Accounting: The Language of Business (Part 18)

“Aggressive accounting does not mean illegal accounting.” —Kenneth Lay

Completing the Accounting Cycle (Part B)

by

Charles Lamson

Financial Statements

The worksheet is an aid in preparing the income statement, the statement of owner's equity, and the balance sheet, which are presented an Exhibits 6 through 8. In the following paragraphs, we discuss these financial statements for NetSolutions, prepared from the completed worksheet in Exhibit 5 from part 17 and reintroduced below.

EXHIBIT 5

Income Statement

The income statement is normally prepared directly from the work sheet. However, the order of the expenses may be changed. We list the expenses in the income statement in Exhibit 6 in order of size, beginning with larger items. Miscellaneous expense is the last item, regardless of its amount. 

EXHIBIT 6

Statement of Owner's Equity

The first item normally presented on the statement of owner's equity is the balance of the proprietor's capital account at the beginning of the period. On the work sheet, however, the amount listed as capital is not always the account balance at the beginning of the period. The proprietor may have invested additional assets in the business during the period. Hence, for the beginning balance and any additional investments, it is necessary to refer to the capital account in the ledger. These amounts, along with the net income (or net loss) and the drawing amount shown in the work sheet, are used to determine the ending capital account balance.

EXHIBIT 7

The basic form of the statement of owner's equity is shown in Exhibit 7. For NetSolutions, the amount of drawings by the owner was less than the net income. If the owner's withdrawals had exceeded the net income, the order of the net income and the withdrawals would have been reversed. The difference between the two items would then be deducted from the beginning capital account balance. Other factors such as additional investments or a net loss, also requires some change in the form, as shown in the following example:

Balance Sheet

The balance sheet in Exhibit 8 was expanded by using subsections for current assets; property, plant, and equipment; and current liabilities. Such a balance sheet is a classified balance sheet. In the following paragraphs, we describe some of the sections and subsections that may be used in a balance sheet. We will introduce additional sections in later posts.

EXHIBIT 8

Assets

Assets are commonly divided into classes for presentation on the balance sheet. Two of these classes are (1) current assets and (2) property, plant, and equipment.

Current Assets Cash and other assets that are expected to be converted to cash or sold or used up usually within one year or less, through the normal operations of the business, are called current assets. In addition to cash, the current assets usually owned by a service business are notes receivable, accounts receivable, supplies, and other prepaid expenses.

Notes receivable are amounts customers owe. They are written promises to pay the amount of the note and possibly interest at an agreed rate. Accounts receivable are also amounts customers owe, but they are less formal than notes and do not provide for interest. Accounts receivable normally result from providing services or selling merchandise on account. Notes receivable and accounts receivable are current assets because they will usually be converted to cash within one year or less.

Property, Plant, and Equipment The property, plant, and equipment section may also be described as fixed assets or plant assets. These assets include equipment, machinery, buildings, and land. With the exception of land, fixed assets depreciate over a period of time. The cost, accumulated depreciation, and book value of each major type of fixed asset is normally reported on the balance sheet or in accompanying notes.

Liabilities

Liabilities are the amounts the business owes to creditors. The two most common classes of liabilities are (1) current liabilities and (2) long-term liabilities.

Current liabilities Liabilities that will be due within a short time (usually 1 year or less) and that are to be paid out of current assets are called current liabilities. The most common liabilities in this group are notes payable and accounts payable. Other current liability accounts commonly found in the ledger are Wages Payable, Interest Payable, Taxes Payable, and Unearned Fees.

Long-Term Liabilities Liabilities that will not be due for a long time (usually more than one year) are called long-term liabilities. If NetSolutions had long-term liabilities, they would be reported below the current liabilities. As long-term liabilities come due and are to be paid within one year, they are classified as current liabilities. If they are to be renewed rather than paid, they would continue to be classified as long-term. When an asset is pledged as security for a liability, the obligation may be called a mortgage note payable or a mortgage payable.

Owner's Equity

The owner's right to the assets of the business is presented on the balance sheet below the liability section. The owner's equity is added to the total liabilities, and this total must be equal to the total assets.

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED.* 

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