“NEW FROM ACCOUNTING, SIR. TWO AND TWO IS FOUR AGAIN.”
THE FINANCIAL STATEMENTS
MBAs are not trained to key transactions into a computer; rather they are schooled to interpret the information that accountants generate. The financial statements are the summary of all the individual transactions recorded during a period of time. Financial statements are the final product of the accounting function. They give interested users the opportunity to see in a neat summary what went on. To know a company, you must be able to read and understand three major financial statements:
The Balance Sheet
The Income Statement
The Statement of Cash Flows
THE BALANCE SHEET
Definitions
To set the stage you need to know the basic vocabulary of the balance sheet. The balance sheet presents the assets owned by a company, the liabilities owed to others, and the accumulated investment of its owners. The balance sheet shows these balances as of a specific date. It is a snapshot of a company’s holdings at a given time. The balance sheet is the foundation for all accounting records, and you must be familiar with it. The following are the components of balance sheets.
Assets are the resources that the company possesses for the future benefit of the business.
Cash
Inventory
Customers receivables—accounts receivable
Equipment
Buildings
Liabilities are dollar-specific obligations to repay borrowing, debts, and other obligations to provide goods or services to others.
Bank debt
Amounts owed to suppliers—accounts payable
Prepaid accounts or advances from customers to deliver goods and services
Taxes owed
Wages owed to employees
Owners’ equity is the accumulated dollar measure of the owners’ investment in the company. Their investment can be either in the form of cash, other assets, or the reinvestment of earnings of the company.
Common stock—investment by owners
Additional paid-in capital—investment by owners
Retained earnings—reinvestment of earnings by owners
The Fundamental Accounting Equation
As the name implies, the balance sheet is a “balance” sheet. The fundamental equation that rules over accounting balance is:
Assets (A) = Liabilities (L) + Owners’ Equity (OE)
What you own (assets) equals the total of what you borrowed (liabilities) and what you have invested (equity) to pay for it. This equation or “identity” explains everything that happens in the accounting records of a company over time. Remember it!
Examples of the “Balancing” Act
Using the example of a new local supermarket called Bob’s Market, I will give you three examples of how the balancing act works.
1. When the market opened up for business, Bob purchased a cash register. Assets increased on the left side of the scale, while bank debt, a liability, was also increased on the right to pay for it. The asset increase was balanced by an increase in liability.
2. When Bob invested some of his own money and attracted some of his father’s to open the market, equity increased on the right side of the scale, and cash, an asset, increased on the left to balance the transaction.
3. When the store becomes successful, it will hopefully be able to pay off its bank debt for the register (liabilities reduced on the right). The cash, an asset, would be reduced, thus balancing the transaction on the left.
All transactions adhere to this balancing concept. There is no way to affect one side of the balance sheet without a balancing entry. The accounting records are therefore said to be in “balance” when the assets equal the liabilities and owners’ equity (A = L + OE). If the records do not balance, an accountant has made a mistake.
The Accounting Process: The Double Entry System
As you may have heard, accountants make journal entries in their books to record each of a business’s individual transactions. Accountants call their books the general ledger. The listing of the accounts is called the chart of accounts. Using the same balancing concept shown by accounting’s fundamental equation, asset additions are placed on the left side, called a debit. Liabilities and owners’ equity additions are placed on the right side, called a credit. In all cases, journal entries have at least two lines of data, a debit and a credit. Entries to reduce assets are placed on the right, a credit, and reductions of liabilities and equity are placed on the left, a debit. Because of this right-side/left-side method, the manual record keeping of each account’s transactions resembles a T, and consequently these records are called T accounts.
RULES FOR ENTRIES INTO ACCOUNTS
To illustrate, at the beginning of the year Bob and his father issued themselves one thousand shares of stock for their initial investment of $15,000 in their store. The journal entry to record the transaction looked like this:
BALANCE SHEET JOURNAL ENTRY #1
ACCOUNT TITLE: Cash
(TYPE): (Asset)
DEBIT: 15,000
CREDIT:
EFFECT: increase
ACCOUNT TITLE: Common Stock
(TYPE): (OE)
DEBIT:
CREDIT: 15,000
EFFECT: increase
Similarly a repayment of a debt would be journalized as:
BALANCE SHEET JOURNAL ENTRY #2
ACCOUNT TITLE: Bank Debt
(TYPE): (Liability)
DEBIT: 15,000
CREDIT:
EFFECT: decrease
ACCOUNT TITLE: Cash
(TYPE): (Asset)
DEBIT:
CREDIT: 15,000
EFFECT: decrease
Because each entry to the records balances, at the end of a period of time, the entire balance sheet that summarizes the individual “accounts” and their net ending balances also balances (A = L + OE).
A Balance Sheet Example
Let’s continue with the local grocery store example and see what balances appeared during its first year of operation.
Bob’s statement below resembles the typical balance sheet of many retail and manufacturing firms. Three things are worth noting. The total of assets equals the total of liabilities and owners’ equity. Second, the assets are on the left and the liabilities and OE are on the right, just like the journal entries of debits and credits. The third noteworthy item is that the balance sheet is as of a point certain in time, December 31, 2012, a specific date. Even though a business is the result of buying and selling over time, the balance sheet is only a “snapshot” of what the company’s resources and obligations are at a stated time.
BOB’S MARKET, FAIRWAY, KANSAS, BALANCE SHEET AS OF DECEMBER 31, 2012
(the first year of operation)
Liquidity: Current and Long-Term Classifications
An important aspect of the balance sheet statement is that the assets and liabilities are listed in order of their liquidity, from most liquid to least. Liquidity means the ability of an asset to be converted to cash. Cash, accounts receivable from customers, and inventory are labeled current and are listed first since they are easily transferred and converted into cash within the next operating period, typically in one year (i.e., they are liquid). Equipment is not easily sold; therefore, it is classified as fixed, long-term, or a noncurrent asset (NCA) and listed below the current items. Check out Bob’s balance sheet to verify the placement of these items.
On the liabilities side, the accounts payable to suppliers, wages payable to employees, and taxes payable are current liabilities. They are short-term obligations that will have to be paid within a year. The bank debt is long-term or a noncurrent liability (NCL) because it will be paid off over a period of years.
Working Capital
A commonly used term in accounting as well as finance is working capital. It refers to the assets and liabilities that a company constantly “works with” as part of its daily business. They are also most l
iquid assets, giving a financial statement reader a clue to a firm’s solvency. Consequently, working capital items are the current assets and liabilities of the firm. Net working capital, a measure of solvency, is the total of current assets less the total of current liabilities.
Current Assets − Current Liabilities = Net Working Capital
At Bob’s Market net working capital amounts to $28,000 ($115,000 − $87,000). That’s Bob’s excess of liquid assets to make good on its current obligations. From a banker’s vantage point, a grocer with a large amount of net working capital may be considered a good credit risk because the business can make its debt payments. Conversely, it could also show a corporate raider or operations analyst that the store owner is mismanaging his inventory by holding too many goods on the shelves or too much cash in the registers. An astute operator would reduce inventory levels and the cash on hand to more efficient levels and pocket the difference as a dividend. The proper amount of working capital depends on the industry.
How Owners’ Equity Fits In
Owners’ equity represents the long-term obligation of a company to its owners. Companies are obligated to pay the owners a return on their investment based on the success of the firm. OE does not carry a set rate of interest or maturity like a bank loan, so it is segregated below the liabilities. Owners are paid only after all other debt payments are made. An owner’s return is dependent on the success of the company. If debt repayments cannot be made, the firm can be forced into bankruptcy. The inability to pay a dividend to investors has no such penalty. If the company is highly profitable, the owners win. If not, they can lose all of their investment. That’s the risk of ownership.
By reversing algebraically our accounting identity from A = L + OE to OE = A − L, you can see that OE is the “residual” interest of the firm, assets less liabilities. OE is also called net worth, as it is the “net” value after all other obligations. In the case of Donald Trump, the notorious real estate magnate of the 1980s, he may have owned billions of dollars of property, but temporarily his net worth reportedly became negative in 1990 as his debts became even larger than the value of his properties in New York City and Atlantic City.
Owners’ equity is increased by conducting business. Businesses buy and sell and provide and receive services. Hopefully after a period of time, the company has increased its wealth with those activities. If the net assets increased over time, then it must have increased its OE.
The OE captions on the balance sheet can be affected in two ways. Investors can contribute more funds or they may elect that the company “retain” its profits. The line “retained earnings” is on the balance sheet for that purpose. If owners want to take out earnings, they may elect to receive dividends. Dividends reduce their accumulated retained earnings.
Accountants sometimes prepare the Statement of Owners’ Equity with the financial statements if the information is useful. These detailed statements outline the owners’ investments, their stock transactions, and the dividends paid to them during the year. These transactions affect the owners’ equity captions on the balance sheet. The Statement of Owners’ Equity, also called the Statement of Changes Shareholders’ Equity, is considered a minor statement. However, it may be important for companies that have a great deal of owner activity. Large companies always produce this statement because it reveals many transactions that interest the public. Take a moment and go back to Bob’s balance sheet and review its presentation before you move on to the income statement.
THE INCOME STATEMENT
As the balance sheet shows balances as of a specific date, the income statement shows the “flow” of activity and transactions over a specific “period.” That period may be a month, a quarter, or a year. There are revenues from sales and expenses relating to those revenues. When revenues and expenses are properly matched using accrual accounting, the difference is “income.”
Revenue − Expenses = Income
An Income Statement Example
Below we’ll look at the income statement of Bob’s Market to see how his operation performed during his first year of business.
BOB’S MARKET, FAIRWAY, KANSAS, INCOME STATEMENT FOR THE YEAR ENDING DECEMBER 31, 2012
Income Statement Terminology
As with the balance sheet, the income statement has several noteworthy features. In the income statement, the classifications of expenses are extremely important because different types of income are calculated. Each offers a particular insight about Bob’s operating results. Please refer to Bob’s income statement as you read through this terminology section.
Gross Margin. The top part of the income statement calculates gross margin.
Gross Margin =
Sales − The “Direct” Cost of the Goods or Services Sold
At this point, the reader can determine if the company is making a profit without considering the burden of corporate expenses. At Bob’s Market gross margin was his sales less the cost of goods sold (COGS). COGS includes the cost of groceries and all costs “directly” related to making the groceries salable, such as the cost of shipment from the wholesaler. In a manufacturing company it includes the costs of production, materials, and labor. In a simple retail situation like Bob’s, COGS is calculated by this formula:
Beginning Inventory + New Purchases − Ending Inventory = Cost of Goods Sold
If a business has a negative gross margin, either costs are out of control, or the pricing structure of the industry does not afford the company a profit. A small electronics manufacturer would encounter this situation if it tried to compete with the Asian Blu-ray manufacturers Sony, Samsung, and Sharp. A small U.S. manufacturer could not be as efficient and could not charge a higher price to cover its higher costs of production.
Operating Profit. The next part of the income statement relates to the operating profit of the company, the earnings before interest and taxes (EBIT). The further we move down the income statement, the more expenses that are deducted. At the operating level of profit measurement, all the other corporate expenses directly related to the revenue process are deducted. In Bob’s case he has employee wages, rent, utilities, advertising, and many other smaller items.
Accrual accounting dictates that the allocated cost of fixed assets, also called depreciation or amortization, be charged to earnings. Using the principle of matching, the cost of providing the company’s products is matched with its related revenues of the period. Accountants divide the cost of equipment, tools, buildings, and other fixed assets by their useful lives to estimate the cost of using up assets needed in the revenue-generating process. In Bob’s case, he spent $30,000 for shelves, carts, and cash registers. Because he estimated that they will last ten years, Bob’s income statement will show an expense of $3,000 ($30,000/10) each year to match and allocate the cost of using those assets with the period of sales benefited. A measure of profitability that many analysts calculate is EBITDA, earnings before interest, taxes, depreciation, and amortization.
“Other expenses” is a catchall category for items not large enough to justify a separate line on the income statement. On Bob’s income statement it includes fixing those annoying stuck wheels on his shopping carts and the losses on bad checks.
Net Income. Below the operational level of profit, items not directly linked to operations are deducted to calculate income. The first is the interest expense for the period. A case can be made that corporate borrowing is used to support the operation. However, the method of financing the company is separate from the operating activities of the business. Accountants do not include interest in operating income, because companies in similar businesses may have been funded by using differing proportions of bank borrowing and investors’ money. Investors’ dividends are not deducted. Owners pay dividends out of the net income at the bottom of the statement.
If interest were to be included in operating income, similar companies could have vastly differing operating incomes just by the way they funded their cash needs. A co
mpany under a different management could fund all its cash needs by additional investments from its owners. These funds would incur no interest charges, and, therefore, the company’s operating income would be higher. If the same company borrowed for all its needs, its operating income would be reduced by the interest expenses. By segregating interest expenses, the operating income reflects only the costs of “operating” the company, rather than “financing” it.
Using the same logic that excluded interest from operating income, tax expenses are segregated to leave operating income free of nonoperating expenses. Different tax strategies can result in greatly different tax expenses. Because taxes are often the product of a skilled tax accountant’s pen instead of operating results, tax expenses are put below operating results as a separate deduction, leaving net income as the final measure of income. Net income is the bottom-line profit of the company, and it is the figure that is reported in the media as the measure of success or failure.
How Income Statement Journal Entries Are Made
In keeping with their age-old duty to count the beans, accountants make journal entries to the company’s books to tally up net income during the year. Net income is the result of subtracting the expenses from the sales made during a defined period of time. Net income is also the net increase in assets for the same period of time. Journal entries keep track of the total of all the revenues and expenses as well as their corresponding increases and decreases in assets. Accountants make the entries for the income statement at the same time as they prepare the balance sheet.
The Ten-Day MBA 4th Ed. Page 9