Your company's full set of financial statements include a balance sheet, an income statement and a cash flow statement. Combined, they answer key questions about your financial health. Is your company carrying too much debt? How profitable is it? How much cash do you have on hand? The five elements of the major financial statements are assets, liabilities, equity, revenues and expenses.
The Five Elements Defined
The big five are the essential elements of your business's financial position. Together they show how well your company is doing.
Assets are anything your business owns that will generate economic benefit through multiple accounting periods, for example; buildings, manufacturing equipment, patents, cash, accounts receivable and land. Assets are different from, say, electricity, which generates economic benefit but you use up immediately. Your power bill is an expense, not an asset. Supplies can go either way. Supplies are assets until they are used and an expense when they are used.
Liabilities are anything you're obligated to pay to a person, business or government. Accounts payable, taxes payable and wages payable are all liabilities. Unlike expenses, which are subtracted from your income in the financial statements, liabilities are subtracted from the total value of your assets. What remains is owners' equity.
Accounting defines equity in some different ways. Owners' equity is the amount the owners invest in a company, plus retained earnings, which is money the company makes and doesn't spend or distribute as dividends. Equity is also defined as part of the balance sheet equation: subtract total liabilities from the total value of the assets and you see what the owner's equity is worth. If the company has a lot of debt or its assets lose value, equity on the balance sheet may be less than the owners contributed.
Revenue is the income the company generates during the period covered by the statement. Operating revenue comes from the company selling goods or services. Non-operating revenue comes from other sources, such as interest on loans or a return on investments. If your accounting runs on a cash basis, you report revenue when you get paid. If you use accrual-basis accounting, you record revenue when you earn it. If, say, you do a $1,000 job for a customer on credit, you record the $1,000 as soon as the job is complete.
An expense, the flip side of revenue, is the money you spend to make money. Rent, utilities and wages are all expenses. Depreciation, which is an asset's loss of value as it ages, is also an expense. Cost of goods sold is an expense category covering the expenses involved in providing the items or services you sell, such as labor, materials and billable hours. If you use the accrual-basis, you report expenses as soon as you owe the money, not when you pay the bill; the cash-basis reports the expense when the bill is paid.
Elements of Financial Position
The five elements of financial statements interact and affect each other. Revenue and expenses, for example, are the components of the income statement. When you're preparing a quarterly statement, the top of the statement shows your net revenue from sales. From this total, you subtract expenses then add in non-operating revenues and subtract non-operating expenses. The result of this calculation is your net income, which tells you how profitable your company was for that period. Did your revenue outstrip your expenses? By how much? Was operating revenue more significant than non-operating revenue? These questions are answered as you review your income statement.
However, the revenue reported on the income statement may not have been collected or expenses may not have been paid. That's where a cash flow statement comes in. Unlike the accrual-based income statement, a cash flow statement focuses only on money changing hands. For instance, customer payments affect cash flow, and conversely, accounts receivable doesn't. One way to create the cash flow statement is to take the income statement and eliminate any revenues you have not collected and expenses you have not paid. If you're running your business using cash accounting, you don't need a separate cash flow statement.
Revenue also affects the balance sheet. Suppose you bring in $475,000 over the quarter, with expenses of $250,000. The net income of $225,000 adds to your assets and is posted to accounts receivable or cash, depending on how it was paid. As the value of assets increases, so does owners' equity.
Why the Five Elements Matter
Financial statements are fundamental to gauging the financial health of your company. The income statement shows your revenue and expenses for the month, quarter or the year. If you're running in the red or profits are wafer-thin, that could be a warning sign of financial troubles ahead. The cash flow statement shows how much money you have on hand. Even if you're profitable, you need cash on hand to pay the water bill or your employees. The balance sheet is a snapshot of your assets, liabilities and equity at the end of the reporting period.
The way the statements portray the five elements (assets, liabilities, equity, revenues and expenses) provides information for anyone inside or outside the company who is concerned about its financial health. The information can lead to more questions, such as, if the revenues are lower this quarter than the previous quarter, is there a problem? If the balance sheet shows significant liabilities, is that a sign you've taken on too much debt? If revenue is high, but there's little cash coming in, do you need to push customers to pay more promptly? Are you doing significantly better or worse than the average in your industry?
Why Audits Are Important
There are many ways that a company can fudge the five elements to make the business look financially healthy on the financial statements when in reality, it's struggling:
- Make up sales that never happened.
- Report revenue before you've earned it.
- Overstate the value of assets.
- Claim assets that don't exist.
- Create false expenses to cover up embezzlement. For example, a manager records a $5,000 purchase that never happened. Instead, the money went right into his own pocket.
Successful businesses put controls in place to prevent this kind of fraudulent reporting. If every large purchase requires two people to sign off on it, for instance, it's harder for one person to commit fraud. Not all companies do this, though. That's one reason financial statements are audited. Another is that standard accounting practices have become increasingly complex, making it easier for errors or fraud to slip through the cracks. Having annual audited statements is mandatory if you're a publicly traded company.
Audited statements are expensive because they are thorough. First, the auditor studies your company and looks at potential errors or fraud in the elements of the financial position. Next, they test your internal controls. If it looks like it would be extremely difficult for someone to make up expenses or create fictitious revenue, the auditor doesn't have to be quite as exhaustive. If your controls are sloppy, though, the audit gets tougher.
- Do the assets you report on the balance sheet exist?
- Is the balance in accounts receivable accurate?
- Do your bank statements confirm the cash assets you say you have?
- Do your creditors confirm the liabilities on the balance sheet are accurate?
- Are the reported expenses on the income statement correct?
After the auditor reviews the five elements and the way you have reported them, you'll receive the auditor's opinion:
- An unqualified opinion sounds bad, but it's actually good news. The auditor says your statements are fine, with no reservations.
- A qualified opinion says your financial statements are mostly good, but some information couldn't be verified.
- An adverse opinion says there are serious problems that need fixing.
- An auditor's disclaimer says it's not possible to form an opinion. This could be because there were too many documents missing to confirm the elements are accurate, or that your management team refused to cooperate.