9.3 The Accounting Equation
Financial Statements
We hope that, so far, at least one thing is clear: If you’re in business, you need to understand financial statements. The law no longer allows high-ranking executives to plead ignorance or fall back on delegation of authority when it comes to responsibility for a firm’s financial reporting. In a business environment tainted by episodes of fraudulent financial reporting and other corporate misdeeds, top managers are now being held responsible for the financial statements issued by the people who report to them. Top managers need to know how well the company is performing. Financial information helps managers identify signs of impending trouble before it is too late.
The Function of Financial Statements
Put yourself in the place of Connor, who runs Connor’s Confections out of his home. He loves what he does, and he feels that he’s doing pretty well. In fact, he has an opportunity to take over a nearby store at a very reasonable rent, and he can expand by getting a modest bank loan and investing some more of his own money. So it’s decision time for Connor: He knows that the survival rate for start-ups isn’t very good, and before taking the next step, he’d like to get a better idea of whether he’s actually doing well enough to justify the risk. The basic financial statements will give him some answers. Here, three common statement types are introduced.
Income Statement = Shows sales, expenses, and whether or not a profit was made.
Balance Sheet = Show assets and liabilities, the amount invested in the business.
Statement of Cash Flows = Show how much cash is coming in and going out.
Since this book is for an introductory course, attention is on the income statement, balance sheet, and cash flow statement only, even though other financial statements are mentioned.
Toying with a Business Idea
To bring this concept closer to home, let’s assume that you need to earn money while you’re in college and that you’ve decided to start a small business. Your business will involve selling stuff to other college students, and to keep things simple, we’ll assume that you’re going to operate on a “cash” basis: you’ll pay for everything with cash, and everyone who buys something from you will pay in cash.
You may have at least a little cash on you right now—some currency, or paper money, and coins. In accounting, however, the term cash refers to more than just paper money and coins. It also refers to the money that you have in chequing and savings accounts and includes items that you can deposit in these accounts, such as money orders and different types of cheques.
Your first task is to decide exactly what you’re going to sell. You’ve noticed that with homework, exams, social commitments, and the hectic lifestyle of the average college student, you and most of the people you know always seem to be under a lot of stress. Sometimes you wish you could just lie back between meals and bounce a ball off the wall. And that’s when the idea hits you: Maybe you could make some money by selling a product called the “Stress-Buster Play Pack.” Here’s what you have in mind: you’ll buy small toys and other fun stuff—instant stress relievers—at a local dollar store and pack them in a rainbow-coloured plastic treasure chest labelled “Stress-Buster.”
And here’s where you stand: You have enough cash to buy a month’s worth of plastic treasure chests and toys. After that, you’ll use the cash generated from sales of Stress-Buster Play Packs to replenish your supply. Each plastic chest will cost $1.00, and you’ll fill each one with a variety of five simple toys, all of which you can buy for $1.00 each.
You plan to sell each Stress-Buster Play Pack for $10 from a rented table stationed outside a major dining hall. Renting the table will cost you $20 a month. In order to make sure you can complete your schoolwork, you decide to hire fellow students to staff the table at peak traffic periods. They’ll be on duty from noon until 2:00 p.m. each weekday except Fridays, and you’ll pay them a generous $7.50 an hour. Wages, therefore, will cost you $240 a month (2 hours × 4 days × 4 weeks = 32 hours × $7.50). Finally, you’ll run ads in the college newspaper at a monthly cost of $40. Thus your total monthly costs will amount to $300 ($20 + $240 + $40).
The Income Statement
Let’s say that during your first month, you sell one hundred play packs. Not bad, you say to yourself, but did I make a profit? To find out, you prepare an income statement showing revenues, or sales, and expenses—the costs of doing business. You divide your expenses into two categories:
- Cost of goods sold: the total cost of the goods that you’ve sold
- Operating expenses: the costs of operating your business except for the costs of things that you’ve sold.
Now you need to do some subtracting:
- The difference between sales and cost of goods sold is your gross profit, also known as gross margin.
- The difference between gross profit and operating expenses is your net income or profit, which is the proverbial “bottom line.” Note we’ve assumed you’re making money, but businesses can also have a net loss.
Below is your income statement for the first month. (Remember that we’ve made things simpler by handling everything in cash.)
|
Stress-Buster Company Income Statement Month Ended April 30, 2018 |
||
|---|---|---|
|
Sales (100 x $10.00) |
$1,000 |
|
|
Less: Cost of Goods Sold (100 x $6) |
$600 |
|
|
Gross profit (100x ($10 – $6)) |
$400 |
|
|
Less: Operating Expenses |
||
|
Salaries |
$240 |
|
|
Advertising |
$40 |
|
|
Table rental |
$20 |
|
|
$300 |
||
|
Net income (Profit) ($400-$300) |
$100 |
Did You Make Any Money?
What does your income statement tell you? It has provided you with four pieces of valuable information:
- You sold 100 units at $10 each, bringing in revenues or sales of $1,000.
- Each unit that you sold cost you $6 – $1 for the treasure chest plus 5 toys costing $1 each. So your cost of goods sold is $600 (100 units × $6 per unit).
- Your gross profit—the amount left after subtracting cost of goods sold from sales—is $400 (100 units × $4 each).
- After subtracting operating expenses of $300 – the costs of doing business other than the cost of products sold—you generated a positive net income or profit of $100.
The Balance Sheet
A balance sheet reports the following information:
- Assets: the resources from which it expects to gain some future benefit
- Liabilities: the debts that it owes to outside individuals or organizations
- Owner’s equity: the investment in the business
Whereas your income statement tells you how much income you earned over some period of time, your balance sheet tells you what you have at a specific point in time.
Companies prepare financial statements on at least a twelve-month basis. This can be for a fiscal year that ends on December 31, or some other logical date, such as June 30 or September 30. Fiscal years can vary because companies generally pick a fiscal-year end date that coincides with the end of a peak selling period; thus a crabmeat processor might end its fiscal year in October, when the crab supply has dwindled. Most companies also produce financial statements on a quarterly or monthly basis. For Stress-Buster, you’ll want to prepare them monthly to stay on top of how your new business is doing. Let’s prepare a balance sheet at the start and end of your first month in business.
To prepare a balance sheet, one must first understand the fundamental accounting equation:
Assets = Liabilities + Owner’s Equity
This simple but important equation highlights the fact that a company’s assets came from somewhere: either from investments made by the owners (owner’s equity) or from loans (liabilities). This means that the asset section of the balance sheet on the one hand and the liability and owner’s-equity section on the other must be equal, or balance. Thus the term balance sheet.
Let’s prepare the two balance sheets we mentioned: one for the first day you started and one for the end of your first month of business. We’ll assume that when you started Stress-Buster, you borrowed $400 from your parents and put in $200 of your own money. If you look at your first balance sheet below, you’ll see that your business has $600 in cash (your assets): Of this total, you borrowed $400 (your liabilities) and invested $200 of your own money (your owner’s equity). So far, so good: your assets section balances with your liabilities and owner’s equity section as follows:
|
Stress-Buster Company Balance Sheet As of April 1, 2018 |
|
|
Assets |
|
|
Cash |
$600 |
|
Liabilities and Owner’s Equity |
|
|
Liabilities |
$400 |
|
Owner’s Equity |
$200 |
|
Total Liabilities and Owner’s Equity |
$600 |
Now let’s see how things have changed by the end of the month. Stress-Buster earned $100 during the month of September and you decided to leave these earnings in the business. This $100 profit increases two items on your balance sheet: the assets of the company (its cash) and your investment in it (its owner’s equity). Below shows what your balance sheet will look like on April 30. You now have $700 in cash: $400 that you borrowed plus $300 that you’ve invested in the business (your original $200 investment plus the $100 profit from the first month of operations, which you’ve kept in the business).
|
Stress-Buster Company Balance Sheet As of April 30, 2018 |
|
|
Assets |
|
|
Cash (original $600 plus $100 earned) |
$700 |
|
Liabilities and Owner’s Equity |
|
|
Liabilities |
$400 |
|
Owner’s Equity ($200 invested by owner plus $100 profits retained) |
$300 |
|
Total Liabilities and Owner’s Equity |
$700 |
The Cash Flow Statement
The Cash Flow Statement provides valuable information about a company’s expenses and receipts and allows insights into its future income needs in order to be able to meet its future obligations (expenses and receipts). The cash flow statement reports cash inflows and outflows, and it will identify the amount of cash the company currently holds, which is also reported in the balance sheet.
Typically the cash flow statement is reported on a month-to-month basis, however, a statement of cash flow will consolidate month-to-month cash flow to meet the requirements of the International Financial Reporting Standards.
A statement of cash flow will report cash in three distinct areas of business:
- Cash from Operations
- Cash from Investing
- Cash from Financing
Now let’s prepare the statement of cash flow for Stress-Buster company for the one-month period ending April 30, 2018. Stress-Buster would have incurred cash from Operations in the form of Net Income incurred after deducting the month’s expenses from the month’s revenues and would have also incurred cash from Financing from the initial $400 loan taken out to start the business and the additional $200 of personal income. As Stress-Buster did not invest in new equipment, machinery or other assets for the business or use prior cash flows and/or retained earnings to earn further investment income, Stress-Buster would not report any cash from investing activities.
|
Stress-Buster Company Statement of Cash Flow Month Ended April 30, 2018 |
||
|
Beginning Cash |
$0 |
|
|
Operating Activities |
$100 |
|
|
Net Income from Operations |
$100 |
|
|
Investing Activities |
$0 |
|
|
Financing Activities |
$600 |
|
|
Increase in Short Term Debt |
$400 |
|
|
Increase in Retained Earnings |
$200 |
|
|
Ending Cash Balance (Net Change) |
$700 |