a bit more about owner’s equity accounting later in this chapter because the owner’s equity sections look different for partnerships and corporations. Before I get into that, however, let me make two important observations about the balance sheet shown in Table 1-4:
✓ A balance sheet needs to balance. This means that the total assets must equal the total liabilities and owner’s equity. In the balance sheet shown in Table 1-4, for example, total assets show as $4,000. Total liabilities and owner’s equity also show as $4,000. This equality is no coincidence. If an accounting system works right, and the accountants and bookkeepers entering information into this system do their jobs right, the balance sheet balances.
✓ A balance sheet provides a snapshot of a business’s financial condition at a particular point in time. I mention in the introductory remarks related to Table 1-4 that the balance sheet in this table shows the financial condition of the hot-dog-stand business immediately before the day’s business activities begin.
By convention, businesses prepare balance sheets to show the financial condition at the end of the period of time for which an income statement is prepared. A business typically prepares an income statement on an annual basis. In this orthodox situation, a firm also prepares a balance sheet at the very end of the year.
At this point, I return to something that I allude to earlier in the chapter: the fact that the owner’s equity section of a balance sheet looks different for different types of businesses.
Table 1-5 shows how the owner’s equity section of a balance sheet looks for a partnership. In Table 1-5, I show how the owner’s equity section of the hot-dog-stand business appears if, instead of having a sole proprietor named S. Nelson running the stand, the business is actually owned and operated by three partners named Tom, Dick, and Harry. In this case, the partners’ equity section shows the amounts originally invested and any amounts reinvested by the partners. As is the case with sole proprietorships, each partner’s contributions and reinvested profits appear on a single line.
TABLE 1-5 Owner’s Equity for a Partnership
Go ahead and take a look at Table 1-6. It shows how the owner’s equity section looks for a corporation.
TABLE 1-6 Owner’s Equity for a Corporation
This next part is a little bit weird. For a corporation, the amounts that appear in the owner’s equity or shareholders’ equity section actually fall into two major categories: retained earnings and contributed capital. Retained earnings represent profits that the shareholders have left in the business. Contributed capital is the money originally contributed by the shareholders to the corporation.
The retained-earnings thing makes sense, right? That’s just the money – the profits – that investors have reinvested in the business.
The contributed-capital thing is more complicated. Here’s how it works. If you buy a share of stock in some new corporation – for, say, $5 – typically, some portion of that price per share is for par value. Now, don’t ask me to justify par value. It stems from business practices that were common a century or more ago. Just trust that typically, if you pay some amount – again, say $5 – for a share, some portion of the amount that you pay – maybe 10 cents a share or $1 a share – is for par value.
In the owner’s equity section of a corporation’s balance sheet, capital that’s contributed by original investors is broken down into the amounts paid for this mysterious par value and the amounts paid in excess of this par value. In Table 1-6, you can see that $100 of shareholders’ equity or owner’s equity represents amounts paid for par value. Another $400 of the amounts contributed by the original investors represents amounts paid in excess of par value. The total shareholders’ equity, or total corporate owner’s equity, equals the sum of the capital stock par value, the contributed capital and excess of par value, and any retained earnings. So in Table 1-6, the total shareholders’ equity equals $1,000.
Statement of cash flows
Now I come to the one tricky financial statement: the statement of cash flows.
Before I begin, I have one comment to make about the statement of cash flows: As an accountant, I’ve worked with many bright managers and businesspeople. No matter how much hand-holding and explanation I (or other accountants) provide, some of these smart people never quite get some of the numbers on the statement of cash flows. In fact, many of the students who major in accounting never (in my opinion, at least) quite understand how a statement of cash flows really works.
For this reason, don’t spend too much time spinning your wheels on this statement or trying to understand what it does. QuickBooks does supply a statement of cash flows, but you don’t need to use this statement. In fact, QuickBooks produces cash basis income statements, which give you almost the same information – and in a format that’s easier to understand.
I think the best way to explain what a statement of cash flows does is to ask you to look again at the balance sheet shown in Table 1-4 earlier in this chapter. This table is the balance sheet for the imaginary hot dog stand at the beginning of the day.
Now take a look at Table 1-7, which shows the balance sheet at the end of the day, after operations for the hot dog stand have ended. Notice that at the start of the day (see Table 1-4), cash equals $1,000, and at the end of the day (see Table 1-7), cash equals $5,000. The statement of cash flows explains why cash changes from the one number to the other number over a period of time. In other words, a statement of cash flows explains how cash goes from $1,000 at the start of the day to $5,000 at the end of the day.
TABLE 1-7 Another Simple Balance Sheet
Table 1-8, not coincidentally, shows a statement of cash flows that explains how cash flowed for your imaginary hot-dog-stand business. If you’re reading this book, presumably you need to understand this statement. I start at the bottom of the statement and work up.
TABLE 1-8 A Simple Statement of Cash Flows
The last three lines of the statement of cash flows are all easily understandable. The cash balance at the end of the period, $5,000, shows what cash the business holds at the end of the day. The cash balance at the start of the period, $1,000, shows the cash that the business holds at the beginning of the day. Both the cash balance at the start of the period and the cash balance at the end of the period tie to the cash balance values reported in the two balance sheets. (Look at Table 1-4 and Table 1-7 to corroborate this assertion.) Clearly, if you start the period with $1,000 and end the period with $5,000, cash has increased by $4,000. That’s an arithmetical certainty. No question there, right?
The financing activities of the statement of cash flows show how firm borrowing and firm debt repayment affect the firm cash flow. If the hot-dog-stand business uses its profits to repay the $1,000 loan payable – and in this case, this is what happened – this $1,000 cash outflow shows up in the financing activities portion of
