financial accounting, accounting equation, and financial statements beginner's guide
As, we begin our study of accounting, we should start at the start with the fundamental, financial statement, the balance sheet the, balance, sheet simply, lists our stuff the technical, term is asset, and how, we've been able to pay for that stuff, assets. Our economic, resources, owned or, controlled by, a company that will provide future benefit, to the company, examples. Include cash, that certainly, provides a future benefit, inventory. Items, help to resell in the future and buildings. And equipment the hope is that these items will provide benefit to the business in the future now. There are two general methods used to finance our assets liabilities. And owner's. Equity. Liabilities. Are obligations, that are satisfied, either through payment or by, providing services to someone else, we. Borrow money to buy assets, and we have to pay that money back someone. Pays us money and we have to provide them a service, with. Liabilities. We owe in the future either money or services. Those. Liabilities go, away when we pay the money or, we provide the service, now. Owner's equity comes, about as owners invest in the company with, no obligation. For the company to repay that investment. Or, the owners leave the profits, generated by, the company in the company those, retained profits can then be used to purchase additional assets. So the balance sheet can be stated as follows assets. Equal, liabilities plus. Owner's equity this. Equality is termed the accounting, equation in, fact. The, name balance, sheet comes from the fact that a proper, balance sheet must always balance total. Assets, must, equal, the total of liabilities, and owner's equity the. Accounting equation is not some miraculous, coincidence. It is true by, definition, the. Two sides of the accounting equation must, always be equal because there are two views of the same company, the left-hand side shows the economic, resources controlled, by a business, and the. Right-hand, side shows, the claims against, those resources. Another. Way to view this equality is that the firm's assets must, have sources and the. Right-hand, side of the equation shows the origin of those resources, this. Equal, sign is, one of the most important, aspects, of accounting, this, mathematical. Fact helps, us to determine if we've identified all the effects of a transaction. It, forces, discipline. On, our analysis, we, are required to think through all aspects. Of a transaction, because at the end of the day the, accounting, equation has.
To Balance we. Receive cash assets. Go up but why what, did that cash come from that. Equals sign requires, us to answer these questions cash. Coming in because of loans is different, than cash coming in from profitable, operations, because. The accounting, equation must, always balance, those. Preparing, the financial statements, for our use must carefully, determine, why assets, changed, why liabilities. Changed, and why, owner's, equity might, have changed, the, Equality, embedded. In the accounting, equation forces. Those, preparing, financial statements to answer, the question, that those of us using, financial statements, often want, answered, why. You. So, you've been introduced, to the, fundamental. Financial statement, the balance sheet but. You've probably heard of others the, other two primary, financial statements are the income, statement, and the statement of, cash flows these, are the big three financial statements all publicly. Traded companies, provide these financial, statements to users and most. Private companies, of any size are also preparing these financial, statements as well for use within their company so. From where do these financial, statements derive well let's. Go back to the accounting equation assets. Equal. Liabilities plus, owner's equity the. Left side of the equation the asset, side is made, up of a bunch of asset accounts, inventory. Supplies, equipment, land, and cash. The. Statement, of cash flows is simply a detailed. Analysis, of the flows of cash going in and, out, of the cash account over a specific time period, those. Inflows, and outflows are, categorized, as being related, to either operating. Activities, things that happen everyday in a business. Investing. Activities, transactions. That affect the productive, capacity of a business like buying a building and, financing. Activities borrowing. And paying back money selling and buying your own stock. Now. For a period of time like a quarter, or a year. Sort. The inflows and outflows of cash, buy activity, and the, result the, statement, of cash flows now, of course that sorting, is easier said than done but. That's the gist of it by drilling down on the asset, side we, separate, the cash account from the other asset, accounts, and then, just do a detailed, analysis, of just that account so. If we know where to look we can see in the accounting, equation exactly. Where. To find the statement of cash flows. You. Now. The income, statement, comes from a detailed, look at an account on the other side, of the accounting equation owner's. Equity just. As assets, is comprised, of a bunch of individual, asset, accounts, owner's. Equity is comprised, of individual, accounts, as well the. Two most common, are paid in capital and retained. Earnings now paid in capital is, exactly, that it is the amount of money directly, invested, by the owners of the business it is the amount of capital that they the owners have paid in hence the name the, other account, retained, earnings is exactly. That it's, the earnings, that have been retained, in the business, since the founding, of the business, earnings. That have not been retained, in the business are called dividends, this is cash that has been returned, to the owners, so. A company's, earnings or income, are disclosed, or added, in owner's equity in, the retained earnings account from. That account the earnings that are not retained, dividends. Are subtracted. And at. This point we must bring revenues, and expenses, into the picture obviously, they are part of every, ongoing, business.
Revenues. Provide resource, inflows, they, are increases. In resources, from the sale of goods or services. Expenses. Represent, resource, outflows. They, are costs, incurred in generating, revenues. Now. Note that revenues, are not synonymous, with cash or other assets, but. They are a way of describing where, the assets, came, from, for. Example cash. Received, from the sale of a product is recorded, as the asset, cash but, the source of that asset would be considered, revenue, in. Contrast. Cash. Received, by borrowing from the bank would not be revenue, but, would be an increase, in a liability. By. The same token. Expenses. Our way of describing how an asset has been used, thus, cash paid for interest on a loan is, an expense, but cash. Paid to buy a building, represents the exchange, of one asset for another, so. How do revenues, and expenses fit into the accounting equation, well. Revenues. Minus expenses, equals. Net income and net. Income as a major source, of, Changez and owner's equity from, one accounting, period to the next, in this. Expanded. Equation, we see the balance sheet the, income statement, and the statement of cash flows if we. Know where to look we, can see each of the primary financial statements, embedded, in the accounting, equation. You. So, let's start drilling down into the balance sheet let's start with assets, what exactly, is an asset. Assets. Are the firm's economic, resources, formally, defined as probable. Future, economic, benefits obtained. Or controlled, by a particular, entity. As a result of past transactions. Or events this. Carefully. Worded definition. Includes. Several important, phrases that merits some discussion, first the word probable. Contrary. To popular belief, accounting. Is not an exact, science, business. Is full of uncertainty, as acknowledged, by inclusion of the word probable. In the definition, of an asset for. Example, will, all people, who owe a business, money pay, probably. Not as. A result, accounts. Receivable, the asset, representing, the amount owed by customers, is reported. And an amount lower, than the gross or face, amount of all receivables, is reported. At the amount that will probably. Be paid. Second. Term future. Economic. Benefits. Although. The balance sheet summarizes, the results of past transactions. And events its. Primary, purpose is, to help forecast, the future, hence. The only items. Included, as assets, are those with implications, for, the future. Let's. Suppose your business, owns a now obsolete patent. That patent, was purchased, ten years ago at a cost of $50,000. It. May have been an asset 10 years ago but. Because it now has no future, economic, benefit, it's. Not an asset now. Finally. The. Term obtained, or controlled. Accountants. Have a phrase substance, over form meaning. That financial, statements, should reflect the underlying, economic. Substance and not the superficial, legal, form, if. A company controls, the future economic benefits associated. With an item that. Item qualifies. As an asset, whether it's legally, owned or not for. Example a company, will sometimes, report a building, as an asset, on the balance sheet, when, in fact the company has not actually purchased. The asset, but, only leased it under a law, term, non-cancellable. Lease if. The lease gives the company control, of the building for most of the building's economic, life then. The leased building is reported, as an asset. Remember. The underlying, concept, here is that the balance, sheet should report economic, substance, not. Legal, form. Now. Assets, generally, are listed on the balance sheet in the order of their liquidity which. Is the ease with which the item can be turned into cash. As a, result, cash, and items that can be turned into cash are listed first these. Items are most commonly cashed short-term, investments, account receivable, inventory and, prepaid expenses, assets. Such, as buildings, and equipment used, in the operation of the business are listed next. Intangible. Assets, are usually, listed last now. At what amounts, are assets, reported, that, is a great question and the answer may, surprise you, it, depends. Some. Assets are reported, at the current market value, like cash what it's worth today some. Assets, are reported, at their net realizable value, the. Amount that the asset is expected, to yield the, accounts receivable example. Mentioned previously, is an example, of an asset that is listed, at the, amount that is expected to be realized, or received, some. Assets, are reported at their historical, cost like buildings, and equipment and land it, is tough in most cases to get at these assets, current, market value so, we go with a measure that everyone, can agree on what, was the original cost hey, hold it you, mean that the amounts listed on a balance, sheet are not all comparable. Some. Are historical. Some. Are a current market value and some are an estimate, of future value, that's, exactly, what I mean amounts.
On The balance sheet are like fruit in a fruit basket there are apples, and there are oranges, but, knowing that fact, there are different valuation, measures puts, you ahead of many users of financial information, many. Think the balance sheet is just a basket of apples now, you, know. Something many people don't when, it comes to amounts, on the financial, statements there are a variety of. Valuation. Measures. You. Assets. And liabilities, are generally classified as current or short-term items, and non current or long-term items, well, how long is current, for, most companies current, means one year or less accordingly. Assets. Expected, to be used and liabilities. Expected, to be paid or otherwise satisfied, within a year or current, items, the. Most common, current assets, are cash account receivable and inventory as. Illustrated. Here the, normal operating cycle, of a business, involves, the use of cash to purchase inventories. The, sale of the inventories. Resulting in a receivable, and ultimately. The cash collection, of those, receivables. For. Financial, reporting purposes cash includes, coins and currency as, well as the balances, in company. Checking, and savings accounts, in addition. Many. Companies, to report investments. In very short term interest, earning securities, such as three months UST, bills as cash. In the balance sheet, account. Receivables, are amounts owed to a business, by its credit customers, and are usually collected in cash within ten to sixty days, companies. May, or may not charge, interest on unpaid, account balances, normally. Credit, agreements, between two businesses, such, as a restaurant buying, lettuce on credit from a produce wholesaler, do, not involve interest, unless payment. Is not received within, the agreed-upon time. Inventory. Is the name given to goods held for sale in the normal, course of business for, example when. You walk into a Walmart, store everything, you see for sale such as shoes clothes, and garden equipment is inventory. Items. Not for sale such as the cash register, and display racks they're not inventory. Prepaid. Expenses, are payments in advance for business, expenses, two. Common, examples are insurance, and rent. Businesses. Like individuals. Usually pay for insurance for six to twelve months in advance rent. Is usually paid at least one month in advance, these. Prepaid expenses. May not look like assets. At first glance but further. Consideration. Reveals that they do fit the definition of an asset by. Paying for an expense. In advance, now, a business. Is able to conserve cash that otherwise, would have had to be spent in the future, so. A prepaid, expense does provide, future economic. Benefit. Companies. Frequently. Have excess cash that they wish to invest temporarily, for example, a company, may have received, the proceeds, from a large loan that, will be used over time for capital expansion in the, mean time the company would like to be able to purchase investment, securities, to earn the highest possible, return on this temporarily, idle, cash.
Investment. Securities, are usually, composed of publicly traded stocks, and bonds if a, company intends to sell its investment, securities within a year, the, securities, are classified. As current assets, current. Assets. Are normally, listed in the balance sheet before long-term. Assets within, the current asset category, items. Are listed in the order of their liquidity with, the most liquid those, closest, to cash listed, first, this. Ordering is a US tradition, not a requirement, most. Utilities. And insurance companies for example reverse. The traditional, order and report, their long term assets, first in, addition, some non-us. Companies start, their balance sheets with long term assets, current. Assets can be kind of viewed as the lifeblood, of a business the oil that, keeps the machine going, cash. Is used to develop products, or services, which are then sold and cash is subsequently, collected, this. Process, is repeated over, and over, and over, the. Profitable, churning, of current assets is what keeps companies, in business. You. Now. Let's turn our attention to the other side, of the accounting equation, liabilities. Liabilities. Are the economic, obligations. Of a company and comprised, primarily, the money or services, that the company owes to, its creditors. Liabilities. Are formally, defined as probable. Future sacrifices. Of economic. Benefits, arising. From, present, obligations, of a particular entity, to transfer, assets or, provide, services to other entities in the future as a, result of past transactions. Or events, Wow. The. Following, phrases in the liability, definition, are important, to consider first, obligation. This. Term includes, legal commitments. As well as moral, social. And implied, obligations. Again the phrase substance. Over form applies. Liabilities. Are recognized, in financial, statements if they can be reasonably, estimated. And represent, obligations. To others. So. Second, transfer. Assets or provide, services. Most. Liabilities. Involve, an obligation, to transfer, assets in, the future an. Obligation. To provide a service however is also, a liability for example, having. Your tuition, check at the beginning of the semester your, college, or university now. Has a liability, to you to provide a top-notch, education during. The semester and. Finally. Past transactions. Or events assets. And liabilities, arise, from transactions. Or events that have already happened, consider. A company, that expects, to pay eighty thousand, dollars next, year for, the electricity, that it will use throughout the next year if the, world ends, on December, 31st of this year does.
The Company have to pay the eighty thousand dollars no. Because. The transaction. The actual, use of the electricity. Will not occur until next, year thus. Says of December, 31st, this, year the company would not report the eighty thousand dollars as a liability there. Would be a liability however. If electricity. Had already been used but not yet paid for. Liabilities. Are sources, of the funds a company has used to acquire its assets, for, example. Businesses, frequently, by goods on credit rather than paying cash thus, creating, a liability called, accounts, payable in, addition. Businesses. Often borrow. Money from banks and other lenders for, various purposes, such as purchasing, land new machinery, or equipment or, additional, merchandise. Now. Loans may be short-term, less, than a year or. Long-term, and unlike, accounts, payable they, usually require, the payment of interest to the lender, other. Liabilities, result. From incurring expenses that, are yet to be paid in cash such, as wages payable and interest payable, now. Liabilities. Generally, are grouped on the balance sheet according to their due dates with, short term liabilities listed. First, for, example, accounts. Payable that's the amount due to suppliers or probably due to be paid within 30 to 60 days in. Contrast. Some of the long-term notes, and debentures, don't have to be paid for 30 years. Now. Quantifying. The amount of a liability can, require extensive, judgment, as one. Example consider, the difficulties. Faced by a company, in quantifying, its obligation. To clean up a toxic waste site in. Many. Cases, the cleanup will take years to complete the. Exact, extent, of the environmental damage at the site is still unknown and, legal. Responsibility. For the toxic, mess is still, in dispute. Properly. Valuing, a company's, liabilities, is one of the biggest if not the biggest, challenge. That an accountant, can face. You. Current. Liabilities are. Those obligations. Expected. To be paid within one year the most common being Accounts Payable other. Current, liabilities, that arise, in the normal course of business are taxes. Wages. And other, expenses. That remain temporarily, unpaid. Now. Accounts, payable, on the flip side of accounts, receivable when. One company sells, on credit, creating. For itself an account receivable the. Company on the other side, of the transaction, is buying on credit creating. An account payable. Companies. Obviously do. Not pay all of their expenses instantly. Employees. Work for a week or two before they get paid interest. On loans accumulates.
And Is paid periodically. And corporate. Income taxes, are paid monthly or quarterly. When. A balance, sheet is prepared, the, total of these unpaid, accruals. As they are called is reported. As a current, liability. One. Important, function of accountants, is to make sure that these accrued, liabilities, are properly, reported. To, avoid understating. Accompanies, liabilities, and the, magnitude, of these items can be significant. For example. In its, January 31st, 2018. Balance, sheet Walmart. Reported, accounts payable, of 46, billion dollars as well, as accrued, liabilities. Of over 22 billion dollars, in, addition. Current liabilities, also, includes short-term, loans and the portion of long-term loans expected, to be repaid in the coming year. Short-term. Loans payable are formal, interest-bearing, loans that, are expected to be paid back within a year a company. With a seasonal, cash needs such as a retailer, that needs to borrow to finance inventory, and staff build up around the Christmas buying season they. Would probably satisfy. Those needs with short-term loans now. Some liabilities, such as mortgages, are. Payable, in equal, monthly installments. Over a specified number of years the. Portion, of these liabilities, that is payable within 12 months from the balance sheet date is called, the current portion, of long-term debt and is, classified as, a current, liability the. Remaining, portion is class if I'd as a long-term, liability, in. Its January 31st, 2018. Balance, sheet for example Walmart. Lists, total loans to be repaid, over extended, periods of. 33.8. Billion, dollars, of which almost 11, percent. 3.7. Billion is to, be repaid within one year and is therefore listed, among current liabilities. Another. Increasingly. Common, current liability, is unearned, revenue, unearned. Revenue, represents, a company's obligation, to provide service, to customers who've paid for a service that they have not yet received you. See this with tech companies they. Receive money upfront and promise, software, upgrades in the future you. See this with subscription-based, companies, where they receive money up front and provide, services, in the future and you. See this with Airlines, who sell tickets collect, the cash and provide, the flight in the future when. For example Delta.
Airlines Sells a ticket they promise a future service. Delta's. Largest. Current liability, is their air-traffic, liability, the, value, of the service they have promised, in the future for which they have already received, the cash as of. December 31st 2017. Their air-traffic. Liability, obligation, was almost four point, nine billion. Dollars, now. The objective, of any business is to not not. Have current liabilities, as you, can see current liabilities, are a consequence. Of doing business, items. Are purchased on credit employees, are paid at the end of a pay period, when. A balance, sheet is prepared, these, obligations, that are still outstanding must, be disclosed, but. Liabilities, aren't bad they, are just a part of doing business and one carefully, managed, are a key. To a company's, success. You. The, remaining claim against, the assets of a business after the liabilities. Have been deducted is owner's, equity, thus, owner's. Equity is a residual, amount it represents. The net assets, total assets, minus total liabilities, available. After all obligations, have, been satisfied. Obviously. If there are no liabilities. An unlikely, situation except. At the start of a business then. The total assets, are exactly. Equal to the owners claims against those assets the owner's, equity in. Order. To get a business started, investors. Transfer, resources, usually cash, to the business, in return, for part ownership, ownership. Of a company can, be restricted to one person, a sole, proprietorship, to. A small group a partnership. Or, to. A diverse, group of owners who often, don't even know one another a corporation. When. Owners initially. Invest money in a corporation, they, receive, evidence, of their ownership in the form of shares of stock represented, by stock certificates. These. Shares, of stock may then be privately, traded, among existing owners of the corporation. Privately. Sold to new owners or, traded. Publicly on an organized stock exchange like, the New York Stock Exchange or, coca-cola shares, are traded or the Nasdaq exchange. Where, Apple shares are traded in a. Corporation, the difference, between assets. And liabilities, is referred, to as stockholders. Or shareholders. Equity or owner's, equity in. Presenting. The owner's equity on the balance sheet a distinction. Is made between the, equity, originating, from the stockholders, investments. Referred. To as contributed, capital or paid in capital and the, equity, originating. From earnings, referred, to as retained, earnings. Owner's. Equity increases. When owners make additional, investments in a business that is when they pay in more, capital, or, when the business generates, profits, that are retained in the business. Owners. Equity decreases. When, the owners take back part of their investment, if the. Business is a corporation. Distributions. To the owners the stockholders. Are called dividends. Owner's. Equity also, decreases. If operations. Generate, a loss instead. Of a profit, in the, extreme, very. Poor performance can, result in the loss of all the assets originally, invested, by the owners, now. For corporation. The amount of accumulated, earnings of the business that have not been distributed. To owners is called retained, earnings, the. Portion, of owner's equity contributed. By owners in exchange, for shares of stock is called paid in capital, the. Amount of retained earnings plus the amount of capital stock, equals, the corporation's, total, owner's equity as an, example consider ExxonMobil. As of. December, 31st 2017. They, reported, paid in capital of fourteen, point seven billion dollars and retained. Earnings of just over four hundred and, fourteen. Billion dollars they. Have been retaining, those earnings since 1870. When john d rockefeller. Formed, Standard Oil Company, contrast. That with Microsoft. Which has been retaining, earnings only since 1976. Their. Retained earnings balance as of September 20th 2017. Was just over ninety, eight billion dollars, so, now we are back to the accounting equation assets. Equal. Liabilities plus.
Owner's Equity the. Resources. Of a company and the sources, of those resources. Some. Of those resources, come through investment, by owners paid, in capital some. Of those resources come, through profitable, operations, retained, earnings, and some. Of those resources result, from obligations. To repay money to creditors, or to provide services, those are liabilities as. We. Proceed, further down this accounting, road it is important, to hold on to the fact that the accounting, equation must balance, always. Always. That, equality is going to make things so, much easier as we, go further down this road. You. As is. Almost, always the case things. Are always a little more complicated, than they appear at first glance. Previously. We said that owner's equity consists. Of two parts paid in capital and retained, earnings and those. Two accounts, cover about 90 percent of the activity, in orders equity but. There are a couple of other things worth mentioning, about owner's equity in addition. To paid in capital and retained earnings the, equity, section of, a corporation, often, includes Treasury, stock and accumulated. Other comprehensive, income, let's. Take a brief look at these two items when, a company, buys back its own shares, accountants. Call the repurchase shares Treasury. Stock the. Amount a company spends to repurchase, its own shares is usually, shown as a subtraction. From, total, stockholders equity, like. A dividend, payment a Treasury, stock purchase, is a way for a corporation, to distribute, cash to stockholders, the, difference. Is that in a dividend, payment the cash is distributed, evenly to all stockholders. And all. Stockholders. Maintain, their ownership in the company, with. The Treasury stock purchase, the, cash only goes to those stockholders. Who decide to terminate their ownership in the company by. Selling their shares back a, company. Can engage in a stock repurchase, for a variety of reasons, one. Of which is to show confidence, in the value of the shares and try, to convince stock, market, participants, that the company shares are currently. Undervalued. Another. Reason is that a stock repurchase. Is a way to distribute, to stockholders, any excess. Cash not, needed for operations, or for business expansion. Many. Large companies have ongoing, programs, to buy back their shares from investors, for example, during. The three-year period ending. September, 30th 2017. Apple. Had spent over ninety, seven billion. Dollars buying back its shares from Apple stock holders. Okay. Since, 1980. The equity, section of us, balance, sheets has begun to fill up with a strange, collection, of items each, the subject, of an accounting controversy. As, companies. Move to disclose, more market, value information in, the financial, statements the, controversy. Has been how to keep the accounting, equation in, balance, remember. If a company writes an asset up or, down in, value, for example the. Equal, sign in the accounting, equation requires something, else to move to balance, the equation, when. Those making, the rules were, considering, requiring, certain, assets, and liabilities, to be reported, at their market, values on the balance sheet companies. Complained, about the income, volatility, that would be caused by recognizing. These changes, as gains, or losses on, the income statement as. Accounting. Rule makers change the rules these, changes, in value are reported, as direct, adjustments, to equity on the balance sheet insulating. The income statement from these changes in market value the. Compromise. That allows market, values in the balance sheet while keeping the income, statement, uncluttered, is the creation, of a separate, category of equity called, accumulated.
Other Comprehensive. Income. Accumulated. Other comprehensive, income is comprised, of certain market, related gains, and losses that are not included, in the computation, of income examples. Of these types of changes include, the change in the equity of foreign subsidiaries as, measured. In terms of US dollars that, occurs, as a result of changes, in foreign, currency, exchange, rates. Another. Example the change in the value of certain investment, securities and changes. In the value of certain derivative, financial instruments. All. Of these changes, in value are typically, way. Beyond, the control of management, and arise from changes, in market, conditions, these. Changes, are not reflected. In the income statement but instead go around, the income statement, to the account accumulated. Other comprehensive, income, this. Account, accumulated. Other comprehensive income as well, as the Treasury, stock account, can often, be found as part of. A, company's, owner's equity on the, balance sheet. You. The. Balance sheet the income statement, and the statement of cash flows don't just drop out of the sky they, don't come down from a mountaintop and they aren't delivered by a stork, these. Financial, statements are the result of a systematic. Method of analyzing, transactions. Inputting. The results, of the analysis, into an accounting, system and then, summarizing. The resulting information into, reports, for decision-makers the, process. Of analyzing business, events, collecting. And processing information. Related, to those events and, summarizing. That information, in report form is called the, accounting, cycle for. Large multinational. Companies, the accounting, system is tailor-made, to process, thousands. Of daily transactions. Conducted, in multiple. Currencies, in, multiple. Locations around. The, world for. A small, sole, proprietorship. The, accounting, system may be required, to process only, a few, transactions. Each day. Now. A common, question that is asked at this point is haven't. Computers, made having a knowledge of the accounting, cycle obsolete. This. Provocative. Question, requires two, answers, first. Even. With computers. Transactions. Need to be analyzed, and their effects recorded. So that summary, financial information, can be prepared, now. It is true that most transactions. Are routine, and computers. Can handle these without, human intervention but. Analysis, of complex, or unusual. Transactions. Or in other words everything, that's really interesting, still. Requires, the exercise, of accounting, judgment, in that sense, computers, have not changed the steps in the accounting cycle at all second. Computers. Have enhanced our ability to process large amounts of information so, that now we can not only identify, the accounts, involved, in a transaction, but. We can also easily, identify. The salesperson. The, exact, item being sold the, address, of the customer the. Customers, bank account number and a whole bunch of other things, Computers. Allow us to collect and process much, more information, than is required by a traditional accounting system but again. Knowing, what data to accumulate, and how to summarize it are still, matters of accounting, judgment, so. Accountants, have developed, a system whereby large, amounts, of information can, be collected, analyzed.
And Summarized. Into, three primary financial, statements. Now, these financial, statements have stood the test of time it's. Hard to believe that the operations, of Microsoft. For example can, be summarized, in three financial, statements, each only one, page, long, but. Microsoft has been providing, these three financial statements to the public since they went public in 1986. The. Balance sheet a listing of a company's resources, and claims against those resources, the, income, statement a measure of a company's economic, performance for a period of time and the, statement, of cash flow is a summary, of cash inflows. And outflows for, a period of time these. Combine, to provide a financial, picture of a company that can allow conclusions. To be drawn and decisions. To be made about, a company's, past and, about, its future. You. Almost. Every day The Wall Street Journal, includes articles, detailing the, income, forecasts. Of many publicly, traded companies, the. Stock prices, of companies go up or down depending on whether information, disclosed, about a company, has a positive. Or a negative impact. On the firm's expected, earnings. Investors. Find this information, about revenues, and income, numbers useful, in evaluating, the health and performance of a business, net. Income is reported in the income statement the, income, statement shows the results, of a company's operations, for a period of time a month a quarter, or a year the. Income, statement summarizes, the revenues, generated and, the, costs, incurred those, are expenses, to generate, those revenues, the. Bottom, line of an income statement is net income or net loss the, difference between revenues. And expenses, to help. You understand, an income statement we must first define its elements, revenues, expenses, and, net income or net loss. Revenue. Is the amount of assets created through the sale of goods and services think, of revenue as another way for a company to acquire assets. Just. As assets, can be acquired by borrowing, or by owners investment. Assets. Can also be acquired by providing, a product or service for which customers, are willing to pay. Manufacturing. And merchandising. Companies receive revenues, from the sale of merchandise, for, example, Kroger's, revenue is the cash that customers. Pay in exchange for groceries, a service. Enterprise generates. Revenue from the fees that are charged for the services, it performs, companies. Might also earn revenues, from other activities such as charging, interest or collecting, rent when. Goods are sold or services, performed, the, resulting, revenue is in the form of cash or accounts. Receivables, that's a promise from the buyer to pay for the goods or services by a specified, date in the future. Revenues. Thus generally, represent, an increase in, total assets these.
New Assets, are not tied to any liability. Obligation, the. Assets, belong to the owners, and thus represent, an increase, in owner's equity, now. Expenses. Are the amount of assets can, zoom through business operations. Expenses. Are the costs, incurred in, normal, business operations to generate, revenues. Employees. Salaries, and utilities. Use during a period are two common, examples of expenses for, Kroger for example, the, primary expense. Is the wholesale costs, of the groceries, that it sells to its customers, at retail. Just. As revenues, represent, an increase in assets and equity. Expenses. Generally, represent, a decrease, in assets and equities, net. Income sometimes, called earnings, or profit, is an, overall measure of a company's performance, net. Income reflects the company's accomplishments. Revenues, in relation. To its efforts, expenses. During, a particular, period of time revenues. Minus, expenses, equal. Net income if, revenues, exceed, expenses net. Income if expenses. Exceed revenues the difference is called net loss, because. Net income, results, in an increase, in resources, from operations, owner's. Equity is also. Increased, a net, loss, decreases. Owner's equity it. Is important, to note the difference, between revenues. And net, income both. Concepts. Represent, an increase, in the net assets, of a firm however. Revenues. Represent, total resource, increases. Expenses. Are subtracted from. Revenues to drive net income or nest loss. Both. Concepts. Represent. An increase in the net assets, of a firm net assets being assets, minus liabilities, however. Revenues. Represent, total, resource, increases. Expenses. Are then subtracted. From revenues to derive net income or net loss thus. Whereas. Revenue, is a gross, concept. Income, or loss is a net, concept. It's. Also important, to note the difference between revenues, and assets. Revenues. Are one activity, of a company that generates assets, for example selling. A product which is revenue results. In an asset, either cash, or an account receivable. Assets. Can also be, generated by other activities, for, example borrowing. Money from a bank, not be considered, of revenue-generating activity. But, it would result in an asset cache, to.
Summarize, Activities. Involving, revenues, results in assets, but. Assets, can result from many, different activities, the, income statement this, is the financial statement, that people talk about all the time and now. You know a little more about, the information that, the income, statement, contains. You. While, the format, of an income statement can vary across companies, there, are typically, several, common, components, the. First is, sales less cost of goods sold or cost of sales the, result is called gross profit, or gross margin, now. Because of its size firms, pay particular, attention to, changes in cost of goods sold relative. To changes in sales, gross. Profit, percentage, computed, by dividing gross profit, by revenue, from net sales provides. A measure of profitability that. Allows comparison. For a firm from year to year gross. Profit, is an important, number if, a company is not generating, enough from the sale of products, or service to cover the cost directly associated. With that product or service that company. Will not be able to stay in that line of business for, very long, now. From gross profit, is subtracted, operating, expenses, operating. Expenses are such items as salaries, advertising. Depreciation. And supplies, used. Subtracting. Operating, expenses, from gross profit, the results in what is called operating. Income. Operating. Income measures, the performance of the fundamental. Business operations. Conducted by a company a general. Rule of thumb is that all expenses. Are operating, expenses, except interest expense and income. Tax expense. Accordingly. Another, name for operating, income is earnings, before interest in taxes, or even, EBIT. You. Will hear the term even a lot now, you know what it means earnings before interest in, taxes. Operating. Income tells, users how well a business is performing in the activities, unique, to that business, separate. From the financing, and income, tax management policies, that are handled at the corporate headquarters level, for. Example. Operating. Income allows you to evaluate Walmart's. Overall ability to choose store locations. Establish. Pricing strategies, train. And retain workers and manage. Relations, with its suppliers. Operating. Income does not tell you anything about, the interest, costs, of Walmart's, loans or how. Successful Walmart's. Tax planners, have been at structuring, and locating. Operations, to minimize income, taxes. From operating, income are deducted, various non operating, expenses, the most common of which is interest, but there are others, if. A firm restructures, its debt and incurs a gain or loss it will typically appear here if a, firm restructures, its operations, the, expenses, associated with doing that will often appear here, as well. Subtracting. These other revenues, and gains and, other expenses. And losses from operating, income results, in income, before taxes, there. Is always, a line on the income statement called, income, before income, taxes. Income. Tax expense is, typically the last expense, item on the income statement, income. Tax expense is the sum of all, the income tax consequences. Of all transactions. Undertaken, by a company during a year it. Is subtracted, to arrive at a firm's net, income net, income, this, figure is the accountants attempt to summarize in one number a company's, overall economic. Performance for a given period, now, not. All income, statements follow the exact, same format, but they get pretty close the, point is this the. Income, statement tells how a company, is doing from doing the business it is in operating, income how. The company, is doing managing. Its financing, and other miscellaneous, items, income, before taxes, and how. A company, is doing overall, now. From the preceding, discussion you can see that when someone refers to a company's, income, or profit. The. Person could be referring to any of a host of numbers gross profit. Operating. Income or net income it is, important, to learn to be very specific. When discussing, a company's, income after, all, comparing. One company's, net income, to another company's operating, income would, be like comparing apples to, oranges. You. Now, let's take a minute and make sure we understand, the difference between revenues. And gains and, expenses. And losses. Revenues. And gains both, sound like good news and they are but. Revenues, are increases, in assets resulting, from what a business is in the business to do, gains. Are increases, in assets, from out of the ordinary activities, the technical, term is from, peripheral, activities.
That, Is activities, not central, to the business for. Example, when, Walmart receives, cash for selling groceries it's called revenue, but. When Walmart makes money by selling an old delivery, truck that. Amount is called a gain not revenue, because. Walmart's, not in the business of selling trucks at, least not yet the. Same reasoning, applies to the difference between expenses. And losses. Expenses. Are decreases. In a firm's assets or increases, in the firm's liabilities, from, what they are on the business to do losses. Result, from peripheral, activities, to, continue with our Walmart example. They purchase, inventory from suppliers, to be sold the customers you and, me when. That inventory an, asset, is sold. Walmart's. Assets, go down the, cost of that inventory is called an expense, to Walmart, it's, called cost of goods sold or cost of sales. Similarly. As employees, work for Walmart the company incurs a liability, they. Owe those employees, that increase, in liability, is an expense, wages. Expense, if. A company restructures, its debt for, example taking out low interest debt to replace high interest debt like you and I would refinance, a mortgage to, get a lower interest rate they. May make money or lose money on that transaction, the. Money made or lost would, be termed a gain or a loss because. Companies typically, aren't in the business of refinancing. Their debt. Another. Item you will see on an income statement is referred to as restructuring. Charges. Restructuring. Charges, are not typically, recurring. Items, at least a company hopes not you don't want to be restructuring, all the time as a, result, they will be called out as a separate, line item on the income statement and not grouped in with the rest of a company's operating, expenses, to. Summarize. Revenues, and expenses result, from what a company is in the business to do regularly, for, Microsoft, revenues. Come from cloud, computing, gaming. Consoles, and other hardware, and software these. Are things that Microsoft, does every. Day. Microsoft's. Expenses, come from the costs, associated with supporting, these revenue, generating, activities things. Like the cost of making computers, the cost of engineers to write code the rent on buildings, and other similar, expenditures. Gains. And losses well, those don't happen all that often and when they do we. Call them out and put them in their own category so. That readers of the income statement will know that these. Are out. Of the ordinary. You.