Is there anything more adrenaline-rushing than debating accounting statements among friends? Boring as it might be for some, this material is tested on many of the regulatory examinations, so you will at least need to learn the basics.
There are three accounting statements—the income statement, balance sheet, and statement of cash flows. The income statement and balance sheet are probably the most analyzed, i.e., the ones most likely to be on your regulatory examination. This summary is a primer for those who have never dealt with either one.
The most straightforward of the three financial reports is the income statement. Simply stated, it takes a company’s revenues and subtracts its expenses to arrive at the firm’s net income—a measure of the firm’s profits or losses over a given period, typically a year.
The first expenses to appear on an income statement are related to the production of the goods or services the company offers. They are operating expenses. The cost of inventory (cost of goods sold) [COGS] represents the amount the firm’s inventory costs to produce. The COGS for the most part includes materials and labor. Selling, general, and administrative expenses (SG&A) represents compensation to sales staff, attorneys, administrative staff, and executives.
Research and development (R&D), you may have guessed, is used to pay researchers and developers. The depreciation and amortization figure (D&A) is one of the more difficult concepts on the income statement. It is the process that accountants use to allocate the cost of equipment.
For example, if UPS buys a delivery truck, they lay out the money this year. However, the truck will provide several years of benefits to the firm. Instead of taking the full purchase price against income in the year the truck is bought, the company will apply some of the value against sales in the next several years. The value taken every year comes under the heading of depreciation and amortization* expense. After all of the aforementioned expenses are applied, you are left with operating income.
*Depreciation applies to tangible assets, such as equipment. Amortization applies to intangible assets, such as patents or trademarks.
Operating income is also referred to as earnings before interest and taxes (EBIT). The next step is to deduct interest. This is an important consideration, since bond interest is deducted before taxes. Firms often prefer to issue bonds over stock where dividends are deducted from net income. There’s a whole academic discussion about issuing bonds versus stock and how taxes affect that decision. After interest is deducted, taxes are paid, leaving the firm with Net Income (the bottom line).
Technically, since other deductions will be made, it is not really the bottom line. Preferred dividends are paid, leaving the firm with earnings available to common shares, which is used in the earnings per share (EPS) calculation. At this point, there’s nothing else left to subtract and the firm is left with retained earnings. Retained earnings are then added to the company’s balance sheet, which is the link between the income statement and the balance sheet.
The balance sheet measures the net worth of a company. It takes what a company owns (i.e., assets) and subtracts what it owes its creditors (i.e., liabilities), leaving net worth, also called shareholders’ equity. The balance sheet gets its name from the balance sheet equation that requires that if you change one component you must also change another component. In other words, all transactions must offset one another—i.e., balance. The balance sheet equation is Equity = Assets – Liabilities, or Assets = Liabilities + Equity.
The asset section of the balance sheet represents what a company possesses to generate revenue—machinery, office space, land, trucks, cash, inventory, and patents. Current assets are items that can be used in one year or less. Cash and inventory are two of the larger items in current assets. Another example is accounts receivables, which is what the firm’s clients owe. For example, if I bought lunch at McDonald’s today using a credit card, my bill would be part of McDonald’s accounts receivables.
Fixed assets have a useful life exceeding one year. Property, plant, and equipment (PP&E) are a big part of fixed assets. Land is also a fixed asset. However, land is different since its value is not depreciated, whereas most other fixed assets are written down every year.
The final section of the assets section is intangibles, which is where the accounting gets less scientific and more theoretical. Intangibles include patents, trademarks, and other intellectual property.** Goodwill is usually listed separately from all the other intangibles. It represents the amount over the asset value a firm pays to acquire another firm.
For example, if Company A bought Company B for $2 million, but B’s assets were worth only $1.5 million on the balance sheet, then $500,000 of goodwill is created. In theory, accountants will tell you that goodwill measures brand loyalty, reputation in an industry, or just a warm and fuzzy feeling about a company. In practice, goodwill is an accountant’s statement that a firm is worth more than the sum of its parts. Goodwill is difficult to measure accurately. In any event, it will be reevaluated and adjusted annually.
**Remember, intangibles are amortized, not depreciated.
Liabilities are obligations that a firm must meet or, more simply, money it owes to others. The balance sheet divides liabilities into two categories. Liabilities that are due this year are current liabilities. Those due beyond this year are long-term. Accounts, dividends, and taxes payable are typical current liabilities. Certain types of leases, promissory notes, and bonds especially are long-term liabilities. Liquidity measurements, such as working capital and the current ratio, compare current assets and current liabilities. The leverage measurements compare interest-related liabilities with cash flows, income, total capitalization*** or even equity. Most analyses regarding liabilities are concerned with making sure they don’t get too large.
***Total Capitalization = Debt + Equity
The equity part of the balance sheet is the most intimidating for beginners. As discussed earlier, shareholders’ equity represents the residual value of a firm (i.e., net worth) after liabilities are paid (i.e., Equity = Assets – Liabilities). If the assets are not large enough to cover the liabilities, the firm will have negative equity. This sometimes occurs in the real world, especially for firms that are going through bankruptcy.
An often misunderstood portion of the equity section is the value of common shares. It is misleading because the figure includes only their par value. Par value of a common share might represent what it costs to create or print the certificate. Accountants don’t put much thought into the par value, usually giving it a nominal value such as $1.00 or $0.01. We must account for more than par value though, since shareholders usually will pay more than par to buy a share at issuance.
For example, if a company issues stock for $40 and par is $1, only $1 goes into common shares. The other $39 goes into paid-in capital, also called capital surplus. Paid-in capital is usually much larger than par value. Other parts of the equity section include noncontrolling interest, which comes up in mergers or acquisitions, and preferred equity, which accounts for the preferred shareholders. Neither one of these is all that relevant to an introductory discussion, so we’ll skip the details.
The largest part of the equity section is typically retained earnings. The retained earnings figure is the historical sum of all the company’s earnings not paid to shareholders. In theory, all of a company’s profits could be redistributed to the shareholders. When a firm pays dividends, the retained earnings figure decreases, since dividends are paid from retained earnings. Reporting a profit on the income statement increases retained earnings. Since not all of the profits are paid to the shareholders, what is not paid goes into retained earnings.
Jumping into the accounting statements can be daunting if you have never studied accounting. While this post is only an introduction to the balance sheet and income statement, your regulatory examinations will go further. The current ratio, quick ratio, working capital, earnings per share, price-earnings ratio, and others metrics, are all based on either the income statement, balance sheet, or both. If you get the basics down, the calculations will follow.
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—Securities Training Corporation