Luca Pacioli, a Renaissance monk, authored the first published work on accounting in 1494. His text described a system that already had been in use for about 200 years. Although present-day technology has altered the way businesses record financial transactions, the antecedents of our present accounting system’s essential functions date back over 700 years.[2]
To ascertain the financial health of an organization, businesses and their stakeholders use financial records and analytical statements that summarize their respective operations. Just as a medical doctor will gauge a person’s health by using blood tests, x-rays and ultrasound readings, a creditor or investor will want to assess the status of a company by measuring its ability to earn a profit for its owners and repay its debts. The critical indicators are what a business owns and what it owes, along with what it earns and what it spends. The element of time is also important in two ways. The first is that a financial record may summarize a business entity’s transactions over a period of time or, alternatively, it may only depict the financial status of a business at a particular point in time. A second concern is how a business will record a transaction that takes place over time.[3]
For example, assume Acme Corporation prepays in full an annual magazine subscription to Industry Today. It pays the subscription fee of $120 in September. Acme could record the subscription as a $120 expense in September or alternatively, it could record the subscription as a $10 expense each month.
The Balance Sheet
To examine the financial status of a company at a fixed point in time, accountants prepare a statement of financial position, which is more commonly called a “balance sheet.”[4] The balance sheet consists of three major components: assets, liabilities and owner’s equity. In a corporation, owner’s equity is called shareholder equity, since it is the shareholders who own the business.
Assets are what a business owns and include cash, inventory, plant and equipment, and intellectual property, such as copyrights, trademarks and patents. Assets also include monies owed to a business, which are called receivables. For example, a business may have accounts that record credit it has extended to its customers. Another type of asset is the expected benefit from an already incurred expense. The expense is referred to as “prepaid,” such as the subscription fee for Industry Today that Acme Corporation paid in our earlier example. Assets are listed on a balance sheet in order of their liquidity, with the most liquid of assets, cash, appearing first.[5]
A second component of the balance sheet is liabilities, which are what the business owes. These accounts include monies owed by the business that represent future obligations, called “payables,” such as payments owed to a business’s suppliers. Payables also include loans, which may be notes payable or mortgages. Liabilities also include deferred income, which is monies the business has received for a good or service that the business has not yet provided. When a business incurs an expense for which there is no present legal obligation, it records it as an “accrued liability.” For example, a balance sheet that is compiled in the middle of a two-week payroll period would reflect an accrued liability of half of the pending payroll amount. The balance sheet reflects the liability, but the company has not yet disbursed the funds.[6]
If assets represent what a business owns and liabilities represent what a business owes, then what is left over- the difference between the two amounts- is called “owner’s equity,” which is, by one measure, the worth of the business. We can represent the relationship among the three components in a mathematical equation, which is called the “fundamental accounting equation.”[7] It may be expressed as: Assets equals liabilities plus owner’s equity. Note that if a company’s liabilities exceed its assets, the company is insolvent. Another way of stating the fundamental accounting equation would be that liabilities equals assets minus owners’ equity, or owners’ equity equals assets minus liabilities.
For example, assume Acme Corporation has $10 million in assets and $7 million in liabilities. Acme Corporation would therefore be worth the difference between the assets and liabilities, that is, $3 million.
Structurally, the assets are listed on the left of a balance sheet while the liabilities are listed on the right side. Also, assets that are expected to be converted into cash or consumed within one year are called “current assets” and are listed first in order of liquidity. Assets not expected to be converted into cash or consumed within one year are called “long-term assets” and are listed after the current assets. It is the same with liabilities. Liabilities that are expected to be paid within one year are short-term liabilities and are listed first and long-term liabilities, which are those liabilities where payment is not expected to occur within one year, follow.[8]
The Income Statement
While the balance sheet shows the financial health of a company at a given time, the statement of results of operations, commonly called the “income statement,” shows the income or loss of a company over a year.[9] The income statement shows revenues and gains, along with expenses and losses. Revenues are the monies earned by a company for the sales of its goods and services, along with miscellaneous earnings which would include interest and dividends. Capital gains are those amounts that the company realizes, not as a result of its ordinary course of business, but, rather, from the sale of its assets, marketable securities and other transactions, collectively referred to as other comprehensive income.[10] Since assets are recorded at historical cost, the gain is the sale price less the amount originally paid for the asset.
For example, Acme Corporation purchases a plant for $1,000,000 in Ohio, but three years later Acme determines it would be better to conduct its manufacturing operations in Michigan. It sells its Ohio plant for $1,300,000, thus realizing a gain of $300,000 on the sale.
The income statement also lists expenses and losses. Expenses are costs incurred in running the business and generating income. They include the cost of goods the company has sold, salaries and wages, rent, interest and income taxes. Since some assets may lose value over time, a company will need to periodically deduct the lost value. This is called “depreciating” an asset, and it is accomplished by recording the reduction in value as a depreciation expense.[11]
For example, Acme Corporation’s plant in Ohio loses value through normal wear and tear. Acme therefore deducts $50,000 annually as a depreciation expense to reflect the loss in value of its Ohio plant. For accounting purposes, the $1,000,000 plant will be worth $950,000 at the end of its first year, $900,000 at the end of its second year, and so on.
Note that, while the building itself can be depreciated, the land itself cannot, as land does not necessarily lose its value as it ages. The amounts that can be depreciated for tax purposes are set forth in tax regulations.
In addition to expenses, the income statement will show losses, which are costs that are not incurred in the ordinary course of business. Losses may include litigation, natural disasters or changes in employee pension fund liabilities.[12]
The income statement typically lists revenues and gains first, followed by expenses and losses. Revenues and gains minus expenses and losses equals “net income,” which is how much the business earned in the time reflected by the income statement. Some companies use this “single step” approach, while others use a “multiple step” approach in the calculation of income or loss.[13]
In the multiple step approach, “gross profit” is sales minus cost of goods sold. Subsequently, subtracting operating expenses from the company’s gross profit will give the company’s “operating margin” or “net operating margin.” Other amounts added or subtracted produce a final “net income” or “net loss” figure. This number, when used in calculations involving the number of outstanding shares held by shareholders, can provide an earnings per share amount, which is an important metric for investors and creditors.[14]
One important relationship between the balance sheet and the income statement is that the increase in net income on the income statement equals the increase in owners’ equity on the balance sheet. For observers to evaluate the financial health of a business, financial statements will typically include income statements for three successive reporting periods.[15]
Other Financial Statement Document
The income statement shows the profitability of the company over a certain period of time, which affects the equity of the owners, but other considerations may also affect owner equity. For this reason, accountants may compile a statement of owners’ equity, which includes contributions to owners’ equity or disbursements from owner’s equity. This statement will show the company owners or shareholders the values of their business stakes. The statement of owner’s equity is also known as the “statement of changes in equity” or the “statement of retained earnings.”[16]
Another statement prepared by accountants is called the statement of cash flows and it focuses on the cash position of the business. Not all of a company’s assets are cash, and many accounts are dependent on credit transactions and future payments. This statement serves as a measure of the company’s ability to pay its debts as they become due.[17] The statement of cash flows has three essential components.
The first component is cash received from the company’s primary earning activities plus interest and dividends from its investments. Sometimes, accountants make adjustments to ensure that a financial statement more accurately reflects the company’s financial position. On the statement of cash flows, income from operations is adjusted for two considerations. Since depreciation expense is not paid out as a true cash expenditure (it is mainly relevant as a tax deduction), it is added back into net income. Second, monies allocated but not collected or expended in cash must be deducted from net income. For example, accounts receivable may reflect sales on credit for which no cash was received and, thus, net income must be reduced by this amount. These adjustments must also be made for other current asset and liability accounts such as inventory and accounts payable.[18]
For example, Acme Corporation earned $400,000 in net income for the past fiscal year as shown on its income statement. It allocated $50,000 to its depreciation expense account for its manufacturing plant and collected $120,000 in credit sales. For the purposes of preparing its statement of cash flows, Acme would add its $50,000 into its net income amount, since that money was deducted in determining net income but was not actually paid out in cash. Acme would then deduct its credit sales, since it did not receive those monies in cash. The result is $400,000 plus $50,000 minus $120,000, or $330,000.
The second component of the statement of cash flows is amounts disbursed and received from investment activities.
The third and final component of the statement of cash flows is monies from financing activities, which includes the funds received from the sale of stock and issuance of debt, loan repayment and monies paid when a company buys its own stock back or stock dividend payments.[19]
In addition to the four essential financial statements, footnotes can provide important information about the financial health of a company. Since accountants apply flexible rules, there may be multiple ways to record one transaction. The footnotes describe the approaches taken by the accountant in preparing the company’s financial statements. The footnotes can be critical to those who need an accurate picture of the company’s financial position, such as regulators and investors. Sometimes, the most important information about a company is contained in the footnotes section. For example, footnotes can reflect contingent liabilities, which may include possible future law suits to which the company may be subject.[20]
Double-Entry Bookkeeping
To maintain the integrity of recording transactions while providing an accurate financial picture of a company’s financial status, accountants employ what is called “double-entry bookkeeping.”[21] Under this approach, a business makes dual entries for one transaction. The company will make the entries in a journal where the account name and description affected by the transaction will be listed on the left and the corresponding amount involved listed on the right.
When figures are entered into the journal, the accountant enters the amounts in one of two columns that reside side by side. The company enters “debit” amounts in the left column and “credit” amounts in the right column. Debit entries increase the value of an asset while credit entries increase the liability and owners’ equity accounts. There must always be equal left and right entries; hence the name “double-entry bookkeeping.”
For example, assume Acme Corporation sells its plant in Ohio for $1,000,000. It would make two entries in its books. The first would be a debit, which is a left-column entry, in its cash account because its cash account has increased by $1,000,000. It would also make a right-column credit entry in its account called “Plant and Equipment” because the company lost the plant. Cash went up by $1,000,000 and Plant and Equipment went down by $1,000,000.
Note that there may be more than two entries. If Acme accepted $200,000 in cash and also negotiated a loan to the buyer for the remaining balance of $800,000, there would be three entries in Acme’s books. There would be a left-column debit entry to the cash account for $200,000 and a left-column debit entry to the Notes Receivable account for $800,000. There would be a right-column credit entry in the Plant and Equipment account of $1,000,000.
As another example, assume Acme Corporation negotiates a loan from First Bank for $100,000. Acme would make a left-column debit entry increasing its cash account by $100,000 and a right-column credit entry increasing its notes payable account to reflect the loan amount owed to First Bank.
In all cases, the total net value of the company is unaffected by these transactions, but they must be properly noted to ensure the integrity of the financial statements.
While these entries are made to a general journal, a company may maintain other specialized journals for cash receipts, cash payments, sales and purchases. Periodically, a company may transfer the general entries to ledger accounts where all of the transactions are summarized in individual accounts.[22]
For example, Acme Corporation manufactures and sells construction equipment. On Monday, Acme sells two front-end loaders for $30,000 each and, on Wednesday, Acme sells a tractor for $15,000. On Friday, Acme buys a computer system for $4,000. The entries in the general journal would be posted to the individual accounts in Acme’s ledgers. Assume Acme’s bookkeeper posts the previous week’s transactions on Mondays. The bookkeeper would increase Acme’s Cash account by $30,000, $30,000, and $15,000 for its weekly equipment sales and decrease its Cash account by $4,000 for the computer purchase. The final balance as reflected in Acme’s ledger Cash Account would, therefore, be $71,000.
The ledger accounts feature left-side and right-side entries ordered to reflect whether their general journal counterparts are debits or credits. Thus, for example, the cash account will have a right side and a left side in the company’s ledger separated by a line in the middle. For this reason, the account resembles the letter “T.” Hence, ledger accounts are sometimes called “T accounts.”[23]
In our next module, we’ll begin discussing the accounting process.
[1]Much of this discussion is based on Charles H. Meyer. Accounting and Finance for Lawyers in a Nutshell. 16. (6th ed.) 2017.
[2] Lawrence A. Cunningham. Introductory Accounting,Finance and Auditing for Lawyers. (6th ed.) 2006.
[3] Meyer, 1-7; Cunningham, 13-14.
[4] See generally, Meyer, 1-15; Cunningham, 13-14.
[5] Cunningham, 14.
[6] Meyer, 4.
[7] Meyer, 5; Cunningham, 33.
[8] Meyer, 6; Cunningham, 40.
[9] Meyer, 9-11; Cunningham, 41-46.
[10] Cunningham, 15.
[11] Meyer, 12-13.
[12] Cunningham, 15.
[13] Meyer, 9-11.
[14] Meyer, 9-11.
[15] Cunningham, 15.
[16] Cunningham, 16.
[17] Cunningham, 16.
[18] Meyer, 12-13.
[19] Meyer, 12-13.
[20] See https://www.investopedia.com/ask/answers/042415/how-are-contingent-liabilities-reflected-balance-sheet.asp
[21] See generally, Meyer, 20-27; Cunningham, 36-37.
[22] Meyer, 22.
[23] Meyer, 23