Brand names such as coca-cola and mcdonald's are examples of intangible assets.

The Balance Sheet

A balance sheet is the financial statement that reports a firm’s financial condition at a specific time. As highlighted in the sample balance sheet in Figure 17.5 (for our hypothetical vegetarian restaurant Very Vegetarian introduced in Chapter 13), assets are listed in a separate column from liabilities and owners’ (or stockholders’) equity. The assets are equal to, or balanced with, the liabilities and owners’ (or stockholders’) equity. The balance sheet is that simple.

figure 17.5: SAMPLE VERY VEGETARIAN BALANCE SHEET

 Current assets: Items that can be converted to cash within one year.

 Fixed assets: Items such as land, buildings, and equipment that are relatively permanent.

 Intangible assets: Items of value such as patents and copyrights that don’t have a physical form.

 Current liabilities: Payments that are due in one year or less.

 Long-term liabilities: Payments not due for one year or longer.

 Owner’s equity: The value of what stockholders own in a firm (also called stockholder’s equity).

balance sheet

Financial statement that reports a firm’s financial condition at a specific time and is composed of three major accounts: assets, liabilities, and owners’ equity.

Let’s say you want to know what your financial condition is at a given time. Maybe you want to buy a house or car and therefore need to calculate your available resources. One of the best measuring sticks is your balance sheet. First, add up everything you own—cash, property, and money owed you. These are your assets. Subtract from that the money you owe others—credit card debt, IOUs, car loan, and student loan. These are your liabilities. The resulting figure is your net worth, or equity. This is fundamentally what companies do in preparing a balance sheet: they follow the procedures set in the fundamental accounting equation. In that preparation, it’s important to follow generally accepted accounting principles (GAAP).

Since it’s critical that you understand the financial information on the balance sheet, let’s take a closer look at what is in a business’s asset account and what is in its liabilities and owners’ equity accounts.

Classifying Assets

Assets are economic resources (things of value) owned by a firm. Assets include productive, tangible items such as equipment, buildings, land, furniture, and motor vehicles that help generate income, as well as intangible items with value like patents, trademarks, copyrights, and goodwill. Goodwill represents the value attached to factors such as a firm’s reputation, location, and superior products. Goodwill is included on a balance sheet when one firm acquires another and pays more for it than the value of its tangible assets. Intangible assets like brand names can be among the firm’s most valuable resources. Think of the value of brand names such as Starbucks, Coca-Cola, McDonald’s, and Apple. Not all companies, however, list intangible assets on their balance sheets.

assets

Economic resources (things of value) owned by a firm.

Accountants list assets on the firm’s balance sheet in order of their liquidity, or the ease with which they can convert them to cash. Speedier conversion means higher liquidity. For example, an account receivable is an amount of money owed to the firm that it expects to receive within one year. It is considered a liquid asset because it can be quickly converted to cash. Land, however, is not considered a liquid asset because it takes time, effort, and paperwork to sell. It is considered as a fixed or long-term asset. Assets are thus divided into three categories, according to how quickly they can be turned into cash:

liquidity

The ease with which an asset can be converted into cash.

1. Current assets are items that can or will be converted into cash within one year. They include cash, accounts receivable, and inventory.

current assets

Items that can or will be converted into cash within one year.

2. Fixed assets are long-term assets that are relatively permanent such as land, buildings, and equipment. (On the balance sheet we also refer to these as property, plant, and equipment.)

fixed assets

Assets that are relatively permanent, such as land, buildings, and equipment.

3. Intangible assets are long-term assets that have no physical form but do have value. Patents, trademarks, copyrights, and goodwill are intangible assets.

intangible assets

Long-term assets (e.g., patents, trademarks, copyrights) that have no real physical form but do have value.

Liabilities and Owners’ Equity Accounts

Liabilities are what the business owes to others—its debts. Current liabilities are debts due in one year or less. Long-term liabilities are debts not due for one year or more. The following are common liability accounts recorded on a balance sheet (look at Figure 17.5 again):

liabilities

What the business owes to others (debts).

1. Accounts payable are current liabilities or bills the company owes others for merchandise or services it purchased on credit but has not yet paid for.

accounts payable

Current liabilities are bills the company owes to others for merchandise or services purchased on credit but not yet paid for.

2. Notes payable can be short-term or long-term liabilities (like loans from banks) that a business promises to repay by a certain date.

notes payable

Short-term or long-term liabilities that a business promises to repay by a certain date.

3. Bonds payable are long-term liabilities; money lent to the firm that it must pay back. (We discuss bonds in depth in Chapters 18 and 19.)

bonds payable

Long-term liabilities that represent money lent to the firm that must be paid back.

As you saw in the fundamental accounting equation, the value of things you own (assets) minus the amount of money you owe others (liabilities) is called equity. The value of what stockholders own in a firm (minus liabilities) is called stockholders’ equity or shareholders’ equity. Because stockholders are the owners of a firm, we also call stockholders’ equity owners’ equity, or the amount of the business that belongs to the owners, minus any liabilities the business owes. The formula for owners’ equity, then, is assets minus liabilities.

(Nickels 473-475)

Nickels, William. Understanding Business, 10th Edition. McGraw-Hill Learning Solutions, 40913. VitalBook file.

The Income Statement

The financial statement that shows a firm’s bottom line—that is, its profit after costs, expenses, and taxes—is the income statement. The income statement summarizes all the resources, called revenue, that have come into the firm from operating activities, money resources the firm used up, expenses it incurred in doing business, and resources it has left after paying all costs and expenses, including taxes. The resources (revenue) left over or depleted are referred to as net income or net loss (see Figure 17.7).

figure 17.7: SAMPLE VERY VEGETARIAN INCOME STATEMENT

 Revenue: Value of what’s received from goods sold, services rendered, and other financial sources.

 Cost of goods sold: Cost of merchandise sold or cost of raw materials or parts used for producing items for resale.

 Gross profit: How much the firm earned by buying or selling merchandise.

 Operating expenses: Cost incurred in operating a business.

 Net income after taxes: Profit or loss over a specific period after subtracting all costs and expenses, including taxes.

income statement

The financial statement that shows a firm’s profit after costs, expenses, and taxes; it summarizes all of the resources that have come into the firm (revenue), all the resources that have left the firm (expenses), and the resulting net income or net loss.

net income or net loss

Revenue left over after all costs and expenses, including taxes, are paid.

The income statement reports the firm’s financial operations over a particular period of time, usually a year, a quarter of a year, or a month. It’s the financial statement that reveals whether the business is actually earning a profit or losing money. The income statement includes valuable financial information for stockholders, lenders, potential investors, employees, and of course the government. Because it’s so valuable, let’s take a quick look at how to compile the income statement. Then we will discuss what each element in it means.

Drew Albert owns popular CJ’s All-American Grill in Walnut Creek, California. The restaurant earns revenue by selling American fare like this “danger dog.” What is the difference between revenue and gross profit? Between gross profit and net income before taxes?

Revenue

Revenue is the monetary value of what a firm received for goods sold, services rendered, and other payments (such as rents received, money paid to the firm for use of its patents, interest earned, etc.). Be sure not to confuse the terms revenue and sales; they are not the same thing. True, most revenue the firm earns does come from sales, but companies can also have other sources of revenue. Also, a quick glance at the income statement shows you that gross sales refers to the total of all sales the firm completed. Net sales are gross sales minus returns, discounts, and allowances.

Cost of Goods Sold

The cost of goods sold (or cost of goods manufactured) measures the cost of merchandise the firm sells or the cost of raw materials and supplies it used in producing items for resale. It makes sense to compare how much a business earned by selling merchandise and how much it spent to make or buy the merchandise. The cost of goods sold includes the purchase price plus any freight charges paid to transport goods, plus any costs associated with storing the goods.

cost of goods sold (or cost of goods manufactured)

A measure of the cost of merchandise sold or cost of raw materials and supplies used for producing items for resale.

In financial reporting, it doesn’t matter when a firm places a particular item in its inventory, but it does matter how an accountant records the cost of the item when the firm sells it. To find out why, read the Spotlight on Small Business box on p. 478 about two different inventory valuation methods.

When we subtract the cost of goods sold from net sales, we get gross profit or gross margin. Gross profit (or gross margin) is how much a firm earned by buying (or making) and selling merchandise. In a service firm, there may be no cost of goods sold; therefore, gross profit could equal net sales. Gross profit does not tell you everything you need to know about the firm’s financial performance. To get that, you must also subtract the business’s expenses.

gross profit (or gross margin)

How much a firm earned by buying (or making) and selling merchandise.

Operating Expenses

In selling goods or services, a business incurs certain operating expenses such as rent, salaries, supplies, utilities, and insurance. Other operating expenses that appear on an income statement, like depreciation, are a bit more complex. For example, have you ever heard that a new car depreciates in market value as soon as you drive it off the dealer’s lot? The same principle holds true for assets such as equipment and machinery. Depreciation is the systematic write-off of the cost of a tangible asset over its estimated useful life. Under accounting rules set by GAAP and the Internal Revenue Service (which are beyond the scope of this chapter), companies are permitted to recapture the cost of these assets over time by using depreciation as an operating expense.

operating expenses

Costs involved in operating a business, such as rent, utilities, and salaries.

depreciation

The systematic write-off of the cost of a tangible asset over its estimated useful life.

 SPOTLIGHT ON SMALL business: What’s Coming and Going at the College Bookstore?

www.aicpa.org

Generally accepted accounting principles (GAAP) sometimes permit an accountant to use different methods of accounting for a firm’s inventory. Let’s look at two possible treatments—FIFO and LIFO.

Say a college bookstore buys 100 copies of a particular textbook in July at $100 a copy. When classes begin, the bookstore sells 50 copies of the text to students at $120 each. Since the book will be used again next term, the store places the 50 copies it did not sell in its inventory until then.

In late December, when the bookstore orders 50 additional copies of the text to sell for the coming term, the publisher’s price has increased to $110 a copy due to inflation and other production and distribution costs. The bookstore now has in its inventory 100 copies of the same textbook from different purchase cycles. If it sells 50 copies to students at $120 each at the beginning of the new term, what’s the bookstore’s cost of the book for accounting purposes? Actually, it depends.

The books are identical, but the accounting treatment could be different. If the bookstore uses a method called first in, first out (FIFO), the cost of goods sold is $100 for each textbook, because the textbook the store bought first—the first in—cost $100. The bookstore could use another method, however. Under last in, first out (LIFO), its last purchase of the textbooks, at $110 each, determines the cost of each of the 50 textbooks sold.

If the book sells for $120, what is the difference in gross profit (margin) between using FIFO and using LIFO? As you can see, the inventory valuation method used makes a difference.

We can classify operating expenses as either selling or general expenses. Selling expenses are related to the marketing and distribution of the firm’s goods or services, such as advertising, salespeople’s salaries, and supplies. General expenses are administrative expenses of the firm such as office salaries, depreciation, insurance, and rent. Accountants are trained to help you record all applicable expenses and find other relevant expenses you can deduct from your taxable income as a part of doing business.

Net Profit or Loss

After deducting all expenses, we can determine the firm’s net income before taxes, also referred to as net earnings or net profit (see Figure 17.7 again). After allocating for taxes, we get to the bottom line, which is the net income (or perhaps net loss) the firm incurred from revenue minus sales returns, costs, expenses, and taxes over a period of time. We can now answer the question “Did the business earn or lose money in the specific reporting period?”

As you can see, the basic principles of the balance sheet and income statement are already familiar to you. You know how to keep track of costs and expenses when you prepare your own budget. If your rent and utilities exceed your earnings, you know you’re in trouble. If you need more money, you may need to sell some of the things you own to meet your expenses. The same is true in business. Companies need to keep track of how much money they earn and spend, and how much cash they have on hand. The only difference is that they tend to have more complex problems and a good deal more information to record than you do.

Most businesses incur operating expenses including rent, salaries, utilities, supplies, and insurance. What are some of the likely operating expenses for this firm?

Users of financial statements are interested in how a firm handles the flow of cash coming into a business and the cash flowing out of the business. Cash flow problems can plague both businesses and individuals. Keep this in mind as we look at the statement of cash flows next.

The Statement of Cash Flows

The statement of cash flows reports cash receipts and cash disbursements related to the three major activities of a firm:

statement of cash flows

Financial statement that reports cash receipts and disbursements related to a firm’s three major activities: operations, investments, and financing.

 Operations are cash transactions associated with running the business.

 Investments are cash used in or provided by the firm’s investment activities.

 Financing is cash raised by taking on new debt, or equity capital or cash used to pay business expenses, past debts, or company dividends.

Accountants analyze all changes in the firm’s cash that have occurred from operating, investing, and financing in order to determine the firm’s net cash position. The statement of cash flows also gives the firm some insight into how to handle cash better so that no cash-flow problems occur—such as having no cash on hand for immediate expenses.26

Figure 17.8 on p. 480 shows a sample statement of cash flows, again using the example of Very Vegetarian. As you can see, the statement of cash flows answers such questions as: How much cash came into the business from current operations, such as buying and selling goods and services? Did the firm use cash to buy stocks, bonds, or other investments? Did it sell some investments that brought in cash? How much money did the firm take in from issuing stock?

figure 17.8: SAMPLE VERY VEGETARIAN STATEMENT OF CASH FLOWS

 Cash receipts from sales, commissions, fees, interest, and dividends. Cash payments for salaries, inventories, operating expenses, interest, and taxes.

 Includes cash flows that are generated through a company’s purchase or sale of long-term operational assets, investments in other companies, and its lending activities.

 Cash inflows and outflows associated with the company’s own equity transactions or its borrowing activities.

Cash flow is the difference between money coming into and going out of a business. Careful cash flow management is a must for a business of any size, but it’s particularly important for small businesses and for seasonal businesses like ski resorts. Have you read of any firms that were forced into bankruptcy because of cash flow problems?

We analyze these and other financial transactions to see their effect on the firm’s cash position. Managing cash flow can mean success or failure of any business, which is why we analyze it in more depth in the next section.

The Need for Cash Flow Analysis

Cash flow, if not properly managed, can cause a business much concern. Understanding cash flow analysis is important and not difficult to understand.27 Let’s say you borrow $100 from a friend to buy a used bike and agree to pay her back at the end of the week. You then sell the bike for $150 to someone else, who also agrees to pay you by the end of the week. Unfortunately, by the weekend your buyer does not have the money as promised, and says he will have to pay you next month. Meanwhile, your friend wants the $100 you agreed to pay her by the end of the week!

What seemed a great opportunity to make an easy $50 profit is now a cause for concern. You owe $100 and have no cash. What do you do? If you were a business, you might default on the loan and possibly go bankrupt, even though you had the potential for profit.

It’s possible for a business to increase its sales and profits yet still suffer cash flow problems.28 Cash flow is simply the difference between cash coming in and cash going out of a business. Poor cash flow constitutes a major operating problem for many companies and is particularly difficult for small and seasonal businesses.29 Accountants sometimes face tough ethical challenges in reporting the flow of funds into a business. Read the Making Ethical Decisions box to see how such an ethical dilemma can arise.

 MAKING ethical decisions: Barking Up the Wrong Financial Statement

www.fasb.gov

The recession of the late 2000s hit small manufacturers very hard. Many did not survive the downturn. You are the lone accountant employed by Keegan’s Feast, a small producer of premium dog food that sells directly online. Many of the company’s customers became cost-conscious during the downturn and purchased lower-cost brands. Fortunately with the economy recovering, many of the firm’s old customers are returning and things are looking up. The problem is the company’s cash flow suffered during the recession, and the firm needs immediate funding to continue to pay its bills. You know the CEO has prepared a proposal to a local bank asking for short-term financing. Unfortunately, you are aware that Keegan’s financial statements for the past year will not show good results. Your expectation is the bank will not approve the loan on the basis of the financial information even though the firm seems to be coming back.

Before you close the books for the end of the year, the CEO suggests you might “improve” the company’s financial statements by treating the sales made at the beginning of January of the current year as if they were made in December of the past year. He is confident the company auditors will not discover the discrepancy.

You know this is against the rules of the Financial Accounting Standards Board (FASB), and you refuse to alter the information. The CEO warns that without the bank loan, the business is likely to close, meaning you and everyone else will be out of a job. You know he’s probably right, and also know it’s unlikely the firm’s employees will find new jobs. What are your alternatives? What are the likely consequences of each? What will you do?

How do cash flow problems start? Often in order to meet the growing demands of customers, a business buys goods on credit (using no cash). If it then sells a large number of goods on credit (getting no cash), the company needs more credit from a lender (usually a bank) to pay its immediate bills. If a firm has reached its credit limit and can borrow no more, it has a severe cash flow problem. It has cash coming in at a later date, but no cash to pay current expenses. That problem could, unfortunately, force the firm into bankruptcy, even though sales may be strong—all because no cash was available when it was most needed. Cash flow analysis shows that a business’s relationship with its lenders is critical to preventing cash flow problems. Accountants can provide valuable insight and advice to businesses in managing cash flow, suggesting whether they need cash and how much.30 After the Progress Assessment, we will see how accountants analyze financial statements using ratios.

cash flow

The difference between cash coming in and cash going out of a business.

progress assessment

 What are the key steps in preparing an income statement?

 What’s the difference between revenue and income on the income statement?

 Why is the statement of cash flows important in evaluating a firm’s operations?

(Nickels 476-482)

Nickels, William. Understanding Business, 10th Edition. McGraw-Hill Learning Solutions, 40913. VitalBook file.

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