Recording events
Certain other events that have a financial impact on the business have to be recorded as well. They’re called events because they’re not based on give-and-take bargaining — unlike the something-given-for-something-received nature of economic exchanges. Events such as the following have an economic impact on a business and are recorded:
A business may lose a lawsuit and be ordered to pay damages. The liability to pay the damages is recorded.
A business may suffer a flood loss that is uninsured. The waterlogged assets may have to be written down, meaning that the recorded values of the assets are reduced to zero if they no longer have any value to the business. For example, products that were being held for sale to customers (until they floated down the river) must be removed from the inventory asset account.
A business may decide to abandon a major product line and downsize its workforce, requiring that severance compensation be paid to the laid-off employees.
As we explain in more detail in Chapter 3, at the end of the year, the accountant conducts a special survey to ensure that all events and developments during the year that should be recorded have been recorded so that the financial statements and tax returns for the year are complete and correct.
Taking the Financial Pulse of a Business
We devote a good deal of space in this book to explaining financial statements. In Chapter 2, we explain the fundamental information components of financial statements, and then Part 2 gets into the nitty-gritty details. Here, we simply want to introduce you to the primary kinds of financial statements so you know from the get-go what they are and why they’re so crucial.
The outside, nonmanager investors in a business receive summary-level financial statements. For example, investors see the total amount of sales revenue for the period but not how much was sold to each and every customer. Financial statements are based on the assumption that you, the reader, are not a manager of the business (see the earlier section “Recognizing users of accounting information”). The managers of the business should make good use of their financial statements, but they also need more detailed information beyond what’s in the business’s financial statements.
Meeting the balance sheet (statement of financial condition)
One type of financial statement is a “Where do we stand at the end of the period?” type of report. This is called the statement of financial condition or, more commonly, the balance sheet. The date of preparation is given in the header, or title, at the top of this financial statement. We present and explain a typical balance sheet in Chapter 2. Our purpose here is simply to present the basic content in a balance sheet.
A balance sheet summarizes the two opposite aspects of a business, which you could think of as the financial yin and yang of the business:
Assets: One side of the balance sheet lists the assets of the business, which are the economic resources owned and being used in the business. The asset values reported in the balance sheet are the amounts recorded when the assets were originally acquired — although we should mention that an asset is written down below its historical cost when the asset has suffered a loss in value. (And to complicate matters, some assets are written up to their current fair values.) Some assets have been on the books only a few weeks or a few months, so their reported historical values are current. The values for other assets, on the other hand, are their costs when they were acquired many years ago.
Sources of assets: On the other side of the balance sheet is a breakdown of where the assets came from, or their sources. Assets do not materialize out of thin air. Assets arise from three basically different sources:Creditors: Businesses borrow money in the form of interest-bearing loans that must be paid back at a later date, and they buy things on credit that are paid for later. So part of total assets can be traced to creditors, which are the liabilities of a business.Owners: Every business needs to have owners invest capital (usually money) in the business.Profit: Businesses retain part or all of their annual profits, increasing the surplus of the business. We use this term earlier in “Thinking about where assets come from.” In most balance sheets, surplus is called retained earnings or an equivalent title. From here on, we stick with the title retained earnings.One final definition: The total of owners’ capital invested in the business and its retained earnings is labeled owners’ equity.
$Assets = $Liabilities + $Capital + $RetainedEarnings
The dollar signs are to remind you that for each item, there’s a dollar amount that goes with it. This depiction of financial condition is referred to as the accounting equation. It stresses the point that the total amount of all assets equals the total amount of liabilities and owners’ equity. One side cannot be heavier than the other side. An imbalance signals accounting errors in recording the transactions of the business.
Looking at the accounting equation, you can see why the statement of financial condition is called the balance sheet; the equal sign means the two sides balance or are equal in total amounts.
Suppose a business reports $2.5 million total assets (without going into the details of which particular assets the business holds). Knowing that total assets are on the books at $2.5 million, we also know that the total of its liabilities, plus the capital invested by its owners, plus its retained profit adds up to $2.5 million.
