Financial Statements: A Step-by-Step Guide to Understanding and Creating Financial Reports (by Thomas R. Ittelson)
- Financial Statements: Structure & Vocabulary
- About this Section
Much of what passes for complexity in accounting and financial reporting is just a specialized vocabulary and a simple numeric structure. This section will introduce the words, the basic accounting principles and the structure of the main financial statements.
- Twelve Basic Principles
Accountants have some basic rules upon which all their work in preparing financial statements is based. Who makes these rules? The simple answer is that the " FASB " makes the rules and they are called " GAAP ." Got that?
- The Balance Sheet
The Balance Sheet is one of the two main financial statements of a business...the other is the Income Statement. The Balance Sheet states the basic equation of accounting at an instant in time: What you have minus what you owe is what you're worth.
- The Income Statement
One of the two main financial statements of a business... the other is the Balance Sheet. The Income Statement gives one significant perspective on the health of the enterprise, its profitability.
- Cash Flow Statement
Where the company gets cash and where that cash goes. The Cash Flow Statement tracks the movement of cash through the business over a defined period of time.
The financial statements are connected; an entry in one may well affect each of the others. This interlocking flow of numbers allows the three statements together to form a cohesive picture of the company's financial position.
- Balance Sheet Connections
- Sales Cycle
- Expense Cycle
- Investment Cycle
- Asset Purchase & Depreciation Cycle
- Transactions: Exploits of AppleSeed Enterprises, Inc.
- About this Section
With our knowledge of the three main financial statements, we will now draft the books of a hypothetical company, AppleSeed Enterprises, Inc. We will report the common and everyday actions that AppleSeed takes as it goes about its business of making and selling applesauce. Accounting for these "transactions" (Ti through T31 below) is the subject of the rest of this book. We will describe the Balance Sheet, Income Statement and Cash Flow entries for business actions from selling common stock, to shipping product, to paying the owners a dividend.
- Startup Financing and Staffing
Welcome to our little business, AppleSeed Enterprises, Inc. Imagine that you are AppleSeed's entrepreneurial CEO. You also double as Treasurer and Chief Financial Officer ( CFO ).
- T1 Sell 150,000 shares of AppleSeed's common stock (par value $1) for $10 per share.
- T2 Pay yourself your first month's salary. Book all payroll-associated fringe benefits and taxes.
- T3 Borrow $1 million to buy a building. Terms of this 10 year mortgage are 10% per annum.
- T4 Pay $1.5 million for a building to be used for office, manufacturing and warehouse space. Set up a depreciation schedule.
- T5 Hire administrative and sales staff. Pay first month's salaries and book fringe benefits and taxes.
- T6 Pay employee health, life and disability insurance premiums plus FICA, unemployment and withholding taxes.
- Staffing & Equipping Facility; Planning for Manufacturing Startup
Now begins the fun stuff. In a few short weeks we will be producing thousands of cases of the best applesauce the world has ever tasted.
- T7 Order $250,000 worth of manufacturing machinery. Pay one-half down now.
- T8 Receive and install manufacturing machinery. Pay the remaining $125,000 due.
- T9 Hire production workers; capitalize first month's salary and wages.
- Prepare bill of materials and establish labor requirements.
- Set up plant and machinery depreciation schedules. .
- Plan monthly production schedule and set standard costs.
- T10 Place standing orders for raw materials with suppliers; receive 1 million jar labels.
- Startup of Manufacturing Operations
We are ready to start producing applesauce. The machinery is up and running, the workers are hired and we are about to receive a supply of raw materials.
- T11 Receive two months' supply of raw materials.
- T12 Start up production. Pay workers and supervisor for the month.
- T13 Book depreciation and other manufacturing overhead costs for the month.
- T14 Pay for the labels received in Transaction 10 in Chapter 7.
- T15 Finish manufacturing 19,500 cases of applesauce and move them into finished goods inventory.
- T16 Scrap 500 cases' worth of work-in-process inventory.
Manufacturing variances: what can go wrong, what can go right.
- T17 Pay for the two months' supply of raw materials received in Transaction ii above.
- T18 Manufacture another month's supply of applesauce.
- Marketing and Selling
A wise old consultant once said, "...really, all you need to be in business is a customer."
- T19 Produce product advertising fliers and T-shirt giveaways.
- Product pricing; break-even analysis
- T20 T22A new customer orders 1,000 cases of applesauce. Ship 1,000 cases per case.
- T21 Take an order (on credit) for 15,000 cases of applesauce at a discounted price of $15.66 per case.
- T22 Ship and invoice customer for 15,000 cases of applesauce ordered in Transaction 21 above.
- T23 Receive payment of $234,900 for the shipment made in Transaction 22 above and pay the broker's commission.
- T24 OOPS! customer goes bankrupt.
Write off cost of 1,000 cases as a bad debt.
- Administrative Tasks
We've been busy making and selling our delicious applesauce. But having been in business for three months, it is time to attend to some important administrative tasks.
- T25 Pay this year's general liability insurance.
- T26 Make principal and interest payments on three months' worth of building debts.
- T27 Pay payroll-associated taxes and insurance benefit premiums.
- T28 Pay some suppliers... especially the mean and hungry ones.
- Growth, Profit and Return
We've had a very good first year of operations. We will determine our profit for the year, compute the taxes we owe, declare a dividend and issue our first Annual Report to Shareholders.
- T29 Fast-forward through the rest of the year. Record summary transactions.
- T30 Book income taxes payable.
- T31 Declare a $0.375 per-share dividend and pay to common shareholders.
- Cash Flow Statement: Changes in Financial Position format.
- AppleSeed Enterprises, Inc. Annual Report to Shareholders.
- What is AppleSeed worth? How to value a business.
- Financial Statements: Construction & Analysis
- About this Section
- Ledgers and Journals
Journals and ledgers are where accountants scribble transaction entries. A journal is a book (or computer memory) in which all financial events are recorded in chronological order. A ledger is a book of accounts. An account is simply any grouping of like-items that we want to keep track of.
- Keeping Track with journals and ledgers:
- Cash Ledger,
- Accounts Payable Ledger
- Accrued Expenses Ledger
- Accounts Receivable Ledger
- Ratio Analysis
Often in judging the financial condition of an enterprise, it is not so much the absolute amount of sales, costs, expenses and assets that are important, but rather the relationships between them.
- Common Size Statements: Income Statement, Balance Sheet
- Liquidity Ratios: Current Ratio, Quick Ratio
- Asset Management Ratios: Inventory Turn, Asset Turn, Receivable Days
- Profitability Ratios: Return on Assets, Return on Equity, Return on Sales, Gross Margin
- Leverage Ratios: Debt-to-Equity, Debt Ratio
- Industry and Company Comparisons
- Alternative Accounting Policies
Various alternative accounting policies and procedures are completely legal and widely used, but may result in significant differences in the values reported on a company's financial statements. Conservative? Aggressive? Some people would call this chapter's topic "creative accounting."
- Cooking the Books
"Cooking the books" means intentionally hiding or distorting the real financial performance or financial condition of a company. Cooking is most often accomplished by incorrectly and fraudulently moving Balance Sheet items onto the Income Statements and vise versa. Outright lying is also a favorite technique.
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