Accounting For Dummies. John A. Tracy

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sheet pointers

      So where does a business get the money to buy its assets? Most businesses borrow money on the basis of interest-bearing notes or other credit instruments for part of the total capital they need for their assets. Also, businesses buy many things on credit and, at the balance sheet date, owe money to their suppliers, which will be paid in the future.

      These operating liabilities are never grouped with interest-bearing debt in the balance sheet. The accountant would be tied to the stake for doing such a thing. Liabilities are not intermingled with assets — this is a definite no-no in financial reporting. You can’t subtract certain liabilities from certain assets and report only the net balance.

Could a business’s total liabilities be greater than its total assets? Well, not likely — unless the business has been losing money hand over fist. In the vast majority of cases, a business has more total assets than total liabilities. Why? For two reasons:

       Its owners have invested money in the business.

       The business has earned profit over the years, and some (or all) of the profit has been retained in the business. Making profit increases assets; if not all the profit is distributed to owners, the company’s assets rise by the amount of profit retained.

      

In the company example (see Figure 2-2), owners’ equity is about $16 million, or $15.959 million to be more exact. Sometimes this amount is referred to as net worth because it equals total assets minus total liabilities. However, net worth can be misleading because it implies that the business is worth the amount recorded in its owners’ equity accounts. The market value of a business, when it needs to be known, depends on many factors. The amount of owners’ equity reported in a balance sheet, which is called the business’s book value, is not irrelevant in setting a market value on the business, but it usually isn’t the dominant factor. The amount of owners’ equity in a balance sheet is based on the history of capital invested in the business by its owners and the history of its profit performance and distributions from profit.

      

A balance sheet could be whipped up anytime you want — say, at the end of every day. In fact, some businesses (such as banks and other financial institutions) need daily balance sheets, but few businesses prepare balance sheets that often. Typically, preparing a balance sheet at the end of each month is adequate for general management purposes — although a manager may need to look at the business’s balance sheet in the middle of the month. In external financial reports (those released outside the business to its lenders and investors), a balance sheet is required at the close of business on the last day of the income statement period. If its annual or quarterly income statement ends, say, September 30, then the business reports its balance sheet at the close of business on September 30.

      The profit for the most recent period is found in the income statement; periodic profit is not reported in the balance sheet. The profit reported in the income statement is before any distributions from profit to owners. The cumulative amount of profit over the years that hasn’t been distributed to the business’s owners is reported in the owners’ equity section of the company’s balance sheet.

By the way, notice that the balance sheet in Figure 2-2 is presented in a top-and-bottom format instead of a left-and-right format. Either the vertical (portrait) or horizontal (landscape) mode of display is acceptable. You see both layouts in financial reports. Of course, the two sides of the balance sheet should be kept together, either on one page or on facing pages in the financial report. You can’t put assets up front and hide the other side of the balance sheet in the rear of the financial report.

The Statement of Cash Flows

      To survive and thrive, business managers confront three financial imperatives:

       Make an adequate profit (or at least break even, for a not-for-profit entity). The income statement reports whether the business made a profit or suffered a loss for the period.

       Keep the financial condition in good shape. The balance sheet reports the financial condition of the business at the end of the period.

       Control cash flows. Management’s control over cash flows is reported in the statement of cash flows, which presents a summary of the business’s sources and uses of cash during the same period as the income statement.

      This section introduces you to the statement of cash flows. (We coauthored Cash Flow For Dummies, published by Wiley, which you may want to take a peek at for more information.) Financial reporting standards require that the statement of cash flows be reported when a business reports an income statement.

      Presenting the components of the statement of cash flows

      Successful business managers tell you that they have to manage both profit and cash flow; you can’t do one and ignore the other. Business managers have to deal with a two-headed dragon in this respect. Ignoring cash flow can pull the rug out from under a successful profit formula.

Figure 2-3 shows the basic information components of the statement of cash flows for the business example we’ve been using in this chapter. The cash activity of the business during the period is grouped into five sections:

       First, almost all statements of cash flow start where the income statement left off — that is, by presenting the net profit or loss for the period. You’ll notice that the net profit at the bottom of the income statement in Figure 2-1 agrees with the net profit at the top of the statement of cash flows in Figure 2-3 (which it should).

       Second, all non-cash expenses such as depreciation and amortization expenses are called out, which get added back to net profit. This should make sense given that the expenses are “non-cash.”

       The third figure reconciles net income for the period with the cash flow from the business’s profit-making activities, or operating activities, including increases and decreases in current assets (for example, trade accounts receivables and inventory) and current liabilities (for example, trade accounts payables and accrued liabilities).

       The fourth figure summarizes the company’s investing transactions during the period, or more specifically, what long-term assets the company purchased or invested in.

       And finally the fifth figure reports the company’s financing transactions, or more specifically, whether the company raised cash from securing a loan or selling stock or whether the company used cash to repay loans or issue a dividend.

      The net increase or decrease in cash from the five types of cash activities during the period is added to or subtracted from the beginning cash balance to get the cash balance at the end of the year.

      In the example, the business earned a $4.482 million profit (net income) during the year (see Figure 2-1), which included non-cash expenses of $1.739 million (primarily for depreciation expense) that need to be added back to properly reconcile cash changes during the period. The cash result of its operating activities was to increase its cash by $1.372 million, which you see in the first part of the statement of cash flows (see Figure 2-3). The actual cash inflows from revenues and outflows for expenses run on a different

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