Welcome back. It's now time to look at some actual financial statements and cover some basics. Our focus today will be on just two of the financial statements, the balance sheet and the income statement. First, let's take a look at a balance sheet. In looking at the balance sheets from several companies, you find that there can be differences in the items listed on the statement or in the level of detail. However, what each balance sheet has in common is that they have three components: assets, liabilities, and equity. Using the balance sheet of the Fortune 500 company, Johnson & Johnson, we'll start with an overview of assets. Assets can be defined as economic resources owned by the company, so assets answer the question, what do you own? Next we see the section of the balance sheet labeled liabilities. Liabilities can be defined as obligations that the company has to others. In other words, liabilities answer the second measurement question, what do you owe? Finally, we see the section of the balance sheet displayed as equity. Although it might show up as owner's equity or shareholders equity, or even partner contributions, depending on the ownership structure of the company. Equity can be thought of as the net worth of the company because mathematically, it represents the difference between assets, what you own, and liabilities, what you owe. However, the equity section of the balance sheet lays out who has the rights to that net worth. Let's now turn to the income statement. The income statement lists the resources the company has earned or dispersed during a period of time. Revenues have a special designation because they represent resources earned from normal operating activities, although resources can be earned outside of normal activities. Expenses are outlays of resources as part of the normal operating activities. Although, again, resources can be dispersed outside of normal activities. The difference between resources earned and resources dispersed is what we call net income, also known as earnings, and answers the question, how did you perform? Two things I want to point out before we go on. If you look at the top of the income statement for the restaurant McDonald's, you'll see dates with a subtle label. Years ended December 31st, 2013, but if you look at the balance sheet, you just see dates without the label. The subtle difference in the label turns out to be fundamental to the differences between the two statements. The balance sheet is describing a picture of the company on a particular date. In other words, the balance sheet is representing a picture of the company on a given date answering the question, what does McDonald's look like on December 31st, 2013? Using our terminology from lesson 1, the balance sheet is a substitute attribute for what the company looks like. That is, it's a substitute attribute for the company's position. By contrast, the income statement describes the transactions that occurred over a designated period of time. That is, the income statement represents how resources were acquired or dispersed during the year that ended December 31st, 2013. We can consider the income statement to be a substitute attribute for McDonald's performance for the 2013 year. Let's take a minute to answer a question to make sure we're on track. With an understanding that the balance sheet and income statements are really substitute attributes for a company's position and performance, I think it's time for us to head back out to the bakery to examine why these financial statements are so important. Now, do you prepare financial statements? Is anybody require you to produce financial statements? I will say, I have a bookkeeper who I will send all of our monthly numbers to, all of our payroll to, all of my expenditures to, all checks written, and he will then produce a report for me saying, at the end of the month, what we spent, what we gained, and what we lost, and how it compared to last year. Okay. Then he sends all that information to Steve, and then Steve will prepare based on what we budgeted for the year, how we're doing, and how close we are, and if we're over or under. You mentioned balance sheet. Do you produce a balance sheet even? He produces, and I guess maybe my definition of balance sheet, but it's basically costs and what sales were, what costs were. Okay. What our electric bill was, what our cost for goods sold were. He'll take all that, what labor was, and then if there's anything else coming in, that again. I'm going to run this by Jed. If financial statements aren't required to be prepared, is there really any value in producing them? As being a small business that's closely held with two partners, we're not required to have an audited financial statements, but we monthly do generate profit/loss statement and balance sheets, and we do that because it's absolutely necessary to have good control of our business. We need that information to make all of our business decision. Even though it's not required, we do, and of course, for income tax purposes, we have to have a financial statement at the end of the year. We also take periodic inventory, we take a shoe inventory, an actual count every six months, and then we take a yearly full inventory of all of our products, an actual count, we'll have a perpetual inventory that's running on our books, but we take an actual count once a year. Great Jed. It looks like preparing financial statements are a good idea for a number of reasons. For some companies, there is a requirement. For example, many of the companies whose financial statements we showed you are publicly traded, which means their stock is traded on a public exchange. Those companies are required to produce financial statements on a regular basis. But even if companies weren't required to generate statements, the demand for financial statements would still compel many companies to undertake the task. Who might demand financial statements? Well, anyone who has an interest in the measurement questions. For instance, let's say I'm purchasing a car that includes a five-year warranty on the car. If anything goes wrong with the car for five years, the manufacturer will fix it at no cost. Would I like to know how the manufacturer is performing so I know whether the company is likely to be around for five years? Of course I would. So as a customer, financial statements can help me make decisions. Or how about a situation where Missy's supplying a local bank with baked goods each day as a service to their customers, but the bank purchases on credit and pays for the goodies at the end of each month? Missy would be really sad if the bank suddenly shuts down before paying for those lovely cinnamon rolls, and it's not like she can retrieve the baked goods. As a supplier, she'd be interested in financial statements as well. Even if companies are not required to produce financial statements, they're important enough that companies would generate them anyway. In our next lesson, we'll dig deeper into the balance sheet as we go back to the bakery to see what Missy has behind that counter. As you might have already guessed, we're going to start hunting for assets. I can't wait to see what we find, but until then, be well.
