Two reasons why the value of a business is not included in the financial statements are:
The financial statements are generally based on the company’s past recorded transactions. The value of the business will more likely be based on the perceived future transactions.
The accountants’ cost principle prohibits a business from reporting some highly-valued assets such as trademarks, brand names, and an effective management team (assuming these were developed internally).
A contemporary example which demonstrates that the financial statements do not reflect the value of a business is a startup company with a promising future. We may have read that a venture capitalist (VC) invested $10 million in a startup. Based on that investment the startup is assumed to have a total value of $100 million. Well the startup’s financial statements will not report amounts anywhere near $100 million. Realistically the financial statements will be reporting negative earnings, few assets and little stockholders’ equity. The company’s value came from the VC’s perception of the company’s new breakthrough system that is projected to generate amazing future revenues with a limited amount of expenses.
In short, the financial statements provide only some of the information needed when attempting to determine the value of a business.
If a creditor required the company to sign a promissory note for the amount owed, the company will record and report the amount as Notes Payable. If a creditor is a vendor or supplier that did not require the company to sign a promissory note, the company will likely report the amounts owed as Accounts Payable. Other examples of creditors include company’s employees (who are owed wages and bonuses), governments (who are owed taxes), and customers (who made deposits or other prepayments).
Some creditors are known as secured creditors because they have a lien or other legal claim to the company’s (debtor’s) assets. Other creditors are often unsecured creditors since they do not have a lien or legal right to specific assets of the company.
Most balance sheets report the amounts owed to creditors in two groupings: current liabilities and non-current (or long-term) liabilities.
A creditor is a person, bank, or other enterprise that has lent money or extended credit to another party. (The party to whom the credit has been granted is often a customer that will now be referred to as a debtor.)
If Company X borrowed money from its bank, Company X is the debtor and the bank is the creditor. If Supplier A sold merchandise to Retailer B, then Supplier A is the creditor and Retailer B is the debtor.
Manufacturers usually have the following categories of inventories: raw materials, work-in-process, finished goods, and manufacturing supplies. The amounts of these categories are usually listed in the notes to its balance sheet.
A company’s cost of inventory is related to the company’s cost of goods sold that is reported on the company’s income statement.
Since the costs of the items purchased or produced are likely to likely to change, companies must elect a cost flow assumption for valuing its inventory and its cost of goods sold. In the U.S. the common cost flow assumptions are FIFO, LIFO, and average.
Sometimes a company’s inventory of goods is referred to as its stock of goods, which is held in its stockroom or warehouse.
Since the costs of products may change during an accounting year, a company must select a cost flow assumption that it will use consistently. For instance, should the oldest cost be removed from inventory when an item is sold? If so, the company will select the cost flow assumption known as first-in, first out (FIFO). In the U.S. an alternative is to remove the period’s most recent cost when an item is sold. This is known as last-in, first-out (LIFO). Another option is to use an average method such as the weighted-average method or the moving-average method. Both the LIFO method and the average methods will result in different values depending on whether a company uses the perpetual method or the periodic method. Still another option is to use the specific identification method.
The LIFO cost flow assumption can be achieved by tracking the units in inventory or by using price indexes. When price indexes are used, it is referred to as dollar-value LIFO. (Retailers often use a technique called dollar-value retail LIFO.)
The accountants’ concept of conservatism can result in some inventories being valued at less than cost. Hence, an additional method for valuing inventory is the lower of cost or market. For example, if the replacement cost of a company’s inventory has declined to an amount that is less than cost, the company may be required to reduce its inventory cost. The amount of the that adjustment will also reduce the current period’s net income.
A company’s inventory must be measured and reviewed very carefully as it is an important amount for determining a company’s financial position and profitability.
Under the accrual method of accounting, an expense is reported on the income statement for the period when 1) the cost best matches the related revenues, 2) the cost is used up or expires, or 3) there is uncertainty or difficulty in measuring the future benefit.
For instance a retailer’s income statement for the month of August should report the cost of the goods that were sold in August. (The date that the retailer had paid for the goods is not pertinent.) The commissions earned by the sales staff for having sold the goods in August is to be reported as an expense on the August income statement (even if the commissions are paid in September). The cost of the electricity used in August must also be included as an expense in the August income statement (even if the bill is received in September and is paid in October). These examples indicate that an expense can occur in an accounting period that is different from the period when the company pays for the item. Hence the word expense has a meaning that is different from payment.
Expenses are often divided into two major classifications: operating and nonoperating. Operating expenses involve a company’s main activities. For example, a retailer’s operating expenses include 1) the cost of goods sold, and 2) the selling, general and administrative (SG&A) expenses. The company may further sort these expenses by department, product line, and so on. A retailer’s nonoperating expenses pertain to its incidental activities. A common nonoperating expense for a retailer is interest expense.
Under the accrual method of accounting, revenues are reported on the income statement for the period when the revenues were earned (not the period when the cash is received). This means that revenues can occur before the cash is received, after the cash is received, or at the same time that the cash is received. Hence, revenues are different from cash receipts.
Revenues are often sorted into two categories: operating revenues and nonoperating revenues. Operating revenues pertain to a company’s main activities. For instance, a retailer’s operating revenues could include sales of merchandise, sales of extended warranties, and repair revenues. Nonoperating revenues pertain to a company’s incidental activities. This means that a retailer’s nonoperating revenues will include the interest and the rent that it earns on its investments.
Temporary accounts include all of the income statement accounts: revenues, expenses, gains, losses. After the amounts for the year have been reported on the income statement, the balances in the temporary accounts will end up in a permanent account such as a corporation’s retained earnings account or in a sole proprietor’s capital account. (In manual systems, the balances in the temporary accounts will be transferred to an income summary account. Next the income summary account will be transferred to retained earnings or to the owner’s capital account. Hence, the income summary account is also a temporary account.)
A temporary account that is not an income statement account is the proprietor’s drawing account. The balance in the drawing account is transferred directly to the owner’s capital account and will not be reported on the income statement or in an income summary account.
Temporary accounts are also referred to as nominal accounts.
Even a company that manufactures small consumer products will have ongoing activities and costs that overlap two years or more. Again, the accountants will assume that the revenues and costs can be assigned or allocated to the appropriate accounting periods. Hence, the accountants will report the company’s net income and cash flows for each accounting period (year, quarter, month, etc.) and the company’s financial position at the end of each accounting period.
Periodicity is also known as the time period assumption.
To illustrate, let’s assume that a new company uses the accrual method of accounting. It provides $10,000 of services to its clients in its first month and the clients are allowed to pay in 30 days. The company will have $10,000 of revenues in its first month, but the cash will not be received until the second month. If the company’s expenses are $7,000 in the first month, the company will report a profit of $3,000 but will not have received any cash from its clients.
Another company might have a profit of $60,000 in its first year, but during its first year it uses $65,000 of cash to acquire equipment that will be put into service at the beginning of the second year. This company will have a profit, but will not have the cash.
Other examples where cash is paid out, but the profits are not reduced at the time of the payment, include prepayments of insurance, payments to increase the inventory of merchandise on hand, and payments to reduce liabilities.
If a company has $200,000 in initial cash and its burn rate is $20,000 per month, the company will be out of cash in 10 months unless it raises additional money, begins to generate significant revenues, or reduces its burn rate. Hence, it is important that a start-up business monitor all of its expenditures and avoid payments that will not speed up or increase revenues.
The cash flow statement, formally known as the statement of cash flows, is an important financial statement that can be helpful in computing a realistic burn rate.
Under the cash basis of accounting…
1. Revenues are reported on the income statement in the period in which the cash is received from customers.
2. Expenses are reported on the income statement when the cash is paid out.
Under the accrual basis of accounting…
1. Revenues are reported on the income statement when they are earned—which often occurs before the cash is received from the customers.
2. Expenses are reported on the income statement in the period when they occur or when they expire—which is often in a period different from when the payment is made.
The accrual basis of accounting provides a better picture of a company’s profits during an accounting period. The reason is that the income statement prepared under the accrual basis will report all of the revenues actuallyearned during the period and all of the expenses incurred in order to earn the revenues.
The accrual basis of accounting also provides a better picture of a company’s financial position at a moment or point in time. The reason is that all assets that were earned are reported and all liabilities that were incurred will be reported.
The accrual basis of accounting is required because of the matching principle.
The balance sheet reports a company’s assets, liabilities, and owner’s equity as of the last instant of an accounting year. Generally, the amount of the owner’s equity will have changed from the previous balance sheet amount due to
the company’s net income
the owner’s additional investments in the business
the owner’s withdrawals of business assets
If the owner did not invest or withdraw, the change in owner’s equity is likely to be the amount of net income earned by the business. The revenues, expenses, gains, and losses that make up the net income are reported on the company’s income statement.The connection between the balance sheet and the income statement results from the use of double-entry accounting or bookkeeping and the accounting equation Assets = Liabilities + Owner’s Equity.
When goods or merchandise are purchased FOB shipping point and the periodic inventory method is used, the buyer will likely record the cost of the carriage inwards in the general ledger account Carriage Inwards (or Freight-in or Transportation-in). The carriage inwards costs are considered to be part of the cost of items purchased. In other words, part of the costs of carriage inwards should be assigned to the units in inventory and some should be assigned to the units that have been sold.
In the case of assets other than inventory items that are purchased FOB shipping point, the buyer should add the carriage inwards cost to the asset’s cost. This is necessary because accountants define an asset’s cost as all of the costs that are necessary to get an asset in place and ready for use.
One limitation of the balance sheet is that only the assets acquired in transactions can be included. Therefore, some of a company’s most valuable assets will not be reported on the balance sheet. For example, assume that a company developed an internet business that now attracts millions of visitors each day and has $10 million in annual revenues. Since the internet business was not purchased from another company and its cost to develop was not significant, the company’s balance sheet will include the business’s cash, receivables and some related payables. However, the company’s balance sheet will not be reporting the internet business at anywhere near the $30 million that the company was offered for the internet business.
Similarly, the immensely talented designers and content writers employed by an internet business cannot be reported as assets on the company’s balance sheet since they were not acquired (and accountants are not able to compute a precise amount for these human resources). This is also the case for a company’s reputation, its brand names that were developed through years of effective marketing, its customers’ future demand for its unique services, etc.
Another limitation of the balance sheet pertains to a company’s long-term (or noncurrent) assets which have increased in value since the time they were purchased in a transaction. For instance, a company’s land will be reported at an amount no greater than its cost (due to the accountant’s cost principle). Its buildings will be reported at their cost minus their accumulated depreciation (due to the cost principle and the matching principle). Hence, the amounts reported on the balance sheet for a company’s land and buildings could be much lower than their market value.
The amount of prepaid expenses that have not yet expired are reported on a company’s balance sheet as an asset. As the amount expires, the asset is reduced and an expense is recorded for the amount of the reduction. Hence, the balance sheet reports the unexpired costs and the income statement reports the expired costs. The amount reported on the income statement should be the amount that pertains to the time interval shown in the statement’s heading.
A common prepaid expense is the six-month premium for insurance on a company’s vehicles. Since the insurance company requires payment in advance, the amount paid is often recorded in the current asset account Prepaid Insurance. If the company issues monthly financial statements, its income statement will report Insurance Expense that is one-sixth of the amount paid. The balance in the account Prepaid Insurance will be reduced by the amount that was debited to Insurance Expense.
Stocks pay dividends to the owners, but only if the corporation declares a dividend. Dividends are a distribution of a corporation’s profits. Bonds pay interest to the bondholders. Generally, the bond contract requires that a fixed interest payment be made every six months.
Every corporation has common stock. Some corporations issue preferred stock in addition to its common stock. Many corporations do not issue bonds.
The stocks and bonds issued by the largest corporations are often traded on stock and bond exchanges. Stocks and bonds of smaller corporations are often held by investors and are never traded on an exchange.
To achieve the matching principle, the corporation must initially defer the issue costs. Deferred expenses or deferred costs or prepaid costs are reported as assets on the balance sheet. In the bond example above, at the time that the corporation pays for its bond issue costs, it will debit Deferred Issue Costs for $500,000 and will credit Cash for $500,000. Then in each of the 10 years of the bond’s life it will credit Deferred Issue Costs for $50,000 and will debit Bond Issue Costs Expense for $50,000.
If the amount of the bond issue costs is not significant, the materiality concept allows the corporation to expense the entire amount of issue costs at the time that the bonds are issued.
If the bond or the note has its principal or maturity due within one year of the balance sheet date and the payment will cause a reduction in working capital, the bond or note will be reported as a current liability. If the bond or note will not be due within one year of the balance sheet date or if the maturity date is within one year but will not cause a reduction in working capital when it becomes due, it will be reported as a long-term liability. (For example, there may be a bond sinking fund or a formal agreement for refinancing the debt with new long-term debt or stock.).
Not all corporations with bonds payable are required to have a bond sinking fund. However, bonds with sinking funds are likely to be viewed as less risky.
A bond sinking fund is reported on the bond issuer’s balance sheet under the caption Investments, the first long-term (or noncurrent) asset section appearing immediately after current assets.
The most common contra liability accounts are Discount on Bonds Payable and Discount on Notes Payable. The debit balances in these accounts are amortized or allocated to Interest Expense over the life of the bonds or notes.
The credit balance in the liability account Bonds Payable minus the debit balance in the contra liability account Discount on Bonds Payable is the carrying value or book value of the bonds. The credit balance in Notes Payable minus the debit balance in Discount on Notes Payable is the carrying value or book value of the notes payable.
In cost accounting, scrap value often refers to the amount that a manufacturer will receive from materials or products that will be scrapped.
Industrial manufacturers are likely to have an enormous number of BOMs. Each of the BOMs will be a very detailed list of all of the quantities of every material used in the various steps of manufacturing each part or product.
There are additional holding costs associated with safety stock. However, the holding costs could be less than the cost of losing a customer if the customer’s order cannot be filled.