# Financial Statements: A Step-by-Step Guide to Understanding and Creating Financial Reports

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## Book Preface

Many people helped make this book possible. My special thanks go to Isay Stemp, who ﬁrst showed me that knowing a little ﬁnance and accounting could be fun; to my agent, Michael Snell, who taught me how to write a book proposal; and to Lisa Berkman, whose encouragement was invaluable as I drafted this revised and expanded edition.
Many thanks to my publisher, Ronald Fry of Career Press, for seeing promise in a preliminary version of this book and to Kristen Parkes, editorial director for Career Press, for her guiding of this book through to publication.
Again with this second edition, as was the case with the ﬁrst, I am indebted to my colleague Jack Turner for his thoughtful review of the words and numbers in this book. Also a special thanks to Graham Eacott for his careful reading and correction of the ﬁrst edition.
These clients, colleagues and friends at one time or another helped me to develop (whether they realized it or not) the concepts presented in this book. My thanks to Gwen Acton, Marci Anderson, Molly Downer, Tim Duncan, Cavas Gobhai, Jack Haley, Katherine Leahey, Paul McDonough, Lita Nelsen, Paul O’Brien, Mel Platte, and Iruna and Chris Simmons.

Contents
Preface ...…………………………………………………………………………………………………………………. 1

Introduction ……………………………………………………………………………………… 3

Section A. Financial Statements:
Structure & Vocabulary

Much of what passes for complexity in accounting and financial reporting
is just specialized vocabulary and simple numeric structures. This section
will introduce the words, the basic accounting principles and the structure
of the main financial statements.

Chapter 1. Twelve Basic Principles ………………………………………………… 11

Accountants have some basic rules upon which all their work in preparing
financial statements is based. Who makes these rules? The simple answer
is that the “FASB” makes the rules and they are called “GAAP.” Got that?

Chapter 2. The Balance Sheet …………………………………………………………. 15

The Balance Sheet is one of the two main business financial statements…
the other is the Income Statement. The Balance Sheet states the basic
equation of accounting at an instant in time: What you have minus what
you owe is what you’re worth.

Chapter 3. The Income Statement …………………………………………………… 43

One of the two main financial statements of a business…the other is the
Balance Sheet. The Income Statement gives a significant perspective on
the health of the enterprise by showing its profitability.

Chapter 4. The Cash Flow Statement ……………………………………………… 61

Where the company gets cash, and where that cash goes. The Cash Flow
Statement tracks the movement of cash through the business over a
defined period of time.

Chapter 5. Connections ……………………………………………………………………. 75

The financial statements are connected; an entry in one may well affect each
of the others. This interlocking flow of numbers allows the three statements
together to form a cohesive picture of the company’s financial position.

A. Balance Sheet Connections

B. Sales Cycle

C. Expense Cycle

D. Investment Cycle

E. Asset Purchase and the Depreciation Cycle

Section B. Transactions:
Exploits of AppleSeed Enterprises, Inc.

With our knowledge of the three main financial statements, we will now
draft the books of a hypothetical company, AppleSeed Enterprises, Inc. We
will report the common and everyday actions that AppleSeed takes as it goes
“transactions” (T1 through T33 below) is the subject of much of this book.
We will describe the Balance Sheet, Income Statement and Cash Flow
Statement entries for common and ordinary business actions from selling
stock, to shipping product, to paying the owners a dividend.

Chapter 6. Startup Financing and Staffing …………………………………….. 95

Welcome to our little business, AppleSeed Enterprises, Inc. Imagine that
you are AppleSeed’s entrepreneurial chief executive officer (CEO). You
also double as treasurer and chief financial officer (CFO).

T1. Sell 150,000 shares of AppleSeed’s common stock (\$1 par value) for
\$10 per share.

T2. Pay yourself your first month’s salary. Book all payroll-associated
fringe benefits and taxes.

T3. Borrow \$1 million to buy a building. Terms of this 10 year mortgage
are 10% per annum.

T4. Pay \$1.5 million for a building to be used for office, manufacturing
and warehouse space. Set up a depreciation schedule.

T5. Hire administrative and sales staff. Pay first month’s salaries and
book fringe benefits and taxes.

T6. Pay employee health, life and disability insurance premiums plus
FICA, unemployment and withholding taxes.

Chapter 7. Staffing and Equipping Facility; Planning for
Manufacturing Startup ………………………………………………….. 109

Now begins the fun stuff. In a few short weeks we will be producing
thousands of cases of the best applesauce the world has ever tasted.

T7. Order \$250,000 worth of manufacturing machinery. Pay one-half
down.

T8. Receive and install manufacturing machinery. Pay the remaining
\$125,000 due.

T9. Hire production workers; expense first month’s salary and wages.

Prepare bill of materials and establish labor requirements.

Set up plant and machinery depreciation schedules.

Plan monthly production schedule and set standard costs.

T10. Place standing orders for raw materials with suppliers; receive
1 million jar labels.

Chapter 8. Startup of Manufacturing Operations …………………………… 125
We’re ready to start producing applesauce. The machinery is up and
running, the workers are hired and we are about to receive a supply of
raw materials.

T11. Receive two months’ supply of raw materials.

T12. Start up production. Pay workers and supervisor for the month.

T13. Book depreciation and other manufacturing overhead costs for the
month.

T14. Pay for the labels received in Transaction 10 in Chapter 7.

T15. Finish manufacturing 19,500 cases of applesauce and move them
into finished goods inventory.

T16. Scrap 500 cases’ worth of work-in-process inventory.

Manufacturing variances: what can go wrong, what can go right and
how to account for both.

T17. Pay for the two months’ supply of raw materials received in
Transaction 11 above.

T18. Manufacture another month’s supply of applesauce.

Chapter 9. Marketing and Selling …………………………………………………… 145

A wise old consultant once said to me, “Really, all you need to be in business
is a customer.”

T19. Produce product advertising fliers and T-shirt giveaways.

Product pricing; break-even analysis

T20. A new customer orders 1,000 cases of applesauce. Ship 1,000 cases
at \$15.90 per case.

T21. Take an order (on credit) for 15,000 cases of applesauce at a discounted
price of \$15.66 per case.

T22. Ship and invoice customer for 15,000 cases of applesauce ordered in
Transaction 21 above.

22 above and pay the broker’s commission.

T24. OOPS! Customer goes bankrupt. Write off cost of 1,000 cases as bad
debt.

We’ve been busy making and selling our delicious applesauce. But having
been in business for three months, it is time to attend to some important

T25. Pay this year’s general liability insurance.

T26. Make principal and interest payments on three months’ worth of
building debts.

T27. Pay payroll-associated taxes and insurance benefit premiums.

T28. Pay some suppliers…especially the mean and hungry ones.

Chapter 11. Growth, Profit & Return ………………………………………………. 173
We’ve had a very good first year of operations. We will determine our profit
for the year, compute the taxes we owe, declare a dividend and issue our
first Annual Report to Shareholders.

T29. Fast-forward through the rest of the year. Record summary transitions.

T30. Book income taxes payable.

T31. Declare a \$0.375 per share dividend and pay to common shareholders.

Cash Flow Statement vs. Changes in Financial Position

AppleSeed Enterprises, Inc. Annual Report to Shareholders.

What is AppleSeed worth? How to value a business.

Section C. Financial Statements:
Construction & Analysis

Here are some of the details of constructing and analyzing a company’s
financial statements, and also some of they ways of fudging them.

Chapter 12. Keeping Track with Journals and Ledgers ………………… 189

Journals and ledgers are where accountants scribble transaction entries.
A journal is a book (or computer memory) in which all financial events are
recorded in chronological order. A ledger is a book of accounts. An account is
simply any grouping of like-items that we want to keep track of.

Cash, Accounts Payable, Accrued Expenses and Accounts Receivable Ledger

Chapter 13. Ratio Analysis ………………………………………………………………. 193

Often in judging the financial condition of an enterprise, it is not so much the
absolute amount of sales, costs, expenses and assets that are important, but
rather the relationships between them.

Common Size Statements: Income Statement, Balance Sheet

Liquidity Ratios: Current Ratio, Quick Ratio

Asset Management Ratios: Inventory Turn, Asset Turn,
Receivable Days

Profitability Ratios: Return on Assets, Return on Equity,
Return on Sales, Gross Margin

Leverage Ratios: Debt-to-Equity, Debt Ratio

Industry and Company Comparisons

Chapter 14. Alternative Accounting Policies and Procedures ………. 207

Various alternative accounting policies and procedures are completely legal
and widely used, but may result in significant differences in the values
reported on a company’s financial statements. Conservative? Aggressive?
Some people would call this chapter’s topic “creative accounting.”

Chapter 15. Cooking the Books ……………………………………………………….. 211
“Cooking the books” means intentionally hiding or distorting the real
financial performance or financial condition of a company. Cooking is most
often accomplished by incorrectly and fraudulently moving Balance Sheet
items onto the Income Statements and vise versa. Outright lying is also a
favorite technique.

Strategy, Risk & Capital

“The numbers” are just a single tool—albeit a very useful one—to use with
other management tools (and common sense) in deciding how to invest capital
for expansion. But remember: A strategically unsound business expansion is
very seldom financially sound…regardless of what the numbers say. Think
strategy first. This section is all about planning the future and raising capital.

Chapter 16. Mission, Vision, Goals, Strategies, Actions and Tactics. 221

How to expand? Why expand? Why stick our necks out? What strategies
should we employ to help us meet our goals? What are our goals anyway?
Think through AppleSeed’s mission, vision, goals, strategies, actions and
tactics. The Board of Directors want to see our strategic plan!

Mission, Vision & Goals…a hierarchy of destinations

Strategies, Actions & Tactics…a hierarchy of ways to get there

Chapter 17. Risk and Uncertainty …………………………………………………… 225

Every action (or even inaction) carries a risk of failure and an uncertainty
of outcome. Understanding risk and uncertainty help minimize the chance
of “negative surprises” coming from important business decisions. This
chapter describes ways to minimize risk and uncertainty.

Risk, Uncertainty, Threats and Avoiding a “Bet-Your-Company Risk.”

Chapter 18. Making Decisions About Appleseed’s Future ……………… 227

AppleSeed’s Board of Directors thinks that we can successfully expand
and that now is a good time to do it. What are our business expansion
alternatives and how should we decide between them?

Decision Tree Analysis

Strategic Alternatives

Chapter 19. Sources and Costs of Capital ……………………………………….. 231

Taking on debt (borrowing money) and/or selling equity (exchanging an
ownership portion of the company for money) are the two ways of raising
capital for expansion. More debt adds risk; but selling stock means our little
portion of the pie gets even smaller. Sigh. AppleSeed will need more capital

to expand. Our venture investor understands the mathematics of buying
and selling stock, and can do the manipulations in her head. We had better
understand as well. Otherwise, this friendly venture investor will eat our
applesauce.

Business Valuation: “Pre-Money” & “Post-Money” Values

Selling Stock & Ownership Dilution.

Cost of Equity Capital & Weighted Average Cost of Capital

T32. Financial expansion! Sell more stock and negotiate a line of credit.

Section E. Making Good Capital
Investment Decisions

Capital investment decisions are among the most important that a company’s
management can make. Often capital is a company’s scarcest resource and
using capital well is essential for success. The chief determinant of what a
company will become is the investments it makes today. Capital budgeting
decisions require analyzing business cash flows spanning years. Accounting
for the “time value of money” is essential in these analyses.

Chapter 20. The Time Value of Money …………………………………………….. 241

Would you rather I give you \$1,000 today or in five years? Most everyone
intuitively knows that a “bird in the hand is worth two in the bush.” Now
you understand the “time value of money.” The rest is details.

Present Value (PV)

Future Value (FV)

Interest and Interest Rates

Discounting and Discount Rates

Computing Discounted Values

Present Value Table

Chapter 21. Net Present Value (NPV) ……………………………………………… 249

We are going to invest cash now with high hopes of a large future return.
But will the anticipated payback be enough to cover our initial investment?
Further, would any of our alternative projects provide us with a better finan-
cial return? Net Present Value (NPV) computations are the “gold standard”
for capital budgeting. NPV and Internal Rate of Return (IRR) are the two
mainstays of investment valuation.

Net Present Value (NPV)

Internal Rate of Return (IRR)

Cash Flow Forecasting for NPV and IRR Analysis

Other Capital Budgeting Techniques: ROI, Payback Period,
Real Options and Monte Carlo Analysis

Chapter 22. Making Good Capital Investment Decisions . ……………… 259
Let’s apply all that we have learned about capital budgeting and select the
best business expansion course for AppleSeed. After all, the kids are getting
older and will graduate soon; maybe one will want to join the business?

Forecasting Cash Flows

NPV & IRR Analysis of AppleSeed’s Expansion Alternatives

T33. Chips-R-Us joins the AppleSeed happy family of companies!

Summary and Conclusion …………………………………………………………………. 269

Appendix A. Short History of Business Fraud and Speculative
Bubbles ………………………………………………………………………… 271

Crooked investment promoters, speculative investment bubbles waiting to
pop and even outright business fraud in high places have been with us for
centuries. There are many ways to lose money. Some of the most infamous
are discussed in this chapter. Congress recently passed far-reaching legis-
lation to stop these shenanigans—the Sarbanes-Oxley Act—requiring that
business bosses certify their company’s financial statements are correct un-
der penalty of going to jail and paying a big fines. Don’t you feel much safer?

Ponzi Schemes and Pyramids

Bubbles: Tulips, Technology Stocks and U.S. Houses

Garden-Variety Frauds

Appendix B. Nominal Dollars vs. Real Dollars ……………………………….. 277

In financial calculations spanning time, currency value can be looked at from
two different perspectives. It’s important when doing historical analysis or
making financial projections to understand these two views of value. In
“nominal dollars” a McDonald’s Big Mac only cost 50¢ 20 years ago, and it
costs \$3.75 today. Prices tend to increase over time primarily due to inflation.
Sometimes it is useful to look at values (i.e., “real dollars”) of goods in the
past (or expected values in the future) rather than what they actually cost
way back when in nominal dollars.

Index ………………………………………………………………………………………………….. 281