The income statement, or profit and loss statement (P&L), tells you how an entity did for a specific period of time. It shows income and expenses. A company records a profit for a period if income exceeds expenses and records a loss if expenses exceed income.
Figure 1: Example of an Income Statement
The balance sheet represents a companys status at a specific point in time and contains three major components: assets, liabilities, and owners equity. The term balance sheet comes from the fact that assets must equal, or balance, the sum of liabilities and owners equity. Assets are economic resources that can be converted to cash or applicable cash equivalents, for example, inventory. Liabilities represent anything owed to other people, for example, ordering inventory on credit. Equity represents the net worth of a company. For example, if a company has $10,000 in assets and $8,000 in liabilities then the owners equity in the company is $2,000.
Figure 2: Example of a Balance Sheet
Assets are anything that has value which a company owns. There are two major asset classes: tangible and intangible.
Tangible Assets- Tangible assets are assets that can be touched physically. Tangible assets are also broken down into subclasses, including current and fixed.
Current Assets- Current assets include the following:
Fixed Assets- Fixed assets are also referred to as property, plant, and equipment, or PPE. This means all buildings, machinery, furniture, and tools are fixed assets. It is noted that fixed assets owned by the company are carried on the balance sheet, while leased assets are not.
Intangible Assets- Intangible assets lack a physical element. This makes them very difficult to gauge. Typical intangible assets include:
The International Accounting Standard Board, or IASB, defines a liability as a present obligation of the enterprise arising from past events, the settlement of which is expected to result in an outflow from the enterprise of resources embodying economic benefits. Liabilities are classified as either current or non-current. Equity represents the last class of accounts.
Current Liability- Current liabilities are liabilities owed to creditors within 12 months. The most common current liability is accounts payable. Other common current liabilities include:
Non-Current Liability- Non-current liabilities are liabilities not due for repayment within the next 12 months. The most common non-current liabilities are:
Equity- Equity represents the value of the company to its owners. It can be determined by netting the total asset and liability values together. The type of organization or the way the company was setup for tax purposes determines what accounts show in the equity section. For example, in a condominium association, the equity is divided into fund balances: operating and reserve funds. In a cooperative, the equity is usually listed as common stock, retained earnings, and additional paid in capital.
Statement of Cash Flow- The statement of cash flows shows the inflows and outflows of cash over a specific period. The period is typically the same period as the income statement and reconciles the periods ending cash balance to the periods beginning balance.
Figure 3: Example of a Statement of Cash Flow
The statement of shareholders, or owners, equity shows the inflows and outflows of equity over a specific period. The period is typically the same period as the income statement and reconciles the periods ending equity balance to the periods beginning balance.
Figure 4: Example of an Owner's Equity Statement
Financial statements can be prepared statements using various bases. The two most common bases are cash and accrual. It is important to note that all financial statements must be completed using an accrual basis to be GAAP compliant. The cash basis is commonly used for internal monthly statements as management typically focuses on where the cash is coming from and going to. Transactions are recorded only when cash is received or paid in the cash basis. The accrual basis records transactions when revenue is earned and expenses are incurred, regardless of whether cash has been collected or changed hands.
Using the cash basis might seem more helpful as it represents the actual cash inflows and outflows; however, there are many pitfalls for using the cash basis of accounting.
As transactions are only recorded when cash is received or expended:
Financial reporting takes place throughout the year. Typically, management evaluates the financials of the company on a monthly, quarterly, and yearly or year-to-date basis. There are many reports that can be generated to show the financial state of a company.
What is a large variance
Management reviews these statements and then documents the reasons for any large variances; typically greater than 20% for the income statement. There are two types of variances: permanent and temporary.
Permanent Variance- Permanent variances are caused because either the certain assumptions in the budget proved to be incorrect, or changes in operations have occurred which were not budgeted. Some permanent differences are due to one-time expenditures, such as a large pipe broke, and others are due to recurring changes in revenues or expenses.
Timing Difference- Timing differences are considered short term variances, as they will reverse themselves later in the year.
Key Variance- Key variance focus areas are:
Other important accounts to review include:
Review General Ledger- The general ledger is used by accountants to track all transactions that occur for an entity. All transactions have two sides (debit/credit), and both sides for every transaction are entered on this report. A review of this report will allow you to know exactly what makes up an income statement or balance sheet. It is critically important that at the end of the report the total debits equal the total credits. If this is not the case, there is an error. Along with the general ledger comes a schedule of adjustments. This report shows all the journal entries made for the month. This schedule needs to be reviewed to understand what happened during the month and to identify any suspect transactions.
Figure 5: Example of a General Ledger
Auditing is a vital aspect of the accounting process. Auditing can be used as a deterrent to prevent financial crimes from being committed and also provides the public a level of assurance that the financial statements they read are accurate and without material misstatement. Audits can be performed both internally and externally, with the former being completed by the company and the latter being performed by an external company.
Internal Audits- Internal audits add value to a company by continually trying to improve a companys operations. Internal audits take place throughout the year with the goal of evaluating and improving the effectiveness of control, or governance, processes. The internal audit department is deemed to be independent of the company, meaning they operate as if they are a separate entity. Typically, the internal audit department will examine each account of a company throughout the year in order to monitor processes and make recommendations based on emerging trends noted during testing. Although the internal audit department is not charged with finding crimes being committed by employees, a strong internal audit presence deters would-be criminals, as a majority of financial crimes that could be committed by employees would show up in testing.
Figure 6: Tips for Performing Audits
External Auditing- If a company is public, meaning they are traded in any of the stock markets, an external audit must be completed yearly on the financial statements. External audits differ from internal audits in that external audits are performed by an accounting firm as opposed to a companys own internal audit department. All external audits must be performed by certified public accountants, while internal audits may be performed by an internal audit department. An external audit provides assurance that every number and statement included in the financial report is accurate and without material misstatement. This provides assurance to shareholders that they can trust the financial statements issued by a company and to prevent the fraudulent events that took place at companies like Enron, WorldCom, and Tyco from happening. With the passing of the Sarbanes-Oxley Act, or SOX, in 2002, even more strict rules and testing must be completed during an external audit, including an evaluation of internal audit controls and their effectiveness.