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The accounts, or basic elements presented in a balance sheet are the result of accrual-basis accounting methods for recording the revenue and expenses of the business. A balance sheet in large part consists of the remains of the profit accounting process. A balance sheet is not based on a complete survey of all the tangible and intangible assets of the business at their current values. For example, a business may have developed a well known and trusted brand name and have a well trained and dedicated workforce. But these two “assets” are not reported in its balance sheet. Having these two assets should be reflected in above-average profit performance, which is reported in the income statement of the business. The chief executive can brag about these two assets in the company’s financial reports to shareowners and lenders, but don’t look for them in the company’s balance sheet.

The balance sheet at the start and end of the year for the business is presented in Figure 2.3. Cash usually is shown first in a balance sheet, as you see in Figure 2.3. Cash includes coin and currency on hand, balances in demand deposit checking accounts with banks, and often cash equivalents such as short-term, marketable securities that can be liquidated at a moment’s notice. The dollar amounts reported in the balance sheet for assets other than cash and for liabilities and owners’ equity accounts are called
book values,
because these are the amounts recorded in the books, or accounts, kept by the business.

Generally, the book values of the liabilities of a business are the amounts of cash owed to creditors and lenders that will be paid later. The book value of the asset
accounts receivable
is the amount of cash that should be received from customers,
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I N T R O D U C I N G F I N A N C I A L S T A T E M E N T S

Note:
Amounts are in millions of dollars.

Assets

Beginning

End

of Year

of Year

Cash

$ 1.6

$ 2.0

Accounts receivable

$ 2.0

$ 2.5

Inventories

$ 3.9

$ 4.7

Prepaid expenses

$ 0.5

$ 0.6

Subtotal of current assets

$ 8.0

$ 9.8

Property, plant, and equipment

$15.5

$19.1

Accumulated depreciation

($ 6.5)

$ 9.0

($ 8.2)

$10.9

Total assets

$17.0

$20.7

Liabilities and Owners’ Equity

Advance payments from customers

$1.0

$1.2

Accounts payable

$1.6

$2.0

Accrued expenses payable

$0.6

$0.8

Short-term notes payable

$1.5

$2.0

Subtotal of current liabilities

$ 4.7

$ 6.0

Long-term notes payable

$ 3.5

$ 4.0

Owners’ equity—invested capital

$4.0

$4.2

Owners’ equity—retained earnings

$4.8

$ 8.8

$6.5

$10.7

Total liabilities and owners’ equity

$17.0

$20.7

Note:
The amounts reported at the beginning of the year are the carryover balances at the end of the preceding year; the amounts continue seamlessly from the end of the preceding year to the start of the following year.

FIGURE 2.3
Format of external balance sheet.

usually within a month or so. The book value of
inventories
(products held for sale) and
property, plant, and equipment
are the costs of the assets. The cost of inventories is relatively recent under one method of accounting or, alternatively, relatively old under another. (Accountants can’t agree on just one method for this particular asset.)

The total cost of property, plant, and equipment is relatively old unless most of these long-lived operating resources were recently acquired by the business. Their cost is spread over
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F I N A N C I A L R E P O R T I N G

the estimated years of their use; the amount of cost that is recorded as depreciation expense is recorded in the accumulated depreciation offset account, which is deducted from the original cost of the assets (see Figure 2.3)

When the shareowners invest capital in the business, the appropriate owners’ equity account is increased. At the end of the year the amount of profit for the year less the amount of profit distributed to the shareowners is recorded as an increase in the second owners’ equity account, which is called
retained earnings
(see Figure 2.3).

The balance sheet assets and liabilities that are directly connected with the sales revenue and expenses of the business are summarized as follows:

•
Accounts receivable.
Receivables from sales made on credit to customers.

•
Inventories.
Products manufactured or purchased that have not yet been sold.

•
Prepaid expenses.
Costs paid ahead for next year’s expenses.

•
Property, plant, and equipment less accumulated depreciation.
The original cost of long-term operating resources less the cumulative amount of the cost that has been recorded as depreciation expense so far.

•
Advance payments from customers.
Just what the account title implies—cash received in advance from customers for future delivery of products, so sales revenue has not yet been recorded.

•
Accounts payable.
Amounts owed to creditors for purchases on credit and for expenses that had not yet been paid to vendors and suppliers at balance sheet date.

•
Accrued expenses payable.
Cumulative amounts owed for certain expenses of period that had not been paid at balance sheet date.

These are called
operating
assets and liabilities because they are generated in the operations of making sales and incurring expenses. Operating liabilities are non-interest-bearing, which sets them apart from the interest-bearing notes owed by the business. Notes payable arise from borrowing money, not from the revenue and expense operations of the business. The operating assets and liabilities of a business constitute a good
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I N T R O D U C I N G F I N A N C I A L S T A T E M E N T S

part of its balance sheet, as illustrated in Figure 2.3. This is typical for most businesses.

The beginning and ending balances in the balance sheet shown in Figure 2.3 are the sources of the data in Figure 2.1

for the cash flow and accrual-basis amounts of revenue and expenses. The derivation of the amounts are summarized as follows (amounts in millions of dollars):

$2.00 beginning balance of accounts receivable

$1.20 ending balance of advance payments from customers $3.20 cash flow from last year’s sales or for next year’s sales $2.50 ending balance of accounts receivable

$1.00 beginning balance of advance payments from customers $3.50 sales made during the year but cash not collected during the year $1.60 beginning balance of accounts payable

$0.60 beginning balance of accrued expenses payable $4.70 ending balance of inventories

$0.60 ending balance of prepaid expenses

$7.50 cash payments during year of last year’s or for next year’s expenses $1.70 depreciation expense for year (increase in accumulated depreciation) $2.00 ending balance of accounts payable

$0.80 ending balance of accrued expenses payable

$3.90 beginning balance of inventories

$0.50 beginning balance of prepaid expenses

$8.90 Expenses recorded during year but not paid during year
THE STATEMENT OF CASH FLOWS

The third primary financial statement in the external financial reports of a business to its shareowners and lenders is the
statement of cash flows.
This financial statement summarizes the cash inflows and outflows of a business during the same period as the income statement. Figure 2.4 presents this financial statement for the business example. The second and third sections of the statement of cash flows are relatively straightforward. In the
investing activities
section, note that the business invested $3.6 million in new long-term operating assets during the year to replace old ones that reached the end of their useful lives and to expand the production and
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F I N A N C I A L R E P O R T I N G

Note:
Amounts are in millions of dollars.

Cash flow from operating activities

Cash collections from revenue

$25.7

Cash payments for expenses

($22.4)

$3.3

Cash flow from investing activities

Investments in new long-term operating assets

($3.6)

Cash flow from financing activities

Increase in short-term notes payable

$ 0.5

Increase in long-term notes payable

$ 0.5

Issuance of additional capital stock shares

$ 0.2

Cash distributions from profit to shareowners

($ 0.5)

$0.7

Net increase of cash during year

$0.4

Beginning cash balance

$1.6

Ending cash balance

$2.0

Note:
Cash flow from operating activities is presented according to the direct method, and cash outflows for expenses are condensed into one amount.

FIGURE 2.4
Format of external statement of cash flows for year.

warehouse capacity of the business. (Proceeds from disposals of long-term operating assets would have been reported as a cash inflow in this section.)

The
financing activities
section in the statement of cash flows summarizes cash flows of borrowing and payments on short-term and long-term debt and investment of additional capital by shareowners during the year as well as return of capital (if any) to them. Usually, the dealings with debt sources of capital are reported net (i.e., only the net increase or increase is disclosed). Reporting practices are not completely uniform in this regard however. It is acceptable to report borrowings separate from payments on debt instead of just the net increase or decrease. Generally, the issuance of new ownership shares should be reported separately from the return of capital to shareowners.

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I N T R O D U C I N G F I N A N C I A L S T A T E M E N T S

The first section of the statement of cash flows, called
cash
flow from operating activities
(which is not the best designation in the world, in my opinion), reports the cash increase or decrease during the year from sales revenue and expense activities. This key figure also is called
operating cash flow
or
cash flow from profit.
To be frank, this is not an easy number to understand. In Figure 2.4, I present cash flow from operating activities about as briefly and simply as you can. Cash inflow from sales revenue was $25.7 million during the year, and cash outflow for expenses was $22.4 million during the year, which yields the $3.3 million cash flow from profit operating activities. This manner of presentation is referred to as the
direct method.

Instead of the direct method, a business has the option of using an alternative method for presenting cash flow from operating activities, which is called the
indirect method.
The large majority of businesses elect the indirect method as a matter of fact—even though the financial reporting rule-making body of the accounting profession has expressed a preference for the direct method. The indirect method is explained next.

Indirect Method of Reporting Cash Flow

from Operating Activities

Based on changes in the operating assets and liabilities from the beginning of the year to the end of the year, Figure 2.5

shows how the business’s cash flow from operating activities would be presented in its statement of cash flows for the year.

The indirect method starts with net income for the year, then “adjusts” net income for the cash flow effects due to changes in the assets and liabilities that are directly connected with recording sales revenue and expenses (called
operating
assets and liabilities). Of course, the $3.3 million cash flow from operating activities for the year is the same whether the direct or the indirect method of presentation is used in the statement of cash flows. To follow the indirect method of presentation, keep in mind the following basic points:

• An increase in operating assets causes a negative effect on cash flow from profit, and a decrease causes a positive effect.

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F I N A N C I A L R E P O R T I N G

Net income

$2.2

Accounts receivable increase

(0.5)

Inventories increase

(0.8)

Prepaid expenses increase

(0.1)

Depreciation expense

1.7

Advance payments from customers increase

0.2

Accounts payable increase

0.4

Accrued expenses payable increase

0.2

Cash flow from operating activities

$3.3

FIGURE 2.5
Indirect method of reporting cash flow from operating
activities.

• An increase in operating liabilities causes a positive effect on cash flow from profit, and a decrease causes a negative effect.

In most situations, the largest decrease in an operating asset is the depreciation expense recorded for the year. Depre-

ciation expense is recorded in order to allocate a portion of the total cost of a business’s long-term operating assets to the year. Recording depreciation expense is not a cash outlay; rather, it is the write-down of the long-term operating assets of the business that were bought and paid for in previous TEAMFLY

years. Note in Figure 2.5 that depreciation expense is by far the largest single factor in cash flow from operating activities.

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END POINT

A business makes regular financial reports to its shareowners and lenders. Because they supply capital to the business, they are entitled to receive regular reports about what the business has done with their money. The hard core of these reports consists of three primary financial statements. They are called
external
financial statements because the information is released outside the business.