Understanding Accounts
Monday, November 25, 2013
It's not just accountancy specialists who deal
with spreadsheets, and figures, and the financial side of
business. It's highly likely that, as a line manager or department
head, you're going to have to analyze a spreadsheet at some point,
or have some form of financial recording to do as part of your job
description.
However, if you feel baffled by balance
sheets, or confused by cash flow statements, then read on. This
article will take you through the basics of finance for
non-financial managers, to help you become familiar with the
terminology – and what it all means.
Financial management is a crucial aspect of
any thriving business. Profit maximization, or stockholder wealth
maximization, are two real concerns for any organization – and
they depend on solid financial decisions. To make good decisions,
management needs good information. And that information comes from
the accounting system.
From the accounting system come the financial
statements. These statements contain important information about
the organization's operating results. This information is
important for effective management, and financial control. As a
manager, or any other person with financial responsibility, you
have to be able to interpret this information yourself.
Financial statements contain important
information about your company's operating results and financial
position. The relationship between certain items of financial data
can be used to identify areas where your firm excels and, more
importantly, where there are opportunities for improvement. Using,
understanding, and interpreting these statements will help you
make much better business decisions.
The Basic Financial Statements
Businesses record their performance in
standard formats called financial statements. The most common of
these are:
Balance Sheet (also known as a Statement of Financial Position,
or a Statement of Financial Condition).
Income Statement (Statement of Profit and Loss, Statement of
Earnings, Statement of Operations).
Cash Flow Statement.
While these statements look at different aspects of the company,
they are interrelated and dependent on each other, as information
from one is needed to prepare the others. The key to understanding
accounts is to have a good grasp of what the basic statements are
there to do: how they are prepared, what they tell you, and what
they don't.
Tip 1:
This article refers to many accounting and finance terms, many
of which can be found in our
Words Used In… Financial Accounting
article.
Tip 2:
If you're not at all familiar with accounts, this article is
going to seem quite complicated. However, this is hugely
important information once you get beyond a certain level in
your career, so it's worth persisting with it!
Read this article three times: firstly, skim it to get an
overview of what the income statement, balance sheet, and cash
flow statements are. Then give it a thorough re-read so that you
understand what's happening in detail. Finally, work through
again to cement your understanding. And if you have any
questions, just ask in the forums!
The Bookkeeping Process
Every time your organization conducts a business transaction, the
status of the accounts changes. In a retail company, for example,
when a sale is made, the cash account increases, and the inventory
decreases. The bookkeeping process keeps track of these changes in
various ledgers and journals. The financial statements are then
prepared using this information.
Accounting is based on the fundamental accounting equation:
Total Assets = Total Liabilities + Equity
This essentially means that the difference between what the
business owns and what it owes represents the equity the company's
owners have.
To keep this equation in balance means that, with each
transaction, at least two accounts – and the balances in those
accounts – will change. Accounting is the process of keeping track
of those changes, and recording and then reporting them.
Transaction Example: On August 2, 2008, Tom's Plumbing purchased a
computer for $1500 with $500 cash deposit, and the remainder on a
store credit program. There are three accounts affected:
The asset account 'Equipment.'
The asset account 'Cash.'
The liability account 'Accounts Payable.'
These specific accounts can be found in what is called the Chart
of Accounts. The titles Equipment, Cash, and Accounts Payable are
not random; these are specific accounts that were identified as
relevant to the company before it began operating as a business.
The Chart of Accounts is a list of all the accounts used by a
company to record financial transactions. The accounts are grouped
according to type, and then numbered using the following
conventions:
Asset 101-199.
Liability 200-299.
Equity 300-399.
Revenue 400-499.
Expense 500-599 (some systems use 600s).
To keep track of transactions efficiently, a General Journal
(Original Book of Entry) is used. The journal records what
happened, the accounts affected, and the dollar amounts.
Once you've identified the accounts that are involved, you need to
apply the rules of what accountants call 'transaction analysis.'
This involves the following:
Asset and Expense accounts are increased by a debit, and decreased by a credit.
Liabilities, Equity, and Revenue accounts are increased by a credit, and decreased by a debit.
Example:
Having a chronological record of the business' transactions is
very useful, should you need to go back and review a particular
transaction at a later date. The problem with keeping information
in this format, though, is that there is no way to determine what
the actual balance in each account is after each transaction. For
example, you may need to know how much cash is actually in the
cash account, and thus in the bank account, at any given time. To
keep track of account balances, accountants use what is called a
General Ledger.
The General Ledger consists of ledger accounts, one for each
account set up in the Chart of Accounts. Debits and credits to
each account are posted to the ledger from the journal, and the
balance is kept current. Posting is the process of transferring
amounts from the general journal to specific general ledger
accounts. Because entries are recorded in the ledger after the
journal, the general ledger is often called the Book of Final
Entry.
Here's an example:
Note the account balances from the previous month in the Cash and
Bank Loan accounts. The 'Balance' column is used to keep a running
total of the account balances.
The journalizing and posting process are the first two steps of
the entire accounting cycle. From there, the Financial Statements
are prepared.
As mentioned earlier, the financial statements are interrelated.
To better understand the relationship between these statements,
we'll look at Tom's Plumbing statements as they change from the
start of an accounting period to the end.
Balance Sheet
A Balance Sheet indicates the financial position of a business at
one point in time; it shows what the business owns and owes. The
general journal captures day-to-day account balances. At the end
of an accounting period, a Balance Sheet is prepared.
The Balance Sheet has three sections:
Assets – the things of value that the company owns.
Liabilities – obligations to pay or provide goods or services at some later date.
Equity – the amount of net assets (assets - liabilities) owing to the owners of the business.
The Balance Sheet is named as such because the total of the assets must equal the total of the liabilities and equity. What a company owns equals what it owes to its creditors and owners.
Tom's Plumbing
Balance Sheet
As at July 31, 2008
Assets
Liabilities
Cash
5,500
Bank Loan
5,000
Inventory
8,000
Accounts Payable
1,000
Accounts Receivable
3,500
Total Liabilities
6,000
Equipment
2,500
Equity
Paid in Capital
10,000
Retained Earnings
3,500
Total Equity
13,500
Total Assets
19,500
Total Liabilities & Equity
19,500
As at July 31, Tom's Plumbing has $19,500 in Assets, $6,000 in
Liabilities, and $13,500 in Equity.
The accounting staff at Tom's Plumbing dutifully record all the
transactions that occur during the month of August, and they
prepare an Income Statement to summarize the information.
Income Statement
At certain points during the year, each business wants to know how
well it is doing. Is it earning a profit? Is it losing money? Just
how well is it doing compared to other firms? Is it likely to be
able to earn a profit in the future? To answer these questions, it
uses an Income Statement.
The Income Statement communicates the inflow of revenue , and the
outflow of expenses , over a given period of time. Revenue is the
inflow of assets (i.e. cash or accounts receivable) to a company
in return for services performed, or goods sold. Expenses are the
outflow or consumption of assets (i.e. cash, inventory, supplies),
or obligations incurred (i.e. accounts payable, taxes payable)
while generating revenue. The difference between these two is the Net Income .
An Income Statement therefore shows the operating profit (or loss)
The Balance Sheet is named as such because the total of the assets must equal the total of the liabilities and equity. What a company owns equals what it owes to its creditors and owners.
Tom's Plumbing
Income Statement
For the month ended August 31, 2008
Revenue
Sales Revenue
7,000
Repair Revenue
3,000
Total Revenue
10,000
Expenses
Rent
550
Wages
2,300
Inventory
4,000
Depreciation
200
Total Expenses
7,050
Net Income
2,950
The Net Income amount is the amount by which a company's equity
increases or decreases for the period. An equity account is used
to record the change that results from business operations. In a
proprietorship, this is typically called Retained Earnings. In
corporations, it is called Owner's Equity.
When Tom's Plumbing goes to prepare its Balance Sheet as at August
31, 2008, it must include the $2950 of Net Income as an increase
to the Retained Earnings Account. The Balance Sheet for the end of
the month is also prepared:
Many people are inclined to think that, because Tom's Plumbing had
a net income of $2950, the cash account increased by $2950. As you
can see, this is not the case: cash increased by only $550. The
reason for this is because income can be accounted for in ways
other than cash; and activities other than operations, like
financing and investment, can affect cash. To get an accurate
picture of the actual cash generated by a business in a period you
must prepare a Cash Flow Statement (Statement of Changes in
Financial Position).
Cash Flow Statement
The Cash Flow Statement records inflows and outflows of cash
during a period of time, and is divided into cash flow from
operations, financing, and investing activities. To prepare a
statement of cash flow you must convert net income from
accrual-based accounting to cash. You therefore have to add and
subtract changes in non-cash accounts that have accrued during the
period.
For instance, you need to add back depreciation amounts, because
although depreciation expense decreases net income, it has no
bearing on actual cash. Likewise, you have to deduct any decreases
in accounts payable because that is a use of cash that was not
accounted for on the Income Statement. The following table
outlines the major sources and uses of cash:
Sources of Cash
Uses of Cash
Operations.
New loans.
New stock issues or owner investment.
Sale of property, plant, or equipment.
Sale of other non-current assets
Cash dividends.
Repayment of loans.
Repurchase of stock.
Purchase of property, plant, or equipment.
Purchase of other non-current asset.
By analyzing the differences between the balance sheets for the
beginning of the period and the end of the period, and accounting
for the net income for the period, you can prepare a Cash Flow
Statement:
The $550 dollar increase in cash has been explained by converting
accrued amounts into actual cash value.
Understanding the interrelatedness of the financial statements is
very important when reading and interpreting them. Understanding
where the numbers come from, and what they actually mean, is
extremely important when evaluating your own performance, or
comparing your performance to others.
Financial Statement Interpretation
Armed with some knowledge of accounts, it's important to
understand what the statements actually tell you.
What an Income Statement says:
The Income Statement reports the main and any secondary sources
of income. For example, Fees Earned would be the primary revenue
in a dental office. If they had bonds, a secondary source of
revenue would be Interest Earned from Bond Investment.
The terms used to describe the revenue will provide a clue about
the nature of the organization. For example, Fees Earned implies a
service company; Commissions Earned implies a brokerage; while
Sales Revenue implies a retail or wholesale firm.
The items listed as expenses are expired, meaning they have no
useful value left.
The result of matching the revenues and expenses yields the Net
Income or Net Earnings if the statement is called the Earnings
Statement. The term 'net' implies that the revenues and expenses
have been matched, and therefore there is not an over or under
statement of the income (loss).
What an Income Statement does not say:
An Income Statement does not predict the future net income for
any accounting period. Since the future is full of uncertainty, a
reader of a historical Income Statement can't rely on the reported
results of any single period for an indication of future results.
An Income Statement, no matter how well prepared, does not
provide an exact measurement of net income for the accounting
period. No matter how hard you try, it is impossible to get an
exact match. Consider, for example, an advertising expense. If
management spent $1,000 in December on advertising, and achieved
$5,000 sales revenue for December, that does not mean that the
advertising brought in exactly $5,000 revenue. There may also be
revenue generated in January that can be attributed to the
December advertising. When it is difficult to measure, the expense
is accounted for in the period it was incurred.
An Income Statement does not report True Profit, which is the
difference between total funds invested over the life of the
company and funds realized from the sale of the company. To
calculate this, you would have to calculate the difference between
assets invested during the lifetime of the business, and the
amount finally received from remaining assets after winding up the
business. You would also have to deduct any personal withdrawals
because these were actually paid out of the 'profits.'
Net Income does not mean cash! Always keep in mind that net
income is the excess revenue over related expenses for a specific
accounting period. Cash has very little to do with determining net
income. True, revenue refers to an inflow of cash and expense to
an outflow, but often the inflow of cash is used for further
investment. Additionally, revenues and expenses are recorded at
the time of occurrence, not when cash changes hands. What about
the case of depreciation expense which does not represent an
outflow of cash at all?
What a Balance Sheet says:
A Balance Sheet gives readers a detailed summary of the assets
and claims against those assets, as at a particular date.
A Balance Sheet provides the reader with information about the
financial position of the firm with regard to its ability to pay
current debts. By comparing the current assets to the current
liabilities, the reader can assess whether the company is in a
position to meet to meet its short-term financial obligations.
A Balance Sheet gives the reader a view of the firm's financial
position to carry on its business operations. The fixed-asset
section indicates how many resources the company has working for
it to assist in revenue generation.
Finally, a Balance Sheet reveals the strength of the owner's
claim against the assets. Remember, however, that this claim is
residual, or the remaining claim after the creditors'.
What a Balance Sheet does not say:
A Balance Sheet does not report the details of how the profits
were made. That information comes from the Income Statement.
A Balance Sheet does not show the claims of the creditors and
the owner(s) against a specific asset. The claims are against the
assets in general.
The word 'Capital' under owner's equity must not be interpreted
as cash. The investment can come in many forms – cash being just
one of them. The owner's original cash investment may have gone
primarily to purchase fixed assets in order to assist revenue
generation. Capital means investment not cash.
A Balance Sheet does not report the market value, current value,
or worth of a business. Many readers believe the total assets
represent a bundle of future cash reserves. This is not true
because fixed assets are reported at historical cost, and their
purpose is to assist revenue generation. They are not intended for
sale to enhance cash flow.
Key Points
Accounting is a language unto itself. To become perfectly fluent
takes a great deal of training and experience. Thankfully,
non-financial managers, and other employees with financial
responsibility, can learn to be conversant with the key
terminology. The bookkeeping process is how day-to-day
transactions are recorded. Balances in the various accounts are
tracked and summarized in the financial statements. The financial
statements bring the cycle full circle as they reflect the changes
that happened during the accounting period. By understanding this
cycle, you have a much better appreciation for the numbers on the
financial statements, and you can use them to make sound
managerial decisions.
Tags:
Career Skills, Skills
with spreadsheets, and figures, and the financial side of
business. It's highly likely that, as a line manager or department
head, you're going to have to analyze a spreadsheet at some point,
or have some form of financial recording to do as part of your job
description.
However, if you feel baffled by balance
sheets, or confused by cash flow statements, then read on. This
article will take you through the basics of finance for
non-financial managers, to help you become familiar with the
terminology – and what it all means.
Financial management is a crucial aspect of
any thriving business. Profit maximization, or stockholder wealth
maximization, are two real concerns for any organization – and
they depend on solid financial decisions. To make good decisions,
management needs good information. And that information comes from
the accounting system.
From the accounting system come the financial
statements. These statements contain important information about
the organization's operating results. This information is
important for effective management, and financial control. As a
manager, or any other person with financial responsibility, you
have to be able to interpret this information yourself.
Financial statements contain important
information about your company's operating results and financial
position. The relationship between certain items of financial data
can be used to identify areas where your firm excels and, more
importantly, where there are opportunities for improvement. Using,
understanding, and interpreting these statements will help you
make much better business decisions.
The Basic Financial Statements
Businesses record their performance in
standard formats called financial statements. The most common of
these are:
Balance Sheet (also known as a Statement of Financial Position,
or a Statement of Financial Condition).
Income Statement (Statement of Profit and Loss, Statement of
Earnings, Statement of Operations).
Cash Flow Statement.
While these statements look at different aspects of the company,
they are interrelated and dependent on each other, as information
from one is needed to prepare the others. The key to understanding
accounts is to have a good grasp of what the basic statements are
there to do: how they are prepared, what they tell you, and what
they don't.
Tip 1:
This article refers to many accounting and finance terms, many
of which can be found in our
Words Used In… Financial Accounting
article.
Tip 2:
If you're not at all familiar with accounts, this article is
going to seem quite complicated. However, this is hugely
important information once you get beyond a certain level in
your career, so it's worth persisting with it!
Read this article three times: firstly, skim it to get an
overview of what the income statement, balance sheet, and cash
flow statements are. Then give it a thorough re-read so that you
understand what's happening in detail. Finally, work through
again to cement your understanding. And if you have any
questions, just ask in the forums!
The Bookkeeping Process
Every time your organization conducts a business transaction, the
status of the accounts changes. In a retail company, for example,
when a sale is made, the cash account increases, and the inventory
decreases. The bookkeeping process keeps track of these changes in
various ledgers and journals. The financial statements are then
prepared using this information.
Accounting is based on the fundamental accounting equation:
Total Assets = Total Liabilities + Equity
This essentially means that the difference between what the
business owns and what it owes represents the equity the company's
owners have.
To keep this equation in balance means that, with each
transaction, at least two accounts – and the balances in those
accounts – will change. Accounting is the process of keeping track
of those changes, and recording and then reporting them.
Transaction Example: On August 2, 2008, Tom's Plumbing purchased a
computer for $1500 with $500 cash deposit, and the remainder on a
store credit program. There are three accounts affected:
The asset account 'Equipment.'
The asset account 'Cash.'
The liability account 'Accounts Payable.'
These specific accounts can be found in what is called the Chart
of Accounts. The titles Equipment, Cash, and Accounts Payable are
not random; these are specific accounts that were identified as
relevant to the company before it began operating as a business.
The Chart of Accounts is a list of all the accounts used by a
company to record financial transactions. The accounts are grouped
according to type, and then numbered using the following
conventions:
Asset 101-199.
Liability 200-299.
Equity 300-399.
Revenue 400-499.
Expense 500-599 (some systems use 600s).
To keep track of transactions efficiently, a General Journal
(Original Book of Entry) is used. The journal records what
happened, the accounts affected, and the dollar amounts.
Once you've identified the accounts that are involved, you need to
apply the rules of what accountants call 'transaction analysis.'
This involves the following:
Asset and Expense accounts are increased by a debit, and decreased by a credit.
Liabilities, Equity, and Revenue accounts are increased by a credit, and decreased by a debit.
Example:
Having a chronological record of the business' transactions is
very useful, should you need to go back and review a particular
transaction at a later date. The problem with keeping information
in this format, though, is that there is no way to determine what
the actual balance in each account is after each transaction. For
example, you may need to know how much cash is actually in the
cash account, and thus in the bank account, at any given time. To
keep track of account balances, accountants use what is called a
General Ledger.
The General Ledger consists of ledger accounts, one for each
account set up in the Chart of Accounts. Debits and credits to
each account are posted to the ledger from the journal, and the
balance is kept current. Posting is the process of transferring
amounts from the general journal to specific general ledger
accounts. Because entries are recorded in the ledger after the
journal, the general ledger is often called the Book of Final
Entry.
Here's an example:
Note the account balances from the previous month in the Cash and
Bank Loan accounts. The 'Balance' column is used to keep a running
total of the account balances.
The journalizing and posting process are the first two steps of
the entire accounting cycle. From there, the Financial Statements
are prepared.
As mentioned earlier, the financial statements are interrelated.
To better understand the relationship between these statements,
we'll look at Tom's Plumbing statements as they change from the
start of an accounting period to the end.
Balance Sheet
A Balance Sheet indicates the financial position of a business at
one point in time; it shows what the business owns and owes. The
general journal captures day-to-day account balances. At the end
of an accounting period, a Balance Sheet is prepared.
The Balance Sheet has three sections:
Assets – the things of value that the company owns.
Liabilities – obligations to pay or provide goods or services at some later date.
Equity – the amount of net assets (assets - liabilities) owing to the owners of the business.
The Balance Sheet is named as such because the total of the assets must equal the total of the liabilities and equity. What a company owns equals what it owes to its creditors and owners.
Tom's Plumbing
Balance Sheet
As at July 31, 2008
Assets
Liabilities
Cash
5,500
Bank Loan
5,000
Inventory
8,000
Accounts Payable
1,000
Accounts Receivable
3,500
Total Liabilities
6,000
Equipment
2,500
Equity
Paid in Capital
10,000
Retained Earnings
3,500
Total Equity
13,500
Total Assets
19,500
Total Liabilities & Equity
19,500
As at July 31, Tom's Plumbing has $19,500 in Assets, $6,000 in
Liabilities, and $13,500 in Equity.
The accounting staff at Tom's Plumbing dutifully record all the
transactions that occur during the month of August, and they
prepare an Income Statement to summarize the information.
Income Statement
At certain points during the year, each business wants to know how
well it is doing. Is it earning a profit? Is it losing money? Just
how well is it doing compared to other firms? Is it likely to be
able to earn a profit in the future? To answer these questions, it
uses an Income Statement.
The Income Statement communicates the inflow of revenue , and the
outflow of expenses , over a given period of time. Revenue is the
inflow of assets (i.e. cash or accounts receivable) to a company
in return for services performed, or goods sold. Expenses are the
outflow or consumption of assets (i.e. cash, inventory, supplies),
or obligations incurred (i.e. accounts payable, taxes payable)
while generating revenue. The difference between these two is the Net Income .
An Income Statement therefore shows the operating profit (or loss)
The Balance Sheet is named as such because the total of the assets must equal the total of the liabilities and equity. What a company owns equals what it owes to its creditors and owners.
Tom's Plumbing
Income Statement
For the month ended August 31, 2008
Revenue
Sales Revenue
7,000
Repair Revenue
3,000
Total Revenue
10,000
Expenses
Rent
550
Wages
2,300
Inventory
4,000
Depreciation
200
Total Expenses
7,050
Net Income
2,950
The Net Income amount is the amount by which a company's equity
increases or decreases for the period. An equity account is used
to record the change that results from business operations. In a
proprietorship, this is typically called Retained Earnings. In
corporations, it is called Owner's Equity.
When Tom's Plumbing goes to prepare its Balance Sheet as at August
31, 2008, it must include the $2950 of Net Income as an increase
to the Retained Earnings Account. The Balance Sheet for the end of
the month is also prepared:
Many people are inclined to think that, because Tom's Plumbing had
a net income of $2950, the cash account increased by $2950. As you
can see, this is not the case: cash increased by only $550. The
reason for this is because income can be accounted for in ways
other than cash; and activities other than operations, like
financing and investment, can affect cash. To get an accurate
picture of the actual cash generated by a business in a period you
must prepare a Cash Flow Statement (Statement of Changes in
Financial Position).
Cash Flow Statement
The Cash Flow Statement records inflows and outflows of cash
during a period of time, and is divided into cash flow from
operations, financing, and investing activities. To prepare a
statement of cash flow you must convert net income from
accrual-based accounting to cash. You therefore have to add and
subtract changes in non-cash accounts that have accrued during the
period.
For instance, you need to add back depreciation amounts, because
although depreciation expense decreases net income, it has no
bearing on actual cash. Likewise, you have to deduct any decreases
in accounts payable because that is a use of cash that was not
accounted for on the Income Statement. The following table
outlines the major sources and uses of cash:
Sources of Cash
Uses of Cash
Operations.
New loans.
New stock issues or owner investment.
Sale of property, plant, or equipment.
Sale of other non-current assets
Cash dividends.
Repayment of loans.
Repurchase of stock.
Purchase of property, plant, or equipment.
Purchase of other non-current asset.
By analyzing the differences between the balance sheets for the
beginning of the period and the end of the period, and accounting
for the net income for the period, you can prepare a Cash Flow
Statement:
The $550 dollar increase in cash has been explained by converting
accrued amounts into actual cash value.
Understanding the interrelatedness of the financial statements is
very important when reading and interpreting them. Understanding
where the numbers come from, and what they actually mean, is
extremely important when evaluating your own performance, or
comparing your performance to others.
Financial Statement Interpretation
Armed with some knowledge of accounts, it's important to
understand what the statements actually tell you.
What an Income Statement says:
The Income Statement reports the main and any secondary sources
of income. For example, Fees Earned would be the primary revenue
in a dental office. If they had bonds, a secondary source of
revenue would be Interest Earned from Bond Investment.
The terms used to describe the revenue will provide a clue about
the nature of the organization. For example, Fees Earned implies a
service company; Commissions Earned implies a brokerage; while
Sales Revenue implies a retail or wholesale firm.
The items listed as expenses are expired, meaning they have no
useful value left.
The result of matching the revenues and expenses yields the Net
Income or Net Earnings if the statement is called the Earnings
Statement. The term 'net' implies that the revenues and expenses
have been matched, and therefore there is not an over or under
statement of the income (loss).
What an Income Statement does not say:
An Income Statement does not predict the future net income for
any accounting period. Since the future is full of uncertainty, a
reader of a historical Income Statement can't rely on the reported
results of any single period for an indication of future results.
An Income Statement, no matter how well prepared, does not
provide an exact measurement of net income for the accounting
period. No matter how hard you try, it is impossible to get an
exact match. Consider, for example, an advertising expense. If
management spent $1,000 in December on advertising, and achieved
$5,000 sales revenue for December, that does not mean that the
advertising brought in exactly $5,000 revenue. There may also be
revenue generated in January that can be attributed to the
December advertising. When it is difficult to measure, the expense
is accounted for in the period it was incurred.
An Income Statement does not report True Profit, which is the
difference between total funds invested over the life of the
company and funds realized from the sale of the company. To
calculate this, you would have to calculate the difference between
assets invested during the lifetime of the business, and the
amount finally received from remaining assets after winding up the
business. You would also have to deduct any personal withdrawals
because these were actually paid out of the 'profits.'
Net Income does not mean cash! Always keep in mind that net
income is the excess revenue over related expenses for a specific
accounting period. Cash has very little to do with determining net
income. True, revenue refers to an inflow of cash and expense to
an outflow, but often the inflow of cash is used for further
investment. Additionally, revenues and expenses are recorded at
the time of occurrence, not when cash changes hands. What about
the case of depreciation expense which does not represent an
outflow of cash at all?
What a Balance Sheet says:
A Balance Sheet gives readers a detailed summary of the assets
and claims against those assets, as at a particular date.
A Balance Sheet provides the reader with information about the
financial position of the firm with regard to its ability to pay
current debts. By comparing the current assets to the current
liabilities, the reader can assess whether the company is in a
position to meet to meet its short-term financial obligations.
A Balance Sheet gives the reader a view of the firm's financial
position to carry on its business operations. The fixed-asset
section indicates how many resources the company has working for
it to assist in revenue generation.
Finally, a Balance Sheet reveals the strength of the owner's
claim against the assets. Remember, however, that this claim is
residual, or the remaining claim after the creditors'.
What a Balance Sheet does not say:
A Balance Sheet does not report the details of how the profits
were made. That information comes from the Income Statement.
A Balance Sheet does not show the claims of the creditors and
the owner(s) against a specific asset. The claims are against the
assets in general.
The word 'Capital' under owner's equity must not be interpreted
as cash. The investment can come in many forms – cash being just
one of them. The owner's original cash investment may have gone
primarily to purchase fixed assets in order to assist revenue
generation. Capital means investment not cash.
A Balance Sheet does not report the market value, current value,
or worth of a business. Many readers believe the total assets
represent a bundle of future cash reserves. This is not true
because fixed assets are reported at historical cost, and their
purpose is to assist revenue generation. They are not intended for
sale to enhance cash flow.
Key Points
Accounting is a language unto itself. To become perfectly fluent
takes a great deal of training and experience. Thankfully,
non-financial managers, and other employees with financial
responsibility, can learn to be conversant with the key
terminology. The bookkeeping process is how day-to-day
transactions are recorded. Balances in the various accounts are
tracked and summarized in the financial statements. The financial
statements bring the cycle full circle as they reflect the changes
that happened during the accounting period. By understanding this
cycle, you have a much better appreciation for the numbers on the
financial statements, and you can use them to make sound
managerial decisions.
