Preparing Financial Statements - Basic Concepts
The Income Statement (Also called the "Profit and Loss" Statement)
The income statement shows the financial results of operations for a period of time. Think of it as a “diary” of what transpired for, say, a 12-month period (e.g., “For the Year Ended 2005”). From the income statement, one can determine the level of profit or loss because amounts received from selling goods and services and other items of income are matched against all the costs and expenses incurred in the delivery of these goods and services. The major elements of an income statement are:
- Net Sales – represents the primary source of money received by the business from its customers for goods sold or services rendered. The net sales item covers the amount received after taking into consideration returned goods and allowances for reduction of prices.
- Cost of Sales and Operating Expenses – all costs incurred in the factory (including depreciation) in order to convert raw materials into finished products.
- Operating Profit – net sales less all operating costs
- Interest Income – additional source of revenue from investments
- Interest Expense – interest paid to creditors
- Provision for Income Tax – amount of income tax due
The Balance Sheet
The balance sheet presents the financial position of a business as of a specific date, much like a “snapshot” (e.g., As of December 2005). It is a report on the financial resources (assets) available to the business to carry out its economic activities as well as claims (liabilities) against its resources. The difference between assets and liabilities is the owner’s equity. This follows the fundamental accounting equation: Assets = Liabilities + Owner’s Equity.
The main elements of the balance sheet are:
- Assets – economic resources of a business such as buildings, equipment, land, motor vehicles, amounts owed by customers (accounts receivable), patents and bank deposits.
- Liabilities – economic obligations to pay definite or reasonably certain amounts at a time in the future. They are claims against the business by creditors.
- Owner’s Equity – residual interest of the owners in the business.
The specific elements of the balance sheet are:
- Current Assets – include cash and those assets which in the normal course of business will be turned into cash generally within a year from date of balance sheet. These consist of cash, marketable securities (or temporary investments), accounts receivable, inventories and prepaid expenses (payments made in advance, such as insurance, from which the business has not yet received benefits). Therefore, current assets are mostly working assets in the sense that they are constantly being converted to cash.
- Fixed Assets – also referred to as property, plant and equipment, these represent those assets not intended for sale that are used over and over again in order to manufacture the product, display it, warehouse it, transport it. Fixed assets generally consist of land, buildings, machinery, and office equipment.
- Depreciation – defined for accounting purposes as the decline in useful value of a fixed asset due to wear and tear from use and passage of time. Fixed assets may also suffer a decline in useful value from obsolescence because new inventions and more advanced technologies are introduced. The cost incurred to acquire the property, plant and equipment must be spread over the expected useful life. The usual method used is straight-line depreciation. Land is not subject to depreciation.
- Current Liabilities – generally includes all debts that fall due in the coming year. Payments made on current debts generally come from a business’ current assets.
- Accounts Payable – represents the amounts that the business owes to its regular business creditors from whom it has bought goods or services.
- Notes Payable – money owed to a bank or other lender (wherein a written promissory note has been given by the borrower).
- Accrued Expenses Payable – may include salaries and wages payable to employees, interest on funds borrowed from banks, insurance premiums and similar items. To the extent that the amounts owed are unpaid as of the balance sheet date, these expenses are grouped as a total under accrued expenses payable.
- Income Taxes Payable – amount of taxes owed and due
- Long-term Liabilities – debts due after one year from the date of the financial report
It would do well to prepare the income statement and the balance sheet on a regular basis to guide the entrepreneur on critical decisions that must be made with regard to the business. There are a number of technology solutions available to aid the entrepreneur in generating these financial reports.