
Liabilities Current liabilities Long-term liabilities Total liabilities
Equity Paid-in capital Retained earnings Total equity
Total liabilities and equity
14,125 175,000 189,125
2,300 90,525 92,825
6,000 90,300 96,300 189,125
Posting Profit or Loss:
The Income Statement
Next up in your exciting walkthrough of the three financial statements is (drum roll, please) . . . the income statement, which shows income, expenses, gains, and losses. It’s also known as a statement of profit or loss (or P&L) — mostly among non-accountants, particularly small business owners. As the true financial accountant that you are (or soon will be!), you use the term income statement rather than statement of profit or loss.
Here, I provide only a brief introduction to the income statement. For the complete scoop on the income statement, the accounts reflecting on it, and how to prepare one, see Chapter 10.
Your generally accepted accounting principles (GAAP) may also refer to this report as statements of income. This is because the income statement shows not only income and expenses from continuing operations but also income from myriad other sources, such as the gain or loss that results when a com- pany sells an asset it no longer needs.
Keeping a scorecard for business activity
The income statement shows financial results for the period it represents. It lets the user know how the business is doing in the short-term. And you have to keep in mind that the company’s performance is not just a question of whether it made or lost money during the financial period. The issue at hand is more a matter of the relationship among the different accounts on the income statement.
For example, maybe you see that a company’s gross profit, which is the differ- ence between sales and cost of goods sold, is $500,000. (Not sure what cost of goods sold is? No worries — you find out in the next section of this chapter!) Based on the amount of gross sales or historical trends, you expect gross profit to be $700,000. Well, your scorecard is coming in $200,000 short — not good. And if you’re a member of company management or an owner, you need to find out why.
Historical trends, which I discuss in Chapter 14, refer to a company’s perfor- mance measured in many different ways tracked over a period of time — usually in years rather than in months.
Perhaps you’re saying, “But wait — what about the equity section of the bal- ance sheet? Doesn’t that provide a scorecard too?” Well, think back to the definition of retained earnings I give earlier in this chapter: Retained earnings is the accumulated total of net income or loss from the first day the company is in business all the way to the date on the balance sheet (less dividends and other items that I discuss in Chapter 9). Retained earnings does provide valu- able information, but because it’s an accumulation of income that you can’t definitely tie to any specific financial period, and because it can potentially be reduced by other accounting transactions such as dividends, it does not provide a scorecard like the income statement does.
Studying the income statement components
Your financial accounting textbook homes in on a few income statement com- ponents: revenue, cost of goods sold, operating expenses, and other items of gain and loss. In this section, I give you just the basics on each. For a more comprehensive explanation of all the income statement accounts, be sure to read Chapter 10.
First up, let’s talk about everyone’s favorite topic: revenue!
Revenue
Revenue is the inflow of assets, such as cash or accounts receivable, that the company brings in by selling a product or providing a service to its custom- ers. In other words, it’s the amount of money the company brings in doing whatever it’s in the business of doing.
The revenue account shows up on the income statement as sales, gross sales, or gross receipts. All three names mean the same thing: revenue before report- ing any deductions from revenue. Deductions from revenue can be sales discounts, which reflect any discount a business gives to a good vendor who pays early, or sales returns and allowances, which reflect all products custom- ers return to the company after the sale is complete.
Cost of goods sold
The cost of goods sold (COGS) reflects all costs directly tied to any product a company makes or sells, whether the company is a merchandiser or a manu- facturing company.
If a company is a merchandiser (it buys products from a manufacturer and sells them to the general public), the COGS is figured by calculating how much it cost to buy the items the company holds for resale. Keep in mind that to accurately calculate this amount, you have to understand how to value ending inventory, which is the inventory remaining on the retails shop’s shelves at the end of the financial period, a topic I discuss in Chapter 13.
Because a manufacturer makes products, its COGS consists of raw material costs plus the labor costs directly related to making any products that the manufac- turer offers for sale to the merchandiser. COGS also includes factory overhead, which consists of all other costs incurred while making the products.
A service company, such as a physician or attorney, will not have a COGS because it does not sell a tangible product.
Operating expenses
Operating expenses are expenses a company incurs that relate to central operations and aren’t directly tied to COGS. Two key categories of operating expenses show up on the income statement:
✓ Selling expenses: Any expenses a company incurs to sell its goods or services to customers. Some examples are salaries and commissions paid to sales staff; advertising expense; store supplies; and deprecia- tion (see Chapter 12) of a retail shop’s furniture, equipment, and store fixtures. Typical retail shop depreciable items include cash registers, display cases, and clothing racks.
✓ General and administrative (G&A) expenses: All expenses a company incurs to keep up the normal business operations. Some examples are office supplies, officer and office payroll, nonfactory rent and utilities, and accounting and legal services. If, after getting an A in your financial accounting class, you’re so bowled over by the subject that you seek employment as a financial accountant, your payroll is lumped into G&A too.
Other income and expense
You classify all other income the company brings in peripherally as other rev- enue or other income; either description is fine. This category includes inter- est or dividends paid on investments or any gain realized when the company disposes of an asset. For example, the company purchases new computers and sells the old ones; the amount the company makes from the sale of the old ones is included in this category.
Other expenses are expenses the company incurs that aren’t associated with normal operations. Here are two types of expenses you typically see:
✓ Interest expense: The cost of using borrowed funds for business opera- tions, expansion, and cash flow.
✓ Loss on disposal of a fixed asset: If the company loses money on the sale of an asset, you report the loss in this section of the income statement.
Seeing an example of an income statement
I show you a full-blown income statement prepared in accordance with gener- ally accepted accounting principles (GAAP — see Chapter 4) in Chapter 10. In Figure 3-2, I give you a very abbreviated version of what an income statement looks like.