The goal of this discussion is not to make you into accountants but to provide an understanding of some accounting terms and concepts.
There are basically two types of accounting systems, the cash system and the accrual system. Many farmers and small businesses are on a cash system. This means you recognize a sale when you receive the money; or you recognize an expense when you write the check to pay the bill. In an accrual system, a sale is recognized when the product is shipped. The money for that product may not come to the company until 30 to 60 days later. The same logic follows for an expense. An expense is recognized when the service or material is used not when it is paid for, which could be 30 to 60 days later.
A processing plant would be on the accrual accounting system, in part, because the Internal Revenue Service might require an accrual system.
If you are the owner of a company, what are you looking to receive from the company? A return on your investment is probably your answer. The company has three primary business objectives. The first is more of an obligation than an objective; that is to provide the owners a return on the investment. This is accomplished by the other two objectives, which are profitability and solvency. Profitability is the ability to generate income. Solvency is the ability to pay debts as they become due. Financial statements provide the management of the company with a way to examine and forecast the company’s ability to achieve these objectives.
There are three basic financial statements. The income statement reflects the profitability of the company. The balance sheet reflects the solvency of the company. The cash flow statement tracks the cash of the company, where it comes from and what it is used for.
The income statement, also called the P&L (or profit and loss) statement, shows how much money the company made or lost for a defined period of time, one month, one quarter or one year. The income statement is like your personal bank statement, it reflects deposits (sales/revenues), expenses and whether or not there is any money left at the end of the month.
The income statement formula is:
Sales – Expenses = Profit or (Loss).
Sales are everything sold (shipped) during the period. Expenses are all the costs to produce everything that was sold plus the recurring period expenses such as the phone, office supplies, etc. If sum of all of the expenses for the period is less than what was sold, you made a profit.
The balance sheet shows what the company is worth at a given point in time. It is a reflection of how much the company owns, how much it is due and how much the company owes. It shows the company’s assets and liabilities, and the owner’s equity.
The formula for a balance sheet is:
Assets = Liabilities + Stockholder’s (Owner’s) Equity.
The asset side of the balance is divided into two areas, current assets that will be used in one year or less and fixed assets which are long term (such as the building or equipment). The liability side is also divided into two sections, current liabilities due in less than a year (like accounts payable) and long-term liabilities, which are due over a longer period of time. A mortgage is a good example of a long-term liability. The other half of the formula is the equity portion. This represents the amount invested in the company. Examples are paid-in capital, stock in the company and retained earnings. Retained earnings are the accumulation of profits (those not paid out as dividends to the stockholders), which the company keeps to expand its assets and grow the company
The cash flow statement summarizes the effects on cash of the operating, investing and financing activities of the company. By understanding this statement, management can see the effects of their decisions. For example, if the company’s operations do not generate enough cash for its upcoming capital projects, then it may want to issue stock to get the cash for the projects.
Besides management using the statement, outsiders such as investors, creditors and others use the statement to assess the company in a number of different ways. Such as, the company’s ability to generate positive future cash flows, the company’s ability to pay its bills and pay dividends, the need for external financing and the reason for the differences between net income and sources and uses of cash.
Samples and explanations of all three statements are included in this section as well as a further definition of terms you may run across in your work.