Financial Statements
After just one job, it’s pretty easy to understand the accounts in the ledger. But when we’ve entered dozens, hundreds, or even thousands of transactions—think how many customers come into a restaurant every day—we need reports that show us what’s going on, i.e. financial statements.
GAAP: The “Rules” of Financial Reporting
The standard format for recording and reporting financial transactions is outlined in guidelines, or rules, called Generally Accepted Accounting Principles (GAAP). These guidelines are published by the accounting profession. They are intended to be the foundation upon which report readers can gauge a company’s progress, compare one company or one accounting period with another, and generally judge the financial effectiveness of its management efforts.
Financial statements are a set of accounting documents prepared for a business that cover a particular time period and describe the financial health of the business.The two most important financial statements are the income andexpense statement (or profit and loss account) and the balance sheet.
If you’re using a computerized accounting package, you simply go to the reports menu, select the report you want, select the start and end dates, and print it out. But, rather than relying on the magic of a computer program, let’s walk through the process of building our financial statements, so that you can see how accounting moves from the recording of each transaction to the presentation of useful reports.
The income and expense statement shows details and totals of income accounts and expense accounts. Note that it does not show individual journal entries. From this report, we don’t know if we did one job or three jobs—just that the total was $1,000 of contracting jobs billed. Revenue or gross income is all the money that has come in, without considering expenses. Net income is gross income less total expenses; that is, it’s the amount of money we’ve made after expenses. Net income is a key factor in business success. When we’re spending more than we’re making, that money is a negative number, called net loss.
The income and expense statement is useful, but it doesn’t show the whole picture. For example, it doesn’t tell us how much money we have in the bank account or even whether or not we’ve paid our subcontractor. To get the rest of the picture, we need a balance sheet.
Now we see that, even though we have $1,000 in the checking account, we owe $200 to someone, so our company is worth only $800. In simple terms, equity is the financial value, or worth, of a company.
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