Financial Statements

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 physical 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.

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

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.

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

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.

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:

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.