Introduction to Financial Statements

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Introduction to Financial Statements

Financial statements are the final result of the accounting system. Stakeholders interpret financial statements to help make business, lending, and investment decisions. Each individual statement has an important role in helping users understand more about the reporting entity. Only when all of the individual statements and the notes to the financial statements are reported together does the user have a complete financial picture.

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The Income Statement

Defined / Example

The first question a stakeholder likely has about any business is whether the business makes money or not, referred generally as profitability. If a business has a profit for a given time period, the revenue (money earned) exceeds expenses (money paid out for business and non-cash expenses). Profit or loss (also referred to as net income or net loss) is reported on the income statement for a given period of time, typically 3 months or 1 year. The ending profit or loss will be combined with prior profit and loss reporting on the balance sheet financial statement. The income statement and balance sheet are therefore related.

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Depending on the business type the income statement might be called a profit and loss statement or other names. Different accounting methodologies can also produce different profit and loss results for the exact same business as long as it is reported consistently. The two general methodologies: Cash basis and accrual basis, will be covered in another lesson.

Reports the profit and loss activity for a specified period of time

  • Different accounting methods produce different income statement results
  • The ending profit or loss will be reported on the balance sheet.

 

The Balance Sheet

Defined / Example

Defined / Example A stakeholder may also be interested in the assets, liabilities, prior performance, and investors a business has.  The balance sheet reports this information in the form of Assets, Liabilities, and Equity. Assets include cash, accounts receivable, equipment, inventory, and more. Liabilities include accounts payablenotes payableaccrued expenses, and more. Equity includes a record of money that has been invested into the business and a record of accumulated profits and losses referred to as retained earnings. The larger the business is there are several different sections of Assets, Liabilities, and Equity, but all balance sheet items are defined in these three categories.

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The balance sheet allows stakeholders critical information that cannot be found on the income statement. A business could be very profitable, but the balance sheet will give clues as to how the business became profitable. A rental building for example could show a large profit, but the balance sheet may show that there is a profit only because an investor contributed $1,000,000 cash to the business. A factory could show losses, but a look at the balance sheet could provide clues that the business owns valuable equipment, inventory, and property that could be sold at a later date. Therefore the income statement and balance sheet form a relationship together and are most valuable when viewed together.

The balance sheet also provides a check and balance to ensure that all transactions have been recorded. The financial statement is referred to as a balance sheet because Assets = Liabilities + Equity. A = L + E forms the accounting equation which also may be expressed as Equity = Assets – Liabilities. Let’s say a $1,000,000 property is purchased with $200,000 cash and $800,000 loan. The balance sheet would be expressed as: $1,000,000 Assets = $800,000 Liability + $200,000 Equity. The Equity at time of purchase roughly translates into the value that the owner has in the property. This same transaction could be expressed as $200,000 Equity = $1,000,000 Assets – $800,000 Liability.

Equity on the balance sheet is generally comprised of investment and the prior profit and loss reporting from the income statement. Let’s say a small business is started with a $50,000 investment. The $50,000 was not earned, so it would not show up on the income statement. The transaction would show up on the balance sheet as $50,000 Asset = $0 Liability + $50,000 Equity. The second major component of equity is retained earnings which tracks the profit and loss over time. Let’s say that this same business earned $10,000 for a speaking engagement and had no other expenses for the year. Now there is $60,000 cash in the bank, and $10,000 profit from