Chapter 8. For now, here’s a brief description of each:
Accounts payable: This is a current liability reflecting the amount of money the company owes to its vendors. This category is the flip side of accounts receivable because an account receivable on one company’s balance sheet appears as an account payable on the other company’s balance sheet.
Payroll liabilities: Most companies accrue payroll and related payroll taxes, which means a company owes its employees money but has not yet paid them. This process is easy to understand if you think about the way you’ve been paid by an employer in the past. Most companies have a built-in lag time between when employees earn their wages and when the paychecks are cut.In addition to recording unpaid wages in this account, the company also has to add in any payroll taxes or benefits that will be deducted from the employee’s paycheck when the check is finally cut.
Short-term notes payable: Notes payable that are due in full less than 12 months after the balance sheet date are short-term — or could be the short-term portion of a long-term note. For example, a business may need a brief influx of cash to pay mandatory expenses such as payroll. A good example of this situation is a working capital loan, which a bank makes with the expectation that the loan will be paid back from the collection of the borrower’s accounts receivable.
Long-term notes payable: If a short-term note has to be paid back within 12 months after the balance sheet date, you’ve probably guessed that a long-term note is paid back after that 12-month period! A good example of a long-term note is a mortgage. Mortgages are used to finance the purchase of real property assets (see Chapters 7 and 12).
Equity
Equity shows the owners’ total investment in the business, which is their claim to the corporate assets. As such, it shows the difference between assets and liabilities. It’s also known as net assets or net worth. Examples of equity are retained earnings and paid-in capital. I fully discuss both equity accounts in Chapter 9. For now, here’s a brief description of each:
Retained earnings: This account shows the result of income and dividend transactions. For example, the business opens on March 1, 2021. As of December 31, 2021, it has cleared $50,000 (woohoo!) but has also paid $10,000 in dividends to shareholders. The retained earnings number is $40,000 ($50,000 – $10,000).Retained earnings accumulate year after year — therefore the “retained” in the account name. So, if in 2022 the same business makes $20,000 and pays no dividends, the retained earnings as of December 31, 2022, are $60,000 ($40,000 + $20,000).
Paid-in capital: This element of equity reflects stock and additional paid-in capital. Nope, you’re not seeing a typo! There is a paid-in capital account called “additional paid-in capital.” In brief, here’s what the two types of equity are:Stock: Corporations raise money by selling stock — pieces of the corporation — to interested investors. Stock sold to investors usually comes in two different types: common and preferred. Each type of stock has its own characteristics and advantages, which I discuss fully in Chapter 9.Additional paid-in capital: This equity account reflects the amount of money the investors pay over the stock’s par value. Par value is the price printed on the face of the stock certificate and quite often is set at a random dollar amount. For example, if the par value of JMS, Inc. stock is $10 per share and you buy 100 shares at $15 per share, additional paid-in capital is $500 ($5 times 100 shares).
Seeing an example of a classified balance sheet
A classified balance sheet groups together similar accounts so the financial statement user has an easier time reading it. In Chapter 7, I show you a blown-out balance sheet that is structured in accordance with generally accepted accounting principles (GAAP; see Chapter 4). In Figure 2-1, I give you a very abbreviated version of what a classified balance sheet looks like.
FIGURE 2-1: An abbreviated classified balance sheet.
Posting Profit or Loss: The Income Statement
Next up in your exciting walkthrough of the three financial statements is (drum roll, please) … the income statement, which shows income, expenses, gains, and losses. It’s also known as a statement of profit or loss (or P&L) — mostly among non-accountants, particularly small business owners. As the true financial accountant that you are (or soon will be!), you use the term income statement rather than statement of profit or loss.
Here, I provide only a brief introduction to the income statement. For the complete scoop on the income statement, the accounts reflecting on it, and how to prepare one, see Chapter 10.
Keeping a scorecard for business activity
The income statement shows financial results for the period it represents. It lets the user know how the business is doing in the short-term. And you have to keep in mind that the company’s performance is not just a question of whether it made or lost money during the financial period. The issue at hand is more a matter of the relationship among the different accounts on the income statement.
For example, maybe you see that a company’s gross profit, which is the difference between sales and cost of goods sold, is $500,000. (Not sure what cost of goods sold is? No worries — you can find out in the next section of this chapter!) Based on the amount of gross sales or historical trends, you expect gross profit to be $700,000. Well, your scorecard is coming in $200,000 short — not good. And if you’re a member of company management or an owner, you need to find out why.
Perhaps you’re saying, “But wait — what about the equity section of the balance sheet? Doesn’t that provide a scorecard too?” Well, think back to the definition of retained earnings I give earlier in this chapter: Retained earnings is the accumulated total of net income or loss from the first day the company is in business all the way to the date on the balance sheet (less dividends and other items that I discuss in Chapter