Chapter 8 Business Accounting
Accounting is a systematic method of recording, analyzing, and summarizing financial transactions. The outcome of accounting is a comprehensive snapshot of a company’s financial health, communicated through financial statements:
- The balance sheet assesses the company’s assets, liabilities, and equity at a given time, reflecting the cumulative outcome of all financial activities.
- The ledger acts as the central repository where all transactions are recorded, reflecting the continuous financial activity that occurs within a company.
- The income statement measures the company’s financial performance over an interval, providing insights into its ability to generate profit.
- The cash flow statement reveals the actual liquidity position of the business, identifying how cash is generated and utilized.
This chapter will guide you through the fundamental principles of business accounting.
8.1 Accounting Standards
Accounting standards serve as the framework for financial reporting, ensuring consistency, reliability, and comparability of financial statements. In the United States, the Financial Accounting Standards Board (FASB, 2023) develops the Generally Accepted Accounting Principles (GAAP), which companies are required to follow when compiling their financial statements. GAAP covers a broad range of accounting practices, from revenue recognition to balance sheet item classification.
Internationally, the International Accounting Standards Board (IASB, 2023) issues the International Financial Reporting Standards (IFRS), which aim to standardize accounting practices across the globe, making it easier for investors to compare financial statements from companies in different countries. While IFRS is used in over 140 jurisdictions, the U.S. has not fully adopted these standards, creating a dichotomy in financial reporting. Nonetheless, there are ongoing discussions and efforts towards convergence between FASB and IASB to enhance the compatibility of the two systems, which would benefit multinational corporations and international investors.
8.2 Accounting Equation
At the heart of accounting lies the fundamental equation:
\[ \text{Assets} = \text{Liabilities} + \text{Equity} \]
- Assets are resources owned by a company with economic value.
- Liabilities are obligations or debts that the company owes to outside parties.
- Equity represents the owner’s claims on the assets after all liabilities have been deducted.
This equation forms the basis for the double-entry system of accounting, which requires that every transaction is recorded in at least two accounts, helping to maintain the balance reflected in the equation. The entries are as follows:
- Debit: An entry that increases an asset account, or decreases a liability or equity account.
- Credit: An entry that increases a liability or equity account, or decreases an asset account.
These definitions imply:
- Increases in assets are debited.
- Increases in liabilities and equity are credited.
- Decreases in assets are credited.
- Decreases in liabilities and equity are debited.
Each transaction involves a debit and a credit that must equal each other in value, preserving the accounting equation.
8.3 Balance Sheet
The balance sheet is a concrete manifestation of the double-entry system of accounting: it is a snapshot of a firm’s assets, liabilities, and equity as of a specific date, reflecting its financial position at that moment. A sample balance sheet for a bakery is shown in Table 8.1.
| Cash | 10,000 | Accounts Payable | 18,000 |
| Accounts Receivable | 8,000 | Accrued Liabilities | 5,000 |
| Inventory | 15,000 | Notes Payable | 17,000 |
| Prepaid Expenses | 2,000 | Long-term Debt | 40,000 |
| Property, Plant, and Equipment (PPE) | 40,000 | Owner’s Equity | 60,000 |
| Land and Buildings | 100,000 | Retained Earnings | 25,000 |
| Total | 175,000 | Total | 165,000 |
Let’s dissect the balance sheet of a bakery as presented in Table 8.1 to understand each component.
8.3.1 Assets
Assets are economic resources that are expected to benefit the bakery’s future operations. They are categorized as either current or non-current:
- Current Assets: These are assets that the bakery expects to convert to cash within one year. For the bakery, this includes:
- Cash: Money in hand and in the bank.
- Accounts Receivable: Money owed by customers who have purchased baked goods on credit.
- Inventory: Ingredients like flour, sugar, and other supplies that are to be used within the year.
- Prepaid Expenses: Payments made in advance for services or goods, such as insurance or rent for the bakery space.
- Non-Current Assets: These assets will be used over a longer period:
- Property, Plant, and Equipment (PPE): This includes the bakery’s ovens, refrigerators, and other long-term equipment, net of depreciation.
- Land and Buildings: If the bakery owns property, the value of these long-term investments is included here.
- Intangible Assets: Any non-physical assets like trademarks or patents, which may not be relevant for all bakeries.
8.3.2 Liabilities
Liabilities represent what the bakery owes to others—these are the financial obligations and debts:
- Current Liabilities: Obligations due within one year, such as:
- Accounts Payable: Money the bakery owes to suppliers for ingredients and other goods.
- Accrued Expenses: Incurred expenses not yet paid, such as utilities or wages.
- Notes Payable: Short-term borrowings or lines of credit.
- Non-Current Liabilities: Debts that are payable over a period longer than one year, like a mortgage on the bakery’s property.
8.3.3 Equity
Equity is what’s left after liabilities are subtracted from assets and includes:
- Owner’s Capital: Initial and additional investments made by the owner(s) into the bakery.
- Retained Earnings: Cumulative earnings retained in the business, reflecting the bakery’s profitability over time.
In the day-to-day operations of the bakery, every purchase made, every sale conducted, and every payment received or expense incurred will interact with this balance sheet. For instance, when the bakery sells its goods, it increases its cash (asset) and simultaneously increases its retained earnings (equity), assuming no new liabilities are created. Conversely, if the bakery incurs a new debt, it might increase cash (asset) while simultaneously increasing accounts payable (liability).
By examining the balance sheet of the bakery in Table 8.1, stakeholders can glean insights into the bakery’s financial stability and operational prowess. It answers crucial questions about liquidity (Can the bakery meet its short-term obligations?), solvency (Can the bakery sustain itself in the long term?), and overall financial health.
8.3.4 Transactions
Every transaction the bakery engages in will have a dual effect on the balance sheet, maintaining the balance of the accounting equation. For example, if the bakery purchases inventory on credit, such as purchasing flour with a credit card, both assets and liabilities increase by the same amount, as demonstrated in Table 8.2.
| Cash | 0 | Accounts Payable | +5,000 |
| Accounts Receivable | 0 | Accrued Liabilities | 0 |
| Inventory | +5,000 | Notes Payable | 0 |
| Prepaid Expenses | 0 | Long-term Debt | 0 |
| Property, Plant, and Equipment (PPE) | 0 | Owner’s Equity | 0 |
| Land and Buildings | 0 | Retained Earnings | 0 |
| Total | +5,000 | Total | +5,000 |
Table 8.3 presents a streamlined version, highlighting only the accounts that were affected.
| Inventory | +5,000 | Accounts Payable | +5,000 |
Table 8.3 confirms the double-entry bookkeeping principle, wherein each transaction is recorded in two accounts to maintain the accounting equation. In this case, the acquisition of inventory is entered as a debit to increase the asset account “Inventory,” and simultaneously, a credit to increase the liability account “Accounts Payable,” thus detailing the purchase made on credit.
When a bakery pays off its accounts payable, such as settling a bill for ingredients purchased on credit, it decreases its liabilities and its assets by the same amount, as the cash is used to pay off the debt. For this example, suppose the bakery pays off $2000 of its accounts payable, as illustrated in Table 8.4.
| Cash | -2,000 | Accounts Payable | -2,000 |
Table 8.4 showcases how settling debts affects financial position without altering the overall balance. In this transaction, the payment of debt with cash results in a credit to the asset account ‘Cash,’ thus decreasing it, and a debit to the liability account ‘Accounts Payable,’ also decreasing it.
Lastly, consider the bakery generating $3000 in cash from the sale of baked goods. This transaction increases assets (Cash) and also increases equity (Retained Earnings), reflecting the income from sales.
| Cash | +3,000 | Retained Earnings | +3,000 |
Table 8.5 illustrates the impact of a revenue transaction on the balance sheet, where assets and equity increase by the same amount. In this entry, the cash receipt from sales is recorded as a debit, increasing the ‘Cash’ account, while a corresponding credit is made to the ‘Retained Earnings’ account, reflecting the income retained in the business.
In summary, Tables 8.3, 8.4, and 8.5 collectively illustrate the fundamental principle of double-entry bookkeeping, where every business transaction is reflected in at least two accounts, maintaining the integrity of the financial statements.
8.3.5 Book vs. Market Value
Analyzing a company’s financial statements requires understanding the distinction between book value and market value, as these are fundamental to asset and equity valuation.
Book value is an accounting measure reflecting the net asset value recorded on the financial statements. It is computed as the difference between total assets and total liabilities:
\[ \text{Book Value of Equity} = \text{Total Assets} - \text{Total Liabilities} \]
For individual assets, book value is calculated by subtracting accumulated depreciation from the asset’s historical cost:
\[ \text{Book Value of an Asset} = \text{Historical Cost} - \text{Accumulated Depreciation} \]
Historical cost encompasses the purchase price and any expenses incurred to bring the asset to its intended use. Accumulated depreciation aggregates the depreciation expenses recognized since the asset’s acquisition, signifying its usage and wear.
Market value, in contrast, reflects the current valuation of a company or its assets in the market. The market value of a company’s equity is the product of the market price per share and the total shares outstanding:
\[ \begin{aligned} \text{Market Value of Equity} \ =&\ \text{Current Market Price per Share} \\ &\times \text{Total Number of Outstanding Shares} \end{aligned} \]
The market value of an individual asset is the expected sale price in the open market:
\[ \text{Market Value of an Asset} = \text{Current Market Selling Price of the Asset} \]
Accounting Rules
Assets on the balance sheet are typically recorded at their book value, not their market value. However, there are some exceptions where market value is used:
- Marketable Securities: Financial assets such as stocks or bonds that are held for trading purposes are often reported at their fair market value due to their liquidity and the ease of determining their current market price.
- Revaluation: Some accounting frameworks, like IFRS, allow for certain assets to be revalued to their current market value. This typically applies to long-term assets that can fluctuate significantly in value, such as real estate or certain investment properties.
- Impairment: If an asset’s market value drops significantly and is not expected to recover, an impairment loss may be recognized, bringing the book value closer to the market value.
It’s important to note that these exceptions are subject to specific accounting rules and standards, which can vary by country and by the accounting framework applied (such as GAAP or IFRS).
Comparison
Key distinctions between book value and market value include:
- Valuation Basis:
- Book value is based on the acquisition cost and accounting adjustments.
- Market value is based on current economic conditions, future prospects, and investor perceptions.
- Stability:
- Book value remains relatively stable over time, only changing due to accounting actions such as depreciation or revaluation.
- Market value is highly volatile, changing with market conditions.
- Purpose:
- Book value is useful for analysts who want to assess the company’s actual invested value in its components and the financial health as per the balance sheet.
- Market value is used by investors to determine a company’s perceived value and to make decisions about buying or selling its stock.
- Relevance:
- Book value provides a conservative measure of a company’s value, important for situations such as liquidation.
- Market value reflects the real-time speculation on a company’s growth potential and profitability, more relevant for investment decisions.
In finance, discerning the nuances between book and market values enables a comprehensive evaluation of a company’s worth. Book value offers a historical basis for valuation, while market value presents an up-to-date appraisal informed by market dynamics. Analysts often examine the divergence between these values to determine market perceptions of over or undervaluation.
8.3.6 Public Company
A public company is a business entity that has issued equity securities through an initial public offering (IPO) and is traded on at least one stock exchange or in the over-the-counter market. Unlike a private company such as a bakery, which is owned by an individual or a small group, the ownership of a public company is distributed among public shareholders. Public companies are required to adhere to strict regulatory standards, which include the obligation to disclose detailed financial reports to the public and regulatory bodies. This results in a balance sheet that not only reflects the company’s financial state but also complies with the established financial reporting frameworks such as the Generally Accepted Accounting Principles (GAAP) for the United States, or the International Financial Reporting Standards (IFRS).
| Account | Description | Amount |
|---|---|---|
| Current Assets | ||
| Cash and Cash Equivalents | Liquid funds available for use | 170,000 |
| Accounts Receivable | Funds to be received from customers | 80,000 |
| Prepaid Expenses | Payments made in advance for services/goods | 20,000 |
| Short-Term Investments | Investments maturing within one year | 250,000 |
| Inventory | Goods available for sale or use | 150,000 |
| Other Current Assets | Other assets converted to cash within one year | 50,000 |
| Non-Current Assets | ||
| Property, Plant, Equipment (PPE) | Assets such as machinery and buildings | 1,000,000 |
| Less Accumulated Depreciation | Reduction in value of PPE due to wear and tear | -150,000 |
| Goodwill | Excess of purchase price over fair market value of acquired assets | 30,000 |
| Other Intangible Assets | Non-physical assets like patents and copyrights | 300,000 |
| Less Accumulated Amortization | Reduction in value of intangible assets over time | -50,000 |
| Investment in Equity Affiliates | Investments in affiliate companies | 150,000 |
| Long-Term Investments | Investments not expected to be sold in a year | 400,000 |
| Deferred Tax Assets | Estimated tax relief from loss carryforwards | 0 |
| Other Non-Current Assets | Other assets used over a longer period | 100,000 |
| Total Assets | 2,500,000 | |
| Current Liabilities | ||
| Accounts Payable | Obligations to suppliers and creditors (invoice received) | 180,000 |
| Accrued Liabilities | Expenses incurred but not yet paid (invoice not yet received) | 90,000 |
| Short-Term Debt | Debt obligations payable within one year | 170,000 |
| Other Current Liabilities | Other short-term financial obligations | 30,000 |
| Non-Current Liabilities | ||
| Long-Term Debt | Financial obligations due after one year | 800,000 |
| Deferred Tax Liabilities | Taxes that are accrued but not yet payable | 60,000 |
| Other Non-Current Liabilities | Other Long-term obligations | 110,000 |
| Total Liabilities | 1,440,000 | |
| Shareholders’ Equity | ||
| Common Stock | Equity raised from issuing common shares | 500,000 |
| Preferred Stock | Equity raised from issuing preferred shares | 100,000 |
| Additional Paid-in Capital | Capital received from investors above the par value of the stock | 200,000 |
| Retained Earnings | Cumulative profits retained in the company | 250,000 |
| Accumulated Other Comprehensive Income | Total of non-owner changes in equity not included in net income | 50,000 |
| Treasury Stock | Company’s own stock that it has reacquired | -40,000 |
| Total Equity | 1,060,000 | |
| Total Liabilities and Equity | 2,500,000 |
The balance sheet of a public company, as seen in Table 8.6, typically exhibits a higher degree of complexity and detail compared to that of a private company like a bakery, detailed in Table 8.1. It would typically feature a broader array of assets, liabilities, and equity types, reflecting the larger scale and more complex financial activities of the entity. Public companies also list items such as diverse equity instruments, long-term investments, and may be required to measure some accounts by their fair market value.
8.3.7 Financial Firm
A financial firm, such as a bank or insurance company, is an institution that provides financial services to its clients, which may include lending, deposit-taking, investment services, and insurance. In contrast to non-financial firms, which primarily produce goods or non-financial services, the core business of financial firms revolves around the management of financial assets and liabilities. Consequently, their balance sheets have distinctive characteristics and line items that reflect their business model.
| Account | Description | Amount |
|---|---|---|
| Current Assets | ||
| Cash and Cash Equivalents | Liquid funds available for use | 6,000,000 |
| Securities Available for Sale | Investment securities that are available for sale | 15,000,000 |
| Loans and Receivables | Loans issued to customers that are expected to be repaid | 8,000,000 |
| Trading Account Assets | Securities purchased to sell in the short term for profit | 4,000,000 |
| Derivative Assets | Financial derivatives used for hedging or trading | 200,000 |
| Prepaid Expenses | Payments made in advance for services/goods | 90,000 |
| Other Current Assets | Other assets that will be converted to cash within one year | 150,000 |
| Non-Current Assets | ||
| Investment Securities Held to Maturity | Debt securities to be held until maturity | 12,000,000 |
| Property, Plant, and Equipment (PPE) | Long-term physical assets like buildings and equipment | 3,400,000 |
| Less Accumulated Depreciation | Reduction in value of PPE due to wear and tear | -500,000 |
| Goodwill | Excess of purchase price over fair market value of acquired assets | 300,000 |
| Other Intangible Assets | Non-physical assets like patents and copyrights | 800,000 |
| Less Accumulated Amortization | Reduction in value of intangible assets over time | -40,000 |
| Deferred Tax Assets | Estimated tax relief from loss carryforwards | 0 |
| Other Non-Current Assets | Long-term assets not readily convertible to cash | 600,000 |
| Total Assets | 50,000,000 | |
| Current Liabilities | ||
| Deposits | Money held for customers in checking and savings accounts | 18,000,000 |
| Short-Term Borrowings | Short-term loans and obligations | 8,000,000 |
| Trading Account Liabilities | Obligations from short-term security trades | 300,000 |
| Derivative Liabilities | Financial derivatives used for hedging or trading | 250,000 |
| Accounts Payable and Other Liabilities | Obligations to suppliers and short-term creditors | 400,000 |
| Non-Current Liabilities | ||
| Long-Term Debt | Borrowings and financial obligations due after one year | 5,000,000 |
| Deferred Tax Liabilities | Taxes that are accrued but not yet payable | 200,000 |
| Other Non-Current Liabilities | Obligations payable over a long period not covered by other categories | 300,000 |
| Total Liabilities | 32,450,000 | |
| Shareholders’ Equity | ||
| Common Stock | Equity raised from issuing common shares | 2,500,000 |
| Preferred Stock | Equity raised from issuing preferred shares | 1,000,000 |
| Additional Paid-in Capital | Capital received from investors above the par value of the stock | 3,000,000 |
| Retained Earnings | Profits reinvested in the firm not distributed as dividends | 500,000 |
| Accumulated Other Comprehensive Income | Changes in equity from non-owner sources not through P&L | 200,000 |
| Treasury Stock | Company’s own stock that it has reacquired | -100,000 |
| Total Equity | 17,550,000 | |
| Total Liabilities and Equity | 50,000,000 |
The balance sheet of a financial firm, illustrated in Table 8.7, typically features assets such as loans and receivables, which are funds lent to consumers and firms expecting repayment with interest. These are considered productive assets for a financial firm, generating revenue through interest income.
Liabilities on a financial firm’s balance sheet are predominantly customer deposits, a primary source of funding for banks. They also include short-term borrowings and long-term debt, reflecting borrowing from other institutions and through debt instruments.
In summary, the balance sheet of a publicly traded financial firm is characterized by a significant presence of financial assets and liabilities that are the direct result of its lending, investing, and deposit-taking activities. This contrasts with the balance sheet of a non-financial firm, as shown in Table 8.6, which is more likely to reflect the operational infrastructure required to produce goods and services.
8.4 Ledger
A ledger is a comprehensive collection of all the accounts of a business, where financial transactions are recorded. It serves as the central repository for accounting data, based on initial recordings made in various types of journals. Journals are chronological records of transactions; the sales journal records sales transactions, the purchases journal documents purchases, and the general journal captures miscellaneous transactions that do not belong in the other specialized journals.
8.4.1 Ledger Accounts
Each ledger account provides a historical view of all changes over time, revealing the current balance for that account. The following is an illustration of an “Inventory” ledger account for a bakery, capturing transactions like purchases of ingredients and the reduction of inventory due to sales or spoilage:
| Date | Description | Reference | Debit | Credit |
|---|---|---|---|---|
| 2023-01-01 | Beginning Inventory | BAL | 1,000 | 0 |
| 2023-01-05 | Flour Purchase | PUR001 | 500 | 0 |
| 2023-01-10 | Sugar Purchase | PUR002 | 900 | 0 |
| 2023-01-18 | Reduction due to Sales | COGS001 | 0 | 300 |
| 2023-01-25 | Dairy Purchase | PUR003 | 150 | 0 |
| 2023-01-30 | Write-off due to Spoilage | WRT001 | 0 | 50 |
| 2023-02-10 | Reduction due to Sales | COGS002 | 0 | 500 |
| etc. | ||||
| Total 2023 | 34,000 | 49,000 |
Table 8.8 demonstrates the “Inventory” ledger account, with debit entries for ingredient purchases and credit entries for sales and spoilage. Transactions include dates and descriptions for clarity, and the “Reference” column links transactions to supporting documents, with “PUR001” for flour purchase on January 5th, and “COGS001” for the cost of goods sold on January 18th. These links ensure traceability for accurate financial reporting and audits.
The “Inventory” account, being an asset, increases with debit entries and decreases with credit entries. The ending balance is calculated as the total debits minus total credits for the period. Hence, the sum of the debit column less the sum of the credit column for all transactions in 2023 equates to 15,000, representing the balance sheet value for the inventory account as of December 31, 2023, as shown in Table 8.1.
On the liability side, the “Accounts Payable” ledger account records increases in liabilities with credit entries and decreases with debit entries, as shown in Table 8.9.
| Date | Description | Reference | Debit | Credit |
|---|---|---|---|---|
| 2023-01-01 | Beginning Balance | BAL | 0 | 12,000 |
| 2023-01-05 | Flour Purchase on Credit | PUR001 | 0 | 500 |
| 2023-01-10 | Sugar Purchase on Credit | PUR002 | 0 | 900 |
| 2023-01-15 | Payment to Flour Supplier | PAY001 | 500 | 0 |
| 2023-01-19 | Oven Purchase on Credit | EQP001 | 0 | 82,000 |
| 2023-01-25 | Dairy Purchase on Credit | PUR003 | 0 | 150 |
| 2023-01-30 | Payment to Sugar Supplier | PAY002 | 900 | 0 |
| 2023-02-01 | Payment for Half of Oven Cost | PAY003 | 41,000 | 0 |
| etc. | ||||
| Total 2023 | 225,000 | 243,000 |
As “Accounts Payable” is a liability account, increases are recorded in the credit column and decreases in the debit column. Therefore, the ending balance is the total of the credit column minus the total of the debit column for all transactions in 2023. This results in 18,000, which is the entry for the accounts payable balance on the balance sheet as of December 31, 2023, as displayed in Table 8.1.
8.4.2 T-Accounts
The structure of a ledger account is often referred to as a T-account, depicted in the shape of the letter “T” which separates debit and credit transactions into the left and right columns, respectively. This format simplifies the visualization of the increases and decreases in the corresponding account.
As per the accounting equation, every transaction is recorded in at least two separate ledger accounts, appearing as a debit in one account and as a credit in another. For instance, the purchase of sugar on January 10 is recorded as a debit in the “Inventory” ledger account (see Table 8.8), reflecting an increase in assets, and as a credit in the “Accounts Payable” ledger account (see Table 8.9), indicating an increase in liabilities. Table 8.10 illustrates this dual entry, showing the transaction in both T-accounts side by side.
| Debit | Credit | Debit | Credit |
|---|---|---|---|
| 900 | 0 | 0 | 900 |
Similarly, the payment of to the sugar supplier on January 30 is recorded as a credit in the “Cash” ledger account, reflecting a decrease in assets, and as a debit in the “Accounts Payable” ledger account (see Table 8.9), indicating a decrease in liabilities. Table 8.11 illustrates this dual entry, showing the transaction in both T-accounts side by side.
| Debit | Credit | Debit | Credit |
|---|---|---|---|
| 0 | 900 | 900 | 0 |
In conclusion, T-accounts provide a clear and structured way to record and track the financial transactions of a business.
8.4.3 Basis for Financial Statements
The information in the ledger is used to prepare Financial Statements, which include:
- The Balance Sheet (already discussed in Chapter 8.3): Shows the company’s assets, liabilities, and owner’s equity at a specific point in time.
- The Income Statement (see Chapter 8.5): Summarizes the company’s revenues and expenses over a period of time to show profit or loss.
- The Cash Flow Statement (see Chapter 8.6): Analyzes the company’s cash inflows and outflows during a period.
Every ledger account will appear in at least one of the three financial statements, as they collectively cover all the financial activities of a company.
- Asset, Liability, and Equity Accounts are summarized on the Balance Sheet, which shows the company’s financial position at a specific date.
- Revenue and Expense Accounts appear on the Income Statement to calculate the net income or loss for the period.
- Cash and Cash Equivalents Accounts are detailed on the Cash Flow Statement, highlighting the sources and uses of cash.
Some ledger accounts are specific to one financial statement and do not appear on the others. For example, the “Buildings” account, classified under Property, Plant, and Equipment (PPE), is presented on the Balance Sheet. It represents the company’s investment in physical, long-term assets. This specific account does not appear on the Income Statement. Instead, the financial effect of the building over time is captured by the “Depreciation” account on the Income Statement. This account reflects the building’s cost allocation over its useful life as an expense, influencing the company’s reported profits.
To summarize, the ledger meticulously records and monitors the business’s financial transactions and forms the basis for creating financial statements.
8.5 Income Statement
An income statement, also known as profit and loss statement (P&L), is a key financial document that summarizes a company’s financial performance over a specific time frame, such as a fiscal quarter or year. It details how a company generates revenue, incurs costs, and the resulting profit or loss.
8.5.1 Stock vs. Flow Variables
The balance sheet and income statement serve distinct roles in financial reporting due to their use of different types of variables. The balance sheet is a financial snapshot capturing a firm’s status at a specific point in time using stock variables. These variables - assets, liabilities, and equity - represent quantities at a moment in time, akin to a photograph of a company’s financial resources, obligations, and net worth.
In contrast, the income statement employs flow variables. These are measures of economic activity over a period, reflecting the changes in stock variables. Revenues and expenses, for example, represent the inflow and outflow of economic value that alter the company’s net worth over time, much like the continuous footage of a film showing the dynamic process of a business’s operations. Thus, flow variables essentially capture the incremental changes that stock variables undergo during the accounting period.
8.5.2 Profit Equation
The income statement follows the basic profit equation:
\[ \text{Profit} = \text{Revenue} - \text{Expenses} \] Here, the profit is what remains after all expenses are deducted from revenues.
The income statement lists different types of profits, such as gross profit, operating income, and net income before and after taxes. Table 8.12 provides an example.
| Account | Amount | Total |
|---|---|---|
| Operating Revenues: | ||
| \(+\) Revenue from Sales of Goods | 1,100,000 | |
| \(+\) Service Revenue | 500,000 | |
| Cost of Sales: | ||
| \(-\) Cost of Goods Sold (COGS) | -400,000 | |
| \(-\) Cost of Services Provided (Direct Labor) | -100,000 | |
| Gross Profit | 1,100,000 | |
| Operating Expenses: | ||
| \(-\) Salaries and Wages (Non-Direct Labor) | -350,000 | |
| \(-\) Payroll Taxes | -35,000 | |
| \(-\) Rent | -50,000 | |
| \(-\) Property Tax | -10,000 | |
| \(-\) Utilities | -20,000 | |
| \(-\) Depreciation | -15,000 | |
| \(-\) Amortization | -5,000 | |
| \(-\) Marketing and Advertising | -30,000 | |
| \(-\) General and Administrative Expenses | -70,000 | |
| \(-\) Other Operating Expenses | -20,000 | |
| Operating Income (EBIT) | 495,000 | |
| Non-Operating Revenues: | ||
| \(+\) Interest Income | 2,000 | |
| \(+\) Rental Income | 12,000 | |
| \(+\) Gain on Sale of Property, Plant, and Equipment (PPE) | 5,000 | |
| \(+\) Gain on Sale of Intangible Assets | 3,000 | |
| \(+\) Net Gain on Trade in Investment Securities | 7,000 | |
| \(+\) Net Gain on Trade in Other Assets | -3,000 | |
| \(+\) Subsidies Received | 1,000 | |
| Non-Operating Expenses: | ||
| \(-\) Interest Expense | -20,000 | |
| \(-\) Non-Operating Rental Expenses | -1,000 | |
| \(-\) Loss on Sale of PPE | -1,000 | |
| \(-\) Loss on Sale of Intangible Assets | 0 | |
| Net Income Before Taxes (EBT) | 500,000 | |
| \(-\) Benefit of Deferred Tax Asset (Loss Carryforwards) | 0 | |
| Net Income Before Taxes (EBT), Adjusted | 500,000 | |
| \(-\) Income Tax Expense (\(=\) Tax Rate \(\times\) Adjusted EBT) | -105,000 | |
| Net Income | 395,000 |
Table 8.12 reveals the financial performance of a business over a fiscal year. The statement categorically separates operating and non-operating sections to clearly distinguish between the core and peripheral activities of the business.
8.5.3 Gross Profit
The Gross Profit represents the profit a company makes after deducting the costs associated with making and selling its products, or the costs associated with providing its services. It is a measure of production efficiency and cost management.
\[ \text{Gross Profit} = \text{Operating Revenues} + \text{Cost of Sales} \]
Here, “Cost of Sales” consists of “Cost of Goods Sold (COGS)” and “Cost of Services Provided,” which are the direct costs attributable to the production of the goods sold. This includes materials and labor directly used in creating the product.
The Gross Profit helps in understanding how well the company is managing its production processes and supply chain.
8.5.4 Operating Income (EBIT)
Operating Income, also known as Earnings Before Interest and Taxes (EBIT), reflects the company’s earnings from its core business operations. It excludes income and expenses from non-operating activities.
\[ \begin{aligned} \text{Operating Income (EBIT)} \ = &\ \text{Gross Profit}\\ &\ - \text{Operating Expenses (OpEx)} \end{aligned} \]
Operating Expenses typically include salaries, rent, utilities, depreciation, and other costs related to the day-to-day operations of the business. This metric is crucial as it focuses solely on the operational performance of a business, excluding external factors like investments, taxes, or financing costs.
8.5.5 Net Income Before Taxes (EBT)
Net Income Before Taxes, also known as Earnings Before Taxes (EBT), accounts for both operating results and non-operating activities, including various incomes and expenses that are not directly tied to the core business operations.
\[ \begin{aligned} \text{Net Income Before Taxes (EBT)} \ = &\ \text{Operating Income (EBIT)} \\ &\ + \text{Non-Operating Revenues} \\ &\ - \text{Non-Operating Expenses} \end{aligned} \]
This includes revenues like interest and rental income, and expenses such as interest expenses and losses on the sale of assets. It shows the company’s profitability before government taxes are applied.
8.5.6 Net Income (EAT)
Net Income, also known as Earnings After Tax (EAT), is the total profit or loss after all revenues, costs, and expenses, including taxes, have been accounted for. It’s the most crucial figure for stakeholders as it represents the company’s profitability and financial health over the accounting period.
\[ \begin{aligned} \text{Net Income (EAT)}\ = &\ \text{Net Income Before Taxes (EBT)} \\ &\ - \text{Income Tax Expense} \end{aligned} \]
Net Income is the bottom line of the income statement and the number from which earnings per share (EPS) are calculated, influencing investment decisions and company valuations.
8.5.7 Transactions
Just as transactions that affect the balance sheet are recorded, so too are transactions that impact the income statement recorded using the double-entry system. This ensures that the accounting equation (Assets = Liabilities + Equity) always remains in balance after each transaction.
The rules for debits and credits, inclusive of revenue and expense accounts, are as follows:
- Assets: Debit to increase, Credit to decrease.
- Liabilities: Credit to increase, Debit to decrease.
- Equity: Credit to increase, Debit to decrease.
- Revenue: Credit to increase, Debit to decrease.
- Expenses: Debit to increase, Credit to decrease.
Overall, the income statement is a key financial document that provides a summary of how the business performs, reflecting its ability to generate profits through operations, manage its expenses, and grow over time.
8.5.8 Corporate Income Tax
The income statement is a critical financial document scrutinized by tax authorities to determine a company’s tax obligations and identify viable deductions and credits.
Taxable Income
The income statement is instrumental in establishing taxable income, specifically the Adjusted Earnings Before Taxes (EBT). Deductions play a crucial role in reducing taxable income and thus tax liabilities. Common deductions include operating expenses like salaries, rent, and utilities, as well as depreciation and amortization of assets. These deductions must be carefully itemized and substantiated in the income statement to ensure compliance with tax laws.
Income Tax Expense
The Income Tax Expense on an income statement represents the cost of income taxes a company paid or is expected to pay to the government for the current reporting period. The basic formula to compute the Income Tax Expense is given by:
\[ \begin{aligned} \text{Income Tax Expense} \ = &\ \text{Tax Rate} \times \text{Adjusted EBT} \end{aligned} \]
In the United States, corporate income tax rates are determined by a combination of federal and state policies. The federal corporate tax rate stands at 21%, instituted by the Tax Cuts and Jobs Act of 2017. This federal rate is compounded by state corporate taxes, which fluctuate widely, from less than 0% to over 11%. Localities may impose additional taxes, further affecting a corporation’s total tax liability.
Tax Shield
A Tax Shield is the reduction in income taxes that results from taking an allowable deduction from taxable income. For example, interest expenses for corporations can act as a tax shield because they lower taxable income and thus results in lower tax obligations.
The value of a tax shield is given by:
\[ \begin{aligned} \text{Value of Tax Shield}\ = &\ \text{Deductible Expense} \times \text{Tax Rate} \end{aligned} \]
This quantifies the tax-saving effect of a deductible expense. Examples are:
\[ \begin{aligned} \text{Tax Shield on Interest Expenses} \ = &\ \text{Interest Expenses} \times \text{Tax Rate} \\ \text{Depreciation Tax Shield} \ = &\ \text{Depreciation Expense} \times \text{Tax Rate} \\ \text{Charitable Contribution Tax Shield} \ = &\ \text{Charitable Contributions} \times \text{Tax Rate} \\ \text{Loss Carryforward Tax Shield} \ = &\ \text{Loss Carryforwards} \times \text{Tax Rate} \end{aligned} \] where “Loss Carryforwards” are discussed next.
Loss Carryforward
When corporations incur a negative taxable income, known as a Net Operating Loss (NOL), they can use this loss to decrease taxable income in subsequent fiscal periods through a mechanism called Loss Carryforward. Loss Carryforward allows companies to apply past losses to future profits, thereby lowering future tax liabilities.
This potential tax benefit is reflected as a Deferred Tax Asset on the balance sheet, signifying probable reductions in future tax payments. The value of this asset hinges on the expectation that the firm will generate enough future taxable income against which the NOLs can be applied.
Other Tax Concepts
- Effective Tax Rate: The effective tax rate is the average rate at which a corporation is taxed on pre-tax profits, taking into account federal, state, and local taxes, as well as any deductions or credits.
- Deferred Tax Liability: When a company’s taxable income is lower than its accounting earnings due to differences in accounting methods, a deferred tax liability is recorded. This liability represents future tax payments a company is expected to make.
In summary, the income statement is indispensable for its role in tax reporting and planning. It not only determines the current tax liabilities but also influences future tax periods through the identification of potential deductions, tax shields, loss carryforwards, and deferred tax items. Accurate and detailed income statements ensure that companies are not only compliant with tax regulations but also strategically positioned to optimize their tax obligations.
8.6 Cash Flow Statement
The Cash Flow Statement is a financial document that provides aggregate data regarding all cash inflows a company receives from its ongoing operations and external investment sources, as well as all cash outflows that pay for business activities and investments during a given period. Unlike the income statement, which is based on the accrual basis of accounting, the cash flow statement reveals the liquidity and solvency of the company, offering a more tangible measure of the cash being generated and used.
Table 8.13 represents an example of a cash flow statement.
| Activity | Amount | Subtotal | Total |
|---|---|---|---|
| Net Income (EAT) | 269,000 | ||
| Adjustments for Non-Cash Items (D&A): | |||
| \(+\) Depreciation | 15,000 | ||
| \(+\) Amortization | 5,000 | ||
| Changes in Working Capital (WC): | |||
| \(+\) Increase in Accounts Payable | 8,000 | ||
| \(-\) Increase in Accounts Receivable | -7,000 | ||
| \(+\) Increase in Accrued Expenses | 4,000 | ||
| \(-\) Increase in Prepaid Expenses | -3,000 | ||
| \(-\) Increase in Inventory | -12,000 | ||
| Net Cash Provided by Operating Activities (CFO) | 279,000 | ||
| Capital Expenditures (CapEx): | |||
| \(-\) Payments for Purchase of PPE | -50,000 | ||
| \(-\) Payments for Acquisition of Intangible Assets | -8,000 | ||
| Disposal of Fixed Assets: | |||
| \(+\) Proceeds from Sale of PPE | 12,000 | ||
| \(+\) Proceeds from Sale of Intangible Assets | 3,000 | ||
| Other Investing Activities: | |||
| \(-\) Payments for Purchase of Investment Securities | -15,000 | ||
| \(+\) Proceeds from Sale of Investment Securities | 7,000 | ||
| \(-\) Loans Provided to Others | -10,000 | ||
| \(+\) Proceeds from Repayment of Loans Made to Others | 5,000 | ||
| Net Cash Provided by Investing Activities (CFI) | -56,000 | ||
| Debt Financing Activities: | |||
| \(+\) Proceeds from Issuance of Debt | 40,000 | ||
| \(-\) Repayments of Debt | -25,000 | ||
| Equity Financing Activities: | |||
| \(+\) Proceeds from Issuance of Equity | 20,000 | ||
| \(-\) Repurchase of Equity | -5,000 | ||
| \(-\) Dividends Paid | -8,000 | ||
| Net Cash Provided by Financing Activities (CFF) | 22,000 | ||
| Net Increase in Cash and Cash Equivalents | 245,000 | ||
| \(+\) Cash and Cash Equivalents at Beginning of Period | 1,200,000 | ||
| Cash and Cash Equivalents at End of Period | 1,445,000 |
As depicted in Table 8.13, the cash flow statement begins with net income, reflecting the firm’s profitability. Yet, not all revenues and expenses that contribute to profit involve immediate cash transactions - some are incurred on credit and therefore do not impact the company’s cash position in the current period. For instance, accounts payable represent the company’s credit-based expenditures and are recorded as liabilities. An increase in accounts payable signifies that the firm owes more to its suppliers or creditors at the period’s end compared to the beginning, indicating that the expenses were not paid in cash. Consequently, this increase is added back to net income when calculating cash flow, as it reflects cash retained by the company.
The different parts of the cash flow statement in Table 8.13 are examined next.
8.6.1 Operating Activities
Cash Flows from Operations (CFO) are the cash flows produced by the primary revenue-generating activities of the business. This section of the cash flow statement is typically derived from the net income figure, with adjustments for:
\[ \begin{aligned} \text{Net Cash Provided by Operating Activities (CFO)} \ = &\ \text{Net Income (EAT)} \\ &\ + \text{Non-Cash Expenses (D\&A)} \\ &\ + \text{Increase in Working Capital (WC)} \end{aligned} \]
The adjustments include adding back non-cash expenses such as depreciation and amortization, and adjusting for changes in working capital (current assets and current liabilities). It reflects the cash effects of transactions that enter into the determination of net income.
8.6.2 Investing Activities
Cash Flows from Investing (CFI) are related to the acquisition and disposal of long-term assets and other investments not included in cash equivalents. This section details the outflows and inflows from purchases and sales of long-term business investments such as property, plant, equipment, and marketable securities.
\[ \begin{aligned} \text{Net Cash Provided by Investing Activities (CFI)} \ = &\ \text{Cash Paid for Investments} \\ &\ - \text{Cash Received from Disposals} \end{aligned} \]
A negative amount indicates that more cash has been spent on investment activities than has been received from such transactions.
8.6.3 Financing Activities
Cash Flows from Financing (CFF) include transactions involving debt, equity, and dividends. This section shows the net flows of cash that are used to fund the company overall, such as the issuance of debt or equity, as well as dividend payments and capital lease obligations.
\[ \begin{aligned} \text{Net Cash Provided by Financing Activities (CFF)} \ = &\ \text{Cash from Issuing Debt} \\ & + \text{Cash from Issuing Equity} \\ & - \text{Cash Paid for Dividends and} \\ & \quad \ \ \text{Reacquisition of Debt/Equity} \end{aligned} \]
The sign of the net cash flow from financing activities indicates whether a company is accumulating or repaying debt, engaging in equity transactions, or returning capital to shareholders.
8.6.4 Net Change in Cash
This final section of the cash flow statement reconciles the net increase or decrease in cash by adding the net cash provided by (or used in) the operating, investing, and financing activities.
\[ \begin{aligned} \text{Net Increase in Cash} \ =&\ \text{Net Cash from Operating Activities (CFO)} \\ &\ + \text{Net Cash from Investing Activities (CFI)} \\ &\ + \text{Net Cash from Financing Activities (CFF)} \end{aligned} \]
This figure is then adjusted by the beginning cash balance to arrive at the ending cash balance for the period. This provides a snapshot of the firm’s liquidity at the end of the period.
8.6.5 Supplemental Information
The cash flow statement often includes supplemental information, such as the amount of interest and income taxes paid, which provides a clearer picture of how cash is moving in and out of the business. The statement also reconciles beginning and ending cash balances, which can be tied back to the balance sheet.
Understanding the cash flow statement is essential as it helps stakeholders determine the short-term viability of the company, particularly its ability to pay bills. Unlike the income statement, it shows the actual cash the business has generated and can be used for expansion, paying dividends, or improving infrastructure.
8.6.6 Free Cash Flows
Free Cash Flow to the Firm (FCFF) and Free Cash Flow to Equity (FCFE) are two critical metrics derived from the cash flow statement that investors use to evaluate a company’s cash generation efficiency. They are not standard items on the cash flow statement; rather, it is a metric that can be calculated using information from the cash flow statement and other financial statements.
Free Cash Flow to the Firm (FCFF)
FCFF, also known as Free Cash Flow (FCF), represents the amount of cash generated by a company’s operations that is available for distribution to all financial claimants, including debt and equity holders, after accounting for necessary capital expenditures (CapEx) and operating expenses (OpEx).
The formula for calculating FCFF is as follows:
\[ \begin{aligned} FCFF \ = &\ \underbrace{\text{EAT}+\text{D\&A}-\text{WC}}_{\text{CFO}} - \text{CapEx} \\ &\ + \underbrace{\text{Interest Expense} - \text{Interest Tax Shield}}_{ \text{Interest Expense} \times (1 - \text{Tax Rate}) } \end{aligned} \] Note that the first three items add up to Cash Flow From Operating Activities (CFO), available on the cash flow statement, and CapEx is also on the cash flow statement under Operating Activities. Interest Expenses are available on the income statement, and the Tax Rate can be calculated using the income statement as Income Tax Expense divided by the Adjusted EBT.
Non-cash expenses typically include items like depreciation and amortization. The tax-adjusted interest expense is added back because FCFF is meant to represent cash available to both debt and equity holders, and interest is a cash flow available to debt holders.
Free Cash Flow to Equity (FCFE)
FCFE, on the other hand, is the amount of cash available to be returned to shareholders after all expenses, reinvestments, and debt repayments have been made. It is essentially the cash flow from operations minus capital expenditures and debt service (including net debt issuance).
The formula for FCFE is: \[ \begin{aligned} FCFE \ = &\ \underbrace{\text{EAT}+\text{D\&A}-\text{WC}}_{\text{CFO}} - \text{CapEx} \\ &\ +\underbrace{\text{Proceeds from Issuance of Debt} - \text{Repayments of Debt}}_{ \text{Net Borrowing}} \end{aligned} \] where net borrowing is the difference between any new debt taken on and debt that is paid off, which is available on the cash flow statement under borrowing financing activities.
Both FCFF and FCFE are leveraged by companies to make investment decisions, determine dividend policies, and assess potential growth opportunities. They are also extensively used in Discounted Cash Flow (DCF) analysis to estimate a company’s value. DCF analysis computes the stock price as the present value of all future dividend payments. Since dividend payments are sometimes arbitrary, influenced by dividend politics, the FCFE is often used for DCF instead of dividends.
8.7 Conclusion
In closing, the discipline of business accounting is the cornerstone of financial transparency and strategic planning within a company. The meticulous art of recording, analyzing, and summarizing financial transactions crystallizes into the foundational financial statements: the balance sheet, the ledger, the income statement, and the cash flow statement. Each statement provides unique insights, capturing different facets of a business’s financial reality.
As we turn the page from understanding the scaffolding of business accounting, we venture into the realm of interpreting and leveraging this financial information. The upcoming Chapter 9 builds upon the data presented in the financial statements to compute a suite of financial performance indicators. These indicators serve as the compass for stakeholders, guiding investment decisions, operational improvements, and strategic shifts. By translating raw financial data into actionable insights, these indicators empower users to analyze a company with precision and context.