CHAPTER 3TOPIC 3

INTERPRETING AN INCOME STATEMENT AND BALANCE SHEET

WHAT DOES AN INCOME STATEMENT SAY?

WHAT DOES A BALANCE SHEET SAY?

REVIEWING GENERALLY ACCEPTED ACCOUNTING PRINCIPLES

• BASIC ACCOUNTING PRINCIPLES

• BROAD ACCOUNTING GUIDELINES FOLLOWED BY THE PROFESSIONAL ACCOUNTANTS IN ALL COUNTRIES

• REVIEW PRINCIPLE

• ASSUMES YOU CAN DEFINE REVENUE, REVENUE MUST BE RECOGNIZED AT THE TIME WHEN THE SALE OF SERVICE (OR GOODS) IS MADE, AND NOT WHEN THE CASH IS RECEIVED FROM THE CUSTOMER.

• EXPENSE PRINCIPLE

• ASSUMES YOU CAN DEFINE EXPENSE, AND IT SAYS THAT AN EXPENSE MUST BE ACCOUNTED FOR WHEN IT IS INCURRED AND NOT WHEN THE CASH PAYMENT IS MADE.

• MATCHING PRINCIPLE

• REVENUES RECOGNIZED DURING ONE ACCOUNTING PERIOD MUST BE MATCHED WITH EXPENSES INCURRED DURING THE SAME ACCOUNTING PERIOD.

• THE ACCOUNTING PERIOD MAY E ANY DESIGNATED LENGTH OF TIME UP TO ONE YEAR.

• OBJECTIVITY PRINCIPLE

• BEFORE A TRANSACTION CAN BE RECORDED, IT MUST HAVE OCCURRED PHYSICAL PROOF OR EVIDENCE IS REQUIRED TO PROVE THAT A TRANSACTION TOOK PLACE, AND SUCH EVIDENCE IS CALLED A SOURCE DOCUMENT.

• COST PRINCIPLE

• FIRST, ALL ASSETS MUST BE ACCOUNTED FOR ON THE BASIS OF HOW MUCH WAS PAID TO GET THOSE ASSETS.

• SECOND, THESE SAME FIGURE COST FIGURES MUST BE KEPT IN THE ASSET ACCOUNTS EVEN IF THE SO-CALLED MARKET OR CURRENT VALUE HAS GONE UP.

GENERAL NOTES• ONLY 5 OF AT LEAST 10 PRINCIPLES – RECOGNIZED

IN ALL COUNTRIES

• BASIC ACCOUNTING PRINCIPLES

• BROAD ACCOUNTING GUIDELINES FOLLOWED BY THE PROFESSIONAL ACCOUNTANTS IN ALL COUNTRIES.

• SPECIFIC ACCOUNTING PRINCIPLES

• MORE SPECIFIC GUIDELINES FOLLOWED BY ACCOUNTANTS IN A PARTICULAR COUNTRY

• EVERY COUNTRY FOLLOWS IT’S OWN ACCOUNTING PRINCIPLES WHICH SERVES AS GUIDELINES FOR ACCOUNTANTS TO FOLLOW.

CANADA• PAST

• THREE ACCOUNTING BODIES (CICA/CA, CMA, AND CGA)

• CICA HANDBOOK

• PRESENT (JANUARY 1, 2013)

• CPA (CHARTERED PROFESSIONAL ACCOUNTANT)

• CPA CANADA HANDBOOK

GUIDELINES:• FINANCIAL STATEMENTS SHOULD BE PREPARED IN SUCH

FORM AND USE SUCH WORDS AND CLASSIFICATIONS THAT READERS CAN EASILY UNDERSTAND THE INFORMATION BEING REPORTED.

• ASSETS REPORTED ON THE BALANCE SHEET SHOULD BE CLASSIFIED UNDER AT LEAST TWO CLASSES: CURRENT AND FIXED.

• THE MAIN ITEMS MAKING UP CURRENT ASSETS SHOULD BE REPORTED SEPARATELY, FOR EXAMPLE, CASH, MARKETABLE SECURITIES, AND ACCOUNTS RECEIVABLE.

• FIXED ASSETS SHOULD BE RECORDED BY MAJOR CATEGORY: FOR EXAMPLE, LAND, BUILDING, AND MACHINERY.

• THE COST VALUE OF FIXED ASSETS SHOULD BE DISCLOSED ON EVERY BALANCE SHEET.

• IF ASSETS OF THE BUSINESS ARE PROMISED AS SECURITY AGAINST LIABILITIES, THE NATURE OF SUCH ASSETS SHOULD BE DISCLOSED. IN OTHER WORDS, READERS OF THE BALANCE SHEET SHOULD KNOW WHICH ASSETS HAVE BEEN PLEDGED S SECURITY AGAINST WHICH DEBTS.

• LIABILITIES REPORTED ON THE BALANCE SHEET SHOULD BE CLASSIFIED UNDER AT LEAST TWO HEADINGS: CURRENT AND LONG-TERM.

• THE CURRENT LIABILITY SECTION REPORTS ALL DEBTS PAYABLE WITHIN ONE YEAR FROM THE DATE OF THE BALANCE SHEET, FOR EXAMPLE, BANK LOANS, ACCOUNTS PAYABLE, OTHER LOANS PAYABLE, TAXES PAYABLE, AND CURRENT PAYMENTS OF LONG-TERM DEBT.

• IF ANY OF THE LIABILITIES ARE SECURED, THEY SHOULD BE STATED SEPARATELY AND THE FACT THAT THEY ARE SECURED SHOULD BE INDICATED.

• ANY PORTION OF A LONG-TERM DEBT OBLIGATION PAYABLE WITHIN A YEAR OUT OF CURRENT FUNDS SHOULD BE INCLUDED IN THE CURRENT LIABILITIES.

• THE INCOME STATEMENT SHOULD REPORT AT LEAST THE FOLLOWING ITEMS: THE MAIN SOURCES OF REVENUE EARNED BY THE BUSINESS FOR A SPECIFIC ACCOUNTING PERIOD, THE MAJOR EXPENSES INCURRED FOR THE SAME PERIOD, AND THE NET INCOME OR NET LOSS FOR THE PERIOD.

• THE FINANCIAL STATEMENTS OF AN UNINCORPORATED BUSINESS (SOLE PROPRIETORSHIP) SHOULD CLEARLY INDICATE THE NAME OF THE BUSINESS AND WHEN NECESSARY, THE NAME OF THE OWNER.

• ANY “SALARY” PAID TO THE OWNER OF A SINGLE PROPRIETORSHIP SHOULD BE CONSIDERED PART OF THE PAYMENT OF THE NET INCOME TO THE OWNER SUCH “SALARIES” SHOULD BE ACCOUNTED FOR IN A SEPARATE, DRAWING ACCOUNT.

WHAT AN INCOME STATEMENT SAYS?

1. MATCHING PRINCIPLE

2. HEADING (WHO WHAT WHEN – FOR THE MONTH ENDED OR FOR THE YEAR ENDED)

3. MAIN AND SECOND SOURCE OF REVENUE• MAIN – REGULAR OPERATIONS OF THE BUSINESS THAT BRING IN

REVENUE

• SECONDARY – SOURCE OF REVENUE WHICH IS NOT PART OF THE REGULAR OPERATIONS OF THE BUSINESS (USUALLY AN INVESTMENT)

4. NATURE OF BUSINESS (COMMISSIONS EARNED/FEES EARNED VS SALES)

5. REVENUE: INFLOW OF ASSETS (CASH OR ACCOUNTS RECEIVABLE) FROM THE SALE OF GOODS AND SERVICES. REVENUE MUST BE RECOGNIZED WHEN THE SERVICES ARE RENDERED.

6. EVERY SOURCE OF REVENUE SHOULD BE TRACED BACK TO A SOURCE DOCUMENT (OBJECTIVITY PRINCIPLE). • AUDITORS – SPECIALIZED ACCOUNTANTS WHO CONDUCT AN

EXAMINATION OF THE ACCOUNTING RECORDS AND OTHER SUPPORTING EVIDENCE OF A BUSINESS.

7. EXPENSE PRINCIPLE - GIVES MEANING OF EXPENSE AND GUIDES ACCOUNTS IN DECIDING WHEN TO RECORD EXPENSES IN ACCOUNTING RECORDS. RECOGNIZED WHEN THE EXPENSE IS INCURRED NOT WHEN PAID.

8. BUSINESS EXPENSES – ARE THE COSTS OF OPERATING A BUSINESS

• COST OF USING A TELEPHONE BRINGS IN REVENUE. THAT COST IS USED UP SO IT BECOMES EXPIRED

• EXPIRED COSTS

• EXPENSES TO BE MATCHED AGAINST REVENUE IN THE INCOME STATEMENT

• USED UP

9. OBJECTIVITY PRINCIPLE – IS

10.NET INCOME/NET LOSS BASED ON REVENUE AND EXPENSES FOR A SPECIFIC PERIOD OF TIME. INCOME STATEMENT (OTHER NAMES: EARNINGS STATEMENT/STATEMENT OF EARNINGS/PROFIT AND LOSS STATEMENT)

WHAT DOES AN INCOME STATEMENT NOT SAY?

• AN INCOME STATEMENT IS A HISTORICAL STATEMENT REPORTING THE MATCHING OF REVENUES WITH RELATED EXPENSES FOR A PERIOD THAT HAS ENDED.

• IT DOES NOT PREDICT INCOME (BUDGETED INCOME STATEMENT – WHAT IFS). YOU CAN COMPARE PREVIOUS YEAR(S) RESULTS.

• DOES NOT PROVIDE AN EXACT MEASUREMENT.

• IS DOES NOT REPORT THE SO-CALLED “TRUE PROFIT” OF ANY BUSINESS – JUST ACCOUNTING PERIOD.

• TRUE PROFIT - THE DIFFERENCE BETWEEN TOTAL FUNDS INVESTED OVER THE LIFE OF THE BUSINESS AND FUNDS REALIZED FROM SALE OF BUSINESS

• NET INCOME IS NOT CASH

• CASH HAS LITTLE TO DO WITH NET INCOME.

• CASH IS OFTEN USED UP TO BUY OTHER ASSETS TO BRING IN MORE REVENUE OR INVESTED.

REVIEW:

• SOURCES OF REVENUE FOR A GIVEN ACCOUNTING PERIOD.

• THOSE EXPENSES WHICH ARE RELATED TO THE REVENUE FOR THE SAME ACCOUNTING PERIOD.

• RESULT OF THE MATCHING IS NET INCOME AND NET LOSS.

WE ARE ALMOST DONE!

WHAT DOES A BALANCE SHEET SAY OR NOT SAY?

SAY• BS – NAME OF BUSINESS

• DETAILED SUMMARY OF THE ASSETS AND CLAIMS AGAINST THOSE ASSETS AT A PARTICULAR DATE.

• FINANCIAL POSITION (ABILITY TO PAY DEBTS)

• GIVES THE READER A VIEW OF THE FIRMS FINANCIAL POSITION TO CARRY ON ITS BUSINESS OPERATIONS.

• STRENGTH OF THE OWNER’S CLAIM AGAINST THE ASSETS.

• ANY LIABILITY THAT IS REPORTED AS SECURED HAS ONE OR MORE ASSETS PLEDGED AS THE SECURITY

• EXAMPLE:• TOTAL ASSETS $128 065

• CREDITORS CLAIM - $24 000• 19%

• JANE’S CLAIM - $104 065• 81% (JANE/TA)

NOT SAY• DOES NOT REPORT THE

DETAILS OF THE PROFIT

• DOES NOT SHOW THE CLAIMS OF CREDITORS AND THE OWNER AGAINST SPECIFIC ASSETS (EXCEPT FOR SECURITY)

• CAPITAL IS NOT CASH (IT IS INVESTMENT – USED UP)

• DOES NOT REPORT THE SO-CALLED MARKET VALUE, CURRENT VALUE OR WORTH OF THE BUSINESS.

• COST PRINCIPLE

• ACCOUNTING VALUE VS MARKET VALUE

• CICA/CPA HANDBOOK

ASSETSUNEXPIRED COSTS

(COSTS NOT USED UP)

ASSETS – ECONOMIC RESOURCES TO BE USED IN THE FUTURE TO CREATE REVENUE

- ORIGINAL COST

- EXAMPLES: ALL THE ONES YOU HAVE LEARNED, PRE-PAID INSURANCE, PRE-PAID ADVERTISING

EXPIRED COSTS(COSTS USED UP)

EXPENSES – COSTS USED UP IN THE PROCESS OF MAKING REVENUE

- WHEN THE COST OF ANY ASSET IS USED UP, THAT COST “EXPIRED” IS NO LONGER THERE.

- EX: SALARIES EXPENSE/CASH – EXPIRED PORTION IS DEBIT (EXPENSE)

PRACTICE• PURCHASED ADVERTISING

WORTH $1200 FOR THE ENTIRE YEAR ON JANUARY 1.

• TRANSACTION:

• PREPAID ADVERTISING 1200

• CASH 1200

• TRANSACTION – SHOW THE STATEMENT FOR FEBRUARY 1 (WHAT HAS BEEN USED UP)

• PURCHASED INSURANCE FOR 6 MONTHS WORTH $600 ON JANUARY 1.

• TRANSACTION:

• PRE-PAID INSURANCE 600

• CASH 600

• TRANSACTION – SHOW THE DEBIT AND CREDIT FOR JUNE 30.

BALANCE SHEET

• A STATEMENT OF FINANCIAL POSITION

INCOME STATEMENT

• REPORTS ONLY A FAIR APPROXIMATION OF NET INCOME FOR AN ACCOUNTING PERIOD.

• HISTORICAL STATEMENT MATCHING REVENUE AND EXPENSES FOR A PERIOD OF TIME.