Go ahead and take a look at Table 1-6. It shows how the owner’s equity section looks for a corporation.
TABLE 1-6 Owner’s Equity for a Corporation
This next part is a little bit weird. For a corporation, the amounts that appear in the owner’s equity or shareholders’ equity section actually fall into two major categories: retained earnings and contributed capital. Retained earnings represent profits that the shareholders have left in the business. Contributed capital is the money originally contributed by the shareholders to the corporation.
The retained-earnings thing makes sense, right? That’s just the money – the profits – that investors have reinvested in the business.
The contributed-capital thing is more complicated. Here’s how it works. If you buy a share of stock in some new corporation – for, say, $5 – typically, some portion of that price per share is for par value. Now, don’t ask me to justify par value. It stems from business practices that were common a century or more ago. Just trust that typically, if you pay some amount – again, say $5 – for a share, some portion of the amount that you pay – maybe 10 cents a share or $1 a share – is for par value.
In the owner’s equity section of a corporation’s balance sheet, capital that’s contributed by original investors is broken down into the amounts paid for this mysterious par value and the amounts paid in excess of this par value. In Table 1-6, you can see that $100 of shareholders’ equity or owner’s equity represents amounts paid for par value. Another $400 of the amounts contributed by the original investors represents amounts paid in excess of par value. The total shareholders’ equity, or total corporate owner’s equity, equals the sum of the capital stock par value, the contributed capital and excess of par value, and any retained earnings. So in Table 1-6, the total shareholders’ equity equals $1,000.
Statement of cash flows
Now I come to the one tricky financial statement: the statement of cash flows.
Before I begin, I have one comment to make about the statement of cash flows: As an accountant, I’ve worked with many bright managers and businesspeople. No matter how much hand-holding and explanation I (or other accountants) provide, some of these smart people never quite get some of the numbers on the statement of cash flows. In fact, many of the students who major in accounting never (in my opinion, at least) quite understand how a statement of cash flows really works.
For this reason, don’t spend too much time spinning your wheels on this statement or trying to understand what it does. QuickBooks does supply a statement of cash flows, but you don’t need to use this statement. In fact, QuickBooks produces cash basis income statements, which give you almost the same information – and in a format that’s easier to understand.
I think the best way to explain what a statement of cash flows does is to ask you to look again at the balance sheet shown in Table 1-4 earlier in this chapter. This table is the balance sheet for the imaginary hot dog stand at the beginning of the day.
Now take a look at Table 1-7, which shows the balance sheet at the end of the day, after operations for the hot dog stand have ended. Notice that at the start of the day (see Table 1-4), cash equals $1,000, and at the end of the day (see Table 1-7), cash equals $5,000. The statement of cash flows explains why cash changes from the one number to the other number over a period of time. In other words, a statement of cash flows explains how cash goes from $1,000 at the start of the day to $5,000 at the end of the day.
TABLE 1-7 Another Simple Balance Sheet
Table 1-8, not coincidentally, shows a statement of cash flows that explains how cash flowed for your imaginary hot-dog-stand business. If you’re reading this book, presumably you need to understand this statement. I start at the bottom of the statement and work up.
TABLE 1-8 A Simple Statement of Cash Flows
The last three lines of the statement of cash flows are all easily understandable. The cash balance at the end of the period, $5,000, shows what cash the business holds at the end of the day. The cash balance at the start of the period, $1,000, shows the cash that the business holds at the beginning of the day. Both the cash balance at the start of the period and the cash balance at the end of the period tie to the cash balance values reported in the two balance sheets. (Look at Table 1-4 and Table 1-7 to corroborate this assertion.) Clearly, if you start the period with $1,000 and end the period with $5,000, cash has increased by $4,000. That’s an arithmetical certainty. No question there, right?
The financing activities of the statement of cash flows show how firm borrowing and firm debt repayment affect the firm cash flow. If the hot-dog-stand business uses its profits to repay the $1,000 loan payable – and in this case, this is what happened – this $1,000 cash outflow shows up in the financing activities portion of the statement of cash flows as a negative $1,000.
The top portion of the statement of cash flows is often the trickiest to understand. Note, however, that I’ve talked about everything else in this statement. So with a strong push, you can fight your way through to understanding what’s going on here.
The operating activities portion of the statement of cash flows essentially shows the cash that comes from the profit. If you look at Table 1-8, for example, you see that the first line in the operating activities portion of the statement of cash flows is net income of $4,000. This is the net income amount reported on the income statement for the period. The net income or operating profit reported in the business’s income statement, however, isn’t necessarily the same thing as cash income or cash profit. A variety of factors must be adjusted to convert this net income amount to what’s essentially a cash amount of operating profit.
In the case of the hot-dog-stand business, if you use some of the profits to pay off all the accounts payable, this payoff uses up some of your cash profit. This is exactly what Table 1-8 shows. You can see that the decrease in the accounts payable from $2,000 to $0 over the day required, quite logically, $2,000 of the net income. Another way to think about this is that essentially, you used up $2,000 of your cash profits to pay off accounts payable. Remember that the accounts payable is the amount that you owed your vendors for hot dogs and buns.
Another adjustment is required for the decrease in inventory. The decrease in inventory from the start of the period to the end of the period produces cash. Basically, you’re liquidating inventory. Another way to think about this is that although this inventory – the hot dogs and buns, in this example – shows up as an expense for the day’s income statement, it isn’t purchased during the day. It doesn’t consume cash during the day; it was purchased at some point in the past.
When you combine the net income, the accounts payable adjustment, and the inventory adjustment, you get the net cash provided by the operating activities. In Table 1-8, these three amounts combine for $5,000 of cash provided by the operations.
After you understand the details of the financing and operating activities areas of the statement of cash flows, the statement makes sense. Net cash provided by the operating activities equals $5,000. Financing activities reduce cash by $1,000. This means that cash actually increased over the period by $4,000, which explains why cash starts the period at $1,000 and ends the period at $5,000.
Other accounting statements
You can probably come up with examples of several other popular or useful accounting reports. Not surprisingly, a good accounting system such as QuickBooks produces most of these reports.