I thought the first post should have something to do with helping you understand accounting. I have always felt that if you can get off to a good start you have a much better chance of succeeding in your accounting classes.
You have probably been back at school for two or three weeks now and are probably two to three chapters in to your course. Let me try to help summarize what you have probably learned so far.
The first chapter in most accounting textbooks is devoted to providing you with background information about the accounting profession and the various forms of business organization (sole proprietorship, partnership, corporation). In addition, the books often describe the various financial statements and show you illustrations of each. There are four financial statements:
- Income statement
- Retained earnings statement
- Balance sheet
- Statement of cash flows
I’ll describe each statement here. You can refer to your textbook to see what they look like.
Income statement
The income statement measures profitability for a given period of time. It contains three sections:
- Revenue
- Expenses
- Net income
Revenues are the amount of goods and services a business provides to its customers. Revenue is “earned,” that is the business has to do something to get it (sell goods or provide services). Revenue is not the same as cash. Another word for revenues is sales.
Expenses are the costs of doing business. Expenses are “incurred,” that is the business uses expenses to help it earn revenues.
Net income results when revenues exceed expenses. In other words:
Revenues – Expenses = Net income
Retained earnings statement
The word retained means to “keep.”
The word earnings refers to net income.
Therefore the retained earnings statement shows you how much “net income” the business “keeps.”
Some businesses keep all of their net income while others share some with the owners (stockholders) of the business. The distribution of net income to the stockholders of the business is call “dividends.”
The retained earnings statement is very brief. It usually only contains four or so lines:
Beginning balance of retained earnings
Add: Net income
Less: Dividends
Equals Ending balance of retained earnings
Balance sheet
The balance sheet is probably the most difficult statement to understand. It contains three sections. The three sections can be expressed as an equation:
Assets = Liabiliites + Stockholders equity
Assets are the resources of the business. They are things the business needs to have in order to do the thing it went in business to do. Many textbooks often refer to assets as a “store of wealth.” I’m not really sure what that means but I think they are trying to say that assets are things that the business will have for a while.
Liabilities are often called debts or obligations. Obligations to pay money back that was borrowed or to pay for something you purchased on credit. I like to refer to liabilities as promises. If you borrow money from the bank you promise to pay it back. If you buy something on credit you agreee to pay for it on or before a designated date.
Stockholders equity represents how much has been invested in the business. It is composed of two parts:
- Common stock
- Retained earnings
Common stock represents the amount that stockholders paid us when they bought shares of our stock. We discussed retained earnings earlier.
To summarize the balance sheet, the assets represent the resources of the business and the liabilities and stockholders equity represent how the business acquired them. How much did they borrow to buy them? How much did the stockholders contribute so the business could buy them?
Statement of cash flows
The statement of cash flows shows where cash came from and where it went.
The life of a business can be divided up in to three activities:
- Financing
- Investing
- Operating
Financing activities – when a business starts it needs cash. It has two primary sources. It can borrow money (liabilities) or it can sell shares of stock (stockholders equity).
Investing activities – now that the business has cash it can go out and purchase the resources (assets) it needs to carry out its mission.
Operating activities – next, the business can open its doors, welcome its customers, and provide them with goods and services (revenues). At the same time, the business has to pay its bills (expenses) in order to stay in business.
I hope you found this useful. I’ll be back in a few days to talk about what happens next.
Be well.