So, you want to learn
Bookkeeping!
by Bean Counter's Dave Marshall

Lesson 6
Financial Statements


Introduction Lesson 1 Lesson 2 Lesson 3 Lesson 4 Lesson 5 Lesson 6 Lesson 7
Bean Counter

The objective of this lesson is not so much a how to do it; but, to inform, introduce, and make you aware of the basic financial statements.

Let's start this lesson by reviewing a few definitions.

Financial Statements are summary accounting reports prepared periodically to inform the owner, creditors, and other interested parties as to the financial condition and operating results of the business. The four basic financial statements or reports are:

Balance Sheet-The financial statement which shows the amount and nature of business assets, liabilities, and owner's equity as of a specific point in time. It is also known as a Statement Of Financial Position or a Statement Of Financial Condition.

Income Statement-The financial statement that summarizes revenues and expenses for a specific period of time, usually a month or a year. This statement is also called a Profit and Loss Statement or an Operating Statement.

Capital Statement-The financial report that summarizes all the changes in owner's equity that occurred during a specific period.

Statement of Changes in Financial Position-The financial statement that reports the sources and uses of cash or working capital for a specific period of time, normally a year.

The Balance Sheet

A Balance Sheet is simply a picture of a business at a specific point in time, usually the end of the month or year. By analyzing and reviewing this financial statement the current financial "health" of a business can be determined. The balance sheet is derived from our accounting equation and is a formal representation of our equation

Assets = Liabilities + Owner's Equity.

If you recall, in an earlier lesson we learned that this equation is also called the Balance Sheet Equation.

The categories and format of the Balance Sheet are based on what are called Generally Accepted Accounting Principles (GAAP). These principles are the rules established so that every business prepares their financial statements the same way.

Assets
Formal Definition:The properties used in the operation or investment activities of a business.

Informal Definition:All the good stuff a business has (anything with value). The goodies.

Additional Explanation: The good stuff includes tangible and intangible stuff. Tangible stuff you can physically see and touch such as vehicles, equipment and buildings. Intangible stuff is like pieces of paper (sales invoices) representing loans to your customers where they promise to pay you later for your services or product. Examples of assets that many individuals have are cars, houses, boats, furniture, TV's, and appliances. Some examples of business type assets are cash, accounts receivable, notes receivable, inventory, land, and equipment.

Assets are listed based on how quickly they can be converted into cash which is called liquidity. In other words, they're ranked. The asset most easily converted into cash is listed first followed by the next easiest and so on. Of course since cash is already cash it's the first asset listed.

Liabilities
Formal Definition:Claims by creditors to the property (assets) of a business until they are paid.

Informal Definition:Other's claims to the business's stuff. Amounts the business owes to others.

Additional Explanation: Usually one of a business's biggest liabilities (hopefully they are not past due) is to suppliers where they have bought goods and services and charged them. This is similar to us going out and buying a TV and charging it on our credit card. Our credit card bill is a liability. Another good personal example is a home mortgage. Very few people actually own their own home. The bank has a claim against the home which is called a mortgage. This mortgage is another example of a personal liability. Some examples of business liabilities are accounts payable, notes payable, and mortgages payable.

Liabilities are listed in the order of how soon they have to be paid. In other words, the liabilities that need to be paid first are also listed first.

Owner's Equity (Capital)
Formal Definition:The owner's rights to the property (assets) of the business; also called proprietorship and net worth.

Informal Definition:What the business owes the owner. The good stuff left for the owner assuming all liabilities (amounts owed) have been paid.

Additional Explanation:Owner's Equity represents the owner's claim to the good stuff (assets). Most people are familiar with the term equity because it is so often used with lenders wanting to loan individuals money based on their home equity. Home equity can be thought of as the amount of money an owner would receive if he/she sold their house and paid off any mortgage (loan) on the property.

Owner's equity (or net worth or capital ) is increased by money or property contributed and any profits earned and decreased by owner withdrawals and losses.

All Balance Sheets contain the same categories of assets, liabilities, and owner's equity.

If you look below at our Balance Sheet for ABC Mowing you can readily see that there are three main sections, assets, liabilities, and owner's equity just like the accounting equation. The major sections of a balance sheet are the heading, the assets, the liabilities, and the owner's equity. The heading contains the name of the company, the title of the statement, and the date of the statement.

Navigation:
Interactive Links are provided in this Balance Sheet.

  • Click on the Underlined ABC Capital Amount to see the amount transferred from the Capital Statement.

  • Click on the Underlined Account Name (Item) in the Balance Sheet to see the amount in the Trial Balance that was used as an aid in preparing the Balance Sheet.
  • ABC Mowing
    Balance Sheet
    As Of December 31, xxxx
    Assets Liabilities
    Cash $5,080 Accounts Payable 2,060
    Accounts Receivable 1,600 Notes Payable 10,000
    Office Supplies 100    
    Mowing Equipment 12,500 Total Liabilities 12,060
     
      Owner's Equity
      ABC Capital 7,220
     
    Total Assets $19,280 Total Liabilities & Equity $19,280

    This layout is called the account form. In this form the major categories are presented side by side.

    Another layout sometimes used is called the report form. In this form the major categories are stacked on top of each other. An example of the report form follows.

    ABC Mowing
    Balance Sheet
    As Of December 31, xxxx
     
    Assets
    Cash $5,080  
    Accounts Receivable 1,600  
    Office Supplies 100  
    Mowing Equipment 12,500  
       Total Assets   $19,280
     
    Liabilities    
    Accounts Payable $2,060  
    Notes Payable-Bank 10,000  
       Total Liabilities   $12,060
     
    Owner's Equity
    ABC Capital   $7,220
     
       Total Liabilities & Equity   $19,280

    The Income Statement

    The Income Statement is a formal financial statement that summarizes a company's operations (revenues and expenses) for a specific period of time usually a month or year.

    A fiscal year is the period used for calculating annual (yearly) financial statements. While a large number of businesses use the calendar year (January-December) as their fiscal year, a business can elect to use any other twelve month period such as June-May as their fiscal year.

    The categories and format(s) of the Income Statement also follow the rules known as Generally Accepted Accounting Principles (GAAP) and contains specific revenue and expense categories.

    The following types of accounts are used to prepare the Income Statement.

    Revenue (Also Called Income)
    Formal Definition:The gross increase in owner's equity resulting from the operations and other activities of the business.

    Informal Definition:Amounts a business earns by selling services and products. Amounts billed to customers for services and/or products.

    Expense (Also Called Cost)
    Formal Definition:Decrease in owner's equity resulting from the cost of goods, fixed assets, and services and supplies consumed in the operations of a business.

    Informal Definition:The costs of doing business. The stuff we used and had to pay for or charge to run our business.

    Additional Explanation: Some examples of business expenses are office supplies, salaries & wages, advertising, building rental, and utilities.

    Hopefully a business earns a profit called net income (revenues are larger than expenses). If however, expenses are larger than revenues a net loss results.

    The major sections of an income statement are the heading, the revenue section, the expense section, and the final calculation of a profit or loss. The heading should contain the name of the company, the title of the statement, and the period covered by the statement.

    An Income Statement is just a formal summary of "Mom Capital's "Kids" Revenue and Expense.

    The Income Statement for ABC Mowing is presented below.

    Navigation:
    Interactive Links are provided in this Income Statement.

  • Click On the Underlined Net Income Amount to see the amount transferred to the Capital Statement .

  • Click on the Underlined Account Name (Item) in the Income Statement to see the amount in the Trial Balance that was used as an aid in preparing the Income Statement.
  • ABC Mowing
    Income Statement
    For The Period Ending December 31, xxxx
     
    Revenue from operations $1,205
     
    Expenses
    Advertising Expense $225  
    Mulch Expense 160  
       Total Expenses $385
     
    Net Income $820

    Note: In the real world an income statement would have many more expense categories than the two types illustrated in our simple example. Some additional expenses that would normally be included are:

    • Office Supplies Used
    • Telephone
    • Building/Office Rent
    • Utilities
    • Depreciation Expense
    • Maintenance and Repairs
    • Interest Expense
    • Memberships
    • Donations
    • Bank Fees and Charges
    • Salaries & Wages
    • Employment Taxes
    • Equipment Rental
    • Contract Labor
    • Professional Fees
    • Travel
    • Entertainment
    • Any other type that your business incurs

    Our Income Statement or what is sometimes also referred to as a Profit and Loss Statement was prepared for a service type of business. Businesses that are retailers, wholesalers, or manufacturers that sell products have a special section included in their income statement called Cost Of Goods Sold. This section computes the Cost Of The Goods Sold that were either purchased and sold or manufactured and sold. In retailing and wholesaling, computing the cost of goods sold during the accounting period involves beginning and ending inventories. In manufacturing it involves finished-goods inventories, raw materials inventories and goods-in-process inventories.

    The Capital Statement

    The next financial statement, the capital statement, is prepared to report all the changes in owner's equity that occurred over a period of time usually a month or year. The major sections of the statement are the heading, the owner's capital balance at the beginning of the period, the increases and decreases during the period , and the calculated ending balance.

    What do you think affects "Mom" (Owner's Equity) ? Of course her "kids" (revenue, expense, and draws) and any capital contributed to the business by the owner. We learned earlier that the activities of the "kids" revenue and expense are summarized in the Income Statement. This net income or loss is presented on a line in the Capital Statement. All the owner withdrawals (kid draws) is also presented on a line in the statement.

    The capital statement serves as the bridge between the income statement and balance sheet. It uses the net income/loss from the income statement in addition to the owner's investments and withdrawal to determine the Owner's Capital balance shown on the balance sheet.

    Let's illustrate this statement with a simple equation.
    Ending Owner's Equity = Beginning Equity + Additional Capital Contributed + Profit or - Loss - Draws

    Navigation:
    Interactive Links are provided in this Capital Statement.

  • Click on the Underlined Ending Capital Amount to see the the amount transferred to the Balance Sheet

  • Click on the Underlined Net Income Amount to see the amount transferred from the Income Statement.

  • Click on the Underlined Capital Beginning Description to see the amount that was transferred from the Trial Balance.

  • Click on the Underlined Less Withdrawals to see the amount that was transferred from the Trial Balance.
  • ABC Mowing
    Capital Statement
    For The Period Ending December 31, xxxx
     
    Capital Beginning $7500
    Capital Contributed 0  
    Net Income 820  
    Less withdrawals 1,100  
    Decrease in capital 280
    Ending Capital $7,220

    How The Balance Sheet, Income Statement, and Capital Statement Are Related.

    If you compare the owner's equity (owner's claim to assets) for two year end balance sheets, the difference (increase or decrease) is explained by the Income Statement and Capital Statement. Remember, revenues increase equity; capital contributed to the business increases equity; expenses decrease equity; and owner's draws decrease equity.

    Statement Of Changes in Financial Position

    The last financial statement, the statement of changes in financial position, is prepared to report all the changes in cash or working capital that occurred over a period of time usually a month or year.

    The working capital form of the statement explains the increase or decrease in working capital for a period.
    Note:Working capital is the difference between current assets and current liabilities (Working Capital = Current Assets - Current Liabilities).

    As you might expect, the cash form of the statement explains the increase or decrease in cash for a period. The statement is often called the Sources and Uses of Cash Statement when cash is used as the basis for preparing the statement.

    Since more and more of the accounting regulatory agencies are promoting using cash instead of working capital as the basis for preparing this statement, our example statement will also use cash.

    The major sections of the statement are the heading, a section for reporting the increases in cash (resources provided by), a section for reporting the decreases in cash (resources applied to), and a summary of the change in cash (increase/decrease) for the period.

    If the business was in operation in the previous year, the prior year balance sheet along with the current year balance sheet and current year income statement is needed in order to prepare the statement. Additional analysis of some of the accounts may also be needed.

    Our example assumes that ABC Mowing's prior year balance sheet is as follows:

    ABC Mowing
    Balance Sheet
    As Of December 31, xxxx (Prior Year)
     
    Assets
    Cash $6,400  
    Accounts Receivable 600  
    Mowing Equipment 2,500  
       Total Assets   $9,500
     
    Liabilities    
    Accounts Payable $2,000  
       Total Liabilities   $2,000
     
    Owner's Equity
    ABC Capital   $7,500
     
       Total Liabilities & Equity   $9,500

    Using the above prior year balance sheet along with the current year balance sheet and income statement we prepared the following Statement Of Changes in Financial Position:

    Summary of how to prepare the statement:

  • The first step is determining the cash provided or used by operations and begins with the operating income for the period.
  • Adjustments are made to the income for revenue or expenses items that did not provide or use cash.
  • Additional adjustments are made for all current and noncurrent accounts and are recorded as addition or subtractions depending upon their effect on cash based on their beginning of the year and end of the year balances.

    ABC Mowing
    Statement Of Changes in Financial Position (Cash)
    As Of December 31, xxxx (Current Year)
     
    Sources of cash:
    Financing from bank loan $10,0000  
    Total sources  $10,000
     
    Uses of cash:
    Income from operations $820      
    Add:
    Increase in accounts payable 60 $880    
    Deduct:
    Increase in supplies inventory 100      
    Increase in accounts receivable 1000 1,100    
    Cash used by operations 220  
    Payment of owner's draws 1,100  
    Acquisition of equipment 10,000  
    Total uses 11,320
     
    Decrease in cash $1,320
     
    Change in cash balance:
    Cash balance, December 31, xxxx (Current Year) $5,080
    Cash balance, December 31, xxxx (Prior Year) 6,400
    Decrease in cash $1,320

    Notes To The Financial Statements

    Notes to the financial statements are an integral part of the statements and are required by Generally Accepted Accounting Principles. Notes to financial statements,sometimes referred to as footnotes, are used to provide additional information about a business's financial condition and methods used at arriving at the amounts presented in the financial statements.

    These notes contain important information about such things as the accounting methods used for recording and reporting transactions, any pending lawsuits or regulations that may affect the business, and other information that should be disclosed in order to properly analyze and evaluate the financial condition of the business.

    Where Do You Get The Information used to prepare these formal financial statements ?

    A Trial Balance/Worksheet that we discussed in Lesson 5 is prepared from the General Ledger. The balances listed on this worksheet are listed in the order of the accounting equation. Asset balances are listed first; followed by Liabilities; and then Owner's Equity ("Ma Capital"); and finally her "kids" Revenues and Expenses.

    Once you have a Trial Balance it's simply a matter of transferring the amounts from the Trial Balance to use to prepare the Balance Sheet, Income Statement, and Capital Financial Statements. Add in the prior year's balance sheet and you have the information needed for preparing the Statement of Changes in Financial Position (cash).

    ABC Mowing's Trial Balance at the end of December

    Navigation:
    Interactive Links are provided in this Trial Balance.

  • Click on the Underlined Account Name in the Trial Balance to be taken to the amounts transferred to the Balance Sheet, Income Statement, or Capital Statement.
  • Account Debit Balances Credit Balances Account Type
    Asset Accounts
    Cash 5080   Balance Sheet
    Accounts Receivable 1600   Balance Sheet
    Inventory-Office Supplies 100   Balance Sheet
    Mowing Equipment 12500   Balance Sheet
     
    Liability Accounts
    Accounts Payable   2060 Balance Sheet
    Note Payable-Bank   10000 Balance Sheet
     
    Equity Accounts
    Owner's Capital   7500 Balance Sheet
    Owner's Draws 1100   Balance Sheet
     
    Revenue Accounts
    Mowing Revenue   1205 Income Statement
     
    Expense Accounts
    Mulch Expense 160   Income Statement
    Advertising Expense 225   Income Statement
     
    Totals 20765 20765  

    It should be apparent that by having the information from the General Ledger and the Trial Balance one can readily prepare the Balance Sheet, Income Statement, and Capital financial statements.

    The Trial Balance/Worksheet normally contains additional columns for adjusting and closing entries. Briefly, closing entries transfer (close) the balances in the General Ledger's individual revenue, expense, and drawing account(s) to the owner's capital account at the end of a period (usually year end) which results in the same General Ledger Capital Account ending balance as contained in the Capital Statement. This Ending Capital balance becomes the new Beginning Capital Balance for the new year. All the revenues, expense, and drawing account balances are reset to zero so that their balances will only represent transaction amounts (increases and decreases to owner's equity) in the new year.

    Due to the fact that this is an introductory tutorial, adjusting and closing entry detail illustrations, discussions, and examples are reserved for a more advanced tutorial. Adjusting and Closing entries are discussed and illustrated in my So, you want to learn Bookkeeping! - Special Journals Tutorial.

    The Good News

    While these financial statements were prepared from just a very few transactions, my goal was to introduce you to what formal financial statements are needed and what's involved in preparing them even though the bookkeeper might not be required or responsible for preparing them. Many businesses have their accountant or CPA (Certified Public Accountant) prepare or review their financial statements. Even if the bookkeeper does not prepare them, they're still a key ingredient in properly analyzing and recording the transactions that are summarized in these statements.

    Another plus, nowadays, good accounting or bookkeeping software will automatically generate these statements. While this is great, we still need to be aware of that ole saying "GIGO - Garbage In Garbage Out".

    Are we there yet ?

    Analyzing Financial Performance

    While preparing financial statements is critical to the success of a business, it's only half the battle. In order for a business to fully benefit the financial information needs to be analyzed and compared. A few tools used are comparing past performance with current performance and comparing how the business stacks up against its competitors or similar businesses.

    While the Financial Statements presented in this lesson are simplified versions of the "real" world and were compiled from only a few financial transactions, the concepts and methods used are the same as you would use for a business with a multitude of transactions.

    So you know - things do change !

    The Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) are currently working on a joint project called the Financial Statement Presentation Project which, if the recommendations are adopted, will change the current formats of the Financial Statements. Basically, the financial information will be organized into groupings that will reflect the results of the operating, investing, and financing activities of a business.

    Is this the last time under that darn light ? I'm not telling. You never know what lies in store for you in the final review lesson. See what you know about Financial Statements.

    Financial Statements

    Now's not the time for nail biting. You've made it this far and have only one lesson left in order to complete the course.

    Yes, if you need one, you can take a break before moving on to the final lesson.

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