How to Read a Financial Report. John A. Tracy

public corporations are required to provide historical information. We need only one year to explain the income statement.

Reporting Financial Condition: The Balance Sheet

      The balance sheet shown in Exhibit 2.2 follows the standardized format regarding the classification and ordering of assets, liabilities, and ownership interests in the business. Financial institutions, public utilities, railroads, and other specialized businesses use somewhat different balance sheet layouts. However, manufacturers and retailers, as well as the large majority of various types of businesses, follow the format presented in Exhibit 2.2.

      The left side of the balance sheet lists assets. The right side of the balance sheet first lists the liabilities of the business, which have a higher-order claim on the assets. The sources of ownership (equity) capital in the business are presented below the liabilities. This is to emphasize that the owners or equity holders in a business (the stockholders of a business corporation) have a secondary and lower-order claim on the assets—after its liabilities are satisfied.

      Roughly speaking, a balance sheet lists assets in their order of nearness to cash. Cash is listed first at the top of the assets. Next, receivables that will be collected in the short run are listed, and so on down the line. (In later chapters, we say much more about the cash characteristics of different assets.) Liabilities are presented in the sequence of their nearness to payment. (We discuss this point as we go along in later chapters.)

      Each separate asset, liability, and stockholders’ equity reported in a balance sheet is called an account. Every account has a name (title) and a dollar amount, which is called its balance. For instance, from Exhibit 2.2 at the end of the most recent year we can determine:

Name of Account	Amount (Balance) of Account
Inventory	$8,450,000

      The other dollar amounts in the balance sheet are either subtotals or totals of account balances. For example, the $17,675,000 amount for “Current Assets” at the end of this year does not represent a single account but rather the subtotal of the four accounts making up this group of accounts. A line is drawn above a subtotal or total, indicating account balances are being added.

      A double underline (such as for “Total Assets”) indicates the last amount in a column. Notice also the double underline below “Net Income” in the income statement (Exhibit 2.1), indicating it is the last number in the column.

      A balance sheet is prepared at the close of business on the last day of the income statement period. For example, if the income statement is for the year ending June 30, 2020, the balance sheet is prepared at midnight June 30, 2020. The amounts reported in the balance sheet are the balances of the accounts at that precise moment in time. The financial condition of the business is frozen for one split second. A business should be careful to make a precise and accurate cutoff to separate transactions between the period just ended and next period.

A balance sheet does not report the flows of activities in the company’s assets, liabilities, and shareowners’ equity accounts during the period. Only the ending balances at the moment the balance sheet is prepared are reported for the accounts. For example, the company reports an ending cash balance of $3,265,000 at the end of its most recent year (see again Exhibit 2.2). Can you tell the total cash inflows and outflows for the year? No, not from the balance sheet; you can’t even get a clue from the balance sheet alone.

      A balance sheet can be presented in the landscape (horizontal) layout mode as shown in Exhibit 2.2, or in the portrait (vertical) layout. The accounts reported in the balance sheet are not thrown together haphazardly in no particular order. According to long-standing rules, balance sheet accounts are subdivided into the following classes, or basic groups, in the following order of presentation:

Left Side (or Top Section)	Right Side (or Bottom Section)
Current assets	Current liabilities
Long-term operating assets	Long-term liabilities
Other assets	Owners’ equity

      Current assets are cash and other assets that will be converted into cash during one operating cycle. The operating cycle refers to the sequence of buying or manufacturing products, holding the products until sale, selling the products, waiting to collect the receivables from the sales, and finally receiving cash from customers. This sequence is the most basic rhythm of a company’s operations; it is repeated over and over. The operating cycle may be short, 60 days or less, or it may be relatively long, taking 180 days or more.

      Assets not directly required in the operating cycle, such as marketable securities held as temporary investments or short-term loans made to employees, are included in the current assets class if they will be converted into cash during the coming year. A business pays in advance for some costs of operations that will not be charged to expense until next period. These prepaid expenses are included in current assets, as you see in Exhibit 2.2.

      The second group of assets is labeled “Long-Term Operating Assets” in the balance sheet. These assets are not held for sale to customers; rather, they are used in the operations of the business. Broadly speaking, these assets fall into two groups: tangible and intangible assets. Tangible assets have physical existence, such as machines and buildings. Intangible assets do not have physical existence, but they are legally protected rights (such as patents and trademarks), or they are such things as secret processes and well-known favorable reputations that give businesses important competitive advantages. Generally intangible assets are recorded only when the assets are purchased from a source outside the business.

      The tangible assets of the business are reported in the “Property, Plant, and Equipment” account (see Exhibit 2.2 again). More informally, these assets are called fixed assets, although this term is generally not used in balance sheets. The word fixed is a little strong; these assets are not really fixed or permanent, except for the land owned by a business. More accurately, these assets are the long-term operating resources used over several years—such as buildings, machinery, equipment, trucks, forklifts, furniture, computers, and telephones.

The cost of a fixed asset—with the exception of land—is gradually charged off to expense over its useful life. Each period of use thereby bears its share of the total cost of each fixed asset. This apportionment of the cost of fixed assets over their useful lives is called depreciation. The amount of depreciation for one year is reported as an expense in the income statement (see Exhibit 2.1). The cumulative amount that has been recorded as depreciation expense since the date of acquisition up to the balance sheet date is reported in the accumulated depreciation account in the balance sheet (see Exhibit 2.2). As you see, the balance in the accumulated depreciation account is deducted from the original cost of the fixed assets.

      In