Four financial statements are widely used: the balance sheet, the income statement, the cash flow statement and the statement of retained earnings. In this section, the main characteristics of each financial statement are discussed and a simple worksheet to record changes to the balance sheet is explained. Also, the relations between the statements are highlighted.
The balance sheet
The balance sheet shows the financial position of the firm at a point in time. The left side of the balance sheet (called the debit side) shows the resources of the company (assets), whereas on the right side (or, credit side), it shows how these resources have been funded. By definition, the funding is either by the owners (equity) or by others (liabilities).
Asset: economic resources (with future value), or, things worth money.
Liability: an obligation resulting from a past transaction to pay money, render services, or deliver goods.
Equity: funding by the owners, or 'residual claim' (to the assets), which always equals total assets minus total liabilities.
Example balance sheet
The assets of the fictitous company ABCD Inc. (which is also used later) on January 31st, 20X0 consist of cash and equipment, 41,500 in total. This amount has been funded with 400 liabilities, and 41,100 equity. The equity consists of 40,000 paid-in capital, which is the amount of money raised by issuing shares. Retained earnings of 1,100 is the total of profits that have not (yet) been paid out as dividend.
For corporations the amount raised by issuing shares is presented separately from the profits retained in the company. For sole proprietorships - a business owned and ran by a single individual with no separate legal entity for the business - paid-in capital and retained earnings are not shown separately. Instead, these items are added and labeled 'capital'.
Liabilities and equity are a means to attract capital for funding of assets. More debt or equity means that the firm can buy more assets. Conversely, paying accounts payable, repaying a loan, buying back shares or paying out a dividend decreases the assets. The optimal amount of debt and equity, as well as the optimal mix between the two is outside the domain of financial accounting.
Since the balance sheet shows the assets and the funding of the assets (liabilities and equity) at a point in time, it is not possible to infer the performance of the firm from the balance sheet. This is because performance is measured over a period. The income statement and the cash flow statement are used for this purpose (discussed later).
The accounting equation
The accounting equation (Assets = Liabilities + Equity) tells us that the balance sheet is balanced by definition, as all assets will be financed either by the owners themselves (equity) or by other people (liabilities).
Since assets are presented on the debit side of the balance sheet and liabilities and equity on the credit side, the accounting equation implies the fundamental equation in accounting that total debits should equal total credits at all times.
It is important to know that the accounting process is governed by accounting principles that sometimes are very binding and sometimes provide some flexibility. Well known principles include International Financial Reporting Standards (IFRS) and U.S. GAAP (Generally Accepted Accounting Principles).
Sometimes economic assets are not allowed to be recognized as accounting assets by accounting principles. In other words: some assets may not be on the balance sheet. This generally is the case when it is difficult to determine the value of the asset.
Further reading: Additional reading on accounting principles.
In general, application of accounting principles results in the situation where the book value of assets (and equity) is below the market value of assets (and equity), since book assets are usually understated. This difference is expressed by the market-to-book ratio (dividing the market value of equity by the book value of equity).
Further reading: Additional reading on the market-to-book ratio.
- the balance sheet shows the financial position at a point in time (a financial ‘snapshot’)
- the accounting equation states that the value of the resources (assets) always equals total funding of these assets (liabilities and equity)
- it is not possible to infer a firm’s profitability from (the) balance sheet(s)
- assets are usually understated relative to the market value, whereas liabilities are not (or to a lesser extent), as a result, equity is usually understated (as equity is defined as the difference between the understated assets and total liabilities)
Using the accounting equation to record transactions
The method to record transactions described in this section is based on the accounting equation. Hence, it only keeps track of items on the balance sheet.
This method is extended in the next lesson double entry bookkeeping, where also changes over time are recorded.
The accounting equation for transactions
The accounting equation states that all assets are funded by either the owners (equity) or others (liabilities):
Assets = Liabilities + Equity.
The accounting equation refers to the balance sheet, where assets are shown on the debit side and the funding (liabilities and equity) on the credit side. If the accounting equation holds for the balance sheet at a point in time, it must hold for the beginning of period balance sheet as well as the end of period balance sheet. It then logically follows the accounting equation must also hold for changes; i.e., for each transaction the change in assets must equal the change in liabilities plus the change in equity: ΔAssets = ΔLiabilities + ΔEquity.
Example transactions for newly incorporated firm ABCD Inc. which offers services for garden design and landscaping. For each transaction the accounting equation is shown.
Jan 1: The firm is incorporated on the 1st of January, 20X0. The owner, Betty, pays 40,000 cash for 10,000 shares.
Following the accounting equation, cash (an asset) will increase by 40,000, as well as paid in capital (equity) increases by 40,000.
Jan 2: ABCD Inc. buys a Grasshopper lawn mower for 8,000 cash.
Cash (assets) decreases with 8,000, while equipment (assets) increases by the same amount. The net change in assets is therefore 0.
Jan 10: ABCD Inc. pays 500 cash for advertising in the local newspaper.
Cash (an asset) will decreases with 500, and retained earnings (equity) decreases with 500.
Jan 15: ABCD Inc receives 3,000 cash for services delivered in January.
Cash (an asset) and retained earnings (equity) increase with 3,000.
Jan 26: ABCD joins the Association of Landscapers, and receives an invoice of 400 to be payable in February.
Accounts payable (liability) increases with 400, and retained earnings (equity) decreases with 400.
|Accounts payable||Retained earnings|
Jan 31: The company pays a 1,000 cash dividend.
Cash (an asset) and retained earnings (equity) decreases with 1,000.
The transactions during an accounting period can be recorded in a worksheet, with columns for each balance sheet item (cash, equipment, etcetera). Each transaction is written in a row, with the increases/decreases added/subtracted in the columns of the affected balance sheet items. For each transaction, the accounting equation will hold: ΔAssets = ΔLiabilities + ΔEquity.
The first row is the opening balance (in the worksheet below this row contains all zeros since in the example the company was newly incorporated). The last row, holding the column totals, contains the ending balance values.
Worksheet with transactions
Note that at all times total assets equal total liabilities plus equity.
Also, note that the example balance sheet shown earlier (section 'The balance sheet') is the ending balance sheet based on this worksheet.
When the accounting equation is used to keep track of the balance sheet, the balance sheet can be constructed by adding the columns after each transaction. In other words, the balance sheet is always up-to-date. Since the balance sheet shows the financial position at a point in time, the main drawback of this method is that it is not clear how well the firm has performed over time. This is because the expenses and revenues are added to retained earnings and are not recorded separately. In the next lesson double entry bookkeeping, changes in retained earnings (expenses, revenues as well as dividends) are separately recorded.
- the accounting equation can be the basis for a simplified bookkeeping method to keep track of balance sheet items only
- sales and expenses are included in retained earnings and are not separately recorded, hence, no information about the performance is readily available
The income statement
Where the balance sheet shows the financial position at a point in time, the income statement shows the change in equity as a result of expenses and revenues (equity can also change for example as a result of issuing shares, repurchasing shares, and paying dividends). Hence, the income statement shows the performance of the firm over some period. In public financial reports, this period typically is a quarter or a year. Within the firm monthly reporting is common practice as well. The income statement is used to assess profitability, as the expenses for the period are deducted from the revenues. When net income is positive, it is a called profit. When negative, it is a loss.
The income statement is sometimes called the profit and loss statement (or, ‘P&L’).
Continuing the worksheet example, the income statement can be derived from the expenses and revenue which were added to retained earnings (transactions on 10, 15 and 26 January; the transaction on 31st of January is a dividend payment, which is not an expense).
Example income statement
Naturally, for-profit firms will engage in activities to maximize net income. Net income increases when assets increase relative to liabilities (abstracting from cash transactions between the firm and the shareholders such as issuing new shares or paying a dividend). For example, a trading firm will try to exchange inventory for more than they have paid for. At the same time, other assets may decline in value (machines need repairs, wages need to be paid, etc) and liabilities may increase (interest expenses are incurred). Thus, the balance sheet has a direct relation with the income statement.
It is important to realize that revenue and expenses are not (always) the same as cash inflows and outflows. For a given cash outflow, an expense can be recognized in a period prior to payment, the same period or a later period. The same idea holds for revenues and incoming cash flows. This is what accounting makes very flexible and at the same time it opens the door for manipulation of net income. Accounting principles provide guidance and rules on when to recognize revenue and expenses.
Generally, accounting principles require that a company recognized revenue when it has delivered the goods/services to the customer, even if the customer has not paid yet. This is quite common in business-to-business transactions where companies grant credit to their customers. Payment by the customer needs to be reasonably certain though for the revenue to be recognized. (I.e., selling goods on credit to customers who are unlikely to pay would not result in revenue.)
The technicalities of this relation as well as the timing differences between cash flows and revenues/expenses are discussed in accrual accounting.
- the income statement shows net income over some period (usually a quarter or a year) - the income statement is sometimes called the profit and loss statement (or, ‘P&L’)
- net income equals revenues minus expenses
- accounting principles determine when revenues and expenses need to be recognized
- the balance sheet and income statement are interconnected
The cash flow statement
The cash flow statement gives insight how cash has been generated and used over the period. The reader of an annual report can tell by comparing the end of year cash balance with the beginning of year cash balance what the change in cash over the year is. However, this information is not very revealing by itself. For example, a decline in the cash balance does not necessarily mean it was a ‘bad’ year. A decline in cash could be due to repaying a loan or investing in new assets.
The cash flow statement shows the change in cash over the period as the sum of cash generated/used by three categories: cash from operating, investing and financing activities.
Cash from operating activities shows how much cash has been generated by daily operations. It is equal to cash received from customers minus cash paid to suppliers, cash paid to employees, interest paid, and other operating items. A positive operating cash flow shows that the business has generated cash. A negative operating cash flow means that cash has been used during the period. Start-up companies usually have negative operating cash flows.
Cash from operating activities shows the balance of cash that has been invested in long term assets and cash received from disinvestments (selling long term assets).
Cash from financing activities shows the cash flows related to the financing of the companies. It equals the cash inflows for attracting funding by issuing shares or obtaining new loans and the cash outflows for repaying loans, paying out dividends, etcetera.
The example cash flow statement below is based on the previous example. The entries in the column 'cash' in the worksheet (40,000, -8,000, -500, etcetera) are organized by type: operating, investing and financing cash flows. Since the corporation is newly incorporated, the beginning of period cash is zero. Hence, the change in cash equals the end of period's cash balance.
Example cash flow statement
The cash flow statement is discussed in more detail in the cash flow statement.
- a negative cash flow means cash has been used
- a positive cash flow means cash has been generated
- the cash flow statement shows operating cash flow, investing cash flow and financing cash flow which add up to the change in cash over the period
- operating cash flow is cash generated/used by day-to-day operations
- investing cash flow is cash generated/used with (dis)investing in/of long term assets
- financing cash flow is cash generated/used with the funding of the company (issue shares, new debt, paying dividend or repaying debt)
The statement of retained earnings
Consider the accounting equation again: Assets = Liabilities + Equity. If a company is profitable, then the assets will grow relative to the liabilities (for example: the company’s bank account increases, or the company invests in new products/markets, or debt is repaid). If the company retains the profit within the firm (as opposed to paying it out as a dividend), equity will also increase (as there is no claim of others on profits; profits do not increase liabilities) with the amount of profits withheld in the firm.
The statement of retained earnings shows the breakdown of retained earnings. Net income for the year is added to the beginning of year balance, and dividends are subtracted. This results in the end of year balance for retained earnings.
Remember that expenses, revenues and dividends impact retained earnings. Since net income equals revenues minus expenses, we need to include dividends when computing end of period retained earnings. I.e., end of period retained earnings equals beginning of period retained earnings, plus net income and minus dividends.
The statement of retained earnings for the sample firm ABCD Inc. used in this lesson is as follows:
Example statement of retained earnings
The information about retained earnings can also be included in a broader statement, where additional information is presented. Consider for example the statement of owner’s equity of Google end of 2008, which presents the changes in the different parts of equity, including retained earnings. The changes in retained earnings are presented in the 2nd column from the right. As Google has a policy of not paying any dividend, retained earnings is increasing in net income while no dividends have been subtracted. At the end of 2008, cumulative retained profits amount to $13.6 billion.
A sole proprietorship is a business owned and ran by a single individual with no separate legal entity for the business as opposed to for example a corporation. While the accounting is practically the same, some differences exist.
For a corporation, the profits that are retained in the company are separately recorded from the amount received when the shares were issued. For sole proprietorships this distinction is not made, both items are added and presented as 'capital'.
In addition, profit distributions are named differently. For corporations, a profit distribution is called a dividend and subtracted from retained earnings. For a sole proprietorship such a distribution is called a withdrawal, which is subtracted from capital, since retained earnings is not separately recorded for these companies.
- the equality of the accounting equation (Assets = Liabilities + Equity) implies that when assets increase with profitable transactions, equity also must increase
- by adding net income to retained earnings, the balance sheet remains balanced
- retained earnings equals all past earnings which have not been paid out as a dividend, in other words, retained earnings increases with net income and decreases with dividends
- the information in this statement is often included in the statement of owner’s equity which also shows changes in other components of equity
- for sole proprietorships, a profit distribution is called a withdrawal; also paid-in capital and retained earnings are not separately shown, but added and presented as 'capital'
Relations between the financial statements
In the figure below the relations between the financial statements are shown for another fictitous company (the company used in the previous examples is not used as the company has no beginning balance). As mentioned above, the balance sheet shows the financial position at a point in time. It therefore cannot contain information that is related to some period, such as sales or wages expense.
It is common practice to include a beginning of period balance sheet as well as an end of period balance sheet in a financial report. This way the reader can form an opinion about how the firm’s financial position has changed.
The cash flow statement and the income statement both give information about the firm’s performance over the period, albeit from different angles. The cash flow statement explains the change in cash. In other words, it explains how the beginning of period cash has turned into the end of period cash by differentiating between operating, investing and financing activities.
The income statement shows a presentation of the sales, the main expenses and the resulting net income over the period. Net income is based on accounting principles which gives guidance/rules on when to recognize revenues and expenses, whereas cash from operating activities, obviously, is cash based.
As dividends do not reduce net income, the income statement does not always explain the change in retained earnings over the year. (Net income only equals the change in retained earnings when no dividend is paid out). The statement of retained earnings (or a similar statement) is included to show how equity has changed because of net income and possible dividend payments. It shows the beginning value of retained earnings, to which net income is added and dividends subtracted, resulting in end of year retained earnings.
- the balance sheet is used to assess the firm’s financial position at a point in time
- the cash flow statement and the income statement are used to assess performance over the period
- the cash flow statement explains the change cash from the beginning of year versus end of year
- the income statement shows the performance over the year
- the statement of retained earnings shows how beginning of year retained earnings increases with net income and decreases with dividends, resulting in end of year retained earnings.
Continue with reading the next tutorial: double entry bookkeeping. In this section a more advanced bookkeeping system is explained where in addition to the balance sheet items also changes in retained earnings (expenses, revenues and dividends) are recorded.