Understanding Business Accounting For Dummies, 2nd Edition (11 page)

Profit and loss account:
A summary of sales revenue and expenses that determines the profit (or loss) for the period just ended. This is also called the
income statement,
or simply abbreviated down to the
P&L statement.
(Alternative titles also include the
operating statement
and the
earnings statement
.)

Cash flow statement:
A summary of cash inflows and cash outflows for the period just ended.

This section gives you a description of these statements that constitute a business's financial centre of gravity. We show you the general format and content of these three accounting reports. The managing director and chief executive officer of a business (plus other top-level managers and financial officers) are responsible for seeing that the financial statements are prepared according to financial reporting standards and that proper accounting methods have been used to prepare the financial statements.

If a business's financial statements are later discovered to be seriously in error or misleading, the business and its top executives can be sued for damages suffered by lenders and investors who relied on the financial statements. For this reason, business managers should understand their responsibility for the financial statements and the accounting methods used to prepare the statements. In a court of law, they can't plead ignorance.

We frequently meet managers who don't seem to have a clue about the three primary statements. This situation is a little scary; a manager who doesn't understand financial statements is like an aeroplane pilot who doesn't understand the instrument readouts in the cockpit. A manager
could
run the business and ‘land the plane safely', but knowing how to read the vital signs along the way is much more prudent.

In short, business managers at all levels - from the board of directors down to the lower rungs on the management ladder, and especially managers of smaller businesses who have to be a jack-of-all-trades in running the business - need to understand financial statements and the accounting methods used to prepare the statements. Also, lenders to a business, investors in a business, business lawyers, government regulators of business, entrepreneurs, employees who depend on the continued financial success of the business for their jobs, anyone thinking of becoming an entrepreneur and starting a business, and, yes, even economists, should know the basics of financial statement accounting. We've noticed that even experienced business journalists, who ought to know better, sometimes refer to the balance sheet when they're talking about profit performance. The bottom line is found in the profit and loss account, not the balance sheet!

The balance sheet

The balance sheet is the essential financial statement that reports the main types of assets owned by a business. Assets are only half the picture, however. Almost all businesses borrow money. At the date of preparing the balance sheet, a business owes money to its lenders, who will be paid sometime in the future. Also, most businesses buy many things on credit and at the balance sheet date owe money to their suppliers, which will be paid in the future. Amounts owed to lenders and suppliers are called
liabilities.
A balance sheet reports the main types of liabilities of the business, and separates those due in the short term and those due in the longer term.

Could total liabilities be greater than a business's 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: (1) its owners have invested money in the business, which is not a liability of the business; and (2) the business has earned profit over the years and some of the profit has been retained in the business. (Profit increases assets.) The sum of invested capital from owners and retained profit is called
owners' equity
. The excess of total assets over total liabilities is traceable to owners' equity. A balance sheet reports the make-up of the owners' equity of a business.

You generally see the balance sheet in the following layout:

Basic Format of the Balance Sheet

Assets,
or the economic resources
Liabilities,
which arise from borrowingthe business owns: examples are money and buying things on credit.cash on deposit, products held for sale to customers, and buildings.

Owners' Equity,
which arises from two sources: money invested by the owners, and profit earned and retained by the business.

One reason the balance sheet is called by this name is that the two sides balance, or are equal in total amounts:

Total Recorded Amount of Assets = Total Recorded Amount of Liabilities + Total Recorded Amount of Owners' Equity


Owners' equity is sometimes referred to as
net worth.
You compute net worth as follows:

Assets - Liabilities = Net Worth


Net worth
is not a particularly good term because it implies that the business is worth the amount recorded in its owners' equity accounts. Though the term may suggest that the business could be sold for this amount, nothing is further from the truth. (Chapter 6 presents more information about the recorded value of owners' equity reported in the balance sheet, and Chapter 14 discusses the market prices of shares, which are units of ownership in a business corporation.)

The profit and loss account

The profit and loss account is the all-important financial statement that summarises the profit-making activities (or operations) of a business over a time period. In very broad outline, the statement is reported like this:

Basic Format of the Profit and Loss Account