and out: The statement of cash flows
This chapter provides a brief overview of the three key financial statements: the balance sheet, income statement, and statement of cash flows. (Later in the book, I go into much more detail about each one.) If you’re going to be an accountant, you have to get to know financial statements backward and forward. To get you moving in the right direction, I show you the purpose of each financial statement and which accounts show up on each. I also offer a thumbnail sketch of how accounts on one statement interact with accounts on another.
You find out about the three balance sheet components: assets, liabilities, and equity. I also discuss the various sections on the income statement, including the difference between revenue from operations and other gains and losses. You learn why a statement of cash flows is so crucially important to users of financial statements that are prepared using the accrual method of accounting. And finally, I introduce the three sections of the statement of cash flows — operating, investing, and financing — and explain what types of information you record in each.
You may never love financial statements so much that they become your bedtime or beachside reading material. But if you decide to pursue a career in accounting, you have to enjoy spending time with them at least a little because they’re crucial to the work you do.
Gauging the Health of a Business through Its Financials
You may have heard accounting referred to as the “language of business.” That’s because financial statements are the end result of the accounting process, and these written reports are used by many different people and entities to make their own important investment and business decisions.
External users of the financial statements differ from internal users in that the external user is generally less educated than the internal user. When I say less educated, I’m not referring to this person’s formal education; an external user may 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
