Painless Financial Literacy

Chapter 1. Financial Statements in General

I am going to assume that since you picked up this book, you are interested in finding out more about financial stuff. Many people dread this topic, but it is very important for every business owner to understand financial matters. How do you make financial decisions if you do not have an understanding of the terms that are being used to describe the options available to you? Questions about pricing and profitability are key to the survival of any business and involve being able to understand financial statements.

This chapter talks about financial statements in general. There are chapters in this book about each of these financial statements. Check out chapters 3 through 5, once you have read this chapter, to get more specific details.

You only need to understand three financial statements—these will tell you the most important things you need to know about your business.

•  Balance sheet

•  Income statement

•  Cash flow statement

The balance sheet shows your assets and liabilities at a particular moment in time. The balance sheet calculates the equity of your business based on some accounting definitions. A business has equity if it has more assets than liabilities. Most businesses exist for the purpose of increasing the shareholder’s equity, so it is crucial that you see how that is calculated. As a business owner, one of your goals is to increase the value of your business so you can eventually sell it—the equity of your business is a key concept! Many business owners want to know what their business is worth.

The income statement is the most popular of the basic financial statements—if I can use that terminology. Popular and accounting aren’t normally found in the same sentence. The income statement tells you if your business is making money or not. Most people care deeply about that calculation. The income statement compares revenues with expenses and tells you whether you have made a profit or not. If you have not heard this, let me be the one to tell you that as a business owner you want to make money.

The cash flow statement is not as popular or prepared as often as the other statements, but it has its uses. The cash flow statement can explain to you where your money came from and more importantly where it went!

So you have three financial statements—the balance sheet tells you what you have and what you owe; the income statement tells you if you are making money or not; and the cash flow statements explain where your money came from and where it went. These are all good things to know. There is more to learn of course, as there are some tricks to understanding the way that items are recorded in the accounting records. So now that you know why you care, let’s get a little deeper into these statements.

Financial statements always reflect historical amounts. There is no future information on the financial statements. If you see the words forecast, projected, or pro forma, then you know that you are dealing with information that has been made up. No one can reliably predict the future, so don’t get too excited about any forecast information. Predictions are just that—when you see the word forecast applied to a financial statement, think about how reliable weather forecasts are.

The actual financial statements that are prepared by professional accountants are historical, that is, they reflect transactions that have already happened. So you should put more faith in financial statements than weather forecasts.

Another very important point is that financial statements reflect transactions. If there is no transaction, then there is nothing recorded on the financial statement. Financial statements are accurate only if all the relevant information is obtained. The financial statements are only as good as the information that was used to prepare them. If you know that some of your transactions have never been given to your accountant, then you should know that your financial statements are not accurate.

There is a chapter in this book about accountant communications, chapter 10, and it explains all about the differences between audits, reviews, and notice to reader communications. They will help you to know what confidence you can place in a particular financial statement depending on what level of assurance an accountant has provided.

Let’s look at some of the accounting definitions so we all understand what is being discussed here. We are going to define assets, liabilities, equity, revenues, and expenses. You will find assets, liabilities, and equity on the balance sheet and revenue and expenses on the income statement.

Assets

Let’s start with assets although assets are one of the hardest terms to understand. The accounting definition for assets is actually fairly narrow.

An asset is a valuable resource owned by the business. What do we mean by resource? An economic resource is either cash or something that can be converted into cash or something that is expected to be used in future activities that will generate cash inflow to the business.

Some examples will help. An amount owing to the business by a customer is an asset because it will turn into cash when the customer pays it. This is an account receivable. If you are a convenience store, then the milk in the cooler is an asset because it will be sold and you trade the milk for cash. A computer is an asset because you use it in your business to make money. (The definition above talks of generating cash inflow to the business, people who are not accountants simply refer to this as making money.) Cash, accounts receivable, and inventory are typical examples of assets.

Let’s work with the definition a little more. The more official definition of an asset is as follows:

•  Must be acquired in a transaction

•  Must be an economic resource providing future benefits to the entity

•  Must be controlled by the entity

•  Must be objectively measurable

Okay, let’s use an example to show how this works. Many annual reports have a line in the report that says something like Our employees are our most important assets. This might make sense to human resource professionals, but a professional accountant would be likely to point out that you will never see the category employee on a balance sheet. Employees do not meet the criteria for being an asset by accounting standards. Let’s look at the definitions. Is an employee acquired in a transaction? Well, slavery is illegal in Canada, so for Canadian accounting purposes employees cannot be assets. How about must be an economic resource? Can we turn an employee into cash? Can we determine the cost of the employee? None of those things will work for accounting purposes. Now, this just means that employees are not assets for accounting purposes. You can still refer to something as an asset, but know that you are not talking about accounting assets.

When I am teaching a course, at this point someone usually says but what about athletes? Is it not true that Sydney Crosby is owned by the Pittsburgh Penguins of the National Hockey League? The answer to that question is no. Sydney’s contract to play hockey is owned by the Penguins; Syd himself is not owned. If he chooses to cease playing hockey then Pittsburgh will no longer be bossing him around.

Assets on the balance sheet must meet the above definition. This can cause some trouble. For example, software development people are often working on a project that they think is a new asset. Accountants do not agree; they need proof that it is a viable product. Until you actually have a purchase order for a new product, it is not considered to be an economic resource providing future benefits. So accountants fight with software designers about showing all their development work as assets on the balance sheet. The software developers feel that they have created an asset and the accountants feel that there is not yet any proof that an asset has been created. Think about how exciting that meeting would be—two different sorts of geeks engaged in combat!

Assets are the hardest category to understand, so we started with that since you are more likely to be rested at the beginning of the chapter than at the end.

Liabilities

Liabilities are a piece of cake to understand after you have spent time thinking about assets. Liabilities are amounts that you owe to others—a claim on the resources of the business.

Here’s the more stuck-up version.

A liability is an obligation to transfer assets or provide services to outside parties arising from events that have already happened.

That definition is a bit shorter than the one for assets.

Examples of liabilities include mortgages, bank loans, accounts payable, and deferred revenue. A mortgage is the obligation to make monthly payments repaying the debt on a house for as many years as it takes to pay it off! Bank loans are for things like buying a car or a big piece of equipment. Accounts payable is the term for when your business owes money to your suppliers. There are other chapters in this book about how to finance your business and how to use debt.

A liability that is occasionally overlooked is deferred revenue. You have deferred or unearned revenue on your books when you have received payment for work that you have not yet completed. Perhaps you asked for payment up front. This amount is treated as a liability because you have the obligation to either do the work or give them back the money. You will record the amount as revenue once you have done the work. Gift certificates are another example of deferred revenue. If your business issues gift cards or certificates, then you have the money from your customers before you give them the product. Gift certificate liability is carried on the balance sheet as a liability until the card holder shows up and gets their products.

Any time your business owes money to someone else, there should be a liability shown on your balance sheet.

Equity

Equity is shown on the bottom of a balance sheet. You see equity when the business has more assets than liabilities. If a business has more liabilities than assets, the name for that is deficiency or deficit. As a business owner, you would prefer to have equity. You would prefer to have more than you owe.

If your business is incorporated, then there will be a category for common shares or preferred shares on your balance sheet. The amount that shows in that section of the balance sheet is the amount that you as an individual paid for the shares that were issued by your corporation. The people who own a corporation are known as shareholders and they have paid for the shares by giving the corporation their money. A business only gets the money that a shareholder pays for a share the first time it is sold, because it is only then that the share is sold by the company. Every other sale after that original transaction is a sale that is made by a shareholder to another shareholder.

In small businesses, you will typically see the common share amount as something like $100. This is the amount that was paid by the original shareholders for the shares. In public companies the share capital is much larger.

There is also a line for retained earnings on the financial statements. This line proves that the balance sheet balances. The line for retained earnings contains the net effect of all of the transactions that have ever been made for this corporation. The idea of retained earnings is much what it sounds like—earnings retained by the business. Say it slowly, earnings retained by the business. So if the business has had more revenues than expenses over its lifetime, then there is a positive amount known as retained earnings. If the corporation has had more expenses then revenue in its lifetime, then the amount that is shown in this section of the balance sheet is called a deficit.

Let’s move on to the income statement. I think you will find that the definitions of revenue and expenses are a little easier to handle.

Revenue

Revenue is the amount that you have charged your customers for your product or service. If you sell chocolate bars for $2, then $2 is your revenue. Revenue is the word we use that also includes the terms sales or fees. We generally refer to sales when we sell a product and fees when we sell a service. It is revenue even if you have not received the money.

Expenses

Remember the discussion about assets? Well, an expense is anything that you have to pay for that does not meet the criteria of being an asset. If you bought something and it is not a fixed asset, an inventory item, or a prepaid, then you have an expense. There is much more information on the differences between assets and expenses in chapter 9.

Cash Flow

When an organization refers to cash flow it can be either positive cash flow which means the organization is receiving more cash than it is sending out, or negative cash flow which means more cash is leaving the organization than is coming in. Cash flow is different than profits. A profit is earned when there is more revenue than expenses. Revenue is not always received as soon as it is billed and expenses are not always paid as soon as they are incurred.

Conclusion

This chapter set the stage for a more detailed understanding of financial statements. We have talked about why you care about financial statements, what they are trying to tell you, and some key definitions. There are other chapters in this book about each statement as well as more detail in areas of expenses, leverage, and revenue recognition. You have much to look forward to.

Notes and Doodles

Chapter 2. Organization Type

How you have organized your business plays a role in how you manage your business and how the profits of your business are taxed. It also determines some of the accounting policies that must be followed. A corporation has to pay more attention to the financial rules than a proprietor does. In fact, the kind of organization you are involved with can also determine the financial statements that have to be prepared and what they are called.

Check out chapter 7—how generally accepted accounting principles (GAAP) have multiplied.

The most common organization types are proprietorship, partnership, corporation, society, or charity. We will talk about each of these possibilities in turn.

Businesses

The simplest form of business is known as a sole proprietorship and is so simple that you may not have even registered the business with anyone. A proprietorship rarely has a balance sheet or a cash flow statement. Most proprietors are running a one-person business that does not have employees. If you have a paper route or you do a little work for someone who does not give you a T4 then you are operating a proprietorship. The proprietorship is the first step in most business ventures. Most people do not incorporate right away—they wait until they are sure that their business idea is going to work for them.

A successful business often starts as a proprietorship and then becomes incorporated as they make more money. Eventually the business may involve holding