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Understanding the Financial Statements

There are 3 questions that should be answered when starting a business as follows:

  • How much profits was generated by the business over a given time
  • What is the accumulated wealth of the business at any point in time
  • How much cash flowed through the business

These three questions are answered by the:

  • Profit and loss statement
  • The balance sheet statement
  • Statement of cash flow

When these 3 statements are viewed together they tell the financial health of the business.

Grouping the elements of financial statements into financial reports:

The element of financial statements are grouped into 2 main financial statements or reports:

  • The Balance Sheet
  • The Profit & Loss Statement

The other 2 financial statements (statement of changes in equity and the cash flow statement) are derived from the 2 statements mentioned above.

The elements of financial statements are represented in the balance sheet and profit and loss statement as follows:

Balance Sheet

1.    Assets

2.    Liabilities

3.    Equity

4.    Investments by owners/ contributed capital

5.    Distributions to owners

Profit and Loss Statement

6.    Revenues

7.    Expenses

9.    Gains

10.    Losses

 

The Balance Sheet

The balance sheet is the statement that expresses the accounting equation Assets= Liabilities + Equity. It is the statement of the financial position at any point in time. The balance sheet can be compared to a picture. A picture freezes a moment in time.

An example:

Its family picture day and you are taking a picture with your children. Just before the picture, your children are teasing each other and making faces. But, just before the picture is taken, everyone puts on a big smile and then, snap, the picture is taken. This is exactly what a balance sheet does, it takes a snapshot so when we see the picture we only see what happened as of that date. Just before the snapshot, assets and liabilities could have changed hands to make the picture look better.

The profit and loss and cash flow statement is a great complement to the balance sheet because it shows the teasing that took just before the picture.

The elements of the financial statement and the balance sheet statement

The elements of financial statement that show up on the balance sheet are as follows:

1.    Assets

2.    Liabilities

3.    Equity

4.    Investments by owners/ contributed capital

5.    Distributions to owners

Element #1: Assets

An asset, is a resource controlled by the business. The major characteristics of assets are as follows:

  1. A probable future benefit: this means that there is expectation of some future monetary value. If Uncle Joe owes you money for lemonade he bought today, the amount he owes you is an asset because you expect to collect in the future.
  2. The business controls the resource and the benefit: unless the business has control it cannot be considered an asset of the business. If a business leases a vehicle, the vehicle cannot be considered an asset to the business if the business does not control or have exclusive rights to the vehicle.
  3. The event or transaction bringing about the benefit must have occurred: For instance if I agree to purchase a piece of equipment next month, the equipment is not an asset to me just yet.
  4. The asset must be measured in monetary terms: you have to be able to assign a value to the asset. The value of loyal customers are hard to determine so do not appear on the balance sheet.

Once an asset has been recognized on the books of a business, it will continue to be considered an asset until the benefits are exhausted or the business disposes of the asset. Also, assets does not have to be a tangible items: There are also intangible assets like patents and copyrights.

Example problem

State which of the following items will appear on the balance sheet as an asset:

  1. Uncle Joe buys lemonade from your lemonade stand and promises to pay later
  2. A business hires a new marketing director who is expected to increase profits by 40 %
  3. Purchased equipment which is expected to save the business $15,000. However, the equipment was purchased on credit.
  4. Purchased inventory which is expected to be resold at 40% profit
  5. A $5,000 debt from a customer who will never pay

Asset Accounts

Detailed information of the elements of the financial statement is kept in records called accounts. For instance, a business usually maintains more than one asset, so dumping every asset into one account will not tell much about the business. An informative statement will have different categories for each asset like cash, equipment, inventory, etc.

Other examples of assets and their definitions are as follows:

Account

Definition

CashCurrency, checks, balances in checking and saving account, money orders, certificate of deposit, and any other item that is payable on demand
Accounts ReceivableExpected future cash from current or past sales. Accounts receivables arise from allowing customers to buy now and pay later
InventoryGoods finished and ready for sale
Prepaid ExpensesFuture benefits arises from prepaying for an expense. For example if you pay your insurance premiums 12 months in advance, the prepayment is an asset to you as you still have unused benefits.
SuppliesItems used in the business. Supplies are often bought in bulk and not immediately consumed. The unconsumed portion is an asset to the business. When an asset is consumed it is expensed to supplies expense.
LandLand
BuildingsBuildings
Computers and EquipmentComputers and equipment

Classification of Assets

Assets are further classified into long and short term.

Long term assets

Long term assets: are assets that will produce future benefits more than a year from now or a business operating cycle.

Long term assets are often referred to as fixed asset. Fixed assets are defined according to the purpose they were acquired for. For example if you buy a vehicle for marketing in the balance sheet it will be labelled “Marketing Vehicle” on the balance sheet. Fixed assets are held with the intention of generating future revenue. Examples of fixed assets are land, building, computer and equipment, etc.

Short term assets

On the other hand, short term assets produce future benefits less than a year/ operating cycle. An operating cycle is the average time it takes a business to convert inventory to accounts receivable and finally into cash.

Short term assets are also referred to as current assets. Current assets are expected to be converted to cash (or use up related benefits) over a relatively short period. The most common type of current assets are cash, accounts receivable and inventory.

Claims on assets

A claim is an obligation of a business to provide some type of benefit to another party. There are 2 types of claims to asset in a business:

  1. Liability
  2. Equity

Element# 2: Liability:

Liabilities represent the claim of parties outside the business on the business assets. These claims arise from past transactions or events. Examples of events that create liabilities are loans from a bank or buying inventory on credit. Once a liability has been incurred, it remains a liability until it has been settled.

An example which is not so obvious to students learning accounting for the first time is unearned revenue. Unearned revenue is liability you incur when customers pay you in advance for a product or service. When customers pay in advance, you are indebted to them until you perform the service or deliver the product.

Other examples of liabilities and their definitions are as follows:

Account

Definition

Accounts payableIs a promise to pay a supplier or vendor for goods delivered now. It’s analogous to buying on credit or buying on account. That is, buy now and pay later.
Short term notes payableShort term notes are promissory notes due in less than 12 months. Short term notes should be used to finance short term cash needs.
Line of creditA line of credit is credit extended by a bank and is available to the borrower at their discretion. A line of credit works a lot like a credit card in that you are extended a credit limit and you do not have to reach your limit every month. The total amount is due in the next billing cycle and any amount not paid is charged interest. Line of credit are good for stabilizing cash flow.
Wages payableWages payable is an account used to record the cash amount you owe your employees for time they have worked but not being paid. This amount is usually determined at the close of an accounting period.
Interest payableThis is the interest owed on unpaid loans, notes or any other payables the business may have.
Unearned revenuesUnearned revenue is a prepayment for goods and services. As a result, you owe the customer the good at a later date. You do not earn the cash given to you until the service is performed.
Long term notes payableIs a note with a payment due longer than 12 months
Long term loansA loan is paid in installments and is normally due over a 12 month period.

Classification of liabilities

Just like assets, liabilities are also classified as long or short term. Long term liabilities are debt that are payable in over a one year term frame and short term liabilities are payable under a year time frame.

Exercise

State which of the following will appear on the balance sheet as a liability:

  • A loan from a bank
  • Inventory bought from a vendor on credit (also called on account)
  • Uncle Joe paid you for a cup of lemonade in you lemonade stand and said he will get the cup of lemonade later
  • Aunty Lucy bought a cup of lemonade but promised to pay later

Element 3: Equity

Equity is the claims of the owner against the business.

How can the owner have claims on the business?

Owners have claim on the business because the owners of the business are regarded as separate entities from the business. This even applies to sole proprietors. In accounting a clear distinction is made between the owner and the business. Therefore, any funds contributed by the owner is seen as a claim against the business.

Retained Earnings: A very important equity account

Retained earnings is the cumulative earnings of the business less distributions. In other words, net income from the profit and loss statement gets added to retained earnings. Owners of the business have claims/ rights to this earnings.

The retained earnings account increases the equity account.

Retained EarningsThis is the accumulative earnings of a business less the withdrawals and distributions.

There are 2 elements of the financial statement that are classified under the equity namely:

  • Element 4: Investments by owners/ contributed capital
  • Element 5: Distributions to owners

Element 4: Investments by owners/ contributed capital

Are increases in equity due to contributions from owners? Owners frequently transfer assets (usually cash) to the business in exchange for equity (ownership). A contribution by owner increases equity.

Other accounts that define owner’s contributions are as follows:

Common StockCommon stock represents ownership in a corporation. It is the owner’s contribution to increase equity in the business.
Owners capitalIn a sole proprietorship or partnership, ownership is represented by capital contributions. Capital contribution increases equity in the business

Element 5: Distributions to owners

Amount withdrawn by owners from the equity of the business. Distributions reduce equity and could take various forms. For example: In a corporation, distributions to owners are called dividends. In a sole proprietorship, these distributions are called drawings.

Owners drawingThis is the amount a sole proprietor takes away from the equity of the business
DividendsThis is money paid to owners of stock in a corporation

Putting it altogether: The Balance Sheet

Once we know what elements belong to the balance sheet statement, we can draw up our first balance sheet. The balance sheet is the statement that represents the accounting equation. The balance sheet has 3 main sections namely:

  1. Assets
  2. Liabilities
  3. Equity

Let us do an example to see what a balance sheet looks like:

A balance sheet example

Uncle Joe deposits $15,000 in a business checking account on January 2nd, 2014 in order to begin Joe & Co., Inc. Uncle Joe is 100% owner of Joe & Co., Inc.

Uncle Joe also borrows money from his sister (your mom) Cecil in the amount of $5,000. Prepare the opening day balance sheet statement.

Joe and Co. Inc.

Balance Sheet as of January 2, 2014

Assets
Cash$20,000
Total Assets$20,000
Liability
Loan from Cecil$5,000
Total Liability$5,000
Equity
Common Stock$15,000
Total Liability and Equity$20,000

The assets of the business must equal the liabilities + equity.

Interpreting the balance sheet

  • The liquidity of the business: Liquidity is the ability of the business to meet short term obligations with its cash. Liquidity is important because business failures happen when business cannot meet it short term obligations.
  • The mix of the assets held by the business: The relationship between fixed and current assets is important. Businesses with funds tied up in fixed assets are vulnerable to financial failure. This is because fixed assets are not easily turned into cash to meet short term obligations.
  • The financial structure: the ratio of debt to equity financing is important. More debt financing means more interest expense and less profits in the business. Debt financing have to be repaid regardless of the cash position of the business and can be a really burden in economic downturns.

Profit and Loss Statement

The balance sheet tells us the financial position of a business at a particular time. However, business exists to generate profits and businesses need a way of knowing how much they have made in their business over a period of time. The profit and loss statement fills this need. The profit and loss statement has been often defined as a moving picture. Unlike the balance sheet, the profit and loss statement tells a story of a period in time.

Revenue is a measure of the inflow of assets (cash) or the reduction of liabilities (unearned revenue).

Relationship between the profit and loss statement and balance sheet

The profit and loss statement links the balance sheet at the beginning of the period with the balance sheet at the end of the period. In other words, the profit and loss shows the wealth generated during the period.

The relationship of the profit and loss to the balance sheet can be expressed in the following way:

Assets = liabilities + owners’ equity

Assets = liabilities + capital contribution + retained earnings

Assets = liabilities + capital contribution + prior earnings +revenue – expenses

Remember – retained earnings is the accumulation of prior earnings retained in the business.

The revenue and expense elements are represented in the profit and loss statement.

The elements if the financial statement represented in the profit and loss statement

Element 6: Revenue

Revenue is income received from the services and products of a business as part of its normal operations. As we mentioned earlier, accounting is a language and just like any language one object could have multiple names. Other names of accounts that represent revenue are shown below:

Service RevenueIs money received in exchange for service provided by the business as part of its operations
Product SalesMoney received in exchange for a product a business sells as part of its operation
Consulting RevenueMoney received in exchange for consulting provided by the business as part of its operations

Element 7: Expenses

An expense is the outflow of assets or increase in liabilities which is incurred from generating revenue. Expenses can also be defined as cash paid out or liabilities incurred to fulfill the needs of the business operations.

Classification of expenses

The classification of expenses is often a matter if judgment of those who design the financial statement. For instance some businesses choose to group all insurance expense into one account and some businesses may break out insurance expense into auto insurance, liability insurance, etc.

The classification is based on the kinds of information useful to the user.

The following are examples of ways expenses are classified in a business:

Salaries/ Wage expenseThis is money paid to employees in exchange of services provided.
Supplies expenseThis is money spent on supplies
Rent expenseMoney paid in exchange for using an asset like a building
Utilities expenseMoney paid for utilities
Marketing expenseMoney paid to promote services and products
Insurance expenseMoney paid to protect the business from risks

Non-operating revenues/ expenses, gains and losses

Non-operating revenue is revenue received by a business from events not part of its normal operations. For example interest received from loaning money to another party. If loaning money is not part of the business operations then the interest received is non-operating revenue.

Examples of non – operating revenue/ expenses are:

Interest revenuesIs revenue received from loans made

Element 8: Gain

Gain is the difference between the sales price and the cost of an asset. When the sales price exceeds the cost we have a gain.

Element 9: Loss

 

Loss is the difference between the sales price and the cost of an asset. When the cost exceeds the sales price we have a loss.

Difference between an asset and expense

The main difference between an asset and an expense is that an expense is consumed in the process of earning revenue while an asset is used in future revenue production.

Putting it altogether: The Profit and Loss Statement

Once we know what elements belong to the profit and loss statement, we can draw up our first profit and loss statement. The profit is the statement that tells how much a business has made in a given period. The profit and loss has has 3 main sections namely:

  1. Revenue
  2. Expenses
  3. Non-operating income

Let us do an example to see what a balance sheet looks like:

A profit and loss example

Uncle Joe received $15,000 in exchange for providing consulting services on January 2nd, 2014. In order to complete the consulting service, Uncle Joe hired Lucy and paid her $5,000 in wages. Uncle Joe also sold business equipment and gained $500 from the sale.

Prepare the profit and loss statement.

Uncle Joe’s Inc.

Profit and Loss Statement

For Period Ended January 31, 2014

Operating Income:
Consulting Revenue $15,000
Operating Expenses:
Wages Expense$5,000
Net Operating Income$10,000
Non-Operating Income
Gains$500
Net Income$10,500

Review questions

  • There has been an ongoing debate about placing the value of human assets on the balance sheet. Do you think humans should be treated as assets? Why or why not?
  • Uncle Joe started a t-shirt printing business. He got $20,000 in cash from Auntie Annie as a loan. Uncle Joe contributed $5,000 of his own money.
    • Define the element of financial statement affected by these transactions
    • Create accounts for each transaction
    • Match the elements to the financial statement
    • Represent the transaction using the accounting equation
  • The following is a list of assets and claims of Uncle Joe’s Kitchen as of December, 31st 2014
    • Cash 20000
    • Vehicles 30000
    • Loan from mom 15000
    • Cash from personal funds 35000

    Required:

    • Define the element of financial statement affected by these transactions
    • Create accounts for each transaction
    • Match the elements to the financial statement
    • Represent the transaction above using the accounting equation
  • What characteristic of an asset differentiates it from an expense?
  • The following account titles were drawn from the general ledger of Joe Co, Inc.
    • Computers
    • Rent Revenue
    • Building
    • Cash
    • Accounts Payable
    • Office Furniture
    • Salaries expense
    • Rent Revenue
    • Service Revenue
    • Dividends
    • Utilities expense
    • Gains
    • Losses

    Required

  1. Match these accounts to the elements of financial statement
  2. Match the element to the right financial statement