Accounting Basics: Master Simple Financial Statements

1. Introduction: In this course, we'll work together to understand the basics of financial statements. You will learn how the balance sheet and income statement are created throughout the first year of a simple small business. We will follow the example of the furniture manufacturer called Bob, who designs and assembles bespoke furniture for his clients. We'll start from a blank balance sheet and income statement and work together to input each entry throughout the year. This includes when Bob invests the capital to start his business, buys a van to deliver his furniture, and even when he takes out a short term loan. At the end of this course, you'll have the opportunity to practice what you've learned with a pre built income statement and balance sheet in Microsoft Excel. With this pre built template, you can practice enter into transactions for another small business. If that sounds good to you, then I'll see you in the course. 2. The Purpose of Financial Statements: There are three different types of financial statements that businesses use the income statement, sometimes known as the profit and loss, the balance sheet, which can also be referred to as the statement of financial position and the cash flow statement. In this basic course, we'll be focusing on the balance sheet and the income statement and how they link together. But why do businesses prepare these statements? Businesses prepare financial statements to get an understanding of how their business is performing. They are also available to help different external users understand the business's activities and performance over a set period of time. For example, imagine being a potential investor. You'd want to understand how likely the company is to generate a positive return on your hard earned money, or you could be a bank looking to lend money to a company. But before you lend the money, you'd like to understand the potential risk of the company being able to pay that money back. You would take time to look at the company's financial statements in detail before you made this decision. Financial statements can vary in complexity, depending on the size of the business. A larger business is likely to have many complex transactions, leading to lots of pages in the financial statements. This can be quite confusing and does require some technical accounting knowledge to interpret a report of that detail. A small business, however, will most likely only have simple transactions to report, which is what we'll be focusing on in this course. 3. Understanding Financial Statements: You may have heard of cash accounting and accrual accounting, but what are the differences? Let's have a look at the basics. The cash accounting method is usually applied by individuals and small businesses. In this method, revenue and expenses are only reported once the cash has been received in the bank or paid out of the bank. This method may have some benefits. For example, the preparation of accounts can be much simpler, as there'll be no need for any accounting adjustments at the year end. And debtors, people who owe the business money, creditors, people who the business owes money, and stock otherwise known as inventory, which can be raw materials that a business uses to manufacture goods can all be ignored. On top of this, there may not be the need to prepare a cash flow statement as the cash paid in and out of the business has already been accurately recorded, and the adjustments that we just mentioned do not affect the income statement. However, the focus in this course is to look at the more commonly used method called accrual accounting. It is important to understand this concept when looking at financial statements. Under the accrual accounting method, entries into the financial statements will be recorded when a bill is received, meaning that a business has incurred an expense, or an invoice is raised to a customer, meaning the business has earned a sal, and the income should be recognized. This is regardless of whether any cash has been paid out or received. Let's take a look at a simple example. If the year end of a company is 31 December 20 X five, and a bill for stationary costing $100 is received on 15 December 20 X five during the current financial year, but it is not paid until January 10, 20 x six in the next financial year, it will need to be recognized in the income statement as an expense and accrued for in the balance sheet under the accrual accounting method. The reason for this is that the bill is relevant for an expense incurred in the current financial year 20 X five, not 20 x six. As we already mentioned, it doesn't matter that no cash has been paid for this bill. Now that we have a basic understanding of the concept of accruals, let's move on to take a look at how we build the balance sheet. 4. The Balance Sheet: The balance sheet or statement of financial position gives a snapshot of a company's assets, liabilities and shareholders equity at a point in time as it's cumulative and does not get reset to zero at the end of every financial year. This will hopefully make more sense later when we compare the balance sheet to the income statement. The balance sheet is split into five main sections, current assets, non current assets, current liabilities, non current liabilities, and finally, a special section called equity. The current assets section, you will find assets that are not expected to stay there for more than one year, such as cash, accounts receivable, and inventory. Current assets will either be expected to be recovered, such as the money owed to the business in accounts receivable or used to make and sell products, such as the items in the inventory section. In the non current assets section, you will find physical assets, such as property, plant, and equipment and assets that you cannot physically touch, which are called intangible assets. An example of an intangible asset would be a patent. Or they can get quite complicated, so we save these for another time. Assets in this section are classified as non current or fixed assets if they're expected to stay there for more than a year. In other words, long term. For example, imagine buying a warehouse for your business, you most likely would not plan to sell that in under a year. In the current liabilities section, you will find accounts payable, which is money that the business owes to its suppliers, short term loans, taxes payable, and accrued expenses. Non current liabilities are also long term, for example, a bank loan with a term that is over one year long. Finally, equity is a slightly different type of section. First, there is capital that has been invested into the business by the owners, and then the retained earnings that the businesses generated. This section shows the money that is eventually owed back to the shareholders of the business, if all of the other assets and liabilities that we just looked at were paid off first and the company were to be liquidated. You should understand equity as a special type of liability. The balance sheet is given that name for a specific and obvious reason being that it should always balance. All transactions entered into the financial statements will have two sides to them. In some cases, one entry may go to the balance sheet whilst the other will go to the income statement. On the other hand, you may have an adjustment where both entries will happen on the balance sheet. In both. The assets or liabilities section. In our example, as we're building a balance sheet from the beginning, it will not balance to start with as we're missing a vital link from the income statement. So keep an eye on the difference here as we go through. This should give you a good understanding of how the financial statements work together. So let's get started by taking a look at how this works with a basic business example for a new company called Bob's Bespoke Furniture. Bob has decided to start a furniture business in which he will personally design and build custom furniture to his client's specifications. To get started, Bob needs a place where he can assemble his furniture. So at the start of the financial year, on 1 January 20 X five, he decided to purchase a warehouse for $400,000. Purchase this warehouse, Bob has invested $100,000 of his own money into his company and taken a loan of $300,000 from the bank with an interest rate of 10% per annum to fund the rest of the purchase. Once the business owns a property, we need to recognize a long term asset in the balance sheet for $400,000. We now have one side of the equation and need to look at the other side, the liability section. The $100,000 of Bob's own money invested into the business will be classed as shareholders equity and will be shown in the equity section of the financial statements under Capital. Remember, this equity is a special type of liability the company ultimately owes back to the shareholders, IE Bop. That leaves the $300,000 long term loan left to balance our equation. This element will be recorded in the long term liability section of the balance sheet, as this loan will be over 12 months long as it's tied to the warehouse, like a mortgage. As we mentioned earlier, we're using the accrual accounting method and need to make some adjustments at the end of the year. So let's make a note section so that we can come back to these. The first note that we need to make is to adjust for depreciation on the warehouse. As you may already know, we need to ensure that assets are valued fairly in the balance sheet. Therefore, we charge an expense to the income statement relevant to the useful life of the asset. In this case, we're assuming that the useful life of the warehouse is ten years. Bob also needs some wood and other materials to make his furniture. So he takes out a short term loan for $50,000 that lasts over six months. The interest rate is 10% per annum, and he will use $30,000 of that loan to buy inventory and leave the remaining $20,000 as cash in his bank account for other expenses. So how does this look on the balance sheet? Well, here we can see that the short term loan for $50,000 will go to the current liability section on the balance sheet as it's under one year, and the $30,000 will go to inventory in the current assets section. Finally, the remaining $20,000 will be left as cash in the bank, as you can see the assets and liabilities now balance. We just have to remember there will be interest expenses related to loan, but we'll look at that later when we take a look at the income statement. So let's just add that to our notes for now. Finally, Bob purchased a van in cash to deliver his furniture. This cost him $10,000. We'll add $10,000 to the non current assets section and take $10,000 from Bob's cash. Again, let's make a note of this as a van will lose value over time and we need to depreciate it over ten years. Now that we have the basic opening entries to the business, let's take a look at how the business progresses as the year goes on in the income statement. We'll need to revisit the balance sheet to make some closing adjustments at the year end, but we have some notes for that anyway. 5. The Income Statement: The income statement, which can also be referred to as the profit and loss or sometimes shortened to P&L, shows a summary of revenue and expenses throughout a period of time. This is usually for a year. However, you can produce a profit and loss statement showing monthly or quarterly results or however your business likes to report its results. For simplicity, our profit and loss will run from January to December 20 x five. But what is an income statement? Well, an income statement will show where a business is generating a profit or a loss. A profit is made when a business's revenue is higher than its expenses. On the other hand, a loss would occur if the business expenses were higher than its revenue. Let's take a look at the income statement in a bit more detail and break down each of the sections that you need to understand. Revenue. The top line of the income statement is known as revenue, which may also be referred to as sales or turnover. This is a total amount of income that is generated by the primary operations of the business. This could be from the sale of physical goods that the company manufactures. Or it could be from services provided such as consulting fees. In our example, revenue will be generated from the sales of furniture that Bob makes, which are physical goods. Cost of goods sold. The cost of goods line is the next line in the income statement. This line refers to costs that are directly related to the products or services that are sold by the company. In our example, this will be materials that Bob has purchased to make his furniture and the direct cost of labor involved in assembling the bespoke furniture. This means that costs of goods sold would not include the wages of someone that is not involved in the direct manufacturing of the furniture, such as an office assistant, as these would be indirect costs. As an example, if Bob were to sell $1,000 of furniture, he would use $500 material in the process. Therefore, Bob's revenue would be $1,000, and the cost of goods sold would be $500. However, if Bob were to double his sales to $2,000, his direct material costs would also double to $1,000. As you can see, Bob cannot create and sell furniture without the direct costs of material related to its creation. This shows that the more Bob sells, the more material costs he will incur. Gross profit. Gross profit is calculated by simply subtracting the costs of goods that are sold from the revenue generated. Operating expenses. These are the costs that are indirectly related to the running of Bob's business. As mentioned earlier, this would include the salary of someone that is not involved in manufacturing of the furniture that's sold. They would also include costs such as marketing, accountancy fees, legal fees, insurance, rent, depreciation, and amortization. These costs are generally fixed, even if Bob sells more furniture. This is slightly different to the direct material cost that we looked at earlier. However, there may be some exceptions. For example, if Bob were to increase his marketing spend, his revenue may also increase in line with this. However, even though marketing costs can be related to revenue increasing, they cannot be directly tied to the production and assembly of furniture. So they cannot go in cost of goods sold. This is also the same for utility bills, such as electricity. And understandably, if Bob uses his machinery more, his electricity bills would increase. But again, the electricity costs cannot be directly tied to the production of the furniture, operating profit. Once we've deducted the variable overhead costs, we're left with the operating profit. This is a measure of how much profit the business is generating for its operations. There may also be some other costs that we need to deduct after operating profit that are not directly related to the operations of the business, such as interest income or interest expenses and tax expenses. You can see that this is why operating profit can also be referred to as EBIT earnings before interest and tax. And you may also have heard of EBITDA earnings before interest, tax, depreciation and amortization, which is where depreciation and amortization are also removed from the operating profit. But let's save that for another time. Net profit. Finally, we reach our net profit, which can sometimes be referred to as the bottom line. This is the profit that is left over after all expenses have been deducted. So in summary, we start at the top with our revenue or sales and deduct the costs that directly related to the manufacturing of the products that we were selling. We're then left with our gross profit. After this, we deduct our overheads, which are indirect costs such as utility bills, and this leaves us with our operating profits. Finally, we deduct other costs that are not related to the operations of the business, such as tax and interest expenses, leaving us with our net profit. The net profit is an important number that we need to be aware of as it links to the balance sheet. Now, let's have a look at Bob's income statement for the year. Throughout the year, Bob managed to design, assemble, and sell 300 sofas for $500 per sofa, generating a total revenue of $150,000. We will put this in the top line of our income statement under revenue. However, Bob only received $125,000 at the end of the year. This means that Bob has still not received the cash for 50 of the sofas that he has sold, which equates to $25,000. Therefore, we can add $125,000 to our cash balance in the balance sheet, but we're now $25,000 short. The remaining $25,000 will need to be added to our accounts receivable balance. Once the customers pay in the next financial year, Bob will remove this from his receivables and increase his cash balance accordingly. We now need to consider the cost of goods sold. Each sofa that Bob produced used $50 worth of his inventory. Bob sold 300 sofas. Therefore, he used up $15,000 of inventory. This will need to be deducted from the inventory section of the balance sheet. To keep this example simple, we're going to disregard the cost of Bob's labor when he was assembling the furniture. Obviously, this is a very simple example. A inventory may be bought at different times throughout the year, not only one time at the start of the year when the business has been formed. Prices of inventory throughout the year may also change. We'll save the complicated calculations of inventory valuations for another video. But for now, we need to know the simple way to calculate the cost of goods sold amount that needs to be recorded on the income statement. The formula for this is opening inventory, which was zero at the beginning of the year, as this was a new business, plus the purchases of inventory. Bob purchased $30,000 of inventory, less the closing inventory, $15,000 as we just calculated in the balance sheet. Let's move on to operating expenses. At the end of the year, Bob had not yet received an invoice for the last quarter of the year in relation to his electricity bill. The electricity bill is $4,000 per year. Therefore, Bob owes the company $100. However, given the fact that Bob has not received an invoice or paid any cash for this bill, he has not yet made any entries into his financial statements. Therefore, under the accruals method, we need to recognize $3,000 of the bill for the first free quarters from January to September as normal by debiting $3,000 to the operating expenses on the income statement and crediting $3,000 to the bank. To recognize the final $1,000, we will debit electricity expenses as normal, but we can't credit the bank, as Bob hasn't paid any cash yet. Therefore, we need to credit accrued expenses instead. Once the invoice has been paid in the following financial year, we can credit the bank to show the cash payment out of the business and debit accrued expenses to remove the amount from the balance sheet. Bob received another bill in December for insurance cost him $500. However, this was sent early by the insurance company and is actually related to the next financial year 20 x six. Bob decided to pay for this bill anyway in December 20 x five. So the adjustment that we need to make for this should consider the fact that although cash has been paid in 20 x five, the insurance is not related to 20 x five. Therefore, under the accruals method of accounting, we should not recognize these expenses in our income statement for 20 X five. So how do we do this? Well, similarly to the accrued expenses that we had not paid, we need to make an adjustment. To start with, as Bob has already paid $500 already, we must credit the bank to Li's cash balance. However, the key part here is a debit. We do not want this expense to show in our income statement. Instead of debiting the insurance expenses, we put this $500 in the balance sheet under prepaid expenses. Then when the next financial year starts, we will debit the income statement for $500 to show the expense and credit the prepaid expenses to remove this from the balance sheet. So in other words, we're just carrying it over to the next year, which is what it's related to. Finally, we also need to remember to check our notes and adjust for the depreciation expense to the van and the warehouse. The van is to be depreciated over ten years, and Bob has decided to depreciate a full year in the first year of operation. Some businesses don't charge depreciation in the first year that an asset is bought. So $10,000 divided by ten years, means that we must expense $1,000 to the income statement and remove this from the carrying value of the van in the non current assets section. This means that the van now has a carrying value of $9,000. The warehouse is also depreciated over ten years and therefore incurs a depreciation charge of $40,000. Is carrying value is now $360,000, and this needs to be adjusted in the non current assets section in the same way as the van. We've now completed the operating expenses of the income statement. If you remember earlier, we said that we need to make a note to remember that there will be interest expenses in relation to the interest from the loan. And on top of that, we also need to consider tax expenses. We have two loans to look at, one long term loan and one short term loan for six months. Let's start with a long term loan. We've already recorded entries on the balance sheet for this loan, we need to consider the interest expenses that should be recorded in the income statement. The loans are both interest only, meaning that the principal balances of the loans will not reduce unless the loan is repaid separately by Bob. So we did not have to think about amending the balance sheet for the long term loan as it is still in force at the end of the year. The interest rates on both loans are 10%. Therefore, for the long term loan, we need to record $30,000 worth of interest expense. The short term loan was for six months. Therefore, we take the balance of the loan, $50,000 and times this by 10%, giving us $5,000. However, as this was only enforced for six out of 12 months, we need to half the interest expense to $2,500, which means the total interest expenses on both loans are $32,500. Let's put this on our income statement. And lower the cash balance. We must also not forget to remove the loan from the balance sheet as it was repaid halfway through the year. So let's remove the short term loan and the corresponding amount from our cash balance. Now let's make our final adjustment for tax. Normally, you would make an estimation of tax payable in the financial statements. So in this case, the number we're going to use is $7,500. And let's also add that to taxes payable in the balance sheet. We now have all of our numbers to calculate our net profit in the income statement. But before we do, remember that we said that the balance sheet wouldn't balance, and there is a link between the income statement and the balance sheet? Well, our balance sheet is currently not balancing by $50,000. Can you guess what our net profit is going to be? That's right. $50,000. This is our missing number and it links to our retained earnings to make the balance sheet balance. Should also remember that the retained earnings will not always match the income statement. As the balance sheet is cumulative, remember? That means that as each year goes on, the net profit or loss for the period will either be added or deducted from the retained earnings in the balance sheet. It is also worth mentioning that business will normally use some form of accounting software throughout the year. And whenever a financial statement needs to be prepared, they will use the accounting system to produce a trial balance or a report. The trial balance will then be used to populate these financial statements. Generally, the adjustments that we've just seen will have already been entered on the accounting software throughout the year. However, to make our example easier and to see the full picture, we've entered all of the transactions and adjustments in one go at the end of the year. Okay, great. So the income statement and balance sheet are complete. Thank you very much for taking this course, and please take a look at your assignment in the next video. 6. Your Assignment: Welcome to your assignment. You'll find the Excel file that contains the income statement, balance sheet, and list of transactions in the download sections of this course. Please have a go at entering the transactions into the income statement and balance sheet. Good luck and remember to make sure your balance sheet balances.