FINANCIAL ACCOUNTING/INTRODUCTION TO ACCOUNTING/PACC

Financial Accounting is the systematic and comprehensive recording of financial transactions pertaining to a business. Accounting also refers to the process of summarizing, analyzing and reporting these transactions to oversight agencies, regulators and tax collection entities.

Users of accounting information

The objective of accounting is to provide information to users for decision-making. But, who exactly are these "users of financial statements"? What information do they need?The users of accounting information include: the owners and investors, management, suppliers, lenders, employees, customers, the government, and the general public.

1. Owners and investorsStockholders of corporations need financial information to help them make decisions on what to do with their investments (shares of stock), i.e. hold, sell, or buy more.Prospective investors need information to assess the company's potential for success and profitability. In the same way, small business owners need financial information to determine if the business is profitable and whether to continue, improve or drop it.

2. ManagementIn small businesses, management may include the owners. In huge organizations, however, management is usually made up of hired professionals who are entrusted with the responsibility of operating the business or a part of the business. They act as agents of the owners.

The managers, whether owners or hired, regularly face economic decisions – How much supplies will we purchase? Do we have enough cash? How much did we make last year? Did we meet our targets? All those, and many other questions and business decisions, require analysis of accounting information.

3. LendersLenders of funds such as banks and other financial institutions are interested in the company’s ability to pay liabilities upon maturity (solvency).4. Trade creditors or suppliersLike lenders, trade creditors or suppliers are interested in the company’s ability to pay obligations when they become due. They are nonetheless especially interested in the company's liquidity – its ability to pay short-term obligations.

5. GovernmentGoverning bodies of the state, especially the tax authorities, are interested in an entity's financial information for taxation and regulatory purposes. Taxes are computed based on the results of operations and other tax bases. In general, the state would like to know how much the taxpayer makes to determine the tax due thereon.

6. EmployeesEmployees are interested in the company’s profitability and stability. They are after the ability of the company to pay salaries and provide employee benefits. They may also be interested in its financial position and performance to assess company expansion possibilities and career development opportunities.

7. CustomersWhen there is a long-term involvement or contract between the company and its customers, the customers become interested in the company’s ability

to continue its existence and maintain stability of operations. This need is also heightened in cases where the customers depend upon the entity.For example, a distributor (reseller), the customer in this case, is dependent upon the manufacturing company from which it purchases the items it resells.8. General PublicAnyone outside the company such as researchers, students, analysts and others are interested in the financial statements of a company for some valid reason.Internal and External UsersThe users may be classified into internal and external users.Internal users refer to managers who use accounting information in making decisions related to the company's operations.External users, on the other hand, are not involved in the operations of the company but hold some financial interest. The external users may be classified further into users with directfinancial interest – owners, investors, creditors; and users with indirect financial interest – government, employees, customers and the others.

We had detailed discussion of trial balance and also learnt that how it is being prepared with the help of ledger account balances. We had also detailed discussion about the preparation of balance sheet with the help of accounting equation or from balances of ledger account for assets, liabilities and capital. Likewise calculations of profits were made with the help of incomes, expenses and inventory accounts.In examinations, financial statements (income statement and balance sheet) are usually prepared with the help of trial balance with separate debit and credit sides. However, sometimes it might show a single column for balances without pointing out debit and credit items separately. Occasionally, a list of balances is given in the exams without a figure for

capital which in that case may be calculated as a balancing item when total of credit items are subtracted from total of debit items.Most of the students should by now be in a position to recognize the items shown in an income statement and the items reported in a balance sheet.

Need for Income Statement:

The balance sheet shows total profit for the year but accounting users need more detailed information. They need to know that how profit was earned. Profit/loss is the difference between total revenue or incomes earned and the total expenses incurred. The income statement is prepared to show performance of the business. Did the firm perform well (by making a profit) or do badly (by incurring a loss)?

Income statement are therefore prepared to set out the financial results of operational activities for a particular period.

Uses of Income Statement:

Income statement helps a business to:

(1) Assess its financial position.

(2) Identify weak and strength areas.

(3) Have a comparison with other businesses or for the previous years for the same business.

Relationship between Income statement and Balance Sheet:

Income statement and balance sheet both are financial statements prepared by a business on regular basis. At this stage of study, this is worth emphasizing that income statement is prepared for a period of time and balance sheet is related to a particular point in time. So we can say that if income statement provides a movie of financial performance for the whole

period whereas a balance sheet gives a snapshot of the financial position of the business at year end. The relationship between income statement and balance sheet may be illustrated as follows:

When preparing the financial accounts of a company there are some theoretical accounting assumptions which are commonly followed. So unless specified otherwise, it will be assumed that such principles were implemented in the final accounts of the company. The three main assumptions we will deal with are – going concern, consistency, and accrual basis. Let us get started!

Fundamental Accounting Assumptions

Accounting assumptions are the three very basic accounting concepts or principles that are assumed to have been followed in the accounting transactions of an entity. So there is a need for a specific notation saying such concepts have been adhered to, it is understood.

However, this does not mean that such fundamental accounting principles have to be compulsorily followed by all organizations. It is absolutely acceptable if the entity does not follow such assumptions while recording their financial transactions. If these fundamental assumptions have not been followed then the entity should specifically disclose this information, along with their financial statements. This way the users know about such facts.

Now let us take a look at the three accounting assumptions as per the Accounting Standards of India.

1] Going Concern

This assumption is based on the principle that while making the financial statements of an entity we will assume that the company has no plans of winding up in the near future. So the assumption is that the company will continue to exist indefinitely (far into the future), i.e. it will keep on going.

This assumption is important as it allows for the appropriate accounting of fixed assets and depreciation. Since traditionally we follow the historical cost method for valuation of assets, we have to assume that the business is in no danger of being shut down in the future. If this is the case then such assets will have to be valued at market value. But in the case of a going concern, we do not take into account the increase/decrease in prices of assets.

Another case would be that of expenses written off over a number of years like Deferred Advertising Expense. The benefit of such an expense is enjoyed over a number of years. So instead of charging the expense in one year, we amortize it. This is also possible due to the going concern assumption.

2] Consistency

This assumption states that unless and until things are mentioned in the accounting policies, procedures,standards,etc, Things that have been followed in accounting remains the same. This allows for uniformity in the financial statements of a company over the years. It also becomes easier to compare financial statements from the previous years, something that is important to potential investors and other external stakeholders.

When the accounting treatments and methodologies remain the same over a period of several years the management can properly draw conclusions about the performance of a company. It is an important aspect of planning and decision-making functions of management.

However, this does not mean that an entity cannot change accounting policies to stay relevant with times. This assumption does not completely prohibit change. Sometimes it is necessary to make changes under the following conditions

If it is a statutory requirement and the entity will have to change its accounting policy to abide by the law

Other times a change in policy will allow them to represent their accounts more fairly and appropriately.

Changes made so books of accounts can be in compliance with the Accounting Standards issued by the ICAI

So when the entity changes their policies or methods for the above reason, the users of the financial statements must be informed. Whether there is a material effect in the current year or upcoming years a disclosure must be made. This disclosure is usually made in the notes at the end of the balance sheet.

3] Accrual

Under this assumption, accounting transactions are recorded in the books of accounts when they occur. This is known as the Mercantile System. So as opposed to the cash system, in accrual concept, the revenue or expenditure is recognized in the year they are realized.

According to this concept, the revenue will be recognized in the year it has been realized in. So say firm XYZ and Co. made credit sales in January of 2108 of 10,000/-. And by 31st March they had received only 7,000/- with 3,000/- still receivable. However, the entire 10,000/- will be recognized in the year 2017-2018, irrespective of how much money was actually received.

Similarly in case of expenses also it is irrespective whether actual cash was paid or not. Expenses are to be recognized in the year in which they facilitate the earnings of revenue. So if the annual electricity bill of XYZ Co. of Rs 20,000/- is unpaid by 1st April, it will still be in the books as Outstanding Expense.

limitations to the accounting assumptions

Yes there are certain limitations to accounting assumptions and principles. For example,

Going Concern: It assumes that an entity will continue indefinitely. Practically though this is hardly ever the case. And in some circumstances, the company winds up immediately after the release of the financial statements. So this assumption can be misleading in such cases.

Consistency: There are some cases, like valuation of inventory, where the business has to make constant changes according to circumstances. The assumption will not apply then.

Accrual: It can be a time consuming and confusing process. Not suitable for small organizations who would prefer the cash system.

Accounting Equation

The accounting equation is a basic principle of accounting and a fundamental element of the balance sheet. The equation is as follows:

Assets = Liabilities + Shareholder’s Equity

This equation sets the foundation of double-entry accounting and highlights the structure of the balance sheet. Double-entry accounting is a system where every transaction affects both sides of the accounting equation. For every change to an asset account, there must be an equal change to a related liability or shareholder’s equity account. It is important to keep the accounting equation in mind when performing journal entries.

The balance sheet is broken down into three major sections and its various underlying items: Assets, Liabilities, and Shareholder’s Equity.

Below are some examples of items that fall under each section:

Assets: 

Fixed assets are assets which are purchased for long-term use and are not likely to be converted quickly into cash, such as land, buildings, and equipment.

Current assets are all assets that can be reasonably converted to cash within one year. They are commonly used to measure the liquidity of a company. A company’s assets on its balance sheet are split into two categories – current assets and non-current assets (long-term or capital assets). Cash, Accounts Receivable, Inventory,

Liabilities: Accounts Payable, Short-term borrowings, Long-term Debt

Current liabilities are financial obligations of a business entity that are due and payable within a year. A liability occurs when a company has undergone a transaction that has generated an expectation for a future outflow of cash or other economic resources. The key operator in this definition is the word “expectation,” as a liability does not necessarily always have to end up resulting in an outflow of value, but must be reasonably expected to on recognition of the liability.

Shareholder’s Equity: Share Capital, Retained Earnings

The accounting equation shows the relationship between these items.

1. Purchasing a Machine with CashCompany XYZ wishes to purchase a $500 machine using only cash. This transaction would result in a debit to Equipment (+$500) and a credit to Cash (-$500). The net effect on the accounting equation would be as follows:

 

 This transaction affects only the assets of the equation, therefore there is no corresponding effect in liabilities or shareholder’s equity in the right side of the equation.

 2. Purchasing a Machine with Cash and Credit

Company XYZ wishes to purchase a $500 machine but it only has $250 of cash in its holdings. The company is allowed to purchase this machine with an initial payment of $250 but it owes the manufacturer the remaining amount. This would result in a debit to Equipment (+$500) and a credit to

both Accounts Payable (+$250) and Cash (-$250). The net effect on the accounting equation would be as follows:

 

 This transaction affects both sides of the accounting equation; both the left and right side of the equation increase by +$250.

Consider the below entries:

On Dec 27, Joe started with a new company by investing $15,000 as equity in the same.

On Jan 3, Joe purchased an office table for his company which cost him $5,000.

He paid wages to his labor on Jan 5 totaling $15,000. On Jan 10, he received a contract from his clients, and they paid him

$2,000. On Jan 13, Joe received another contract for which the client paid

$4,000 in advance. On Jan 15, he completed the service contract that was received on Jan

13, and remaining amount of $8,000 was paid by the client.

The Journal entries for the above transactions are as below:

CASH BOOK

A cash book is a financial journal that contains all cash receipts and disbursements, including bank deposits and withdrawals. Entries in the cash book are then posted into the general ledger.

A cash book is a subsidiary to the general ledger in which all cash transactions during a period are recorded.

The cash book is recorded in chronological order, and the balance is updated and verified on a continuous basis.

There are three common types of cash books: single column, double column, and triple column.

 How a Cash Book Is UsedA cash book is set up as a subsidiary to the general ledger in which all cash transactions made during an accounting period are recorded in chronological order. Larger organizations usually divide the cash book into two parts: the cash disbursement journal which records all cash payments, and the cash receipts journal, which records all cash received into the business.

The cash disbursement journal would include items such as payments made to vendors to reduce accounts payable, and the cash receipts journal would include items such as payments made by customers on outstanding accounts receivable or cash sales.

Cash Book vs. Cash AccountA cash book and a cash account differ in a few ways. A cash book is a separate ledger in which cash transactions are recorded, whereas a cash account is an account within a general ledger. A cash book serves the purpose of both the journal

and ledger, whereas a cash account is structured like a ledger. Details or narration about the source or use of funds are required in a cash book but not in a cash account.

There are numerous reasons why a business might record transactions using a cash book instead of a cash account. Daily cash balances are easy to access and determine. Mistakes can be detected easily through verification, and entries are kept up-to-date since the balance is verified daily. With cash accounts, balances are commonly reconciled at the end of the month after the issuance of the monthly bank statement.

Recording in a Cash BookAll transactions in the cash book have two sides: debit and credit. All cash receipts are recorded on the left-hand side as a debit, and all cash payments are recorded by date on the right-hand side as a credit. The difference between the left and right sides shows the balance of cash on hand, which should be a net debit balance if cash flow is positive.

The cash book is set up in columns. There are three common versions of the cash book: single column, double column, and triple column. The single-column cash book shows only receipts and payments of cash. The double-column cash book shows cash receipts and payments as well as details about bank transactions. The triple column cash book shows all of the above plus information about purchase or sales discounts.

A typical single column cash book will have the column headers: date, description, reference (or folio number), and amount. These headers are present for both the left side showing receipts and for the right side showing payments. The date column is the date of the transaction.

Because the cash book is updated continuously, it will be in chronological order by the transaction. In the description column, the accountant writes a short description or narration of the transaction. In the reference or ledger folio column, the accountant inputs the account number for the related general ledger account. The amount of the transaction is recorded in the final column.

Two column cash book

Cash A/c and Bank A/c are two busiest accounts in ledger and they are removed from the ledger to reduce its volume and size. Cash A/c is removed from the ledger and instead of it the Single Column Cash Book is kept to record cash transactions. In the same way no Bank A/c is opened in ledger for recording bank transactions, rather an additional amount column is provided on each side of 'Single Column Cash Book' for recording bank transactions. One more column for amount is provided on the debit side and one on credit side of Single Column Cash Book. These two amount columns on debit side and credit side will serve as Bank A/c and so it will not be necessary to open a Bank A/c in the ledger. The Cash Book having two Amount Columns on both sides is called 'Double Column Cash Book'.

Advantages:

The following advantages are derived from Double Column Cash Book:

1. All entries made in "Bank" Column of Double Column Cash Book form a part of double entry system and hence a separate Bank A/C need not be opened in ledger. It saves time, labour and cost.

2. Both cash transactions and bank transactions are recorded in the same book. So both cash balance and bank balance are easily available from the same book.

Thus it is said that the Double Column Cash Book has two accounts in it, the Cash A/C and the Bank A/C.

Contra Entry

In any account we can only have one half of a double entry. An account cannot be debited and credited at the same time. For example, when we sell goods for cash, cash received will be recorded on the debit side of Cash Book and the goods sold will be posted on the credit side of Sales Account. But in Double Column Cash Book, we have two accounts, Cash A/c and the Bank A/c, so it is possible to have both a debit entry and a credit entry at the same time. For example, cash of $5,000 is deposited into the bank. In this transaction both Bank A/c and Cash A/c are involved and they will be recorded on both sides of Double Column Cash Book i.e. on the debit side in bank column and on the credit side in cash column.

Thus a transaction in which Cash A/c and Bank A/c are involved, is recorded on both the sides of Double Column Cash Book, it is called "contra entry", from the Latin prefix contra meaning 'opposite to or against'.

In recording such a transaction the letter "C", is written in 'L.F' column because both aspects of the transactions are recorded and there is no need to post them into the ledger.

In this connection, the difference between contra entry and other entries in Cash Book may be noted. ''The Double entry work of contra entry is completed in Cash Book. They need not be posted to ledger". But the double entry work of other entries in Cash Book is not completed, one aspect (i.e. cash aspect) of the transaction is, however, completed in Cash Book, but the other aspect is not completed, which is to be posted to the concerned account in ledger.

Contra entry will be passed in the following cases:

When cash is deposited into the Bank:

Bank column - debit -- Cash column-credit.

When cash is drawn from the bank for business purposes:

Cash Column - debit -- Bank column - credit.

When a cheque received from a debtor on a date subsequent to its receipt is deposited into the bank:

Bank column - debit -- Cash column - credit.

More Hints:

While writing Double Column Cash Book, keep in mind that there are two separate boxes - one for the cash and other for the bank:

Dr→

Cash Box Cr→

Dr→ Bank Box Cr

→

When cash or Cheques (Cheques received but not deposited on the same date ) enters into cash box, Cash Column is debited and when cash or cheque goes out of the cash box. Cash Column is credited. On the other hand, when Cash or cheque enters into bank box, Bank Column is debited and when cash goes out of bank box, bank column is credited.

Example 1:

Enter the following transactions in a double column cash book/two column cash book.

2005 $

March 1 Cash in hand 80,000

March 1 Bank Balance 120,000

March 3 Received a cheque from Osman 24,000

March 4 Deposited Osman's cheque with bank --

March 8 Withdrawn from bank for business use 20,000

March 10 Goods sold for cash 30,000

March 15 Goods bought for cash 80,000

March 18 Goods sold for cash 60,000

March 20 Paid Rahim by cheque 26,000

March 30 Deposited into bank 16,000

March 31 Paid salary in cash 10,000

March 31 Paid rent by cheque 6,000

Solution:

Double Column Cash Book

Date Particulars V/N L/F Cash $ Bank $ Date Particulars V/N L/F Cash $ Bank $

2005 2005

Mar. 1 Balance b/d 80,000 120,000 Mar. 4 Bank A/c(Being cheque deposited)

C 24,000

3 Osman A/c(Being cheque received)

24,000 8 Cash A/c(Being cash withdrawn from bank)

C 20,000

4 Cash A/c(Cheque deposited with bank)

C 24,000 15 Purchase A/c(Being goods bought)

80,000

8 Bank A/c(Being cash drawn from bank)

C 20,000 18 Cash A/c C 16,000

 10 Sales A/c(Being goods sold 'for cash)

 30,000 20 Rahim A/c(Cheque issued)

26,000

 18 Sales A/c(Being goods sold for cash)

 60,000 31 Salary A/c(Being salary paid)

10,000

30 Cash A/c(Being cash deposited)

C 16,000 31 Rent A/c(Being rent paid by cheque)

6,000

 31 Balances c/d 84,000 108,000

214,000 160,000 214,000 160,000

April. 1

Balance b/d 84,000 108,000

Example 2:

Enter the following transactions of M. Rauf in a Double Column Cash Book and post them to concerned accounts in ledger:

2005 $

Jan. 1 Cash in hand 100,000

Jan. 1 Cash at Bank 60,000

Jan. 3 Cash Sales 40,000

Jan. 4 Paid M. Arshad by a cheque 14,000

Jan. 6 Received a cheque from Babar 8,000

Jan. 8 Cash deposited into bank 19,000

Jan. 8 Babar's cheque deposited into bank  --

Jan. 10 Drew from bank for office use 15,000

Jan. 11 Drew from bank for personal use of owner 24,000

Jan. 12 Cash purchases 57,000

Jan. 15 Received a cheque from S. Rashid 10,000

Jan. 16 Rashid's cheque endorsed to Shakeel  --

Jan. 17 Paid Arshad Khan by a cheque 36,000

Jan. 18 Rashid's cheque returned dishonored  --

Jan. 19 Our cheque to Arshad Khan was dishonored  --

Jan. 21 Received interest from bank 1,400

Jan. 24 Cash sales 33,00

Jan. 27 Incidental charges debited by bank 700

Jan. 31 Salary paid by cheque 14,000

Solution:

Cash Book (double column)

Date

Particular

V/N L/F

Cash $ Bank $ Date

Particular

V/N L/F

 Cash $ Bank $

2005

2005

Jun. 1

Balance b/d

100,000 60,000 Jan. 4

M. Arshad A/c

7 14,000

3 Sales A/c 5 40,000 8 Bank A/c

C 19,000

6 1Babar A/c

9 8,000 8 Bank A/c

C 8,000

8 Cash A/c C 19,000 10 Cash A/c

C 15,000

8 2Cash A/c

C 8,000 11 Drawing A/c

11 24,000

10 Bank A/c C 15,000 12 Purchase A/c

13 57,000

15 3

S.Rashid's A/c

15 10,000 16 Shakeel A/c

16 10,000

19 4Arshad Khan A/c

17 36,000 17 Arshad Khan A/c

17 36,000

21 5Interest A/c

19 1,400 27 Bank charges A/c

20 700

24 Sales A/c 5 33,000 31 Salary A/c

21 14,000

31 Balance C/d

112,000 20,7000

206,000 124,400 206,000 124,400

Feb. 1

Balanced b/d

112,000 20,700

1. On 6.1.2005, cheque received from Babar is treated as cash because it is not deposited into the bank on the same date.

2. A contra entry is passed when Babar's cheque (which was treated as cash) is deposited into the bank on 8.1.2005.

3. On 15.1.2005, cheque received from S. Rashid is treated as cash, so recorded in Cash Column.

4. Cheque issued to Arshad Khan on 17.1.2005 is dishonored, so the bank is debited again and Arshad Khan became a creditor again.

5. On 21.1.2005, the bank allowed us interest which is revenue for the business and our bank balance is increased by $1,400.

CONTROL ACCOUNTS

Control Accounts are the total accounts in the cost ledger which summarizes the totals of individual accounts (subsidiary ledger). In these accounts, entries are made once at the end of each accounting period based on the periodical totals of transactions in related subsidiary ledgers and books.

Control accounts act as a double check on the accuracy of the analysis. The balance of the control account at any time should equal to the sum of the balances of all individual accounts in subsidiary ledger.

For example, purchases of individual items of stores appearing in individual accounts in the stores ledger are totaled and posted in Stores Ledger Control Account in the cost ledger as total purchases. Thus, Stores Ledger Control Account is stores ledger in a summary form.

Similarly, a control account is also maintained for each of the other subsidiary ledger. The objective of opening a control account for cost ledger is to complete the double entry and to make the cost ledger self-balancing.

Advantages of Control Accounts

Provides a checking mechanism to detect errors and fraud at an early stage; Removes bulky details from the general ledger; Larger companies can set up accounting departments for specific areas;

Trial balance figures provide a summary of totals, rather than individual accounts

Sales Ledger Control Account is a summary account which checks the arithmetical accuracy of the Sales Ledger.  It enables us to see at a glance whether the general ledger balance for the sales ledger agrees with the total of all the individual trade receivable accounts held within the sales ledger. 

Sales Ledger Control Account typically looks like a "T-Account" or a replica of an Individual Trade Receivable ( Debtor) account, but instead of containing transactions related to one trade receivable (Debtor) it contains transactions related to all the trade receivables (all the debtors) in the business.  As this control account contains the summarized information of all the trade receivables accounts in the sales ledger, it is also called as "Total Trade Receivables Account"("Total Debtors Account").

Check out the format of this control account below and try to perceive the similarities with individual trade receivable account (Debtors account).

Format:

Format for Debtors Control Account

Sales ledger control account is generally prepared at the end of the financial year or "whenever" it is required to check the arithmetical accuracy of the individual trade receivable accounts.

As we discussed earlier, this control account is prepared as an independent check on the arithmetical accuracy of the sales ledger (Debtors Ledger). S

Purchases Ledger Control Account is a summary account which checks the arithmetical accuracy of the Purchases Ledger.  It enables us to see at a glance whether the general ledger balance for the purchases ledger agrees with the total of all the individual trade payable accounts held within the purchases ledger.

This Control Account typically looks like a "T-Account" or a replica of an Individual Trade Payable ( Creditor) account, but instead of containing transactions related to one trade payable (creditor) it contains transactions related to all the trade payables (all the creditors) in the business.  As this control account contains the summarized information of all the trade payables accounts in the purchases ledger, it is also called as "Total Trade Payables Account"("Total Creditors Account").

Check out the format of this control account below and try to perceive the similarities with individual trade payables account (creditors account).

Format:

Purchases ledger control account is generally prepared at the end of the financial year or "whenever" it is required to check the arithmetical accuracy of the individual trade payable accounts.

FINANCIAL STATEMENTS OF A SOLE TRADER/COMPANIE

Financial statements are reports prepared and issued by company management to give investors and creditors additional information about a company’s performance and financial standings. The four general purpose financial statements include:

Income Statement Balance Sheet Statement of Stockholders Equity Statement of Cash Flows

Income StatementWhat is an Income Statement?The income statement, also called the profit and loss statement, is a report that shows the income, expenses, and resulting profits or losses of a company during a specific time period. The income statement is the first financial statement typically prepared during the accounting cycle because the net income or loss must be calculated and carried over to the statement of owner’s equity before other financial statements can be prepared.The income statement calculates the net income of a company by subtracting total expenses from total income. This calculation shows investors and creditors the overall profitability of the company as well as how efficiently the company is at generating profits from total revenues.The income and expense accounts can also be subdivided to calculate gross profit and the income or loss from operations. These two calculations are best shown on a multi-step income statement. Gross profit is calculated by subtracting cost of goods sold from net sales. Operating income is calculated by subtracting operating expenses from the gross profit.

Unlike the balance sheet, the income statement calculates net income or loss over a range of time. For example annual statements use revenues and expenses over a 12-month period, while quarterly statements focus on revenues and expenses incurred during a 3-month period.

What is an Income Statement Used For?It’s important to note that there are several different types of income statements that are created for different reasons. For example, the year-end statement that is prepared annually for stockholders and potential investors doesn’t do much good for management while they are trying to run the company throughout the year. Thus, interim financial statements are prepared for management to check the status of operations during the year.

Management also typically prepares departmental statements that break down revenue and expense numbers by business segment.

In the end, the main purpose of all profit and loss statements is to communicate the profitability and business activities of the company with end users. Each one of these end users has their own use for this information. Let’s look at who uses the P&L and what they use it for.

Who Uses an Income Statement?There are two different groups of people who use this financial statement: internal users and external users.

Internal users like company management and the board of directors use this statement to analyze the business as a whole and make decisions on how it is run. For example, they use performance numbers to gauge whether they should open new branch, close a department, or increase production of a product.

External users like investors and creditors, on the other hand, are people outside of the company who have no source of financial information about the company except published reports. Investors want to know how profitable a company is and whether it will grow and become more profitable in the future. They are mainly concerned with whether or not investing their money is the company with yield them a positive return.

Creditors, on the other hand, aren’t as concerned about profitability as investors are. Creditors are more concerned with a company’s cash flow and if they are generating enough income to pay back their loans.

Competitors are also external users of financial statements. They use competitors’ P&L to gauge how well other companies are doing in their space and whether or not they should enter new markets and try to compete with other companies.

Income Statement ComponentsRevenueRevenue is the money an entity receives from the sale of goods or services. Other terms frequently used for revenue are sales, net sales, or sale revenue. It is also referred to as the “top line” because revenues are reported at the top of the income statement.Cost of Goods SoldCost of goods sold are the direct costs of producing the goods being offered by the entity. This would include the materials, labor, and other resources required for production.Gross ProfitGross profit is the difference between the revenue received for the product less the cost of goods sold.Operating ExpensesOperating expenses are the amount an entity expends to maintain and operate the general business. Operating expenses include research and development, marketing, general and administrative, amortization of intangible assets (i.e. patents, good will, etc.), etc.In addition, when an entity purchases a capital asset, such as a building or equipment, they expense a portion of the asset over a number of years; this is called depreciation. Depreciation expense is an accounting expense that is deducted from net income.

Operating IncomeOperating income is equal to revenues minus cost of goods sold and operating expenses. In other words, it measures the profits or losses of the day to day operations of the business.  Another name for Operating Income is Earnings Before Interest and Taxes (EBIT).Related Reading:  What is Operating Cash Flow?Other Income/ExpensesTo obtain net income, further adjustments must be made to account for interest income and expense, income tax expenses, and other extraordinary and miscellaneous  items.ProfitsRevenues minus all expenses equals net income (profits or losses). Profits are also referred to as net income or the “bottom line” because profits are reported at the bottom of the income statement. Some analysts call these “accounting profits” because they include non-cash accounting entries such as depreciation and amortization.Income Statement FormatRevenue–  Cost of Goods Sold Expense= Gross Profit (or Loss)–  Operating Expenses (R&D, selling & adm., depreciation, etc)= Operating IncomeOther Income/Expenses+ investment income– Interest Expense– Taxes+/- Non Recurring Events (Extraordinary items)=  Profit or Net Income

BALANCE SHEETWhat is a Balance Sheet?The balance sheet, also called the statement of financial position, is the third general purpose financial statement prepared during the accounting cycle. It reports a company’s assets, liabilities, and equity at a single moment in time. You can think of it like a snapshot of what the business looked like on that day in time.Unlike the income statement, the balance sheet does not report activities over a period of time. The balance sheet is essentially a picture a company’s recourses, debts, and ownership on a given day. This is why the balance sheet is sometimes considered less reliable or less telling of a company’s current financial performance than a profit and loss statement. Annual income statements look at performance over the course of 12 months, where as, the statement of financial position only focuses on the financial position of one day.

The balance sheet is basically a report version of the accounting equation also called the balance sheet equation where assets always equation liabilities plus shareholder’s equity.In this way, the balance sheet shows how the resources controlled by the business (assets) are financed by debt (liabilities) or shareholder investments (equity). Investors and creditors generally look at the statement of financial position for insight as to how efficiently a company can use its resources and how effectively it can finance them.

FormatThis statement can be reported in two different formats: account form and report form. The account form consists of two columns displaying assets on the left column of the report and liabilities and equity on the right column. You can think of this like debits and credits. The debit accounts are displayed on the left and credit accounts are on the right.The report form, on the other hand, only has one column. This form is more of a traditional report that is issued by companies. Assets are always present first followed by liabilities and equity.

In both formats, assets are categorized into current and long-term assets. Current assets consist of resources that will be used in the current year, while long-term assets are resources lasting longer than one year.

Liabilities are also separated into current and long-term categories.

Let’s look at each of the balance sheet accounts and how they are reported.

Asset SectionSimilar to the accounting equation, assets are always listed first. The asset section is organized from current to non-current and broken down into two or three subcategories. This structure helps investors and creditors see what assets the company is investing in, being sold, and remain unchanged. It also helps with financial ratio analysis. Ratios like the current ratio are used to identify how leveraged a company is based on its current resources and current obligations.

The first subcategory lists the current assets in order of their liquidity. Here’s a list of the most common accounts in the current section:

Current Cash Accounts Receivable Prepaid Expenses Inventory Due from Affiliates

The second subcategory lists the long-term assets. This section is slightly different than the current section because many long-term assets are depreciated over time. Thus, the assets are typically listed with a total accumulated depreciation amount subtracted from them. Here’s a list of the most common long-term accounts in this section:

Long-term Equipment Leasehold Improvements Buildings Vehicles Long-term Notes Receivable

Many times there will be a third subcategory for investments, intangible assets, and or property that doesn’t fit into the first two. Here are some examples of these balance sheet items:

Other Investments

Goodwill Trademarks Mineral Rights

According to the historical cost principle, all assets, with the exception of some intangible assets, are reported on the balance sheet at their purchase price. In other words, they are listed on the report for the same amount of money the company paid for them. This typically creates a discrepancy between what is listed on the report and the true fair market value of the resources. For instance, a building that was purchased in 1975 for $20,000 could be worth $1,000,000 today, but it will only be listed for $20,000. This is consistent with the balance sheet definition that states the report should record actual events rather than speculative numbers.

Liabilities SectionLiabilities are also reported in multiple subcategories. There are typically two or three different liability subcategories in the liabilities section: current, long-term, and owner debt.

The current liabilities section is always reported first and includes debt and other obligations that will become due in the current period. This usually includes trade debt and short-term loans, but it can also include the portion of long-term loans that are due in the current period. The current debts are always listed by due dates starting with accounts payable. Here’s a list of the most common current liabilities in order of how they appear:

Current Liabilities Accounts Payable Accrued Expenses Unearned Revenue Lines of Credit Current Portion of Long-term Debt

The second liabilities section lists the obligations that will become due in more than one year. Often times all of the long-term debt is simply grouped into one general listing, but it can be listed in detail. Here are some examples:

Long-term Liabilities Mortgage Payable Notes Payable Loans Payable

A lot of times owners loan money to their companies instead of taking out a traditional bank loan. Investors and creditors want to see this type of debt differentiated from traditional debt that’s owed to third parties, so a third section is often added for owner’s debt. This simply lists the amount due to shareholders or officers of the company.

Equity SectionUnlike the asset and liability sections, the equity section changes depending on the type of entity. For example, corporations list the common stock, preferred stock, retained earnings, and treasury stock. Partnerships list the members’ capital and sole proprietorships list the owner’s capital.

Like all financial statements, the balance sheet has a heading that display’s the company name, title of the statement and the time period of the report. For example, an annual income statement issued by Paul’s Guitar Shop, Inc. would have the following heading:

Paul’s Guitar Shop, Inc. Balance Sheet December 31, 2015

ExampleHere is an example of how to prepare the balance sheet from our unadjusted trial balance and financial statements used in the accounting cycle examples for Paul’s Guitar Shop.Account Format Balance Sheet

Report Format Balance Sheet

As you can see, the report format is a little bit easier to read and understand. That is why most issued reports are presented in report form. Plus, this report form fits better on a standard sized piece of paper.