Understanding the Income statement and Statement of financial position (EMBA27)

What is accounting? Accounting makes it possible to systematically record, analyse, and report important financial information, and communicate the financial health of a business to all interested parties. It’s called the language of business, and it’s the backbone of any company because every business needs reliable data to make informed decisions.

To understand the basics of accounting, I’ll give you an introduction to accounting by telling you a story. It’s a story about Adenike, and how she runs her business in Lagos.

There is a woman called Adenike who sells bread to individual and companies. In the morning, she leaves his home with N10,000, and goes to the manufacturer of the bread. Each bread costs N500, so Adenike buys 20 pieces with his N10000. She walks to a school and sells the bread to students for N1000 per bread, and by noon, she sold out. She goes home happily, and repeats the same process the next day.

After a month, she wants to know how much the business made. What if she sold more than one item? Which one was more profitable? Would it make sense to expand her business, like rent a fixed shop by the school at the beach?

Without a way of recording the daily activities of her business, she’s not going to be able to answer these questions. Accounting makes this possible. Not only will each financial transaction be recorded, but Adenike will also get detailed reports, summarizing her financial performance. We call these reports financial statements. There are 3 basic financial statement, however, I will explain two (2).

Let’s explain Adenike’s profitability/Income statement.

If you want to find out about a business’s profitability, you go to their income statement. This is one of the main financial statements. There you can find out how much sales a business had in a certain period, which costs, and what was the resulting profit or loss. Another name people call it is the P& L account.

The P&L for Adenike’s business would look like this. She sold 20 plates for N1,000 each. That’s what we call sales or revenue, which were N20,000.  The bread she sold; she didn’t get for free. She incurred costs to buy them. Each bread cost her N500. Therefore, in total, her costs were N10,000. We call this the cost of goods, which we need to deduct from revenue.

Although there may be other cost like fees, transport, rent and taxes., but we want to keep this simple for easier understanding, hence we don’t consider any other costs for now, if we add this up, we can see that Adenike made a profit, or a net income of N10,000. This is how a simple income statement would look like.

The Balance Sheet

Next, I will explain the second main financial statement, the balance sheet. The balance sheet shows which assets the company owns, the liabilities it owes to others, and the equity that belongs to the owners. Assets are usually things of value, or resources the company owns and uses. For instance, land and buildings, office equipment, inventory, or cash. Liabilities are what you owe to others. For example, a bank loan, or what you owe to your suppliers for goods, or to the IRS in taxes. The third component is equity. It’s the residual amount that would be left if the company sold all its assets and paid off all its liabilities. In other words, it’s the difference between total assets and total liabilities. This leftover money belongs to the owners of the company.

In the balance sheet, the assets are on one side, and equity&liabilities are on the other side.  Note that everything the company owns, its assets, was purchased either from debt (somebody else’s money), or its own money (meaning equity). Hence all assets equal liability plus equity. Both sides are always in balance, hence the name balance sheet. This is the foundation for any accounting system, the accounting equation.

With that in mind, let’s see how the balance sheet looks like for Adenike. A balance sheet is always created at a certain point in time, like at the end of the business year, or at the end of a quarter. In our example, it’s the end of Adenike’s business day. Claudio started out with N10,000 in cash, which is also equity, she invested into the business. The cash which is an asset equals equity.  The balance sheet, at this point, is in balance.

Then, she spent the cash in the morning, to buy the bread. The bread is what we call her inventory. In the process, her cash got reduced to zero, but in exchange, she received another asset, inventory. She didn’t get richer or poorer. The total amount of assets is still N1,000, but of course, her equities too. After she sold the plates N1,000 each, she ended up with N20,000 in her pocket at the end of the day.

Her inventory is gone because she sold all the bread to the students. At the end of the day, her inventory value, therefore, is zero. She doesn’t have any more bread. If we look at Adenike’s balance sheet at the end of the day, we can see that the total value of assets, the left side, is N20,000. That’s the cash she came home with. On the credit side, we only have N10,000. The balance sheet is out of balance. As we know, this can’t be. Both sides always need to be in balance.

So, what’s wrong here? The missing component is the profit she made during the day. If you go back to the income statement, we see that Adenike’s net income was N10,000. This will be added to equity, why? Because due to his successful business, he made the business more valuable. When he started out the day, it was worth only N10,000, which was the money he put into the business when she walked out the door. When she came home, she had sold all her bread with a profit of N10,000. So, her business is now worth more, which is reflected in a higher equity. Net income is the link between the income statement and the balance sheet. So, when we add the net income of N10,000 she achieved to equity, also the right side gets to a total of N20,000 naira, and the balance sheet balances like it should.  So, that’s how it would look like for Adenike at the end of her successful day at the school.

These financial statement are highly valuable will be very needed in making the decisions in the organisation.