very well hold a PhD from an Ivy League school! What I mean is that the external user is less educated about the company’s operations. The external user usually has no clue what is going on within the company because this person isn’t privy to the day-to-day operations.
In contrast, the internal users of the financial statements are employees, department heads, and other company management — all folks who work at the business.
The facts and figures shown on the financial statements give the people and businesses using them a bird’s-eye view of how well the business is performing. For example, looking at the balance sheet, you can see how much debt the business owes and what resources it has to pay that debt. The income statement shows how much money the company is making, both before and after business expenses are deducted. Finally, the statement of cash flows shows how well the company is using its cash. A company can bring in a boat-load of cash, but if it’s spending that cash in an unwise manner, it’s not a healthy business.
This chapter provides only a brief look at each financial statement. While you prepare each statement using the same accounting facts (see Chapter 5), each one presents those facts in a slightly different way. I provide more detailed information about the three financial statements in other sections of this book: Look to Part 3 for balance sheet info, Chapter 10 for the lowdown on the income statement, and Chapter 11 for a discussion of counting dollars and cents on the statement of cash flows.
Reporting Assets and Claims: The Balance Sheet
The balance sheet shows the health of a business from the day the business started operations to the specific date of the balance sheet report. Therefore, it reflects the business’s financial position. Most accounting textbooks use the clichéd expression that the balance sheet is a “snapshot” of the company’s financial position at a point in time. This expression means that when you look at the balance sheet as of December 31, 2021, you know the company’s financial position as of that date.
The proof of this balancing act is shown in the balance sheet when the three balance sheet components perfectly interact with each other. This interaction is called the fundamental accounting equation and takes place when
Assets = Liabilities + Equity
Not sure what assets, liabilities, and equity are? No worries — you find out about each later in this section. But first, I explain the classification of the balance sheet. And nope, all you James Bond fans, it doesn’t have anything to do with having top-secret security clearance.
Realizing why the balance sheet is “classified”
A classified balance sheet groups similar accounts together. For example, all current assets (see Chapter 7) such as cash and accounts receivable show up in one grouping, and all current liabilities (see Chapter 8) such as accounts payable and other short-term debt show up in another. This grouping is done for the ease of the balance sheet user so that person doesn’t have to go on a scavenger hunt to round up all similar accounts.
Also, people who aren’t accounting geeks (poor them!) may not even know which accounts are short-term versus long-term (continuing more than one year past the balance sheet date), or equity as opposed to assets. By classifying accounts on the balance sheets, the financial accountant gives them information that is easy to use and more comparable.
Studying the balance sheet components
Three sections appear on the balance sheet: assets, liabilities, and equity. Standing on their own, they contain valuable information about a company. However, a user has to see all three interacting together on the balance sheet to form a reliable opinion about the company.
Assets
Assets are resources a company owns. Examples of assets are cash, accounts receivable, inventory, fixed assets, prepaid expenses, and other assets. I fully discuss each of these assets in other chapters in this book (starting with Chapter 7), but here’s a brief description of each to get you started:
Cash: Cash includes accounts such as the company’s operating checking account, which the business uses to receive customer payments and pay business expenses, and imprest accounts, in which the company maintains a fixed amount of cash, such as petty cash. Petty cash refers to any bills and coins the company keeps handy for insignificant daily expenses. For example, the business runs out of toilet paper in the staff bathroom and sends an employee to the grocery store down the block to buy enough to last until the regular shipment arrives.
Accounts receivable: This account shows all money customers owe to a business for completed sales transactions. For example, Business A sells merchandise to Business B with the agreement that B pays for the merchandise within 30 business days. Business A includes the amount of the transaction in its accounts receivable.
Inventory: For a merchandiser — a retail business that sells to the general public, like your neighborhood grocery store — any goods available for sale are included in its inventory. For a manufacturing company — a business that makes the items merchandisers sell — inventory also includes the raw materials used to make those items. See both Chapters 7 and 13 for more information about inventory.
Fixed assets: The company’s property, plant, and equipment are all fixed assets. This category includes long-lived tangible assets, such as the company-owned car, land, buildings, office equipment, and computers. See Chapters 7 and 12 for more information about fixed assets.
Prepaid expenses: Prepaids are expenses that the business pays for in advance, such as rent, insurance, office supplies, postage, travel expense, or advances to employees.
Other assets: Any other resources owned by the company go into this catch-all category. Security deposits are a good example of other assets. Say the company rents an office building, and as part of the lease it pays a $1,000 security deposit. That $1,000 deposit appears in the “other assets” section of the balance sheet until the property owner reimburses the business at the end of the lease.
Liabilities
Liabilities are claims against the company’s assets. Usually, they consist of money the company owes to others. For example, the debt can be owed to an unrelated third party, such as a bank, or to employees for wages earned but not yet paid. Some examples of liabilities are accounts payable, payroll