Accounting For Dummies. John A. Tracy

Setting the Stage for Financial Statements

      This chapter focuses on the basic information components of each financial statement reported by a business. The first step is to get a good idea of the information content reported in financial statements. The second step is to become familiar with more details about the “architecture,” rules of classification, and other features of financial statements (see Part 2).

      Offering a few preliminary comments about financial statements

      Realistic examples are needed to illustrate and explain financial statements. But this presents a slight problem. The information content of a business’s financial statements depends on whether it sells products, services, or both (for instance, Apple sells both products and services); invests in other businesses; and so on. For example, the financial statements of a movie theater chain are different from those of a bank, which are different from those of an airline, which are different from an automobile manufacturer’s, which are different from — well, you name it.

      The classic example used to illustrate financial statements involves a business that sells both products and services, and sells on credit to its customers. Therefore, the assets in the example include receivables from the business’s sales on credit and inventory of products it has purchased or manufactured that are awaiting future sale. Keep in mind, however, that many businesses that sell products do not sell on credit to their customers. Many retail businesses sell only for cash (or accept credit or debit cards that are near cash). Such businesses do not have a receivables asset.

      

The financial statements of a business do not present a “history” of the business. Financial statements are, to a large extent, limited to the recent profit performance and financial condition of the business. A business may add some historical discussion and charts that aren’t strictly required by financial reporting standards. (Public corporations that have their ownership shares and debt traded in open markets are subject to various disclosure requirements under federal law, including certain historical information.)

      The illustrative financial statements that follow in this part and Part 2 do not include a historical narrative of the business. Nevertheless, whenever you see financial statements, we encourage you to think about the history of the business. To help you out in this regard, here are some particulars about the business example we use in this chapter:

       It sells products and services to other businesses (not on the retail level).

       It sells on credit, and its customers take approximately a month or so before they pay.

       It holds a fairly large stock of products awaiting sale.

       It owns a wide variety of long-term operating assets that have useful lives from 3 to 30 years or longer (building, machines, tools, computers, office furniture, goodwill, intellectual property, and so on).

       It has been in business for many years and has made a profit most years.

       It borrows money for part of the total assets it needs.

       It’s organized as a corporation and pays federal and state income taxes on its annual taxable income.

       It has never been in bankruptcy and is not facing any immediate financial difficulties.

      The following sections present the company’s annual income statement for the year just ended, its balance sheet at the end of the year, and its statement of cash flows for the year.

      Looking at other aspects of reporting financial statements

      

Dollar amounts in financial statements are typically rounded off, either by not presenting the last three digits (when rounded to the nearest thousand) or by not presenting the last six digits (when rounded to the nearest million). We strike a compromise on this issue: We show the last three digits for each item as 000, which means that we rounded off the amount but still show all digits. Many smaller businesses report their financial statement dollar amounts to the last dollar or even the last penny, for that matter. Keep in mind that having too many digits in a dollar amount makes it hard to comprehend.

      The financial statements in this chapter are more in the nature of an outline. Actual financial statements use only one- or two-word account titles on the assumption that you know what all these labels mean. What you see in this chapter, on the other hand, are the basic information components of each financial statement. We explain the full-blown, classified, detailed financial statements in Part 2. (We know you’re eager to get to those chapters.) In this chapter, we offer descriptions for each financial statement element rather than the terse and technical account titles you find in actual financial statements. Also, we strip out subtotals that you see in actual financial statements because they aren’t necessary at this point.

      

Oops! We forgot to mention a few things about financial reports. Financial reports are rather stiff and formal. No slang or street language is allowed, and we’ve never seen a swear word in one. Financial statements would get a G in the movies rating system. Seldom do you see any graphics or artwork in a financial statement itself, although you do see a fair amount of photos and graphics on other pages in the financial reports of public companies. And there’s virtually no humor in financial reports. However, we might mention that Warren Buffett, in his annual letter to the stockholders of Berkshire Hathaway, includes some wonderful humor to make his points.

The Income Statement

First on the minds of financial report readers is the profit performance of the business. The income statement is the all-important financial statement that summarizes the profit-making activities of a business over a period of time. Figure 2-1 shows the basic information content of an external income statement for our company example. External means that the financial statement is released outside the business to those entitled to receive it — primarily its shareowners and lenders. Internal financial statements stay within the business and are used mainly by its management; they aren’t circulated outside the business because they contain competitive and confidential information.

      Presenting the components of the income statement

      Figure 2-1 presents the major ingredients, or information packets, in the income statement for a technology company that sells products and services. As you may expect, the income statement starts with sales revenue on the top line. There’s no argument about this, although in the past, certain companies didn’t want to disclose their annual sales revenue (to hide the large percent of profit they were earning on sales revenue).

      Sales revenue is the total amount that has been or will be received from the company’s customers for the sales of products and services to them. Simple enough, right? Well, not really. The accounting profession is currently reexamining the technical accounting standards for recording sales revenue, and this has proven to be a challenging task. Our business example, like most businesses, has adopted a certain set of procedures for the timeline of recording its sales revenue.

      Recording expenses involves much more troublesome accounting problems than revenue problems for most businesses. Also, there’s the fundamental question regarding which information to disclose about expenses and which information to bury in larger expense categories in the external income statement. We say much more about expenses