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The Beginner’s Guide to Financial Statements

Financial Accounting

The Beginner’s Guide to Financial Statements

Accounting generates lots of report covering all of the business activities. The main and most important among those reports is called “financial statements.”

The essence of studying accounting is basically trying to understand the process of generating financial statements and train yourself so that, one day, you will be able to generate one.

So, it is a must to know about what financial statements, at least in a quick overview, before other basic accounting concepts. Otherwise, the learning process is not intuitive.

If you have studied accounting lately but still have difficulties in understanding the ‘debit-and-credit’ procedures, do not worry and do not need to feel bad. I also experienced a similar situation in the first years of studying accounting in the college, about 20 years ago. I think you’re luckier with the availability of so many online learning materials today.

In this post, I am going to show you what financial statements, what it contains, how it is presented, and how you can use that understanding to boost the process of learning the accounting equation and the ‘debit-and-credit’ procedures which I will discuss in the coming post.

Let’s start with a simple question…

 

What is financial statements?

Financial statements is a set of reports about company’s financial position at a certain date, financial result for a certain period of operation, and cash flow during the same period.

For example, John Doe LLC issued financial statements dated December 31, 2017. It means that John Doe LLC issued a set of reports regarding:

  • John Doe’s financial position on December 31, 2017, titled “Balance Sheet” about what owned and what owed.
  • John Doe’s financial result for the period January 01 to December 31, 2017, titled “Income Statements” about what earned or what loss
  • John Doe’s cash flow for the same period titled “Statement of Cash Flows” about cash received and cash paid out.

Those three reports are the prime part of the financial statements. To give a clearer picture about the financial condition of the company to its users, the company also reports on changes in the company’s capital and called “Retained Earnings Statement.” We will discuss all of them in the next section.

For Your Information: Under the International Financial Reporting Standard (IFRS), the Balance Sheet is called “Statement of Financial Position.” A company may use a term “Profit and Loss Statements” or “Statement of Earnings” for the Income Statements. A company may title “Cash Flow Statement” instead of Statement of Cash Flows, both are meant for the same report.

The financial statement is the main output of the accounting process within a company and is (or at least expected to be) useful for users as input in the decision-making process related to the business. In general, the financial statements is (or expected to be) able to answer the following questions:

  • What is the company’s current financial status?
  • What were the company’s operating results for the period?
  • How did the company obtain and use cash during the period?

In the relationship between manager and shareholders of a company, the financial statements serve as the manager’s assertions to the owner of the business. In this case, the financial statements can be viewed as a form of accountability of managers to shareholders about how effective they use company’s resources in order to generate profit.

“What is the content of each report” you may ask. Read on.

What is the content of a Financial Statements?

The standard financial statements is consisted of the following:

1. Balance Sheet

It is a financial statement that reports a company’s assets, liabilities, and owners’ equity at a particular date. Here are some more details:

(a) Assets are economic resources that are owned by a company. These then could be grouped into two categories: Current Assets and Long-term Assets. Common items included in the current assets are, cash, accounts receivable, inventories, prepaid, short-term investments. While assets that fall into the long-term includes: long-term investments, land, building, machinery, equipment, vehicles, and intangibles (see on the balance sheet example in the next section.)

FYI: In a personal life, your personal assets might include your smartphone, computer, camera, books, and any stuff belongs to you that is capable of making money OR can be sold or exchange with the stuff of others, including your skills/expertises and any intellectual property that capable of creating money or other forms of asset.

Values of the asset increase when the company bring in more asset or repair the existing one in a way so that they could be used longer than normal use. And they decrease when used (and get depreciated) or sold (traded) by the company.

(b) Liabilities are the company’s obligations to pay other parties (individual or organization) in the future. The payment could be in the form of cash, other assets, or services. The liabilities that will be paid soon are grouped into Short-term Liabilities and includes accounts payable, accruals, unearned revenue (such as deposit from customers,) and current portion of notes payable. While the liabilities that will be paid in years to come are grouped into the Long-term Liabilities and includes: notes payable and bank loans. (see the Balance Sheet example in the next section.)

FYI: Your personal liabilities might include unpaid phone bills, the remaining balance on a car loan, or an obligation to complete work for which you have already been paid.

The amount of the liabilities increases every time the company get an asset or a benefit and postpone the payment. For example, the company buy raw materials in credit, or purchase a machine in credit, or get a bank loan. And the amount decreases every time the company made payment.

(c) Owners’ Equity, are the remaining claim against the assets of a business after the liabilities have been deducted. It could also be seen as the ownership interest in the net assets of an entity which equals total assets minus total liabilities. Thus, owners’ equity section of a balance sheet is sometimes referred to as Stockholders’ Equity OR Shareholder’s Equity. Common items on the owner’s equity include common stocks and retained earnings. Common stock increase when the company sold more stocks and decrease when the company bought back some past issued stocks. While retained earnings increase when the company make more profit (net income) and decrease when the company shared dividends to the stockholders.

FYI: A balance sheet in which assets and liabilities are sub-divided into current and long-term categories is called a classified balance sheet.

  • Current assets are cash and other assets that can be easily converted to cash within a year.
  • Long-term assets are assets that a company needs in order to operate its business over an extended period of time.
  • Current liabilities are obligations that are expected to be satisfied within a year or the current operating cycle (whichever is longer.)
  • Long-term liabilities are obligations that are not expected to be satisfied within a year.

And, a balance sheet that includes financial information for both the current year (e.g. 2017) and the preceding year (e.g. 2016) is called a comparative balance sheet.

Note also here that balance sheet has certain limitation thus isn’t perfect; it does not always reflect the current value or worth of a company. If a balance sheet perfectly represents the company’s value, then the amount of owners’ equity would be equal to the market value of the company. In reality, it doesn’t or rarely does.

In the case of John Doe LLC’s balance sheet for example (see the example in the next section,) the net value of the company equals total asset – total liabilities = $887 – 240 = $647 referred to as “net worth.” But the actual market value could be more or less than $647. The discrepancy between recorded balance sheet value and actual market value is the result of the following two factors:

  • John Doe’s Accountants record assets at their purchase cost, not at their current market value. Particularly land’s price always increase year-to-year but the company probably does not revalue it; OR
  • Not all John Doe’s economic assets are included in the balance sheet,  commonly intangibles such as public image, its name recognition, and its reputation. These intangible factors could affect market value of a company; OR

A combination of both.

Despite its deficiencies, the balance sheet is a useful source of information regarding the financial position of a business. A lender would never loan a company money without knowing what assets the company has and what other loans the company is already obligated to repay. An investor shouldn’t pay money in exchange for ownership in a company without knowing something about the company’s existing resources and obligations.

FYI: Market Value is the price that would have to be paid to buy the same asset today.

2. Income Statement

It is a financial statement that reports the amount of net income (popularly known as profit) earned by a company during a period. The income statement shows the results of a company’s operations for a period of time. It summarizes the revenues generated and the costs incurred (expenses) to generate those revenues. The “bottom line” of an income statement is net income (or net loss) which is the difference between revenues and expenses.

Here are major items included in the income statements:

(a) Revenue is a certain amount of assets created through business operations, either in the form of cash or receivables or both. To link the income statements with the balance sheet, think of revenue as another way for a company to acquire assets. In the same way that assets can be acquired by borrowing or by owners’ investment, assets can also be acquired by providing a product or service for which customers are willing to pay.

Manufacturing and merchandising companies receive revenues from the sale of merchandise. For example, John Doe’s revenue is the cash that customers pay in exchange for products. A service company generates revenues from the fees it charges for the services it performs. Companies might also earn revenues from other activities, such as charging interest or collecting rent. When goods are sold or services performed, the resulting revenue is in the form of cash or accounts receivable.

Revenues thus generally represent an increase in total assets. These new assets are not tied to any liability obligation; therefore, the assets belong to the owners and thus represent an increase in owners’ equity.

FYI: Receivables is a promise from the buyer to pay for the goods or services by a specified date in the future

(b) Cost of Goods Sold and Expenses are the costs incurred in normal business operations to generate revenues. To link the income statement to the balance sheet, see expenses as a certain amount of assets consumed through business operations. Employee salaries and utilities used during a period are two common examples of expenses. Just as revenues represent an increase in assets and equity, expenses generally represent a decrease in assets and in equity.

(c) Net Income (or Net Loss) sometimes called earnings or profit, is an overall measure of the performance of a company. Net income reflects the company’s accomplishments (revenues) in relation to its efforts (expenses) during a particular period of time. If revenues exceed expenses, the result is called net income (revenues – expenses = net income). If expenses exceed revenues, the difference is called “net loss.” Because net income results in an increase in resources from operations, owners’ equity is also increased; a net loss decreases owners’ equity.

The income statement usually shows two main categories: revenues and expenses. Revenues are listed first. And then followed by Cost of Goods Sold. The difference between sales and cost of goods sold is called “gross profit” or “gross margin” (Revenues – Cost of Goods Sold = Gross Profit.) Typical operating expenses for most businesses are employee salaries, utilities, and advertising, which are listed subsequent the Gross Profit’s line.

The expenses are sometimes divided into operating and nonoperating categories. The primary nonoperating expenses are interest and income taxes. These expenses are called nonoperating because they have no connection with the specific nature of the operation of the business.

Two other items that commonly appear in the income statement are “gains” and “losses” that listed as “other revenues” and “other expenses.” These refer to money made or lost on activities outside the normal business of a company.

It is important to note the difference between revenues and net income. Both concepts represent an increase in the net assets (assets – liabilities) of a company. However, revenues represent total resource increases; expenses are subtracted from revenues to derive net income or net loss. Thus, whereas revenue is a “gross” concept, income (or loss) is a “net” concept.

Another thing to note is the difference between revenues and assets. Revenues are one activity of a company that generates assets. For example, selling a product (which is revenue) results in an asset (either cash or accounts receivable).

Assets can also be generated by other activities. For example, borrowing money from a bank would not be considered a revenue-generating activity, but it would result in a cash (increase in the asset). Activities involving revenue result in assets, but assets can result from many different activities.

Like the balance sheet,  income statement might also present in the form of comparative income statements, allowing investors and creditors to evaluate how profitable the company has been during the current period
as compared with earlier periods.

Be Ware: In considering revenues and expenses, remember that not all inflows of assets are revenues; nor are all outflows of assets considered to be expensed. For example, cash may be received by borrowing from a bank, which is an increase in a liability, not a revenue. Similarly, cash may be paid for supplies, which is an exchange of one asset for another asset, not an expense.

 

3. Retained Earnings Statements

It is a financial statement that reports the changes in retained earnings during a period of time. In addition to an income statement, corporations sometimes prepare a statement of retained earnings. This statement identifies changes in retained earnings from one accounting period to the next (see the example in the next section.)

The statement shows a beginning retained earnings balance, the net income for the period, a deduction for any dividends paid (which were $226 for John Does LLC), and an ending retained earnings balance.

To link the retained earnings statement to the income statements and balance sheet, note that net income results in an increase in net assets and a corresponding increase in retained earnings, which increases owners’ equity (see in the example) that amount of the net income (on the income statement) is stored on the retained earnings statement. Dividends reduce net assets (e.g., cash) and similarly reduce retained earnings, which reduces owners’ equity.

Again, retained earnings is a certain amount of earnings of a business that have been retained in the business (this is why the name is “Retained Earnings”). The earnings that have not been retained in the business have been distributed to owners in the form of a dividend. The earnings that have been retained have been reinvested back into the business to become inventory and equipment and to pay down debt.

To see where a company has reinvested the earnings it has retained would require you to examine the assets on the firm’s balance sheet. Odds are that many of those assets will have been provided by the earnings that have been reinvested in the business.

This is important to note, however, that Retained Earnings IS NOT always cash. Some of the earnings that have been retained in a business may be retained in the form of cash, but it is more likely that the cash has been used to purchase other assets or to pay off liabilities.

To determine how much cash a company has, you would examine the balance in the company’s cash account—not the balance in the company’s retained earnings account.

FYI: Corporations sometimes present a statement of stockholders’ equity instead of a statement of retained earnings. The statement of stockholders’ equity is more detailed and includes changes in capital stock as well as changes in retained earnings.

 

4. Statement of Cash Flows

It is a financial statement that reports the amount of cash collected and paid out by a company during a period of time. In the statement of cash flows, individual cash flow items are classified according to three main activities as follows: operating, investing, and financing.

Here are some more details:

(a) Operating Activities are activities that are part of the day-to-day business of a company. Cash receipts from selling goods or from providing services are the major operating cash inflow. Major operating cash outflows include payments to purchase inventory and to pay wages, taxes, interest, utilities, rent, and similar expenses.

(b) Investing Activities are activities associated with buying and selling long-term assets. The primary investing activities are the purchase and sale of land, buildings, and equipment. You can think of investing activities as those activities associated with buying and selling long-term assets.

(c) Financing Activities are those activities whereby cash is obtained from or repaid to owners and creditors. For example, cash received from owners’ investments, cash proceeds from a loan, or cash payments to repay loans would all be classified under financing activities.

Why does a company need to report Statement of cash flows?” you may ask.

While net income (on the income statement) is indeed the best measure of a company’s “economic performance,” other parties want “cash,” NOT “economic performance”! Accordingly, in addition to net income, investors and creditors also want to know how much actual cash a company’s operations generate during a period and how that cash is used.

The statement of cash flows shows the cash inflows (received) and cash outflows (paid out) of a company during a period of time. Companies receive cash primarily by selling goods or providing services, selling other assets, borrowing, and receiving cash from investments by owners. Companies also use cash to pay current operating expenses such as payroll, wages, utilities, and taxes; to purchase additional buildings, land, and otherwise expand operations (to repay loans, and to pay their owners a return on the investments that have been made.)

Theoretically, the statement of cash flows is the easiest to prepare of the three primary financial statements. However, actual preparation of a statement of cash flows, sometimes, can be somewhat challenging. Imagine examining every check and deposit slip you have written in the past year and sorting them into three piles—operating, investing, and financing.

In addition to the tedious works, you would have to exercise some professional judgment in deciding which pile some items go into (for example, is a cash receipt of old fixed asset sale an operating or an investing activity?). I put some common items on each of the activity in the example (see the example in the next section.) Hopefully, you can get the point.

FYI: Among four reports above, the Retained Earnings Statements is not always required. And, small businesses usually generate Income Statements and Balance Sheet only.

To help users to understand the financial statements better, the accounting standard (both under the IFRS and US’s GAAP) also requires publicly-held companies to present supplemental notes (referred to as “disclosures”) to the four report above, as follows:

  • Statement of compliance (with IFRS or US’s GAAP)
  • Summary of significant accounting policies applied
  • Supporting information for items presented in the financial statements

So, those are pretty much all about the content of financial statements.

Next questions is…

 

When Does a Company Publish Financial Statements?

For the internal user (the management) evaluation purpose, the accountant generates financial statement on monthly basis; by the closing date of the book which is by end of each month. Note that the financial statements should clearly shows a date as follows:

  • Balance Sheet reports the company’s financial position at a point of a time, so it is dated with the closing date of the book. For example, Januar 31, 2017 for January, February 28, 2017, for February.
  • Income Statements reports the company’s financial result for a period of time and Statements of Cash Flows reports the company’s cash flow for a period of time. So the date of both reports should the period. For example, January o1 to 31, 2017 for January.

For external users, the accountant issues financial statements on yearly basis or annually, and dated as follows:

  • Balance Sheet, December 31, 2017
  • Income Statements and Statement of Cash Flows, January 31 to December 31, 2017

In addition to the annual statements, the SEC also requires publicly-held entities quarterly financial statements.

See the date on the next examples

 

How Is Financial Statements Presented?

For internal users (the management of the company), the form of the financial statements varied between one another. Depending on the needs of each management, financial statements may be customized, especially in terms of the level of detail.

But for external parties (investors, creditors, government agencies, suppliers, customers, employees, and the press,) the form and format of the financial statements is relatively the same for all companies, following one of the big accounting frameworks (depending on the jurisdiction of the company.) Even if there are differences usually only in the presence (or absence) of certain items (depending on the type and scale of the company.) In the United States, for example, the form and format of the financial statements are usually as follows:

1. Balance Sheet:

Financial Statements, Balance Sheet

 

2. Income Statements:

Financial Statements-Income Statements

 

3. Retained Earnings Statement:Financial Statements-Retained Earnings

 

4. Cash Flow Statements:

Financial Statements-Cash Flows

How does the Understanding on Financial Statements Help Me Understand the concepts of Accounting?

What is the most important procedure that you should know about in accounting? The “debit-and-credit procedure,” obviously. This procedure is based on a basic algebraic formula called “accounting equation.” Here is the basic equation:

A = L+E

whereas:

A = Assets

L = Liabilities

E = Equity (or shareholder’s equity)

The balance sheet presents information based on that equation. Indeed, the name balance sheet comes from the fact that a proper balance sheet must always balance—total assets must equal the total of liabilities and owners’ equity. So, a change in the assets group is followed by a change either in the liabilities or shareholders equity and vice versa.

For example, the business owner put a $10 capital (common stock for a corporation) into the business for the first time, so the shareholder’s equity increases. The equation requires that the increase must be followed by an increase in the asset group as well. If the capital was put in the form of cash deposit then the cash account in the asset group also increases by $10.

A = L + E

$10 = 0 + $10

Based on this concept, a bookkeeper is able to record the transaction as follows:

[Debit] Cash = $10 (asset)

[Credit] Common Stock = $10 (shareholder’s equity.)

The question is: how would one know these while he doesn’t know what assets, what liabilities, and what shareholder’s equity? Impossible. He has no clue.

Memorizing the equation and ‘debit-and-credit’ procedures is important but, without knowing the concept behind it, one will be confused when dealing with complicated cases.

Another benefit of knowing financial statements before starting to learn accounting equation and ‘debit-credit’ procedures is that you can develop a kind of visual mental exercise, in daily life, by making use the balance sheet, income statements, and retained earning statements. The exercise, at least in my personal experience, could make the learning process much easier.

I will discuss accounting equation and debit-credit procedures in more detail, with more actionable case examples, in the coming posts, including the mental exercise.

 

 

Executive Summary

1. Instantly, a financial statements is Financial statements is a set of reports about company’s financial position at a certain date, financial result of a certain period of operation, and cash flow during the same period. The financial statements is consisted of the followings: Balance Sheet, Income Statements, Retained Earnings Statement, and Statement of Cash Flows.

2. Balance Sheet is a summary of the financial position of a company at a particular date and contains the followings:

  • Asset – It is the economic resource owned or controlled by a company, current and non-current.
  • Liability – It is the economic obligation to deliver assets or provide a service, short-term and long-term.
  • Equity – It equals to total assets minus total liabilities and representing the book value of the assets that belongs to the owners after the liability obligations have been satisfied; stems from direct owner investment and past profits retained in the business.

3. In the balance sheet, assets and liabilities are typically separated into current and long-term items with data for both the current and the preceding year reported for comparison. It might, sometimes, reflects assets acquired at their historical cost, thus frequently ignoring changes in value and gradual development of intangible assets.

4. Income statements is a report of a company’s performance for a particular period of time and includes the followings:

  • Revenue – It is an increase in a company’s resources (assets) through a normal business transaction
  • Expense – It is a decrease in a company’s resources (assets) through a normal business transaction
  • Net income – It equals to revenues minus expenses and represents the net amount of assets created through business operations during a particular period of time.

5. It is usually several years of income statements data are reported side by side for comparison and called a “comparative income statements.”

6. Retained earnings is equal to the total earnings that have been retained in the company; this amount accumulates each year and is computed as beginning retained earnings plus net income minus dividends

7. Statement of cash flows is a report of a company’s cash inflows and outflows categorized into operating, investing, and financing activities and consisted of the following 3 elements:

  • Operating activities – These are activities that are part of a company’s day-to-day business. Examples include collecting cash from customers, paying employees, and purchasing inventory.
  • Investing activities – These activities involving the purchase and sale of long-term assets such as buildings, trucks, and equipment.
  • Financing activities – These are activities that surrounding acquiring the capital needed to purchase the company’s assets; examples include getting cash from loans, repaying loans, receiving invested cash from owners, and paying dividends

8. Remember about the three primary financial statements linked each other as follows: The income statement explains the change in the retained earnings balance on the balance sheet. The statement of cash flows explains the change in the cash balance on the balance sheet. The relationship between an operating statement (the income statement or the statement of cash flows) and comparative balance sheets, whereby an item on the operating statement helps explain the change in an item on the balance sheet from one period to the next.

10. The notes to the financial statements contain additional information not included in the financial statements themselves and consisted of the followings: explain the company’s accounting assumptions and practices, provide details of financial statement summary numbers and additional disclosure about complex events, and report supplementary information required under both the IFRS and the US’ GAAP.

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