Accounting For Dummies. John A. Tracy

order: First is cash, then receivables, then cost of products held for sale, and finally the long-term operating assets of the business. Moving to the other side of the balance sheet, the liabilities section starts with the trade liabilities (from buying on credit) and liabilities for unpaid expenses. Following these operating liabilities is the interest-bearing debt of the business. Owners’ equity sources are then reported below liabilities. So a balance sheet is a composite of assets on one hand and a composite of liabilities and owners’ equity sources on the other hand.

A balance sheet is a reflection of the fundamental two-sided nature of a business (expressed in the accounting equation, which we discuss in Chapter 1). In the most basic terms, assets are what the business owns, and liabilities plus owners’ equity are the sources of the assets. The sources have claims against the assets. Liabilities and interest-bearing debt have to be paid, of course, and if the business were to go out of business and liquidate all its assets, the residual after paying all its liabilities would go to the owners.

      A company that sells services doesn’t have an inventory of products being held for sale. A service company may or may not sell on credit. Airlines don’t sell on credit, for example. If a service business doesn’t sell on credit, it won’t have two of the sizable assets you see in Figure 2-2: receivables from credit sales and inventory of products held for sale. Generally, this means that a service-based business doesn’t need as much total assets compared with a products-based business with the same size sales revenue.

      The smaller amount of total assets of a service business means that the other side of its balance sheet is correspondingly smaller. In plain terms, this means that a service company doesn’t need to borrow as much money or raise as much capital from its equity owners.

      As you may suspect, the particular assets reported in the balance sheet depend on which assets the business owns. We include six basic types of assets in Figure 2-2. These are the hardcore assets that a business selling products or services on credit would have. It’s possible that such a business could lease (or rent) virtually all its long-term operating assets instead of owning them, in which case the business would report no such assets. In this example, the business owns these so-called fixed assets. They’re fixed because they are held for use in the operations of the business and are not for sale, and their usefulness lasts several years or longer.

      Balance sheet pointers

      So where does a business get the money to buy its assets? Most businesses borrow money on the basis of interest-bearing notes or other credit instruments for part of the total capital they need for their assets. Also, businesses buy many things on credit and, at the balance sheet date, owe money to their suppliers, which will be paid in the future.

      These operating liabilities are never grouped with interest-bearing debt in the balance sheet. The accountant would be tied to the stake for doing such a thing. Liabilities are not intermingled with assets — this is a definite no-no in financial reporting. You can’t subtract certain liabilities from certain assets and report only the net balance.

Could a business’s total liabilities be greater than its total assets? Well, not likely — unless the business has been losing money hand over fist. In the vast majority of cases, a business has more total assets than total liabilities. Why? For two reasons:

       Its owners have invested money in the business.

       The business has earned profit over the years, and some (or all) of the profit has been retained in the business. Making profit increases assets; if not all the profit is distributed to owners, the company’s assets rise by the amount of profit retained.

      

In the company example (see Figure 2-2), owners’ equity is about $16 million, or $15.959 million to be more exact. Sometimes this amount is referred to as net worth because it equals total assets minus total liabilities. However, net worth can be misleading because it implies that the business is worth the amount recorded in its owners’ equity accounts. The market value of a business, when it needs to be known, depends on many factors. The amount of owners’ equity reported in a balance sheet, which is called the business’s book value, is not irrelevant in setting a market value on the business, but it usually isn’t the dominant factor. The amount of owners’ equity in a balance sheet is based on the history of capital invested in the business by its owners and the history of its profit performance and distributions from profit.

      

A balance sheet could be whipped up anytime you want — say, at the end of every day. In fact, some businesses (such as banks and other financial institutions) need daily balance sheets, but few businesses prepare balance sheets that often. Typically, preparing a balance sheet at the end of each month is adequate for general management purposes — although a manager may need to look at the business’s balance sheet in the middle of the month. In external financial reports (those released outside the business to its lenders and investors), a balance sheet is required at the close of business on the last day of the income statement period. If its annual or quarterly income statement ends, say, September 30, then the business reports its balance sheet at the close of business on September 30.

      The profit for the most recent period is found in the income statement; periodic profit is not reported in the balance sheet. The profit reported in the income statement is before any distributions from profit to owners. The cumulative amount of profit over the years that hasn’t been distributed to the business’s owners is reported in the owners’ equity section of the company’s balance sheet.

By the way, notice that the balance sheet in Figure 2-2 is presented in a top-and-bottom format instead of a left-and-right format. Either the vertical (portrait) or horizontal (landscape) mode of display is acceptable. You see both layouts in financial reports. Of course, the two sides of the balance sheet should be kept together, either on one page or on facing pages in the financial report. You can’t put assets up front and hide the other side of the balance sheet in the rear of the financial report.

The Statement of Cash Flows

      To survive and thrive, business managers confront three financial imperatives:

       Make an adequate profit (or at least break even, for a not-for-profit entity). The income statement reports whether the business made a profit or suffered a loss for the period.

       Keep the financial condition in good shape. The balance sheet reports the financial condition of the business at the end of the period.

       Control cash flows. Management’s control over cash flows is reported in the statement of cash flows, which presents a summary of the business’s sources and uses of cash during the same period as the income statement.

      This section introduces you to the statement of cash flows. (We coauthored Cash Flow For Dummies, published by Wiley, which you may want to take a peek at for more information.) Financial reporting standards require that the statement of cash flows be reported when a business reports an income statement.

      Presenting the components of the statement of cash flows

      Successful business managers tell you that they have to manage both profit and cash flow; you can’t do one and ignore the other. Business managers have to deal with a two-headed dragon in this respect. Ignoring cash flow can pull the rug out from under a successful profit formula.

Figure 2-3 shows the basic information components of the statement