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CONTENTS

List of Exhibits

Preface to the Eighth Edition

Part One: Fundamentals

Chapter 1: Starting with Cash Flows

Cash Flows Summary for a Business

What Does Cash Flows Summary Not Tell You?

Profit Cannot Be Measured by Cash Flows

Cash Flows Do Not Reveal Financial Condition

A Final Note before Moving On

Chapter 2: Three Financial Statements

Reporting Financial Condition, Profit Performance, and Cash Flows

Income Statement

Balance Sheet

Statement of Cash Flows

Chapter 3: Profit Accounting

An Important Question

Nature of Profit

Recording Revenue and Expenses

Winding Up

Chapter 4: Profit Isn’t Everything

Threefold Financial Task of Business Managers

One Problem in Reporting Financial Statements

Interlocking Nature of the Three Financial Statements

Connecting the Dots

Part Two: Connections

Chapter 5: Sales Revenue and Accounts Receivable

Exploring One Link at a Time

How Sales Revenue Drives Accounts Receivable

Accounting Issues

Chapter 6: Cost of Goods Sold Expense and Inventory

Holding Products in Inventory before They Are Sold

Accounting Issues

Chapter 7: Inventory and Accounts Payable

Acquiring Inventory on the Cuff

Accounting Issues

Chapter 8: Operating Expenses and Accounts Payable

Recording Expenses before They Are Paid

Accounting Issues

Chapter 9: Operating Expenses and Prepaid Expenses

Paying Certain Operating Costs before They Are Recorded as Expenses

Accounting Issues: Using Prepaid Expenses to Massage the Numbers

Chapter 10: Depreciation Expense and Property, Plant, and Equipment; Intangible Assets

Brief Review of Expense Accounting

Depreciation Expense

Accumulated Depreciation and Book Value of Fixed Assets

Book Values and Current Replacement Costs

Intangible Assets

Accounting Issues

Chapter 11: Accruing the Liability for Unpaid Expenses

Recording the Accrued Liability for Operating Expenses

Bringing Interest Expense Up to Snuff

Accounting Issues

Chapter 12: Income Tax Expense and Its Liability

Taxation of Business Profit

Accounting Issues

Chapter 13: Net Income and Retained Earnings; Earnings per Share (EPS)

Net Income into Retained Earnings

Earnings per Share (EPS)

Accounting Issues

Part Three: Cash Flow

Chapter 14: Cash Flow from Operating (Profit-Making) Activities

Profit and Cash Flow from Profit: Not Identical Twins!

A Quick Word about the Direct Method for Reporting Cash Flow from Operating Activities

An Alternative View of Cash Flow and Cash Flow

Accounting Issues

Chapter 15: Cash Flows from Investing and Financing Activities

Rounding Out the Statement of Cash Flows

Seeing the Big Picture of Cash Flows

Accounting Issues

Chapter 16: Growth and Decline Impacts on Cash Flow

Setting the Stage

Cash Flows in the Steady-State Case

Cash Flow Growth Penalty

Cash Flow “Reward” from Decline

Red Ink and Cash Flow

Final Comment

Part Four: Analysis

Chapter 17: Footnotes to Financial Statements

Financial Statements—Brief Review

Why Footnotes?

Two Types of Footnotes

Management Discretion in Writing Footnotes

Analysis Issues

Chapter 18: Financial Statement Ratios

Financial Reporting Ground Rules

Financial Statement Preliminaries

Benchmark Financial Ratios

Final Comments

Chapter 19: Profit Analysis for Business Managers

Managerial Accounting

Beyond the Income Statement

Classifying Operating Expenses

Comparing Changes in Sales Prices and Sales Volume

Breakeven Point

Final Point

Part Five: Truthfulness

Chapter 20: Choosing Accounting Methods and Massaging the Numbers

Chapter Preamble

Choosing Accounting Methods

Massaging the Numbers

Business Managers and Their Accounting Methods

Consistency of Accounting Methods

Quality of Earnings

Chapter 21: Audits of Financial Reports

Why Audits?

Certified Public Accountant (CPA)

Are Audits Required?

Clean Audit Opinion

Do Auditors Discover Accounting Fraud?

Reading an Auditor’s Report

Post-SOX

Chapter 22: Basic Questions, Basic Answers

When You Sell a Stock Does the Company Get Your Money?

Are Financial Reports Reliable and Trustworthy?

Nevertheless, Are Some Financial Statements Misleading and Fraudulent?

Is It Worth Your Time to Compute Financial Statement Ratios?

Why Read Financial Statements, Then, If You Won’t Find Information That Has Been Overlooked by Others?

The Financial Statements and Footnotes of Large Public Companies Would Take Several Hours to Read Carefully. What’s the Alternative?

Is There Any One Basic Litmus Test for a Quick Gauge of a Company’s Financial Performance?

Do Financial Statements Report the Truth, the Whole Truth, and Nothing but the Truth?

Does Its Financial Report Explain the Basic Profit-Making Strategy of the Business?

Does the Market Price of a Public Company’s Stock Shares Depend Directly and Only on the Information Reported in Its Financial Statements?

Does the Balance Sheet of a Private Business Tell the Market Value of the Business?

Do Books on Investing and Personal Finance Refer to Financial Statements?

A Very Short Summary

Chapter 23: Small Business Financial Reporting

Different Standards for Different Businesses

Reading a Small Business Financial Report

About the Authors

Index

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LIST OF EXHIBITS

Exhibit 1.1 Summary of Cash Flows during Year
Exhibit 2.1 Year-End Balance Sheets
Exhibit 2.2 Income Statement for Year
Exhibit 2.3 Statement of Cash Flows for Year
Exhibit 2.4 Single Step Income Statement
Exhibit 3.1 Income Statement and Balance Sheet Changes during Year from Profit-Making Activities
Exhibit 4.1 Connections between the Three Financial Statements
Exhibit 5.1 Sales Revenue and Accounts Receivable
Exhibit 6.1 Cost of Goods Sold Expense and Inventory
Exhibit 7.1 Inventory and Accounts Payable
Exhibit 8.1 Selling, General, and Administrative Expenses and Accounts Payable
Exhibit 9.1 Selling, General, and Administrative Expenses and Prepaid Expenses
Exhibit 10.1 Property, Plant, and Equipment, Depreciation Expense and Accumulated Depreciation
Exhibit 11.1 Accruing Unpaid Expenses
Exhibit 12.1 Income Tax Expense and Income Tax Payable
Exhibit 13.1 Net Income and Retained Earnings, Earnings per Share
Exhibit 14.1 Cash Flow from Operating (Profit-Making) Activities
Exhibit 14.2 Direct Method Format for Reporting Cash Flow from Operating Activities in the Statement of Cash Flows
Exhibit 15.1 Cash Flows from Investing and Financing Activities
Exhibit 16.1 Cash Flow from Operating (Profit-Making) Activities in Steady-State Scenario
Exhibit 16.2 Cash Flow from Operating (Profit-Making) Activities in Growth Scenario
Exhibit 16.3 Cash Flow from Operating (Profit-Making) Activities in Decline Scenario
Exhibit 17.1 Three Financial Statements and Footnotes
Exhibit 18.1 External Financial Statements of Business (without Footnotes)
Exhibit 19.1 External Income Statement for Year
Exhibit 19.2 Management Profit Report for Year
Exhibit 19.3 5% Sales Prices versus 5% Sales Volume Increase
Exhibit 19.4 EBIT Breakeven Point for Lower Sales Prices and Lower Sales Volume

PREFACE TO THE EIGHTH EDITION

When I started this book my new co-author on this edition, my son Tage, was entering his senior year of high school. Today he is a successful business and financial consultant in San Diego. Truth be known, he writes better than his old man. So, it is with great personal pleasure and pride that I welcome my son Tage as co-author on this edition. He’s a chip off the old block. In case you’re wondering about his name, it is Swedish and Danish in origin.

At the time the first edition was released in 1980, the Dow Jones Industrial Average hovered around 850 (really!). This most-watched stock market index reached 11,700 in early 2000, and then it abruptly plunged, causing a big dent in my retirement savings. The Dow recovered over the following years, but then dropped again. As I write this sentence the Dow is about 15,000. As J. P. Morgan once said, “The market will fluctuate.” Millions of individuals keep their money in the stock market, and stock investments are a large part of most retirement plans. Knowing how to read a financial report is as important as ever.

This edition catches up with the major changes in financial reporting since the previous edition. At the top of this list is the movement toward different financial reporting standards for private and small businesses. At the same time, the basic architecture of the book remains unchanged. The framework of the book has proved very successful for more than 33 years. I’d be a fool to mess with this success formula. My mother did not raise a fool. Cash flows are underscored throughout the book. This cash flow emphasis is the hallmark of the book.

I prepared all the exhibits in the book as Excel worksheets. To request a copy of the workbook file of all the exhibits, please contact me at my e-mail address: tracyj@colorado.edu. I express my sincere thanks to all of you who have sent compliments about my book. The royalties from sales of the book are nice, but the bouquets from readers are icing on the cake.

Not many books of this ilk make it to the eighth edition. It takes a good working partnership between the author and the publisher. I thank most sincerely the many persons at John Wiley & Sons who have worked with me on the book for more than three decades now. The suggestions on my first draft of the book by Joe Ross, then national training director of Merrill Lynch, were extraordinarily helpful. The continuing support of Debra Englander over the years is very much appreciated. And I’d be remiss without mentioning Tula Batanchiev and Judy Howarth, who have been a pleasure to work with on this edition. They have made the new edition much better than if we had been left on our own. Books are the collaboration of good editors and good authors. We had good editors; you’ll have to be the judge how good the authors are.

I rededicate this book to Gordon B. Laing, my original editor and sponsor of the book. His superb editing was a blessing that few authors enjoy. His guidance, encouragement, and enthusiasm made all the difference. He was a true gentleman who taught me a great deal about writing. His criticisms of my manuscript drafts were sharp but always kindly and supportive. Gordon took much pride in the success of the book—as well he should have! Gordon has passed but I’d like to say again that I couldn’t have done it without him.

John A. Tracy

Boulder, Colorado
August, 2013

PART ONE

FUNDAMENTALS

CHAPTER 1

STARTING WITH CASH FLOWS

Cash Flows Summary for a Business

Savvy business managers, lenders, and investors pay a lot of attention to cash flows. Cash inflows and outflows are the heartbeat of every business. Without a steady heartbeat of cash flows, a business would soon have to go on life support, or die.

So, we start with cash flows. For our example we use a business that has been operating many years. This established business makes profit regularly and, equally important, it keeps in good financial condition. It has a good credit history, and banks lend money to the business on competitive terms. Its present stockholders would be willing to invest additional capital in the business, if needed. None of this comes easy. It takes good management to make profit consistently, to secure capital, and to stay out of financial trouble. Many businesses fail these imperatives, especially when the going gets tough.

Exhibit 1.1 summarizes the company’s cash inflows and outflows for the year just ended, and shows two separate groups of cash flows. First are the cash flows of its profit-making activities—cash inflows from sales and cash outflows for expenses. Second are the other cash inflows and outflows of the business—raising capital, investing capital in assets, and distributing some of its profit to shareowners.

We assume you’re fairly familiar with the cash inflows and outflows listed in Exhibit 1.1. Therefore, we are brief in describing the cash flows at this early point in the book:

EXHIBIT 1.1—SUMMARY OF CASH FLOWS DURING YEAR

Dollar Amounts in Thousands

Cash Flows of Profit-Making Activities
From sales of products to customers, which includes some sales made last year $ 51,680
For acquiring products that were sold, or are still being held for future sale $(34,760)
For operating expenses, some of which were incurred last year $(11,630)
For interest on short-term and long-term debt, some of which applies to last year $ (520)
For income tax, some of which was paid on last year’s taxable income $ (1,665)
Cash flow from profit-making activities during year
$ 3,105
Other Sources and Uses of Cash
From increasing amount borrowed on interest-bearing notes payable $ 625
From issuing additional capital stock (ownership shares) in the business $ 175
For building improvements, new machines, new equipment, and intangible assets $ (3,625)
For distributions to stockholders from profit $ (750)
Net cash decrease from other sources and uses of cash
$ (3,575)
Net cash increase (decrease) during year $ (470)

What Does Cash Flows Summary Not Tell You?

In Exhibit 1.1 we see that cash, the all-important lubricant of business activity, decreased $470,000 during the year. In other words, the total of cash outflows exceeded the total of cash inflows by this amount for the year. The cash decrease and the reasons for the decrease are important information. The cash flows summary tells an important part of the story of the business. But, cash flows do not tell the whole story. Business managers, investors in a business, business lenders, and many others need to know two other types of information about a business that are not reported in its cash flows summary.

The two most important types of information that a summary of cash flows does not tell you are:

1. The profit earned (or loss suffered) by the business for the period.
2. The financial condition of the business at the end of the period.

Now hold on. Didn’t we just see in Exhibit 1.1 that the net cash increase from sales revenue less expenses was $3,105,000 for the year? You may ask: “Doesn’t this cash increase equal the amount of profit earned for the year?” No, it doesn’t. The net cash flow from profit-making operations during the year does not equal the amount of profit earned for the year. In fact, it’s not unusual that these two numbers are very different.

Profit is an accounting-determined number that requires much more than simply keeping track of cash flows. The differences between using a checkbook to measure profit and using accounting methods to measure profit are important to understand. Hardly ever are cash flows during a period the correct amounts for measuring a company’s sales revenue and expenses for that period. Summing up, profit cannot be determined from cash flows.

Furthermore, a summary of cash flows reveals virtually nothing about the financial condition of the business. Financial condition refers to the assets of the business matched against its liabilities at the end of the period. For example: How much cash does the company have in its checking account(s) at the end of the year? From the summary of cash flows (Exhibit 1.1) we see that the business decreased its cash balance $470,000 during the year. But we can’t tell from the cash flows summary the company’s ending cash balance. And, more importantly, the cash flows summary does not report the amounts of assets and liabilities of the business at the end of the period.

Profit Cannot Be Measured by Cash Flows

The company in this example sells products on credit. The business offers its customers a short period of time to pay for their purchases. Most of the company’s sales are to other businesses, which demand credit. (In contrast, most retailers selling to individuals accept credit cards instead of extending credit to their customers.) In this example the company collected $51,680,000 from its customers during the year. However, some of this cash inflow was for sales made in the previous year. And, some sales made on credit in the year just ended had not been collected by the end of the year.

At year-end the company had receivables from sales made to its customers during the latter part of the year. These receivables will be collected early next year. Because some cash was collected from last year’s sales and some cash was not collected from sales made in the year just ended, the total amount of cash collections during the year differs from the amount of sales revenue for the year.

Cash disbursements during the year are not the correct amounts for measuring expenses. The company paid $34,760,000 for products that are sold to customers (see Exhibit 1.1). At year-end, however, many products were still being held in inventory. These products had not yet been sold by year-end. Only the cost of products sold and delivered to customers during the year should be deducted as expense from sales revenue to measure profit. Don’t you agree?

Furthermore, some of the company’s product costs had not yet been paid by the end of the year. The company buys on credit and takes several weeks before paying its bills. The company has liabilities at year-end for recent product purchases and for operating costs as well.

Its cash payments during the year for operating expenses, as well as for interest and income tax expenses, are not the correct amounts to measure profit for the year. The company has liabilities at the end of the year for unpaid expenses. The cash outflow amounts shown in Exhibit 1.1 do not include the amounts of unpaid expenses at the end of the year.

In short, cash flows from sales revenue and for expenses are not the correct amounts for measuring profit for a period of time. Cash flows take place too late or too early for correctly measuring profit for a period. Correct timing is needed to record sales revenue and expenses in the right period.

The correct timing of recording sales revenue and expenses is called accrual-basis accounting. Accrual-basis accounting recognizes receivables from making sales on credit and recognizes liabilities for unpaid expenses in order to determine the correct profit measure for the period. Accrual-basis accounting also is necessary to determine the financial condition of a business—to record the assets and liabilities of the business.

Cash Flows Do Not Reveal Financial Condition

The cash flows summary for the year (Exhibit 1.1) does not reveal the financial condition of the company. Managers certainly need to know which assets the business owns and the amounts of each asset, including cash, receivables, inventory, and all other assets. Also, they need to know which liabilities the company owes and the amounts of each.

Business managers have the responsibility for keeping the company in a position to pay its liabilities when they come due to keep the business solvent (able to pay its liabilities on time). Business managers also have to keep the business liquid (having enough available cash when you need it). Furthermore, managers have to know whether assets are too large (or too small) relative to the sales volume of the business. Its lenders and investors want to know the same things about a business.

In brief, both the managers inside the business and lenders and investors outside the business need a summary of a company’s financial condition (its assets and liabilities). They need a profit performance report as well, which summarizes the company’s sales revenue and expenses and its profit for the year.

A cash flows summary is useful. In fact, a slightly different version of Exhibit 1.1 is one of the three primary financial statements reported by every business, but in no sense does the cash flows report take the place of the profit performance report and the financial condition report. The next chapter introduces these two financial statements, and shows the generally accepted format of a summary of cash flows (instead of the informal format shown in Exhibit 1.1).

A Final Note before Moving On

Over the past century (and longer) a recognized profession has developed, one of whose main functions is to prepare and report business financial statements—the accounting profession. A primary goal of the accounting profession has been to develop and enforce accounting and financial reporting standards that apply to all businesses. In other words, there is a “rule book” that businesses should obey in accounting for profit and in reporting profit, financial condition, and cash flows. Businesses are not free to make up their own individual accounting methods and financial reporting practices. The established rules and standards are collectively referred to as generally accepted accounting principles (GAAP). But things are getting more complicated these days, that’s for sure.

In the United States there are serious beginnings to adopt separate rules for private companies versus public companies, and for small companies versus larger companies. Furthermore, the efforts to develop international accounting and financial reporting standards keep slogging along, with mixed results so far. We say more about the changing landscape of accounting and financial reporting standards in Chapter 23.

CHAPTER 2

THREE FINANCIAL STATEMENTS

Reporting Financial Condition, Profit Performance, and Cash Flows

Business managers, lenders, and investors need to know the financial condition of a business. For this purpose they need a report that summarizes its assets and liabilities, as well as the ownership interests in the residual of assets in excess of liabilities. And they need to know the profit (or loss) performance of the business. They need a report that summarizes sales revenue and expenses for the most recent period and the resulting profit or loss. And, they need a summary of its cash flows for the period. Therefore, these three types of financial information are reported regularly by businesses to their managers, lenders, and investors.

Financial condition is communicated in an accounting report called the balance sheet, and profit activities are presented in an accounting report called the income statement. Cash flows are communicated in the statement of cash flows. Alternative titles for the balance sheet include “statement of financial condition” or “statement of financial position.” An income statement may be titled “statement of operations” or “earnings statement.” We stick with the names balance sheet and income statement to be consistent throughout the book. The statement of cash flows is almost always called just that.

The term financial statements, in the plural, generally refers to a complete set that includes a balance sheet, an income statement, and a statement of cash flows. Informally, financial statements are called just “financials.” In almost all cases the financial statements need to be supplemented with additional information, which is presented in footnotes and supporting schedules. One supporting schedule is very common—the statement of changes in stockholders’ (owners’) equity. The broader term financial report refers to all this, plus any additional commentary from management, narrative explanations, graphics, and promotional content that accompany the financial statements and their footnotes and supporting schedules.

The three financial statements for the company example introduced in Chapter 1 are now presented here in Exhibits 2.1, 2.2, and 2.3. The format and content of these three financial statements apply to manufacturers, wholesalers, and retailers—businesses that make or buy products that are sold to their customers. Although the financial statements of service businesses that don’t sell products differ somewhat, Exhibits 2.1, 2.2, and 2.3 illustrate the basic framework and content of balance sheets, income statements, and statements of cash flows for all businesses.

EXHIBIT 2.1—YEAR-END BALANCE SHEET

Dollar Amounts in Thousands

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EXHIBIT 2.2—INCOME STATEMENT FOR YEAR

Dollar Amounts in Thousands

Sales Revenue $ 52,000
Cost of Goods Sold Expense (33,800)
Gross Margin $ 18,200
Expenses (12,480)
Depreciation Expense (785)
Earnings before Interest and Income Tax $ 4,935
Interest Expense (545)
Earnings before Income Tax $ 4,390
Income Tax Expense (1,748)
Net Income $ 2,642

EXHIBIT 2.3—SINGLE STEP INCOME STATEMENT

Dollar Amounts in Thousands

Cash Flow from Operating Activities
Net Income (from Income Statement) $ 2,642
Accounts Receivable Increase (320)
Inventory Increase (935)
Prepaid Expenses Increase (275)
Depreciation Expense 785
Accounts Payable Increase 645
Accrued Expenses Payable Increase 480
Income Tax Payable Increase 83 $ 3,105
Cash Flow from Investing Activities
Expenditures for Property, Plant, and Equipment $ (3,050)
Expenditures for Intangible Assets (575) (3,625)
Cash Flow from Financing Activities
Increase in Short-Term Debt $ 125
Increase in Long-Term Debt 500
Issuance of Additional Capital Stock Share 175
Distribution of Cash Dividends from Profit (750) 50
Decrease in Cash During Year $ (470)
Cash Balance at Start of Year 3,735
Cash Balance at End of Year $ 3,265

Side notes: The term profit is not popular in income statements (or elsewhere in financial reports), so not many companies use the term (although some do). Profit comes across to many people as greedy or mercenary. The term suggests an excess or a surplus over and above what’s necessary. You may hear the term profit & loss or P&L statement for the income statement. But this title is not used in external financial reports released outside a business.

Many businesses present a two-year comparative income statement and statement of cash flows, either because they legally have to or they decide to do so. In this chapter we don’t need the previous year’s information in these two statements. So, to keep it simple we do not include this information. In contrast, we need the previous year-end amounts in the balance sheet. Accordingly, the balance sheet in Exhibit 2.1 includes last year’s amounts (as well as changes during the year).

Income Statement

The first question on everyone’s mind usually is whether a business made a profit or suffered a loss and how much. We start with the income statement and then move on to the balance sheet and statement of cash flows. The income statement summarizes sales revenue and expenses for a period of time—one year in Exhibit 2.2. All the dollar amounts reported in this financial statement are cumulative totals for the whole period.

The top line is the total amount of proceeds or gross income from sales to customers, and is generally called sales revenue. The bottom line is called net income (also net earnings, but seldom profit or net profit). Net income is the final profit after all expenses are deducted from sales revenue. The business in this example earned $2,642,000 net income on its sales revenue of $52,000,000 for the year; only a smidgeon more than 5 percent of its sales revenue remained as final profit (net income) after deducting all expenses.

The income statement is read in a step-down manner, like walking down stairs. Each step down is a deduction of one or more expenses. The first step deducts the cost of goods (products) sold from the sales revenue of goods sold, which gives gross margin (also called gross profit—one of the few instances of using the term profit in income statements). This measure of profit is called gross because many other expenses are not yet deducted.

Next, the broad category of operating expenses called selling, general, and administrative expenses and the depreciation expense (a unique expense) are deducted from gross margin, giving earnings before interest and income tax. This measure of profit is also called operating earnings, or a similar title. Next, interest expense on debt is deducted, which gives earnings before income tax. The last step is to deduct income tax expense, which gives net income, the bottom line in the income statement.

Instead of the multiple-step income statement shown in Exhibit 2.2, which has three intermediate measures of profit, you may see a single-step income statement that reports only the final line of net income, which is shown in Exhibit 2.4.

EXHIBIT 2.4—SINGLE STEP INCOME STATEMENT

Dollar Amounts in Thousands

Sales Revenue $ 52,000
Cost of Goods Sold $ (33,800)
Selling, General, and Administrative Expenses $ (12,480)
Depreciation Expense $ (785)
Interest Expense $ (545)
Income Tax Expense $ (1,748)
Net Income $ 2,642

Publicly owned business corporations are required to report earnings per share (EPS), which basically is annual net income divided by the number of capital stock shares. Privately owned businesses don’t have to report EPS, but this figure may be useful to their stockholders. We explain earnings per share in Chapters 13 and 18.

In our income statement example (Exhibit 2.2) you see five different expenses. You may find more expense lines in an income statement, but seldom more than 10 or so as a general rule (unless the business had a very unusual year). Companies selling products are required to report their cost of goods sold expense. Some companies do not report depreciation expense on a separate line in their income statements. However, depreciation is such a unique expense that we prefer to keep it separate from the other expenses.

Other than depreciation, Exhibit 2.2 includes just one broad, all-inclusive operating expenses line—“Selling, General, and Administrative Expenses.” However, a business has the option of disclosing two or more operating expenses, and many do. Marketing, promotional, and selling expenses often are separated from general and administration expenses. The level of detail for expenses in income statements is flexible; financial reporting standards are somewhat loose on this point.

The sales revenue and expenses reported in income statements follow generally accepted conventions, which we briefly summarize here:

Balance Sheet

The balance sheet shown in Exhibit 2.1 follows the standardized format regarding the classification and ordering of assets, liabilities, and ownership interests in the business. Financial institutions, public utilities, railroads, and other specialized businesses use somewhat different balance sheet layouts. However, manufacturers and retailers, as well as the large majority of various types of businesses, follow the format presented in Exhibit 2.1.

On the left side the balance sheet lists assets. On the right side the balance sheet first lists the liabilities of the business, which have a higher-order claim on the assets. The sources of ownership (equity) capital in the business are presented below the liabilities, to emphasize that the owners or equity holders in a business (the stockholders of a business corporation) have a secondary and lower order claim on the assets—after its liabilities are satisfied.

Each separate asset, liability, and stockholders’ equity reported in a balance sheet is called an account. Every account has a name (title) and a dollar amount, which is called its balanceExhibit 2.1