Balance Sheet and Income Statement

Financial Statements

Financial statements communicate the financial condition of a company to external users. Effective managers understand how to interpret what financial statements communicate about the business performance. Businesses are required to prepare four financial statements. These four financial statements are the income statement, statement of retained earnings, balance sheet, and statement of cash flows. These financial statements are prepared in this order. This lecture will focus on the income statement and balance sheet.

Income Statement

The first statement prepared is the income statement. The income statement shows all revenues and expenses incurred by a company during a specific period. Cost of goods sold is an expense for a merchandising or manufacturing company accountants list separately on the income statement. The income statement also provides information on extraordinary gains and losses not associated with the normal course of business. Finally, the income statement shows the corporate tax rate and earnings per share.

Revenue and expense accounts are known as temporary accounts. These are considered temporary accounts because these accounts are closed on a monthly basis and the net income or loss is incorporated into the new retained earnings balance. This retained earnings balance is needed to ensure the balance sheet is in balance.

Companies incur extraordinary gains and losses when equipment or investments are sold above or below the current book value. These are extraordinary as these transactions are not considered part of the normal business operations. The reason these gains and losses are listed separately is so an outside person can see the amount of income or loss that is directly related to these extraordinary activities, providing the information to evaluate net income and loss related to normal business operations.

Companies are expected to improve performance over time. One measurement of the performance of a company is evaluated by calculating the percent change in revenues and expenses year-over-year. The percentage change demonstrates whether a company is improving performance over time. For example, consider a fictitious company called StoryTime, Inc. The simplified income statement for two years is as follows:

StoryTime, Inc.

Income Statement (000 $)

Year ended

20X1    20X0     % change

Sales Revenue   $15.0   $14.1  6%

Expenses             $9.8     $7.5    31%

Net Income         $5.2     $6.6    -21%

While the sales revenue growth of 6% is promising, the expense growth at 31% suggests that the company is losing control of their growth. Change in both revenues and expenses measure company performance.

Balance Sheet

The balance sheet is a financial statement that shows the balance of all assets, liabilities, and shareholder equity accounts on a specific date. This date is typically the end of the accounting period, generally a quarterly or yearly report. The accounting equation is:

Assets = Liabilities + Shareholders Equity

The balance sheet must be in balance, meaning the amount of liabilities plus shareholders equity must equal assets. The accounts listed on the balance sheet are known as permanent accounts. The amount of assets tells the reader what the company owns. The total amount of liabilities is the amount of what the company owes. The equity account is the difference between what is owned and what is owed and represents the net worth of the company. Many of the account balances on the balance sheet are used in calculating financial ratios.

Company performance is affected by many outside factors. One factor that affects overall performance are lawsuits. Lawsuits relating to product liability are common when consumers are harmed by products. If companies are expecting to incur a loss based on a pending lawsuit, the value and estimated value must be reserved from the net worth of the company. This amount will be shown as a contingent liability in the shareholders equity section of the balance sheet.

What compromises the income statement?

REVENUES / EXPENSES

The income statement shows all revenues and expenses incurred by a company during a specific period.

Revenue and expense accounts are known as temporary accounts. These are considered temporary accounts because these accounts are closed on a monthly basis and the net income or loss is incorporated into the new retained earnings balance. This retained earnings balance is needed to ensure the balance sheet is in balance.

GAINS / LOSSES

The income statement also provides information on extraordinary gains and losses not associated with the normal course of business. Companies incur extraordinary gains and losses when equipment is sold above

or below the current book value or sell investments above or below the current book value. These are

extraordinary as these transactions are not considered part of the normal business operations. The reason

these gains and losses are listed separately is so an outside person can see the amount of income or loss

that is directly related to these extraordinary activities, providing the information to evaluate net income and

loss related to normal business operations.

CORPORATE TAX / EARNINGS PER SHARE

Finally, the income statement shows the corporate tax rate and earnings per share. Companies are expected to improve performance over time. The performance of a company is evaluated by calculating the change in revenue and expenses year-over-year. The percentage change demonstrates whether a company is improving performance over time.

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