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With the background information just provided, I’m ready to talk about some of the common financial statements or accounting reports that an accounting system like QuickBooks produces. If you understand which reports you want your accounting system to produce, you should find it much easier to collect the raw data necessary to prepare these reports.

In the following sections, I describe the three principal financial statements: the income statement, the balance sheet, and the statement of cash flows. I also briefly describe a fourth, catch-all category: accounting reports.

Don’t worry – I go through this material slowly. You need to understand what financial statements your accounting systems are supposed to provide and what data these financial statements supply.

The income statement

Perhaps the most important financial statement that an accounting system produces is the income statement. The income statement is also known as a profit and loss statement. An income statement summarizes a firm’s revenues and expenses for a particular period of time. Revenue represents amounts that a business earns by providing goods and services to its customers. Expenses represent amounts that a firm spends providing those goods and services. If a business can provide goods or services to customers for revenue that exceeds its expenses, the firm earns a profit. If expenses exceed revenue, obviously, the firm suffers a loss.

To show you how this all works – and it’s really pretty simple – take a look at Tables 1-1 and 1-2. Table 1-1 summarizes the sales that an imaginary business enjoys. Table 1-2 summarizes the expenses that the same business incurs for the same period. These two tables provide all the information necessary to construct an income statement.

TABLE 1-1 A Sales Journal

TABLE 1-2 An Expenses Journal

Using the information from Tables 1-1 and 1-2, you can construct the simple income statement shown in Table 1-3. Understanding the details of an income statement is key to your understanding of how accounting works and what accounting tries to do. Therefore, I want to go into some detail discussing this income statement.

TABLE 1-3 Simple Income Statement

The first thing to note about the income statement shown in Table 1-3 is the sales revenue figure of $13,000. This figure shows the sales generated for a particular period of time. The $13,000 figure shown in Table 1-3 comes directly from the sales journal shown in Table 1-1.

One important thing to recognize about accounting for sales revenue is that revenue gets counted when goods or services are provided, not when a customer pays for the goods or services. If you look at the list of sales shown in Table 1-1, for example, Joe (the first customer listed) may have paid $1,000 in cash, but Bob, Frank, and Abdul (the second, third, and fourth customers) may have paid for their purchases with a credit card. Yoshio, Marie, Jeremy, and Chang (the fifth through eighth customers listed) may not have even paid for their purchases at the time the goods or services were provided. These customers may have simply promised to pay for the purchases at some later date. The timing of payment for goods or services doesn’t matter, however. Accountants have figured out that you count revenue when goods or services are provided. Information about when customers pay for those goods or services, if you want that information, can come from lists of customer payments.

Cost of goods sold and gross margins are two other values that you commonly see in income statements. Before I discuss cost of goods sold and gross margins, however, let me add a little more detail to this example. Suppose that the financial information in Tables 1-1, 1-2, and 1-3 shows the financial results from your business: the hot dog stand that you operate for one day at the major sporting event in the city where you live. Table 1-1 describes sales to hungry customers. Table 1-2 summarizes the one-day expenses of operating your super-duper hot dog stand.

In this case, the actual items that you sell – hot dogs and buns – are shown separately in the income statement as cost of goods sold. By separately showing the cost of the goods sold, the income statement can show what is called a gross margin. The gross margin is the amount of revenue left over after paying for the cost of goods. In Table 1-3, the cost of goods sold equals $3,000 for purchases of dogs and buns. The difference between the $13,000 of sales revenue and the $3,000 of cost of goods sold equals $10,000, which is the gross margin.

Knowing how to calculate gross margin allows you to estimate firm break-even points and to perform profit, volume, and cost analyses. All these techniques are extremely useful for thinking about the financial affairs of your business. In fact, Book 6, Chapter 1 describes how you can perform these analyses.

The operating expenses portion of the simple income statement shown in Table 1-3 repeats the other information listed in the expenses journal. The $1,000 of rent, the $4,000 of wages, and the $1,000 of supplies get totaled. These operating expenses are then subtracted from the gross.

Do you see, then, what an income statement does? An income statement reports on the revenue that a firm has generated. It shows the cost of goods sold and calculates the gross margin. It identifies and shows operating expenses, and finally shows the profits of the business.

One other important point: Income statements summarize revenue, expenses, and profits for a particular period. Some managers and entrepreneurs, for example, may want to prepare income statements on a daily basis. Public companies are required to prepare income statements on a quarterly and annual basis. And taxing authorities, such as the Internal Revenue Service (IRS), require tax return preparation both quarterly and annually.

Technically speaking, the quarterly statements required by the IRS don’t need to report revenue. The IRS requires quarterly statements only of wages paid to employees. Only the annual income statements required by the IRS report both revenue and expenses. These income statements are produced to prepare an annual income tax return.

Balance sheet

The second most important financial statement that an accounting system produces is a balance sheet. A balance sheet reports on a business’s assets, liabilities, and owner contributions of capital at a particular point in time:

✓ The assets shown in a balance sheet are those items that are owned by the business, which have value and for which money was paid.

✓ The liabilities shown in a balance sheet are those amounts that a business owes to other people, businesses, and government agencies.

✓ The owner contributions of capital are the amounts that owners, partners, or shareholders have paid into the business in the form of investment or have reinvested in the business by leaving profits inside the company.

As long as you understand what assets and liabilities are, a balance sheet is easy to understand and interpret. Table 1-4, for example, shows a simple balance sheet. Pretend that this balance sheet shows the condition of the hot dog stand at the beginning of the day, before any hot dogs have been sold. The first portion of the balance sheet shows and totals the two assets of the hot-dog-stand business: the $1,000 cash in the cash register in a box under the counter and the $3,000 worth of hot dogs and buns that you’ve purchased to sell during the day.

TABLE 1-4 A Simple Balance Sheet

Balance sheets can use several other categories to report assets: accounts receivable (amounts that customers owe), investments, fixtures, equipment, and long-term investments. In the case of a small owner-operated business, not all these asset categories show up. But if you look at the balance sheet of a very large business – say, one of the 100 largest businesses in the United States – you see these other categories.

The liabilities section of the balance sheet shows the amounts that the firm owes to other people and businesses. The balance sheet in Table 1-4 shows $2,000 of accounts payable and a $1,000 loan payable. Presumably, the $2,000 of accounts payable is the money that you owe to the vendors who supplied your hot dogs and buns. The $1,000 loan payable represents some loan you’ve taken out – perhaps from some well-meaning and naive relative.

The owner’s equity section shows the amount that the owner, the partners, or shareholders have contributed to the business in the form of original funds invested or profits reinvested. One important point about the balance sheet shown in Table 1-4: This balance sheet shows how owner’s equity looks when the business is a sole proprietorship. In the case of a sole proprietor, only one line is reported in the owner’s equity section of the balance sheet. This line combines all contributions made by the proprietor – both amounts originally invested and amounts reinvested.

I talk a bit more about owner’s equity accounting later in this chapter because the owner’s equity sections look different for partnerships and corporations. Before I get into that, however, let me make two important observations about the balance sheet shown in Table 1-4:

✓ A balance sheet needs to balance. This means that the total assets must equal the total liabilities and owner’s equity. In the balance sheet shown in Table 1-4, for example, total assets show as $4,000. Total liabilities and owner’s equity also show as $4,000. This equality is no coincidence. If an accounting system works right, and the accountants and bookkeepers entering information into this system do their jobs right, the balance sheet balances.

✓ A balance sheet provides a snapshot of a business’s financial condition at a particular point in time. I mention in the introductory remarks related to Table 1-4 that the balance sheet in this table shows the financial condition of the hot-dog-stand business immediately before the day’s business activities begin.

You can prepare a balance sheet for any point in time. It’s key that you understand that a balance sheet is prepared for a particular point in time.

By convention, businesses prepare balance sheets to show the financial condition at the end of the period of time for which an income statement is prepared. A business typically prepares an income statement on an annual basis. In this orthodox situation, a firm also prepares a balance sheet at the very end of the year.

At this point, I return to something that I allude to earlier in the chapter: the fact that the owner’s equity section of a balance sheet looks different for different types of businesses.

Table 1-5 shows how the owner’s equity section of a balance sheet looks for a partnership. In Table 1-5, I show how the owner’s equity section of the hot-dog-stand business appears if, instead of having a sole proprietor named S. Nelson running the stand, the business is actually owned and operated by three partners named Tom, Dick, and Harry. In this case, the partners’ equity section shows the amounts originally invested and any amounts reinvested by the partners. As is the case with sole proprietorships, each partner’s contributions and reinvested profits appear on a single line.

TABLE 1-5 Owner’s Equity for a Partnership

Go ahead and take a look at Table 1-6. It shows how the owner’s equity section looks for a corporation.

TABLE 1-6 Owner’s Equity for a Corporation

This next part is a little bit weird. For a corporation, the amounts that appear in the owner’s equity or shareholders’ equity section actually fall into two major categories: retained earnings and contributed capital. Retained earnings represent profits that the shareholders have left in the business. Contributed capital is the money originally contributed by the shareholders to the corporation.

The retained-earnings thing makes sense, right? That’s just the money – the profits – that investors have reinvested in the business.

The contributed-capital thing is more complicated. Here’s how it works. If you buy a share of stock in some new corporation – for, say, $5 – typically, some portion of that price per share is for par value. Now, don’t ask me to justify par value. It stems from business practices that were common a century or more ago. Just trust that typically, if you pay some amount – again, say $5 – for a share, some portion of the amount that you pay – maybe 10 cents a share or $1 a share – is for par value.

In the owner’s equity section of a corporation’s balance sheet, capital that’s contributed by original investors is broken down into the amounts paid for this mysterious par value and the amounts paid in excess of this par value. In Table 1-6, you can see that $100 of shareholders’ equity or owner’s equity represents amounts paid for par value. Another $400 of the amounts contributed by the original investors represents amounts paid in excess of par value. The total shareholders’ equity, or total corporate owner’s equity, equals the sum of the capital stock par value, the contributed capital and excess of par value, and any retained earnings. So in Table 1-6, the total shareholders’ equity equals $1,000.

Statement of cash flows

Now I come to the one tricky financial statement: the statement of cash flows.

Before I begin, I have one comment to make about the statement of cash flows: As an accountant, I’ve worked with many bright managers and businesspeople. No matter how much hand-holding and explanation I (or other accountants) provide, some of these smart people never quite get some of the numbers on the statement of cash flows. In fact, many of the students who major in accounting never (in my opinion, at least) quite understand how a statement of cash flows really works.

For this reason, don’t spend too much time spinning your wheels on this statement or trying to understand what it does. QuickBooks does supply a statement of cash flows, but you don’t need to use this statement. In fact, QuickBooks produces cash basis income statements, which give you almost the same information – and in a format that’s easier to understand.

I think the best way to explain what a statement of cash flows does is to ask you to look again at the balance sheet shown in Table 1-4 earlier in this chapter. This table is the balance sheet for the imaginary hot dog stand at the beginning of the day.

Now take a look at Table 1-7, which shows the balance sheet at the end of the day, after operations for the hot dog stand have ended. Notice that at the start of the day (see Table 1-4), cash equals $1,000, and at the end of the day (see Table 1-7), cash equals $5,000. The statement of cash flows explains why cash changes from the one number to the other number over a period of time. In other words, a statement of cash flows explains how cash goes from $1,000 at the start of the day to $5,000 at the end of the day.

TABLE 1-7 Another Simple Balance Sheet

Table 1-8, not coincidentally, shows a statement of cash flows that explains how cash flowed for your imaginary hot-dog-stand business. If you’re reading this book, presumably you need to understand this statement. I start at the bottom of the statement and work up.

TABLE 1-8 A Simple Statement of Cash Flows

By convention, accountants show negative numbers inside parentheses. These parentheses flag negative values more clearly than a simple minus sign can.

The last three lines of the statement of cash flows are all easily understandable. The cash balance at the end of the period, $5,000, shows what cash the business holds at the end of the day. The cash balance at the start of the period, $1,000, shows the cash that the business holds at the beginning of the day. Both the cash balance at the start of the period and the cash balance at the end of the period tie to the cash balance values reported in the two balance sheets. (Look at Table 1-4 and Table 1-7 to corroborate this assertion.) Clearly, if you start the period with $1,000 and end the period with $5,000, cash has increased by $4,000. That’s an arithmetical certainty. No question there, right?

The financing activities of the statement of cash flows show how firm borrowing and firm debt repayment affect the firm cash flow. If the hot-dog-stand business uses its profits to repay the $1,000 loan payable – and in this case, this is what happened – this $1,000 cash outflow shows up in the financing activities portion of the statement of cash flows as a negative $1,000.

The top portion of the statement of cash flows is often the trickiest to understand. Note, however, that I’ve talked about everything else in this statement. So with a strong push, you can fight your way through to understanding what’s going on here.

The operating activities portion of the statement of cash flows essentially shows the cash that comes from the profit. If you look at Table 1-8, for example, you see that the first line in the operating activities portion of the statement of cash flows is net income of $4,000. This is the net income amount reported on the income statement for the period. The net income or operating profit reported in the business’s income statement, however, isn’t necessarily the same thing as cash income or cash profit. A variety of factors must be adjusted to convert this net income amount to what’s essentially a cash amount of operating profit.

In the case of the hot-dog-stand business, if you use some of the profits to pay off all the accounts payable, this payoff uses up some of your cash profit. This is exactly what Table 1-8 shows. You can see that the decrease in the accounts payable from $2,000 to $0 over the day required, quite logically, $2,000 of the net income. Another way to think about this is that essentially, you used up $2,000 of your cash profits to pay off accounts payable. Remember that the accounts payable is the amount that you owed your vendors for hot dogs and buns.

Another adjustment is required for the decrease in inventory. The decrease in inventory from the start of the period to the end of the period produces cash. Basically, you’re liquidating inventory. Another way to think about this is that although this inventory – the hot dogs and buns, in this example – shows up as an expense for the day’s income statement, it isn’t purchased during the day. It doesn’t consume cash during the day; it was purchased at some point in the past.

When you combine the net income, the accounts payable adjustment, and the inventory adjustment, you get the net cash provided by the operating activities. In Table 1-8, these three amounts combine for $5,000 of cash provided by the operations.

After you understand the details of the financing and operating activities areas of the statement of cash flows, the statement makes sense. Net cash provided by the operating activities equals $5,000. Financing activities reduce cash by $1,000. This means that cash actually increased over the period by $4,000, which explains why cash starts the period at $1,000 and ends the period at $5,000.

Other accounting statements

You can probably come up with examples of several other popular or useful accounting reports. Not surprisingly, a good accounting system such as QuickBooks produces most of these reports. One very common report or financial statement, for example, is a list of the amounts that your customers owe you. It’s a good idea to prepare and review such reports on a regular basis to make sure that you don’t have customers turning into collection problems.

Table 1-9 shows how the simplest sort of accounts receivable report may look. Each customer is named along with the amount owed.

TABLE 1-9 An Accounts Receivable Report at End of Day

Table 1-10 shows another common accounting report: an inventory report that the hot dog stand may have at the start of the day. An inventory report like the one shown in Table 1-10 would probably name the various items held for resale, the quantity held, and the amount or value of the inventory item. A report such as this is useful to make sure that you have the appropriate quantities of inventory in stock. (Think of how useful such a report would be if you really were planning to sell thousands of hot dogs at major sporting events in your hometown.)

TABLE 1-10 An Inventory Report at Start of Day

Putting it all together

By now, you should understand what an accounting system does. When you boil everything down to its essence, it’s straightforward, isn’t it? Really, an accounting system just provides you the financial information that you need to run your business.

Let me add a tangential but important point: QuickBooks supplies all this accounting information. For the most part, preparing these sorts of financial statements in QuickBooks is pretty darn easy. But first, you’ll find it helpful to know a bit more about accounting and bookkeeping. I go over that information in the coming chapters. Also, note that the big-picture stuff covered in this chapter is the most important knowledge that you need. If you understand the ideas described in this chapter, the battle is more than half won.

CURIOUS ABOUT DIFFERENT BUSINESS FORMS?

Are you curious about the differences among a sole proprietorship, a partnership, and a corporation? A sole proprietorship is formed automatically in most states and in most industries when an individual decides to go into business. In many jurisdictions, the sole proprietor needs to acquire or apply for a business license from the state or local city government. Other than clearing that modest hurdle, sole proprietorship requires no special prerequisites.

A partnership is formed automatically when two or more people enter into a joint business or investment activity for the purpose of making a profit. As is the case with a sole proprietorship, partnerships typically need to acquire a business license from the state and perhaps the federal government. Partnership formation doesn’t necessarily require any additional paperwork or legal maneuvering. If you do enter into a partnership, however, most attorneys (probably all attorneys) will tell you that you do so at a certain amount of risk if you don’t have an attorney draw up a partnership agreement that outlines the duties, rights, and responsibilities of the partners. Also be aware that you can actually form a partnership simply by collaborating in business with someone. The law books are full of stories of people who inadvertently created partnerships merely by collaborating on some project, sharing office space, or working together on some activity.

By comparison, most states allow several other business forms, including corporations, limited liability companies, and limited liability partnerships. These other business forms sometimes require considerably more work to set up, sometimes the assistance of a good attorney or accountant, and sometimes payment of several hundred – and possibly several thousand – dollars in legal and licensing fees. The unique feature of most of these other business forms is that the corporation, limited liability company, or limited liability partnership becomes a separate legal entity. In many cases, this separate legal entity protects investors from creditors that have a claim on the assets of the business. By comparison, in a sole proprietorship or a partnership, the sole proprietor and the partners are liable for the debts and obligations of the proprietorship or the partnership.

If you have questions about the correct business form in which to operate, talk with a good local attorney or accountant. He or she can assist you in choosing the appropriate business form and in considering both the legal and tax aspects of choosing a particular form. As a general rule, more sophisticated business forms such as corporations, limited liability companies, and limited liability partnerships deliver significant legal and tax benefits to investors and managers. Unfortunately, these more sophisticated business forms also require considerably more legal and accounting fiddle-faddling.