Companies report their yearly financial information on
the Balance Sheet. Throughout the year all financial transactions are recorded on
separate accounts, and at the end of the year are posted on the Balance Sheet.
The Balance sheet, and this is the most important point here, is a reflection
of the financial position of the company on that specific date (of the balance
sheet).
Before going further, it is important to mention the
type of financial reporting requirements: 10-K is for an annual report, 10-Q is
for a quarterly report which has less disclosure information, and 8-K, is a
current report, which provides material information like stock price. Financial
statements are prepared according to the Generally Accepted Accounting Principle
(GAAP), which is a globally applicable method of reporting accounting
information, which will ultimately end up on the Balance Sheet. It is like an
accepted yardstick method. These rules are determined by Financial Accounting
Standards Board (FASB).
We will begin with the basic accounting identity which
is Assets= Liabilities + Owners Equity. This equation must be balanced
arithmetically, which means that the left side of the equation must equal the
sum of the right. Assets are resources owned by the company that are expected
to provide future economic benefits. Some examples of assets are land, or
accounts receivables (customers that owe the company).
Liabilities are claims on assets by creditors. They
represent an obligation to make future payments of cash, goods, or services. To
be recognized that a future liability exists, two criteria must be recognized:
(1) the obligation is based on benefits or services received currently or in
the past, and (2) the amount and timing of payment is certain.
So for example,
if a company had taken a loan from the bank during the year, then at year end
it would report on its balance sheet, on the liabilities side, the amount it owes
the bank (bank debt).
Stockholders’ Equity is the claims on the assets by
the shareholders. It is the residual claim on assets after settling claims of
creditors. Many times we hear that companies declare bankruptcy. Well, the
first in line to get claims are the creditors from this account. Stockholder’s
Equity is known as Net Worth or Net Book Value. If a company is just forming
and all the share owners contribute capital to form the company, then the Net
Worth of that company is worth the amount of the contributed capital by the
owners.
Other sources of stockholders’ equity, besides
contributed capital, are common stock at par value, additional paid in capital(
in excess of par), and treasury stock, which is issued stock that companies
many times buy back.
Retained earnings also go under the stockholders’
Equity. Retained earnings are any earnings that are not distributed as
dividends to the shareholders, but are reinvested in the company.
Now let us look at Revenues and Expenses which are
very common in the business language. Revenues and Expenses are on the Income
Statement. The Income Statement reports increases in stockholders’ equity due
to operations over a period of time. In the Income Statement companies report
Net Income. Net Income is Revenues less Expenses. If at the end of the year a
company reports a positive Net Income, this will increase the Stockholders’
Equity (SE) of the balance sheet. If a company reports a loss, then this will
decrease the company’s SE, and the balance sheet equation will balance
accordingly.
An important term that we should mention is Accrual
Accounting. In the Income Statement where revenues and expenses are recorded,
items are recorded based on accrual accounting principle. That is, to recognize
revenue or an expense, they must be tied to the business activity. They are not
cash flows. For example, when a business sells goods or services as part of its
usual business activity, revenues are recognized. Expenses are recognized
during the same period of providing the goods or services, as the revenues they
help to generate.
Revenue is the price of goods sold or services
rendered during a giving accounting period. So an increase in revenue increases
owners’ equity. When a business renders services or sells merchandise to its
customers, it receives cash or acquires an accounts receivable, which is an
asset because the customer has not paid yet. The day the business renders the
service to customers or it sells goods and are delivered, is the day to record
the revenue. This is the Realization Principle. Revenue is recognized when it
is earned without regard when the company received cash.
Expenses are incurred for the purpose of producing
revenue. It is the costs of goods and services used up in the process of
earning revenue. Expenses decrease the Net Worth of the company.
