Double-entry bookkeeping, which requires two-sides to every journal entry, gave birth to the income statement and balance sheet. Together with the cash-flow statement, they create a financial reporting system that keeps your books in equilibrium. Before we explore just how this triad works, let’s review the 500 year-old profession.
It Takes Two
Debits equal credits and everything must balance. Therefore, everything that happens in the books must have two entries, a debit and a credit. Where you are in the process and what’s taking place will determine whether the entries are reflected on the balance sheet, income statement or both.
Generally Accepted Accounting Principles (GAAP) in the United States stipulate when and how entries should occur between the balance sheet and the income statement. International Financial Reporting Standards (IFRS) govern the accounting rules adopted by most other countries.
The Balance Sheet is a measurement of your financial position at a specific point in time. Based on Piacoli’s principle of Assets Always = Liabilities + Equity, what you have is the difference between what you own and what you owe.
Because accounting is still formulated on historical cost, assets will essentially have two values. What you assign today on paper, which includes depreciation, is the book value. The book value of long-lived assets is a prescribed calculation using historical cost less some devaluation due to the aging process. It is rarely equal to the market value of the asset. This is considered a fundamental flaw in modern accounting (is anything over 500 years old modern?)
The income statement is a measurement of your business performance over a period of time. Revenue – Expenses = Earnings sums up your day-to-day operations of sales, purchases and expenses resulting in profit.
When to recognize revenue during the sales process is tightly prescribed by GAAP. Companies run into trouble when they aren’t familiar with the revenue recognition rules (or ignore them) and record sales before or after the appropriate time.
The cash flow statement is where it all comes together. Beginning Cash + Inflow – Outflow = Ending Cash is a reconciliation of how your cash was used and sourced over a period of time. This is a significant tool for newer businesses with limited revenue during startup. It shows how much was generated from operations and financing, and how much was put into investments and long-term assets. A healthy business will maintain a good ratio in these areas. For instance, having your entire cash inflow from bank loans is not a sustainable way of doing business. Likewise, investing all your cash in long-term assets will leave you short of working capital.
Preparing a financial statement is a combination of art and science. If you’re doing it right, doing it on time and following the rules, you will always have a beautiful piece of work that tells a story about your company—and that’s something you can close the books on.