owns a wide variety of long-term operating assets that have useful lives from 3 to 30 years or longer (building, machines, tools, computers, office furniture, goodwill, intellectual property, and so on).
It has been in business for many years and has made a profit most years.
It borrows money for part of the total assets it needs.
It’s organized as a corporation and pays federal and state income taxes on its annual taxable income.
It has never been in bankruptcy and is not facing any immediate financial difficulties.
The following sections present the company’s annual income statement for the year just ended, its balance sheet at the end of the year, and its statement of cash flows for the year.
Looking at other aspects of reporting financial statements
The financial statements in this chapter are more in the nature of an outline. Actual financial statements use only one- or two-word account titles on the assumption that you know what all these labels mean. What you see in this chapter, on the other hand, are the basic information components of each financial statement. We explain the full-blown, classified, detailed financial statements in Part 2. (We know you’re eager to get to those chapters.) In this chapter, we offer descriptions for each financial statement element rather than the terse and technical account titles you find in actual financial statements. Also, we strip out subtotals that you see in actual financial statements because they aren’t necessary at this point.
The Income Statement
First on the minds of financial report readers is the profit performance of the business. The income statement is the all-important financial statement that summarizes the profit-making activities of a business over a period of time. Figure 2-1 shows the basic information content of an external income statement for our company example. External means that the financial statement is released outside the business to those entitled to receive it — primarily its shareowners and lenders. Internal financial statements stay within the business and are used mainly by its management; they aren’t circulated outside the business because they contain competitive and confidential information.
Presenting the components of the income statement
Figure 2-1 presents the major ingredients, or information packets, in the income statement for a technology company that sells products and services. As you may expect, the income statement starts with sales revenue on the top line. There’s no argument about this, although in the past, certain companies didn’t want to disclose their annual sales revenue (to hide the large percent of profit they were earning on sales revenue).
Sales revenue is the total amount that has been or will be received from the company’s customers for the sales of products and services to them. Simple enough, right? Well, not really. The accounting profession is currently reexamining the technical accounting standards for recording sales revenue, and this has proven to be a challenging task. Our business example, like most businesses, has adopted a certain set of procedures for the timeline of recording its sales revenue.
Recording expenses involves much more troublesome accounting problems than revenue problems for most businesses. Also, there’s the fundamental question regarding which information to disclose about expenses and which information to bury in larger expense categories in the external income statement. We say much more about expenses in later chapters. At this point, direct your attention to the five kinds of expenses in Figure 2-1. Expenses are deducted from sales revenue to determine the final profit for the period, which is referred to as the bottom line. Actually, the preferred label is net income, as you see in the figure.
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FIGURE 2-1: Income statement information components for a technology company that sells products and services.
Only one conglomerate operating expense has to be disclosed. In Figure 2-1, it’s called selling, general, and administrative expenses, which is a popular title in income statements. This is an all-inclusive expense total that mixes together many kinds of expenses, including administrative employee wages and benefit costs, advertising expenses, depreciation of assets, and so on. But it doesn’t include interest expenses, income tax expenses, or other expenses; these three expenses are generally reported separately in an income statement.
The cost of goods sold or cost of sales expense and the selling, general, and administrative expenses take the biggest bites out of sales revenue. The other three expenses (interest, income tax, and other expenses) are relatively small as a percent of annual sales revenue but are important enough in their own right to be reported separately. And though you may not need this reminder, bottom-line profit (net income) is the amount of sales revenue in excess of the business’s total expenses. If either sales revenue or any of the expense amounts are wrong, then profit is wrong.
