Offering a few preliminary comments about financial statements

Realistic examples are needed to illustrate and explain financial statements, which presents a slight problem. The information content of a business’s financial statements depends on whether it sells products or services, invests in other businesses, and so on. For example, the financial statements of a movie theater chain are different from those of a bank, which are different from those of an airline, which are different from an automobile manufacturer’s, which are different from — well, you name it.

The classic example used to illustrate financial statements involves a business that sells products and sells on credit to its customers. Therefore, the assets in the example include receivables from the business’s sales on credit and inventory of products it has purchased or manufactured that are awaiting future sale. Keep in mind, however, that many businesses that sell products do not sell on credit to their customers. Many retail businesses sell only for cash (or accept credit or debit cards that are near cash). Such businesses do not have a receivables asset.

The financial statements of a business do not present a history of the business. Financial statements are, to a large extent, limited to the recent profit performance and financial condition of the business. A business may add some historical discussion and charts that aren’t strictly required by financial reporting standards. (Public corporations that have their ownership shares and debt traded in open markets are subject to various disclosure requirements under federal law, including certain historical information.)

The illustrative financial statements that follow do not include a historical narrative of the business. Nevertheless, whenever you see financial statements, we encourage you to think about the history of the business. To help you out in this regard, here are some particulars about the business example in this chapter:

• It sells products to other businesses (not on the retail level).
• It sells on credit, and its customers take a month or so before they pay.
• It holds a fairly large stock of products awaiting sale.
• It owns a wide variety of long-term operating assets that have useful lives from 3 to 30 years or longer (building, machines, tools, computers, office furniture, and so on).
• It has been in business for many years and has made a profit most years.
• It borrows money for part of the total assets it needs.
• It’s organized as a corporation and pays federal and state income taxes on its annual taxable income.
• It has never been in bankruptcy and is not facing any immediate financial difficulties.

The following sections present the company’s annual income statement for the year just ended, its balance sheet at the end of the year, and its statement of cash flows for the year.

Presenting the components of the income statement

Figure 1-1 presents the major ingredients, or information packets, in the income statement for a company that sells products. As you may expect, the income statement starts with sales revenue on the top line. There’s no argument about this, although in the past, certain companies didn’t want to disclose their annual sales revenue (to hide the large percent of profit they were earning on sales revenue).

Sales revenue is the total amount that has been or will be received from the company’s customers for the sales of products to them. Simple enough, right? Well, not really. The accounting profession is currently reexamining the technical accounting standards for recording sales revenue, and this has proven to be a challenging task. Our business example, like most businesses, has adopted a certain set of procedures for the timeline of recording its sales revenue.

Recording expenses involves much more troublesome accounting problems than revenue problems for most businesses. Also, there’s the fundamental question regarding which information to disclose about expenses and which information to bury in larger expense categories in the external income statement. Direct your attention to the four kinds of expenses in Figure 1-1. Expenses are deducted from sales revenue to determine the final profit for the period, which is referred to as the bottom line. The preferred label is net income, as you see in the figure.

The four expense categories you see in Figure 1-1 should almost always be disclosed in external income statements. These constitute the minimum for adequate disclosure of expenses. The cost of goods sold expense is just what it says: the cost of the products sold to customers. The cost of the products should be matched against the revenue from the sales, of course.

Only one conglomerate operating expense has to be disclosed. In Figure 1-1, it’s called selling, general, and administrative expenses, which is a popular title in income statements. This all-inclusive expense total mixes together many kinds of expenses, including labor costs, utility costs, depreciation of assets, and so on. But it doesn’t include interest expenses or income tax expense; these two expenses are always reported separately in an income statement.

The cost of goods sold expense and the selling, general, and administrative expenses take the biggest bites out of sales revenue. The other two expenses (interest and income tax) are relatively small as a percent of annual sales revenue but are important enough in their own right to be reported separately. And though you may not need this reminder, bottom-line profit (net income) is the amount of sales revenue in excess of the business’s total expenses. If either sales revenue or any of the expense amounts are wrong, profit is wrong

A service business does not sell products; therefore, it doesn’t have the cost of goods sold expense. In place of cost of goods sold, it has other types of expenses. Most service businesses are labor extensive; they have relatively large labor costs as a percent of sales revenue. Service companies differ in how they report their operating expenses. For example, United Airlines breaks out the cost of aircraft fuel and landing fees. The largest expense of the insurance company State Farm is payments on claims. The movie chain AMC reports film exhibition costs separate from its other operating expenses. We offer these examples to remind you that accounting should always be adapted to the way the business operates and makes profit. In other words, accounting should follow the business model.

Income statement pointers

Most businesses break out one or more expenses instead of disclosing just one very broad category for all selling, general, and administrative expenses. For example, Apple, in its condensed income statement, discloses research and development expenses separate from its selling, general, and administrative expenses. A business could disclose expenses for advertising and sales promotion, salaries and wages, research and development (as does Apple), and delivery and shipping — though reporting these expenses varies quite a bit from business to business. Businesses do not disclose the compensation of top management in their external financial reports, although this information can be found in the proxy statements of public companies that are filed with the Securities and Exchange Commission (SEC). In summary, the extent of details disclosed about operating expenses in externally reported financial reports varies quite a bit from business to business. Financial reporting standards are rather permissive on this point.

Inside most businesses, a profit statement is called a P&L (profit and loss) report. These internal profit performance reports to the managers of a business include more detailed information about expenses and about sales revenue — a good deal more! Reporting just four expenses to managers (as shown in Figure 1-1) would not do.

Sales revenue refers to sales of products or services to customers. In some income statements, you also see the term income, which generally refers to amounts earned by a business from sources other than sales. For example, a real estate rental business receives rental income from its tenants. (In the example in this chapter, the business has only sales revenue.)

The income statement gets the most attention from business managers, lenders, and investors (not that they ignore the other two financial statements). The much-abbreviated versions of income statements that you see in the financial press, such as in The Wall Street Journal, report the top line (sales revenue and income) and the bottom line (net income) and not much more. Refer to Chapter 2 in this minibook for more information on income statements.

Presenting the components of the balance sheet

Figure 1-2 shows the building blocks of a typical balance sheet for a business that sells products on credit. As mentioned, one reason the balance sheet is called by this name is that its two sides balance, or are equal in total amounts. In this example, the $5.2 million total assets equals the $5.2 million total liabilities and owners’ equity. The balance or equality of total assets on the one side of the scale and the sum of liabilities plus owners’ equity on the other side of the scale is expressed in the accounting equation. Note: The balance sheet in Figure 1-2 shows the essential elements in this financial statement. In a financial report, the balance sheet includes additional features and frills, which we explain in Chapter 3 of this minibook.

Take a quick walk through the balance sheet. For a company that sells products on credit, assets are reported in the following order: First is cash, then receivables, then cost of products held for sale, and finally the long-term operating assets of the business. Moving to the other side of the balance sheet, the liabilities section starts with the trade liabilities (from buying on credit) and liabilities for unpaid expenses. Following these operating liabilities is the interest-bearing debt of the business. Owners’ equity sources are then reported below liabilities. So a balance sheet is a composite of assets on one hand and a composite of liabilities and owners’ equity sources on the other hand.

A balance sheet is a reflection of the fundamental two-sided nature of a business (expressed in the accounting equation). In the most basic terms, assets are what the business owns, and liabilities plus owners’ equity are the sources of the assets. The sources have claims against the assets. Liabilities and interest-bearing debt have to be paid, of course, and if the business were to go out of business and liquidate all its assets, the residual after paying all its liabilities would go to the owners.

A company that sells services doesn’t has an inventory of products being held for sale. A service company may or may not sell on credit. Airlines don’t sell on credit, for example. If a service business doesn’t sell on credit, it won’t have two of the sizable assets you see in Figure 1-2: receivables from credit sales and inventory of products held for sale. Generally, this means that a service-based business doesn’t need as much total assets compared with a products-based business with the same size sales revenue.

The smaller amount of total assets of a service business means that the other side of its balance sheet is correspondingly smaller. In plain terms, this means that a service company doesn’t need to borrow as much money or raise as much capital from its equity owners.

As you may suspect, the particular assets reported in the balance sheet depend on which assets the business owns. We include just four basic types of assets in Figure 1-2. These are the hardcore assets that a business selling products on credit would have. It’s possible that such a business could lease (or rent) virtually all its long-term operating assets instead of owning them, in which case the business would report no such assets. In this example, the business owns these so-called fixed assets. They’re fixed because they are held for use in the operations of the business and are not for sale, and their usefulness lasts several years or longer.

Balance sheet pointers

So, where does a business get the money to buy its assets? Most businesses borrow money on the basis of interest-bearing notes or other credit instruments for part of the total capital they need for their assets. Also, businesses buy many things on credit and, at the balance sheet date, owe money to their suppliers, which will be paid in the future.

These operating liabilities are never grouped with interest-bearing debt in the balance sheet. The accountant would be tied to the stake for doing such a thing. Liabilities are not intermingled with assets — this is a definite no-no in financial reporting. You can’t subtract certain liabilities from certain assets and report only the net balance.

Could a business’s total liabilities be greater than its total assets? Well, not likely — unless the business has been losing money hand over fist. In the vast majority of cases, a business has more total assets than total liabilities. Why? For two reasons:

• Its owners have invested money in the business.
• The business has earned profit over the years, and some (or all) of the profit has been retained in the business. Making profit increases assets; if not all the profit is distributed to owners, the company’s assets rise by the amount of profit retained.

In the product company example (see Figure 1-2), owners’ equity is about $2.5 million, or $2.47 million to be more exact. Sometimes this amount is referred to as net worth because it equals total assets minus total liabilities. However, net worth can be misleading because it implies that the business is worth the amount recorded in its owners’ equity accounts. The market value of a business, when it needs to be known, depends on many factors. The amount of owners’ equity reported in a balance sheet, which is called the business’s book value, is not irrelevant in setting a market value on the business, but it usually isn’t the dominant factor. The amount of owners’ equity in a balance sheet is based on the history of capital invested in the business by its owners and the history of its profit performance and distributions from profit.

A balance sheet could be whipped up anytime you want — say, at the end of every day. In fact, some businesses (such as banks and other financial institutions) need daily balance sheets, but few businesses prepare balance sheets that often. Typically, preparing a balance sheet at the end of each month is adequate for general management purposes — although a manager may need to take a look at the business’s balance sheet in the middle of the month. In external financial reports (those released outside the business to its lenders and investors), a balance sheet is required at the close of business on the last day of the income statement period. If its annual or quarterly income statement ends, say, September 30, then the business reports its balance sheet at the close of business on September 30.

The profit for the most recent period is found in the income statement; periodic profit is not reported in the balance sheet. The profit reported in the income statement is before any distributions from profit to owners. The cumulative amount of profit over the years that hasn’t been distributed to the business’s owners is reported in the owners’ equity section of the company’s balance sheet.

By the way, note that the balance sheet in Figure 1-2 is presented in a top-and-bottom format instead of a left-and-right format. Either the vertical (portrait) or horizontal (landscape) mode of display is acceptable. You see both layouts in financial reports. Of course, the two sides of the balance sheet should be kept together, either on one page or on facing pages in the financial report. You can’t put assets up front and hide the other side of the balance sheet in the rear of the financial report.

Presenting the components of the statement of cash flows

Successful business managers tell you that they have to manage both profit and cash flow; you can’t do one and ignore the other. Business managers have to deal with a two-headed dragon in this respect. Ignoring cash flow can pull the rug out from under a successful profit formula.

Figure 1-3 shows the basic information components of the statement of cash flows for the business example we use in the chapter. The cash activity of the business during the period is grouped into three sections:

• The first reconciles net income for the period with the cash flow from the business’s profit-making activities, or operating activities.
• The second summarizes the company’s investing transactions during the period.
• The third reports the company’s financing transactions.

The net increase or decrease in cash from the three types of cash activities during the period is added to or subtracted from the beginning cash balance to get the cash balance at the end of the year.

The business earned $520,000 profit (net income) during the year (refer to Figure 1-1). The cash result of its operating activities was to increase its cash by $400,000, which you see in the first part of the statement of cash flows (see Figure 1-3). This still leaves $120,000 of profit to explain. This doesn’t mean that the profit number is wrong. The actual cash inflows from revenues and outflows for expenses run on a different timetable from when the sales revenue and expenses are recorded for determining profit. For a more comprehensive explanation of the differences between cash flows and sales revenue and expenses, see Book 1, Chapter 4.

The second part of the statement of cash flows sums up the long-term investments the business made during the year, such as constructing a new production plant or replacing machinery and equipment. If the business sold any of its long-term assets, it reports the cash inflows from these divestments in this section of the statement of cash flows. The cash flows of other investment activities (if any) are reported in this part of the statement as well. As you can see in Figure 1-3, the business invested $450,000 in new long-term operating assets (trucks, equipment, tools, and computers).

The third part of the statement sums up the dealings between the business and its sources of capital during the period — borrowing money from lenders and raising capital from its owners. Cash outflows to pay debt are reported in this section, as are cash distributions from profit paid to the owners of the business. The third part of the example statement shows that the result of these transactions was to increase cash by $200,000. (By the way, in this example, the business didn’t make cash distributions from profit to its owners. It probably could have, but it didn’t — which is an important point that we discuss later in “Why no cash distribution from profit?”)

As you see in Figure 1-3, the net result of the three types of cash activities was a $150,000 increase during the year. The increase is added to the cash balance at the start of the year to get the cash balance at the end of the year, which is $1.0 million. We should make one point clear: The $150,000 cash increase during the year (in this example) is never referred to as a cash flow bottom line or any such thing.

The term bottom line is reserved for the final line of the income statement, which reports net income — the final amount of profit after all expenses are deducted.

Statement of cash flows pointers

In 1987, the American rulemaking body for financial accounting standards (the Financial Accounting Standards Board) made the cash flow statement a required statement. Relatively speaking, this financial statement hasn’t been around that long. How has it gone? Well, in our humble opinion, this financial statement is a disaster for financial report readers.

Statements of cash flows of most businesses are frustratingly difficult to read and far too technical. The average financial report reader understands the income statement and balance sheet. Certain items may be hard to fathom, but overall, the reader can make sense of the information in the two financial statements. In contrast, trying to follow the information in a statement of cash flows — especially the first section of the statement — can be a challenge even for a CPA. (More about this issue in Chapter 4 of this minibook.)

Imagine you have a highlighter and the three basic financial statements of a business in front of you. What are the most important numbers to mark? Bottom-line profit (net income) in the income statement is one number you’d mark. Another key number is cash flow from operating activities in the statement of cash flows. You don’t have to understand the technical steps of how the accountant gets this cash flow number, but pay attention to how it compares with the profit number for the period. (We explain this point in detail in Chapter 5 of this minibook.)

Cash flow is almost always different from net income. The sales revenue reported in the income statement does not equal cash collections from customers during the year, and expenses do not equal cash payments during the year. Cash collections from sales minus cash payments for expenses gives cash flow from a company’s profit-making activities; sales revenue minus expenses gives the net income earned for the year. Sorry, mate, but that’s how the cookie crumbles.