Intro to Financial Accounting

The Income Statement

The income statement, also known as the profit and loss statement, includes the company’s revenues and expenses over a period of time. This is the simplest way to see if a company is making or losing money. An income statement starts with the company’s revenues which would include any sales generated from products or services and then subtracts the expenses of the company to ultimately reach a final profit number. An income statement can show a company’s profitability over a period of time, whether that is quarterly, annually, or any other time frame.

The main things you will generally see on an income statement:

• Revenues: the sale of products or services

• Cost of good sales (COGS): the direct cost associated with the delivery of those goods or services. For example, this would include the cost of parts of the phone as well as the labor costs associated with making the phone

• Marketing expenses: expenses associated with advertising or sales to promote the company’s products or services

• Research & development (R&D): the cost of testing, trialing, and creating new products

• Selling, general & administrative (SG&A): corporate expenses such as management, salaries and incentives, corporate offices, and other expenses needed to run the company.

• Interest expense: interest on debt that the company might have (bonds or loans)

• Interest income: interest received on cash or investments that the company has

• Income taxes: federal, state, local, and any additional income taxes owed from the profits of the business

• Depreciation and amortization (D&A): a non-cash expense that represents the “spreading out” of larger investments. For example, a large purchase of a new machine for a factory would be depreciated over the course of many years. Different categorization of items will dictate how they are depreciated (i.e. the period of time).

• Gross profit: the gross profit is calculated by taking revenue minus the cost of goods sold, which measures the company’s profit only accounting for the direct cost of goods

• Operating income: calculate by taking revenue minus operating expenses, representing the company’s pre-tax income directly related to its operations

• EBIDTA: commonly used profit metric, earnings before interest taxes, depreciation, and amortization 

• Net income: the company’s bottom line profit and loss, representing revenue minus all expenses

Read more about Income Statements

The Difference Between Cash and Accrual Accounting

One of the fundamental concepts underlying financial accounting is the difference between cash and accrual accounting. Cash-based accounting is what we might think of intuitively, adding revenue when we collect money and adding expenses when we pay for them. 

Accrual Accounting

Accrual accounting, the generally accepted way of accounting for larger companies, accounts for revenue when goods or services are delivered (as opposed to paid for) and recognizes expenses when they are incurred (as opposed to when they are paid for). 

For example, if a company delivers a service but has not yet been paid, the revenue would still be recorded. The money owed would be added as an account receivable, an asset on the company’s balance sheet, to represent money that they are expecting to receive.

If a company collects cash before delivering a service, they would not record that revenue until the service is delivered. In the meantime, that cash would be recorded as “unearned revenue,” representing money they have collected and not “earned” yet.

Another example of accrual accounting is when suppliers are paid for goods, often up to 30 days after the goods have been delivered. In the time that the company has not paid the supplier, they would record that liability as accounts payable, which represents money that the company owes based on goods or services that have been delivered. 

On the flip side, expenses are sometimes paid before they are incurred. For example, a company might pay rent at the beginning of the month or even a month before, and in this case, they would record a prepaid expense. The prepaid expense, as it sounds, shows an expense that has not been incurred yet but has been paid for.

As mentioned earlier, depreciation is the “spreading out” of a larger investment. An example of this would be a company buying a new production plant for $5M. Since this production plant will be used over a long period of time, the expense should not all be incurred immediately, which is where depreciation comes in. Say this new plant lasts for 5 years, the company would spread the expense over the 5 years, recording $1M each year.

When it comes to taxes, the expense is recorded when the income is earned, as opposed to when the taxes are paid. If a company owes a tax bill for the prior year but has not paid it, the tax expense would still show up on the prior year’s income statement. If the company chooses to prepay taxes for the year, then it would be recorded as a prepaid expense. 

The Balance Sheet

A company’s balance shows the company’s assets, liabilities, and shareholders’ equity for a specific point in time (as opposed to income statement which shows profitability over a period of time).

The three sections of the balance sheet are:

1. Assets: anything of value that the company owns, including cash, investments, PP&E, intangible assets, goodwill, accounts receivable, and prepaid expenses

2. Liabilities: anything the company owes, including debt, accounts payable, accrued expenses, etc.

3. Shareholders’ equity: capital paid by owners of the company through equity contributions or retaining profits of the business (retained earnings)

Continue learning about the Balance Sheet

Statement of Cash Flows

With accrual accounting, a company’s profit is not equal to its net cash, which is why we also have the statement of cash flows. The statement of cash flows is broken down into three sections:

• Cash flow from operations, which includes everything except for activities related to investments and financing

• Cash flow from investments, which includes cash flows from capital expenditures, acquisition of businesses and other assets not in the ordinary course of business, and purchase or sale of investment securities

• Cash flow from financing, including transactions with equity and debt holders like capital raises, distributions to shareholders, repurchase of shares, and borrowing or debt repayment

The cash flow from operation typically begins with the company’s net income and then adds or subtracts any items that would impact its cash flow. For example, depreciation and amortization are added back to net income since it is a non-cash expense.

Learn more about the Statement of Cash Flows

The Accounting Identity Formula

Assets = Liabilities + Shareholders’ Equity

Think of a company as having a bunch of assets that were paid for with a combination of liabilities and shareholders’ equity. For example, you own a small business and need to purchase machinery for $100,000. Here are a few ways you can purchase that asset:

• The business has made money over the years and you keep that in the company bank account. This would be using the company’s retained earnings

• We could go to the bank and take out a loan. The loan would show up as debt and be considered a liability

• The owner of the business could contribute the capital too and this would show up as shareholders’ equity

All assets must have been paid for from a combination of liabilities and shareholders’ equity, and every transaction must maintain that identity.