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Accounting Basics: Financial Statements

Financial statements present the results of operations and the financial position of the company. Four
statements are commonly prepared by publicly-traded companies: balance sheet, income statement,
cash flow statement and statement of changes in equity.

Balance Sheet (Statement of Financial Position)

Heading has three items: (1) the legal name of the entity; (2) the title (i.e., balance sheet or statement of
financial position); and (3) the date of the statement.
The balance sheet itself presents the company's assets, liabilities and shareholders' equity.
Assets are items that provide probable future economic benefits
Liabilities are obligations of the firm that will be settled by using assets
Equity (variously called stockholders equity, shareowners equity or owners equity) is the residual
interest that remains after you subtract liabilities from asset

Assets = Liabilities + Owners Equity

Assets are broken down into current and noncurrent (or long-term). Assets are listed from top to
bottom in order of decreasing liquidity, i.e., how fast they can be converted to cash.

Current assets are cash and other assets that are expected to be used during the normal operating cycle of
the business, usually one year. They typically include cash and cash equivalents, short-term investments,
accounts receivables, inventory and prepaid expense. Noncurrent assets will not be realized in full within
one year. They typically include long-term investments: property, plant and equipment; intangible assets
and other assets.

Liabilities are listed in order of expected payment. Obligations expected to be satisfied within one year
are current liabilities. They include accounts payable, trade notes payable, advances and deposits, current
portion of long-term debt and accrued expenses. Noncurrent liabilities include bonds payable and other
forms of long-term capital.

The structure of the owners' equity section depends on whether the entity is an individual, a partnership or
a corporation. Assuming it's a corporation, the section will include capital stock, additional paid-in
capital, retained earnings, accumulated other comprehensive income and treasury stock.

Balance sheet data can be used to compute key indicators that reveal the company's financial structure
and its ability to meet its obligations. These include working capital, current ratio, quick ratio, debt-equity
ratio and debt-to-capital ratio.

Income Statement
The income statement (also known as the profit and loss statement or P&L) tells you both the earnings
and profitability of a business. The P&L is always for a specific period of time, such as a month, a quarter
or a year. Because a company's operations are ongoing, from a business perspective these cut-offs are
arbitrary, and they result in many of the problems in income measurement. Nevertheless, periodic income
statements are essential, because they allow users to compare results for the company over time and to the
results of other firms for the same period. Depending on the industry, year over year comparisons that
eliminate seasonal variables may be especially useful.

Of course, accounting is vastly more complicated than this representation, and debits and credits are
recorded under many rules and treatments for many accounts. But ultimately, if all the credits to OE
during a period are greater than the debits, you have net income and OE (in the form of retained earnings)
increases; if there are more debits than credits, you have a net loss and OE decreases.
The format of the income statement is broken into several parts:
Net Sales
Cost of Goods Sold / Manufactured and Sold
Gross Profit
Operating Expenses
Distribution / Selling
General & Administrative
Operating Income
Other Income (Expense)
Taxable Income
Income Tax Expense

 Income from continuing operations


 Results from discontinued operations (if any)
 Extraordinary items (if any)
 Cumulative effect of a change in accounting principle (if any)
 Net income
 Other comprehensive income
 Earnings per share information

Income from continuing operations is the heart of the P&L. It includes sales (or revenue), cost of goods
sold, operating expenses, gains and losses, other revenue and expense items that are unusual or infrequent
but not both, and income tax expense.

This section of the income statement is used to compute the key profitability ratios of gross margin,
operating margin, and pretax margin that help readers assess the ability of the company to generate
income from its activities. Results from continuing operations are of primary interest because they are
ongoing and can be predictive of future earnings; investors put less weight on discontinued operations
(which are about the past) and extraordinary items (unusual and infrequent, thus unlikely to reoccur).

Net income is the "bottom line"; it is expressed both on an actual and, after comprehensive income, on a
per share basis.

Statement of Changes in Owners Equity


A separate Statement of Changes in Stockholders' (or Owners) Equity is also prepared that reconciles the
various components of OE on the balance sheet for the start of the period with the same items at the end
of the period. The statement recognizes the primacy of OE for investors and other readers of financial
statements.

Statement of Cash Flows


The cash flow statement tells you the sources and uses of cash during the period. It also provides
information about the company's investing and financing activities during the period.

The format of a cash flow statement is typically:

 Net cash flow from operating activities (sales, inventories, rent, insurance, etc.)
 Cash flow from investing activities (e.g. buying and selling equipment)
 Cash flow from financing activities (e.g. selling common stock, paying off long-term debt)
 Exchange rate impact
 Net increase (decrease) in cash
 Cash and equivalents at start of period
 Cash and equivalent at end of period
 Schedule of non-cash financing and investing activities (e.g. conversion of bonds)
There are two methods for preparing the cash flow statement, direct and indirect. Using the direct method,
the accountant shows the items that affected cash flow, such as cash collected from customers, interest
received, cash paid to suppliers, etc. The indirect method adjusts net income for any revenue and expense
item that did not result from a cash transaction.

Basic Accounting Terms


1. Accounts Receivable
The amount of money owed by your customers after goods or services have been delivered and/or used.
2. Accounting
A systematic way of recording and reporting financial transactions.
3. Accounts Payable
The amount of money you owe creditors (suppliers, etc.) in return for good and/or services they have
delivered. .
4. Assets
Current assets are those that will be used within one year. Typically this could be cash, inventory or
accounts receivable.
Non current or Fixed assets are more long-term and will likely provide benefits to a company for more
than one year, such as a building, land or machinery.
5. Balance Sheet
A financial report that summarizes a company's assets (what it owns), liabilities (what it owes)
and owner’s equity at a given time.
6. Capital
A financial asset and its value, such as cash or goods.
Working capital is calculated by taking your current assets subtracted from current liabilities.
7. Cash Flow
The revenue or expense expected to be generated through business activities (sales, manufacturing, etc.)
over a period of time. Having a positive cash flow is essential in order for businesses to survive in the
long run.
8. Certified Public Accountant – CPA
A designation given to someone who has passed a standardized CPA exam and met government-
mandated work experience and educational requirements to become a CPA.
9. Cost of Goods Sold
The direct expense related to producing the goods sold by a company. This may include the cost of the
raw materials (parts) and amount of employee labor used in production.
10. Credit
An accounting entry that may either decrease assets or increase liabilities and equity on the company's
balance sheet, depending on the transaction. When using the double-entry accounting method there will
be two recorded entries for every transaction: a credit and a debit.
11. Debit
An accounting entry where there is either an increase in assets or a decrease in liabilities on a company's
balance sheet.
12. Expenses (Fixed, Variable, Accrued, Operation) – FE, VE, AE, OE
The fixed, variable, accrued or day-to-day costs that a business may incur through its operations.
Examples of expenses include payments to bank charges, suppliers, employees or maintenance for
equipment.
13. Generally Accepted Accounting Principles – GAAP
A set of rules and guidelines developed by the accounting industry for companies to follow when
reporting financial data. Following these rules is especially critical for all publicly traded companies.
14. General Ledger – GL
A complete record of the financial transactions over the life of a company.
15. Liabilities (Current and Long-Term)
A company's debts or financial obligations it incurred during business operations. Current liabilities are
those debts that are payable within a year, such as a debt to suppliers. Long-term liabilities are typically
payable over a period of time greater than one year. An example of a long-term liability would be a bank
loan.
16. Net Income
A company's total earnings, also called net profit or the “bottom line.”
Net income is calculated by subtracting totally expenses from total revenues.
17. Owner's Equity
An owner’s equity is typically explained in terms of the percentage amount of stock a person has
ownership interest in the company.
The owners of the stock are commonly referred to as the shareholders.
18. Present Value – PV
The value of how much a future sum of money is worth today. Present value helps us understand how
receiving P100 now is worth more than receiving P100 a year from now.
19. Statement of Income or Profit and Loss Statement – P&L
A financial statement that is used to summarize a company’s performance and financial position by
reviewing revenues, costs and expenses during a specific period of time; such a quarterly or annually.
20. Return on Investment – ROI
A measure used to evaluate the financial performance relative to the amount of money that was invested.
The ROI is calculated by dividing the net profit by the cost of the investment.
The result is often expressed as a percentage.

Accounting - process of identifying, measuring, and reporting financial information of an entity


Accounting Equation - assets = liabilities + equity
Accounts Payable - money owed to creditors, vendors, etc.
Accounts Receivable - money owed to a business, i.e. credit sales
Accrual Accounting - a method in which income is recorded when it is earned and expenses are
recorded when they are incurred, all independent of cash flow
Accruals - a list of expenses that have been incurred and expensed, but not paid or a list of sales that
have been completed, but not yet billed
Amortization – gradual reduction of amounts in an account over time, either assets or liabilities
Asset - property with a cash value that is owned by a business or individual
Audit Trail – a record of every transaction, when it was done, by whom and where, used by auditors
when validating the financial statement
Auditors – third party accountants who review an entity’s financial statements for accuracy and provide
a statement to that effect
Balance Sheet - summary of a company's financial status, including assets, liabilities, and equity
Bookkeeping - recording financial information
Budgeting – the process of assigning forecasted income and expenses to accounts, which amounts will
be compared to actual income and expense for analysis of variances
Capital Stock – found in the equity portion of the balance sheet describing the number of shares sold to
shareholders at a predetermined value per share, also called “common stock” or “preferred stock”
Capital Surplus – found in the equity portion of the balance sheet accounting for the amount
shareholders paid that is greater or lesser than the “capital stock” amount
Capitalized Expense – expenses that are accumulated, not expensed as incurred, to be amortized over a
period of time; i.e. the development cost of a new product
Chart of Accounts - a listing of a company's accounts and their corresponding numbers
Cash-Basis Accounting - a method in which income and expenses are recorded when they are paid.
Cash Flow - a summary of cash received and disbursed showing the beginning and ending amounts
Closing the Books/Year End Closing – the process of reversing the income and expense for a fiscal or
calendar year and netting the amount into “retained earnings”
Cost Accounting - a type of accounting that focuses on recording, defining, and reporting costs
associated with specific operating functions
Credit - an account entry with a negative value for assets, and positive value for liabilities and equity.
Debit - an account entry with a positive value for assets, and negative value for liabilities and equity.
Departmental Accounting – separating operating divisions into their own sub entities on the income
statement, showing individual income, expenses, and net profit by entity
Depreciation - recognizing the decrease in the value of an asset due to age and use
Dividends – amounts paid to shareholders out of current or retained earnings
Double-Entry Bookkeeping - system of accounting in which every transaction has a corresponding
positive and negative entry (debits and credits)
Equity - money owed to the owner or owners of a company, also known as "owner's equity"
Financial Accounting - accounting focused on reporting an entity's activities to an external party; ie:
shareholders
Financial Statement - a record containing the balance sheet and the income statement
Fixed Asset - long-term tangible property; building, land, computers, etc.
General Ledger - a record of all financial transactions within an entity
Goodwill – an intangible asset reflecting the value of an entity in excess of its tangible assets
Income Statement - a summary of income and expenses
Inventory – merchandise purchased for resale at a profit
Inventory Valuation – the method to set the book value of unsold inventory: i.e. “FIFO,” first in, first
out; “average,” an average cost over a given period, Specific Identification Method or “serialized,”
based on a uniquely identifiable serial number or character of each inventory item
Invoice – the original billing from the seller to the buyer, outlining what was purchased and the terms of
sale, payment, etc.
Job Costing - system of tracking costs associated with a job or project (labor, equipment, etc) and
comparing with forecasted costs
Journal - a record where transactions are recorded, also known as an "account"
Liability - money owed to creditors, vendors, etc
Liquid Asset - cash or other property that can be easily converted to cash
Loan - money borrowed from a lender and usually repaid with interest
Controlling or Master Account – an account on the general ledger that subtotals the “subsidiary
accounts” assigned to it; i.e. Cash might be the master account for a list of depository accounts at banks
Net Income (Cash Basis) - money remaining after all expenses and taxes have been paid
Non Cash Expense - recognizing the decrease in the value of an asset; i.e. depreciation and amortization
Non-operating Income - income generated from non-recurring transactions; ie: sale of an old building
Note - a written agreement to repay borrowed money; sometimes used in place of "loan"
Operating Income - income generated from regular business operations
Other Income - income generated from other than regular business operations, i.e. interest, rents, etc.
Payroll - a list of employees and their wages
Posting – the process of entering then permanently saving or “archiving” accounting data
Profit – The results of operations when revenues earned are greater than cost of sales and operating
expenses or the "net income"
Profit/Loss Statement – another term for "statement of income"
Reconciliation – the process of matching one set of data to another; i.e. the bank statement to the
check register (Bank Reconciliation), the accounts payable journal to the general ledger, etc.
Retained Earnings – the amount of net profit retained and not paid out to shareholders over the life of
the business
Revenue - total gross amount of sales from items sold or receipts from service rendered before the
direct cost and operating expenses.
Shareholders’ Equity - the capital and retained earnings in an entity attributed to the shareholders
Single-Entry Bookkeeping - system of accounting in which transactions are entered into one account
Statement of Account - a bill for the summary of amounts owed to a vendor, lender, etc.
Subsidiary Accounts – the individual record of customers or suppliers or subaccounts that are totalled
on the financial statement under control or “master accounts;” i.e. “Cash-ABC Bank” might be one of
several subsidiary accounts that are subtotaled under “Cash”
Supplies – consumable assets purchased to be consumed by the entity
Treasury Stock – shares purchased by the entity from shareholders, reducing shareholder equity
Write-down/Write-off – an accounting entry that reduces the value of an asset due to an impairment of
that asset; i.e. the account receivable from the bankrupt customer

Strauss Printing and Publishing, Inc.


Statement of Comprehensive Income
For the Year Ended December 31, 2011

Service Revenue P 160,000


Less: Expenses
Salaries Expense P 40,000
Supplies Expense 26,100
Rent Expense 20,500
Utilities Expense 11,300
Depreciation Expense 5,000 102,900
Net Income P 57,100
Other Comprehensive Income
Revaluation Surplus P 20,000
Unrealized Translation Gain 10,200 30,200
Total Comprehensive Income P 87,300
Target profit analysis and break-even analysis are used to answer questions such as how
much would we have to sell to make a profit of $10,000 per month or how much would we have
to sell to avoid incurring a loss?

Determine the level of sales needed to achieve a desired target profit.


One of the key uses of CVP analysis is called target profit analysis. In target profit analysis, we estimate
what sales volume is needed to achieve a specific target profit.

The margin of safety is the excess of budgeted (or actual) sales dollars over the break-even volume of
sales dollars. It is the amount by which sales can drop before losses are incurred. The higher the margin
of safety, the lower the risk of not breaking even and incurring a loss. The formula for the margin of
safety is:
Margin of safety in dollars = Total budgeted (or actual) sales − Break-even sales
The margin of safety can also be expressed in percentage form by dividing the margin of safety in dollars
by total dollar sales

Target Sales Revenue = Fixed Cost + Desired Profit / (1 - tax rate)


1 - (Variable cost / Sales Revenue)
Target Sales Volume = Fixed Cost + Desired Profit / (1 – tax rate)
Unit Contribution Margin

The breakeven point is the sales volume at which a business earns exactly no money. The breakeven point is useful
for the following reasons:

 Determine the amount of remaining capacity after the breakeven point is reached, which tells you the
maximum amount of profit that can be generated.
 Determine the impact on profit if automation (a fixed cost) replaces labor (a variable cost)
 Determine the change in profits if product prices are altered
 Determine the amount of losses that could be sustained if the business suffers a sales downturn

Management should constantly monitor the breakeven point, particularly in regard to the last item noted, in order to
reduce the breakeven point whenever possible. Ways to do this include:

 Cost analysis. Continually review all fixed costs, to see if any can be eliminated. Also review variable costs
to see if they can be eliminated, since doing so increases margins and reduces the breakeven point.
 Margin analysis. Pay close attention to product margins, and push sales of the highest-margin items, to
reduce the breakeven point.
 Outsourcing. If an activity involves a fixed cost, consider outsourcing it in order to turn it into a per-unit
variable cost, which reduces the breakeven point.
 Pricing. Reduce or eliminate the use of coupons or other price reductions, since it increases the breakeven
point.

To calculate the breakeven point Sales Revenue, divide total fixed expenses by the contribution margin.
Contribution margin is sales minus all variable expenses, divided by sales. The formula is:

Total fixed expenses


Contribution margin %

A more refined approach is to eliminate all non-cash expenses (such as depreciation) from the numerator, so that the
calculation focuses on the breakeven cash flow level.

Another variation on the formula is to focus instead on the number of units that must be sold in order to break even,
rather than the sales level in dollars. This formula is:

Total fixed expenses


Average contribution margin per unit