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92 Part II: Figuring Out Financial Statements Typical Business Inc. Summary of Changes in Assets and Liabilities from Sales and Expenses and Allied Transactions Through Year Ended December 31, 2009 Figure 4-2: Summary of changes in assets and liabilities from sales, expenses, and their allied transactions during the year. Assets Cash Receivables from credit sales Cost of unsold products in inventory Amount of expenses paid in advance Cost of fixed assets, net of depreciation Change in total assets Liabilities Payables for products and things bought on credit Unpaid expenses Income tax payable Change in liabilities Net income for year $1,515,000 $450,000 $725,000 $75,000 ($775,000) $1,990,000 $125,000 $150,000 $25,000 $300,000 $1,690,000 Note in Figure 4-2 that I use descriptive names for the assets and liabilities, instead of the formal account titles that you see in actual financial statements. You can refer to the formal account titles earlier in the chapter (see the section “Getting Particular about Assets and Liabilities”). When explaining the balance sheet in Chapter 5, I stick to the formal titles of the accounts. Other transactions also change the assets, liabilities, and owners’ equity of a business, such as borrowing money and buying new fixed assets. These nonrevenue and non-expense transactions are reported in the statement of cash flows, which I explain in Chapter 6. Reporting Extraordinary Gains and Losses I have a small confession to make: The income statement example shown in Figure 4-1 is a sanitized version as compared with actual income statements in external financial reports. If you took the trouble to read 100 income statements, you’d be surprised at the wide range of things you’d find in these statements. But I do know one thing for certain you would discover. Chapter 4: Reporting Revenue, Expenses, and the Bottom Line Many businesses report unusual, extraordinary gains and losses in addition to their usual revenue, income, and expenses. In these situations, the income statement is divided into two sections:  The first section presents the ordinary, continuing sales, income, and expense operations of the business for the year.  The second section presents any unusual, extraordinary, and nonrecurring gains and losses that the business recorded in the year. The road to profit is anything but smooth and straight. Every business experiences an occasional discontinuity — a serious disruption that comes out of the blue, doesn’t happen regularly or often, and can dramatically affect its bottom-line profit. In other words, a discontinuity is something that disturbs the basic continuity of its operations or the regular flow of profit-making activities. Here are some examples of discontinuities:  Downsizing and restructuring the business: Layoffs require severance pay or trigger early retirement costs; major segments of the business may be disposed of, causing large losses.  Abandoning product lines: When you decide to discontinue selling a line of products, you lose at least some of the money that you paid for obtaining or manufacturing the products, either because you sell the products for less than you paid or because you just dump the products you can’t sell.  Settling lawsuits and other legal actions: Damages and fines that you pay — as well as awards that you receive in a favorable ruling — are obviously nonrecurring extraordinary losses or gains (unless you’re in the habit of being taken to court every year).  Writing down (also called writing off) damaged and impaired assets: If products become damaged and unsellable, or fixed assets need to be replaced unexpectedly, you need to remove these items from the assets accounts. Even when certain assets are in good physical condition, if they lose their ability to generate future sales or other benefits to the business, accounting rules say that the assets have to be taken off the books or at least written down to lower book values.  Changing accounting methods: A business may decide to use a different method for recording revenue and expenses than it did in the past, in some cases because the accounting rules (set by the authoritative accounting governing bodies — see Chapter 2) have changed. Often, the new method requires a business to record a one-time cumulative effect caused by the switch in accounting method. These special items can be huge. 93 94 Part II: Figuring Out Financial Statements  Correcting errors from previous financial reports: If you or your accountant discovers that a past financial report had an accounting error, you make a catch-up correction entry, which means that you record a loss or gain that had nothing to do with your performance this year. According to financial reporting standards (GAAP), which I explain in Chapter 2, a business must make these one-time losses and gains very visible in its income statement. So in addition to the main part of the income statement that reports normal profit activities, a business with unusual, extraordinary losses or gains must add a second layer to the income statement to disclose these out-of-the-ordinary happenings. If a business has no unusual gains or losses in the year, its income statement ends with one bottom line, usually called net income (which is the situation shown in Figure 4-1). When an income statement includes a second layer, that line becomes net income from continuing operations before unusual gains and losses. Below this line, each significant, nonrecurring gain or loss appears. Say that a business suffered a relatively minor loss from quitting a product line and a very large loss from adopting a new accounting standard. The second layer of the business’s income statement would look something like the following: Net income from continuing operations $267,000,000 Discontinued operations, net of income taxes ($20,000,000) Earnings before cumulative effect of changes in accounting principles $247,000,000 Cumulative effect of changes in accounting principles, net of income taxes ($456,000,000) Net earnings (loss) ($209,000,000) The gains and losses reported in the second layer of an external income statement are generally complex and may be quite difficult to follow. So where does that leave you? In assessing the implications of extraordinary gains and losses, use the following questions as guidelines:  Were the annual profits reported in prior years overstated?  Why wasn’t the loss or gain recorded on a more piecemeal and gradual year-by-year basis instead of as a one-time charge?  Was the loss or gain really a surprising and sudden event that could not have been anticipated?  Will such a loss or gain occur again in the future? Chapter 4: Reporting Revenue, Expenses, and the Bottom Line Every company that stays in business for more than a couple of years experiences a discontinuity of one sort or another. But beware of a business that takes advantage of discontinuities in the following ways:  Discontinuities become continuities: This business makes an extraordinary loss or gain a regular feature on its income statement. Every year or so, the business loses a major lawsuit, abandons product lines, or restructures itself. It reports “nonrecurring” gains or losses from the same source on a recurring basis.  A discontinuity is used as an opportunity to record all sorts of writedowns and losses: When recording an unusual loss (such as settling a lawsuit), the business opts to record other losses at the same time, and everything but the kitchen sink (and sometimes that, too) gets written off. This so-called big-bath strategy says that you may as well take a big bath now in order to avoid taking little showers in the future. A business may just have bad (or good) luck regarding extraordinary events that its managers could not have predicted. If a business is facing a major, unavoidable expense this year, cleaning out all its expenses in the same year so it can start off fresh next year can be a clever, legitimate accounting tactic. But where do you draw the line between these accounting manipulations and fraud? All I can advise you to do is stay alert to these potential problems. Closing Comments The income statement occupies center stage; the bright spotlight is on this financial statement because it reports profit or loss for the period. But remember that a business reports three primary financial statements — the other two being the balance sheet and the statement of cash flows, which I discuss in the next two chapters. The three statements are like a three-ring circus. The income statement may draw the most attention, but you have to watch what’s going on in all three places. As important as profit is to the financial success of a business, the income statement is not an island unto itself. Also, keep in mind that financial statements are supplemented with footnotes and contain other commentary from the business’s executives. If the financial statements have been audited, the CPA firm includes a short report stating whether the financial statements have been prepared in conformity with GAAP. Chapter 15 explains audits and the auditor’s report. I don’t like closing this chapter on a sour note, but I must point out that an income statement you read and rely on — as a business manager, investor, or lender — may not be true and accurate. In most cases (I’ll even say in the large majority of cases), businesses prepare their financial statements in 95 96 Part II: Figuring Out Financial Statements good faith, and their profit accounting is honest. They may bend the rules a little, but basically their accounting methods are within the boundaries of GAAP even though the business puts a favorable spin on its profit number. But some businesses resort to accounting fraud and deliberately distort their profit numbers. In this case, an income statement reports false and misleading sales revenue and/or expenses in order to make the bottom-line profit appear to be better than the facts would support. If the fraud is discovered at a later time, the business puts out revised financial statements. Basically, the business in this situation rewrites its profit history. I wish I could say that this doesn’t happen very often, but the number of high-profile accounting fraud cases in recent years has been truly alarming. The CPA auditors of these companies did not catch the accounting fraud, even though this is one purpose of an audit. Investors who relied on the fraudulent income statements ended up suffering large losses. Anytime I read a financial report, I keep in mind the risk that the financial statements may be “stage managed” to some extent — to make year-to-year reported profit look a little smoother and less erratic, and to make the financial condition of the business appear a little better. Regretfully, financial statements don’t always tell it as it is. Rather, the chief executive and chief accountant of the business fiddle with the financial statements to some extent. I say much more about this tweaking of a business’s financial statements in later chapters. Chapter 5 Reporting Assets, Liabilities, and Owners’ Equity In This Chapter
Identifying three basic types of business transactions
Classifying assets and liabilities
Connecting revenue and expenses with their assets and liabilities
Examining where businesses go for capital
Understanding balance sheet values T his chapter explores one of the three primary financial statements reported by businesses — the balance sheet, which is also called the statement of financial condition and the statement of financial position. This financial statement is a summary at a point in time of the assets of a business on the one hand, and the liabilities and owners’ equity sources of the business on the other hand. It’s a two-sided financial statement, which can be condensed in the accounting equation: Assets = Liabilites + Owners’ equity The balance sheet may seem to stand alone — like an island to itself — because it’s presented on a separate page in a financial report. But keep in mind that the assets and liabilities reported in a balance sheet are the results of the activities, or transactions, of the business. Transactions are economic exchanges between the business and the parties it deals with: customers, employees, vendors, government agencies, and sources of capital. Transactions are the stepping stones from the start-of-the year to the endof-the-year financial condition. 98 Part II: Figuring Out Financial Statements Understanding That Transactions Drive the Balance Sheet A balance sheet is a snapshot of the financial condition of a business at an instant in time — the most important moment in time being at the end of the last day of the income statement period. If you read Chapter 4, you’ll notice that I continue using the same business example in this chapter. The fiscal, or accounting, year of the business ends on December 31. So its balance sheet is prepared at the close of business at midnight December 31. (A company should end its fiscal year at the close of its natural business year or at the close of a calendar quarter — September 30, for example.) This freeze-frame nature of a balance sheet may make it appear that a balance sheet is static. Nothing is further from the truth. A business does not shut down to prepare its balance sheet. The financial condition of a business is in constant motion because the activities of the business go on nonstop. The activities, or transactions, of a business fall into three basic types:  Operating activities: This category refers to making sales and incurring expenses, and also includes the allied transactions that are part and parcel of making sales and incurring expenses. For example, a business records sales revenue when sales are made on credit, and then, later, records cash collections from customers. Another example: A business purchases products that are placed in its inventory (its stock of products awaiting sale), at which time it records an entry for the purchase. The expense (the cost of goods sold) is not recorded until the products are actually sold to customers. Keep in mind that the term operating activities includes the allied transactions that precede or are subsequent to the recording of sales and expense transactions.  Investing activities: This term refers to making investments in assets and (eventually) disposing of the assets when the business no longer needs them. The primary examples of investing activities for businesses that sell products and services are capital expenditures, which are the amounts spent to modernize, expand, and replace the long-term operating assets of a business.  Financing activities: These activities include securing money from debt and equity sources of capital, returning capital to these sources, and making distributions from profit to owners. Note that distributing profit to owners is treated as a financing transaction, not as a separate category. Wondering where to find these transactions in a financial report? See the sidebar “How transactions are reported in financial statements.” Chapter 5: Reporting Assets, Liabilities, and Owners’ Equity How transactions are reported in financial statements Sales revenue and expenses, as well as any gains or losses that are recorded in the period, are reported in the income statement. However, the total flows during the period of the allied transactions connected with sales and expenses are not reported. For example, the total of cash collections from customers from credit sales made to them is not reported. The net changes in the assets and liabilities directly involved in operating activities are reported in the statement of cash flows (see Chapter 6). Financing and investing transactions are also found in the statement of cash flows. (Reporting the cash flows from investing and financing activities is one of the main purposes of the statement of cash flows.) Figure 5-1 shows a summary of changes in assets, liabilities, and owners’ equity during the year for the business example I introduce in Chapter 4. Notice the middle three columns in Figure 5-1, for each of the three basic types of activities of a business. One column is for changes caused by its revenue and expenses and their allied transactions during the year, which collectively are called operating activities. The second column is for changes caused by its investing activities during the year. The third column is for the changes caused by its financing activities. Typical Business, Inc. Statement of Changes in Assets, Liabilities, and Owners’ Equity for Year Ended December 31, 2009 (Dollar amounts in thousands) Beginning Balances Cash Accounts receivable Inventory Prepaid expenses Figure 5-1: Fixed assets, net of depreciation Assets Summary of changes in assets, liabilities, and owners’ equity during the year. Accounts payable Accrued expenses payable Income tax payable Interest-bearing debt O.E.-invested capital O.E.-retained earnings Liabilities & owners’ equity Operating Activities Investing Activities Financing Activities Ending Balances $2,275 $2,150 $2,725 $525 $5,535 $13,210 $1,515 $450 $725 $75 ($775) $1,990 ($1,275) ($350) ($350) $2,165 $2,600 $3,450 $600 $6,035 $14,850 $640 $750 $90 $6,000 $3,100 $2,630 $13,210 $125 $150 $25 $250 $150 ($750) ($350) $765 $900 $115 $6,250 $3,250 $3,570 $14,850 $1,690 $1,990 $1,275 99 100 Part II: Figuring Out Financial Statements Note: Figure 5-1 is not — I repeat not — a balance sheet. The balance sheet for this business is presented later in the chapter (see Figure 5-2). Businesses do not report a summary of changes in assets, liabilities, and owners’ equity such as the one that I show in Figure 5-1 (although personally I think that such a summary would be helpful to users of financial reports). The purpose of Figure 5-1 is to leave a trail of how the three major types of transactions during the year change the assets, liabilities, and owner’s equity accounts of the business during the year. The 2009 income statement of the business in the example is shown in Figure 4-1 in Chapter 4. You may want to flip back to this financial statement. On sales revenue of $26 million, the business earned $1.69 million bottom-line profit (net income) for the year. The sales and expense transactions of the business during the year plus the allied transactions connected with sales and expenses cause the changes shown in the operating activities column in Figure 5-1. You can see in Figure 5-1 that the $1.69 million net income has increased the business’s owners’ equity–retained earnings by the same amount. The operating activities column in Figure 5-1 is worth lingering over for a few moments because the financial outcomes of making profit are seen in this column. In my experience, most people see a profit number, such as the $1.69 million in this example, and stop thinking any further about the financial outcomes of making the profit. This is like going to a movie because you like its title, but you don’t know anything about the plot and characters. You probably noticed that the $1,515,000 increase in cash in this column differs from the $1,690,000 net income figure for the year. That’s because the cash effect of making profit (which includes the allied transactions connected with sales and expenses) is almost always different than the net income amount for the year. Chapter 6 on cash flows explains this difference. The summary of changes presented in Figure 5-1 gives a sense of the balance sheet in motion, or how the business got from the start of the year to the end of the year. It’s very important to have a good sense of how transactions propel the balance sheet. A summary of balance sheet changes, such as shown in Figure 5-1, can be helpful to business managers who plan and control changes in the assets and liabilities of the business. They need a clear understanding of how the two basic types of transactions change assets and liabilities. Also, Figure 5-1 provides a useful platform for the statement of cash flows, which I explain in Chapter 6. Presenting a Balance Sheet Figure 5-2 presents a two-year, comparative balance sheet for the business example that I introduce in Chapter 4. The balance sheet is at the close of business, December 31, 2008 and 2009. In most cases financial statements are not completed and released until a few weeks after the balance sheet date. Chapter 5: Reporting Assets, Liabilities, and Owners’ Equity Therefore, by the time you would read this financial statement it’s already out of date, because the business has continued to engage in transactions since December 31, 2009. (Managers of a business get internal financial statements much sooner.) When substantial changes have occurred in the interim, a business should disclose these developments in its financial report. When a business does not release its annual financial report within a few weeks after the close of its fiscal year, you should be alarmed. There are reasons for such a delay, and the reasons are all bad. One reason might be that the business’s accounting system is not functioning well and the controller (chief accounting officer) has to do a lot of work at year-end to get the accounts up to date and accurate for preparing the financial statements. Another reason is that the business is facing serious problems and can’t decide on how to account for the problems. Perhaps a business may be delaying the reporting of bad news. Or the business may have a serious dispute with its independent CPA auditor that has not been resolved (see Chapter 15 where I explain audits). Typical Business, Inc. Statement of Financial Condition at December 31, 2008 and 2009 (Dollar amounts in thousands) Assets Cash Accounts receivable Inventory Prepaid expenses Current assets Property, plant, and equipment Accumulated depreciation Net of depreciation Total assets Figure 5-2: The balance sheets of a business at the end of its two most recent years. Liabilities and Owners’ Equity Accounts payable Accrued expenses payable Income tax payable Short-term notes payable Current liabilities Long-term notes payable Owners’ equity: Invested capital Retained earnings Total owners’ equity Total liabilities and owners’ equity 2008 $2,275 $2,150 $2,725 $525 $7,675 $11,175 ($5,640) $5,535 $13,210 2009 $2,165 $2,600 $3,450 $600 $8,815 $12,450 ($6,415) $6,035 $14,850 2008 $640 $750 $90 $2,150 $3,630 $3,850 2009 $765 $900 $115 $2,250 $4,030 $4,000 $3,100 $2,630 $5,730 $13,210 $3,250 $3,570 $6,820 $14,850 101