Financial Statements

INCOME STATEMENT

The income statement reports the profit that a business generates over a period of time.  Profit is calculated as revenue minus expenses and is typically measured over a month, quarter or year.  Matching is an accounting principle that requires the revenue in a period to be aligned with the expenses to generate that revenue.  This timing is accomplished by recording accruals, prepaid expenses, and depreciation of assets.  The income statement has a standard presentation format.

Accruals

A business might pay the interest expense on a loan at the end of each quarter.  Therefore, when producing a monthly income statement, one third of the quarterly interest expense should be reported, or accrued, even though it hasn’t actually been paid yet.

Prepaids

Whereas an accrual is used for expenses that haven’t been paid yet, a prepaid expense is one that has been paid, but not yet fully consumed.  For example, a company may pay its annual insurance premium as a one-time payment in advance.    This should be booked initially to the balance sheet as an asset, then one twelfth amortized each month in the income statement.

Depreciation

A company may purchase equipment that has a useful life of multiple years.  It would be misleading to report such a large expense in a single month in the income statement.  Therefore, an asset is first recorded on the balance sheet, then depreciated.  The depreciation expense is typically calculated on a straight-line basis, by dividing the cost of the asset by the number of months of estimated useful life.

Presentation & Materiality

The income statement is presented in a logical flow, with the type of account in rows.  Revenue is reported in the top row.  This is followed by cost of goods sold (COGS), which is the raw material costs, plus other direct expenses required to make the products that were sold.  Typically, the next row is a sub total called gross profit, which is revenue minus COGS.

Then all the other expenses are listed, such as payroll, sales and general administrative expenses, interest, depreciation and taxes.  The bottom line is called net income, which is the company’s profit (or loss) after subtracting all the expenses from revenue.

Materiality is a concept used in accounting and when recording transactions.  For example, if a small equipment item is purchased that has a useful life of two years, can this simply be expensed in the month purchased instead of setting up a depreciation schedule?  This determination should be made based on an assessment of materiality.  An item is considered material if, individually or in aggregate, a misstatement would influence the judgement of a user of the financial statements.

 

BALANCE SHEET

Whereas the income statement reports results over a period of time, the balance sheet is a statement of a company’s financial net worth at a point in time.  It shows what a company owns and what it owes at the end of a period, such as the last day of the month, or year.  There are three main categories on the balance sheet: assets, liabilities and equity.  The balance sheet can be represented by an algebraic formula:

Assets = Liabilities + Equity

Assets

Assets are items that have future economic value and will typically be consumed in business operations as an expense over time.  Assets that will be consumed within the next 12 months are called current assets, while fixed assets have a life longer than one year.  Examples of assets are cash, inventory, unpaid customer invoices (accounts receivable), plant, property and equipment.  Prepaid expenses, and intangibles like goodwill, patents and other intellectual property are also assets.  Assets can be converted to other assets, for example cash can be used to buy equipment.  Alternatively, assets are consumed, such as selling inventory, amortizing prepaid expenses, or depreciating fixed assets.  Note that such consumption will show up in the income statement.

Liabilities

Liabilities are future obligations, or something the company must pay in the future.  Current liabilities are expected to be settled in the next 12 months, while long-term liabilities would be paid beyond that period.  Examples of liabilities are bills owed to suppliers (accounts payable), taxes payable, or loans.

Equity

Equity is the company net worth or capital that belongs to the owners.  If the company sold all its assets and paid all the liabilities, the money left would be the equity and belong to the owners.  However, it’s important to realize that the balance sheet reflects the accounting equity, or book value of the company, not necessarily its true market value.  For example, if a building was purchased ten years ago for $1 million and partially depreciated, it would be reflected on the balance sheet at this historic cost less the depreciation.  However, the building might be worth $2 million today due to appreciation in the real estate market.

 

STATEMENT OF CASH FLOWS

Profit does not always translate to cash, due to items like accruals and depreciation discussed above.  The cash flow statement reports the inflow and outflow of cash, and provides a reconciliation of net income to operating cash flow.   It’s typically broken out in three sections.

Cash from Operating Activities

This section starts with net income from the income statement and adjusts for non-cash items, such as adding back depreciation expense, subtracting unpaid customer invoices from revenue, and subtracting expenses that have not been paid yet to suppliers, due to credit terms.

Cash from Investing Activities

This section reports the cash received or used from selling or purchasing fixed assets, or long-term securities.

Cash from Financing Activities

The final section deals with cash obtained from loans, or cash used to pay back loans, and money distributed to the business owners.

The bottom line of the cash flow statement shows the net change in cash for the period, and the ending cash balance, which will match the cash amount on the balance sheet.

 

In conclusion, financial statements are key tools to analyze business performance.  Business owners should review them regularly and may benefit from the assistance of an accounting professional for a more in-depth understanding of financial results.