So, you want to
by Bean Counter's Dave Marshall
|Introduction||Lesson 1||Lesson 2||Lesson 3||Lesson 4||Lesson 5||Lesson 6||Lesson 7|
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
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
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.
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.
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)
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.
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.
The Income Statement
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:
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
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 working capital form of the statement
explains the increase or decrease in working capital for a period.
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:
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:
Notes To 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
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.