Many business owners think the terms Income Statement and Financial Statement are interchangeable. The Income Statement is indeed one part of a Financial Statement package, but owners should know there are usually three other statements and why they are important.
There are four basic financial statements are:
- Income Statement
- Balance Sheet
- Statement of Cash Flows
- Statement of Changes in Equity
Let’s start with the Balance Sheet.
The balance sheet is made up of three sections: Assets, Liabilities, and Equity. The basic accounting equation is Assets = Liabilities + Equity. The balance sheet shows a company’s financial position on a specific date.
Assets are the resources of the company that have been acquired through past transactions and have future economic value. Examples of assets are:
- Cash in Bank
- Accounts Receivable (amounts due from customers)
- Inventory (merchandise for re-sale or materials to be used in production)
- Prepaid Expenses (items paid in advance like insurance and property taxes)
- Machinery (used in manufacturing production)
- Computer Equipment
- Trademarks, Patents, or Copyrights
Assets are classified into distinct groupings.
- Current Assets are assets that will generally be used within an accounting cycle. They include cash, accounts receivable, inventory, and prepaid expenses.
- Fixed Assets are items that provide long-term use for the company. Things like land, buildings, machinery, and computer equipment will benefit a company for longer than one accounting cycle.
- Intangible Assets are those items that are not physical and will last longer than one account cycle, like computer software or trademarks.
Liabilities represent obligations for past transactions that must be paid by a company. Liabilities can be thought of as a source of the company’s assets and claims against those assets. They include:
- Accounts Payable (amounts due to suppliers)
- Short-Term Notes Payable (the portion of any loans due within one year)
- Wages Payable (amounts due to employees but not paid as of the date of the statement)
- Interest Payable
- Customer Deposits (advance payments received for work or goods not yet provided)
- Accrued Expenses (obligations that have been incurred but not yet recorded in Accts Payable)
- Notes Payable
Liabilities are also classified into groupings:
- Current Liabilities are obligations that are due within an accounting cycle. Accounts payable, wages payable, customer deposits, and accrued expenses are examples of Current Liabilities.
- Long-Term Liabilities are obligations that are due over more than one accounting cycle. Notes payable (less the current portion shown in Current Liabilities) are listed here.
The items listed in the Equity section vary, depending on the legal form of the business. Owner’s Equity is used when a company is a Sole Proprietorship; Members’ Equity is used for a Limited Liability Company; Stockholders’ Equity is used for a corporation.
The Equity accounts for a Sole Proprietorship will include:
- John Smith, Capital
- John Smith, Draws
- Net Income (cumulative for the current year)
Equity accounts for an LLC are:
- Members’ Equity
- Members’ Draws
- Net Income
Equity accounts for a corporation include:
- Common Stock (shows the original cost of the company shares sold to stockholders)
- Preferred Stock (not every corporation has this)
- Retained Earnings (the cumulation of net profits/losses from prior years)
- Net Income
An accountant who understands how to properly classify items on the balance sheet is crucial to having useful financial statements. Staying on top of accounts receivable is essential for good cash flow; knowing how often inventory turns over can help you determine if you are carrying obsolete items; recognizing when an item should be recorded as a fixed asset and when it should be expensed will keep you out of trouble with the IRS.