Accounting For Dummies. John A. Tracy

are recorded. For example, if one asset goes up, another asset goes down — or, alternatively, either a liability or owners’ equity element goes up. In accounting, double-entry means two-sided, not that transactions are recorded twice.

      A POP QUIZ

Here’s a teaser for you. If a business’s total assets equal $2.5 million and its total liabilities equal $1.0 million, we know that its total owners’ equity is $1.5 million. Question: Could the owners have invested more than $1.5 million in the business? Answer: Yes. One possibility is that the owners invested $2.5 million, but the business has so far accumulated $1.0 million of losses instead of making a profit. The accumulated loss offsets the amount invested, so the owners’ equity is only $1.5 million net of its cumulative loss of $1.0 million. The owners bear the risk that the business may be unable to make a profit. Instead of retained earnings, the business would report a $1.0 million deficit in its balance sheet.

      Reporting profit and loss

      

Everyone (including managers, lenders, and owners) is interested in whether the business enjoyed a profit or suffered a loss for the year. Suppose you have in your hands the balance sheet of a business showing the end of last year and the end of the year just ended. You can calculate profit or loss for the most recent year by computing the increase in retained earnings and adding the amount of distributions from profit during the year. Suppose the business’s retained earnings increased $5.0 million during the year and it paid out $2.0 million cash from profit to its owners. Therefore, its profit for the year is $7.0 million.

      Oh, you want to know its revenue and expenses for the year — not just the profit for the year. In fact, the standard practice in financial reporting is to present a financial statement that discloses the total revenue and total expenses for the period and ends with the profit (or loss) on the bottom line of the statement. The income statement summarizes sales revenue and other income, which are offset by the expenses and losses during the period. Deducting expenses from revenue and income leads down to the well-known bottom line, which is the final net profit or loss for the period and is called net income or net loss (or some variation of these terms). Alternative titles for this financial statement are the statement of operations and the statement of earnings. Inside a business, but not in its external financial reports, the income statement is commonly called the P&L (profit and loss) report.

      

Of course, the bottom line of the income statement should be the same amount that could be computed by adding the change in retained earnings and distributions to owners during the year from the profit.

      Reporting cash flows and changes in owners’ equity

      Cash is king, as business managers and investors will tell you. More than a quarter of a century ago, the rule-making authority in financial accounting said a business should report a statement of cash flows to supplement the income statement and balance sheet. This financial statement summarizes the business’s cash inflows and outflows during the period.

      A highlight of this statement is the cash increase or decrease from profit (or loss) for the period. This key amount in the cash flow statement is called cash flow from operating activities. We explain the statement of cash flows in Chapters 2 and 8. Be warned early on that many argue that this cash flow figure is more important than bottom-line profit for the period. Well, we’ll see about that!

      

It becomes clear throughout this book that we harp on and emphasize the importance of the statement of cash flows because it offers critical financial information about how a business generates and consumes cash. What we have found over our vast experience is that while most parties (internal and external — both are equally guilty) jump right to the income statement to identify the growth in top-line sales revenue or how much bottom-line profit was generated, or focus on the balance sheet to evaluate the company’s financial strength, the statement of cash flows tends to get passed over relatively quickly. Why? you may ask. It usually comes down to either the party being lazy, having a lack of understanding (as to the purpose of this statement), or believing that the statement of cash flows is overly complex and is not particularly important. All are poor excuses because, in order to truly understand accounting and a company’s financial statements, the statement of cash flows should never be overlooked!

      Also, it’s common for many businesses to include a summary of changes in their owners’ equity accounts during the year. Typically it’s called a statement of changes in stockholders’ equity. We could argue that it’s not a full-fledged financial statement, but there’s little point in arguing semantics here — although the other three financial statements (balance sheet, income statement, and cash flows statement) are “full-size” statements. Larger, public corporations are required to present this statement, whereas smaller, private businesses have more leeway in deciding whether to include such a summary. We explain the statement of changes in stockholders’ equity in Chapter 2.

      Remembering management’s role

We explain more about the three primary financial statements (balance sheet, income statement, and statement of cash flows) in Chapter 2. They constitute the hard core of a financial report to those persons outside a business who need to stay informed about the business’s financial affairs. These individuals have invested capital in the business, or the business owes them money; therefore, they have a financial interest in how well the business is doing.

      To keep informed about what’s going on and the financial position of the business, the managers of a business also use these three key financial statements. These statements are essential in helping managers control the performance of a business, identify problems as they come up, and plan the future course of a business. Managers also need other information that isn’t reported in the three basic financial statements. (In Chapter 13, we explain these additional reports.)

      The three primary financial statements constitute a business’s financial center of gravity. The president and chief executive officer of a business (plus other top-level officers) are responsible for seeing that the financial statements are prepared according to applicable financial reporting standards and according to established accounting principles and methods.

      

If a business’s financial statements are later discovered to be seriously in error or deliberately misleading, the business and its top executives can be sued for damages suffered by lenders and investors who relied on the financial statements. For this reason, business managers must understand their responsibility for the financial statements and the accounting methods used to prepare the statements. In a court of law, managers can’t plead ignorance.

      We’ve met more than one business manager who doesn’t have a clue about his or her financial statements. This situation is a little scary; a manager who doesn’t understand financial statements is like an airplane pilot who doesn’t understand the instrument readouts in the cockpit. Such a manager could run the business and “land the plane safely,” but knowing how to read the instrument panels along the way is much more prudent.

      Business managers at all levels need to understand financial statements and the accounting methods used to prepare them. Also, lenders to a business,