CHAPTER 1
The Big Three Financial Statements

STARTING WITH A QUICK BACKSTORY

As we launch into the content and concepts presented throughout this book, I would like to begin by referring to a book my father and I coauthored, titled How to Read a Financial Report (now in its ninth edition). This book, first written by my father and published by Wiley over 30 years ago, has stood the test of time and represents one of the top "go-to" technical accounting and financial references used by businesses, colleges, and organizations around the world. The book has so much useful information that you will find several overlaps and references to key financial and accounting concepts discussed in this book. However, there are also significant differences between these books that at heart are centered in the following two items:

• First, our book How to Read a Financial Report is centered on the premise of an external party (e.g., an investor, lender, etc.) evaluating or analyzing an organization from the outside looking in. That is, all the financial and accounting information produced has been done with the understanding that the audience will be external, independent third parties who are not privy to the organization's internal operations and related financial information and data. This represents a critical difference between this book and How to Read a Financial Report that will become evident moving through the material. The content of this book has been structured to look at financial and accounting information from the inside out with a heavy emphasis on business management (as opposed to adhering to guidelines, rules, and regulations established by external bodies or organizations such as the SEC).
• Second, How to Read a Financial Report is presented from more of a technical/accounting perspective or, for lack of a better term, a bit more black-and-white (as it relates to providing an understanding of accounting and financial concepts and how the big three financial statements are interconnected). This book is based on more of an internal business approach where, while it adheres to general or standard accounting rules and guidelines, its primary purpose is to assist with socializing accounting concepts, financial analyses and reporting strategies, and business planning from an internal operating or strategic perspective. Or, as I told my dad (a retired professor emeritus from the University of Colorado), "That is how you teach it in the classroom, but this is how it is done on the street."

So, with this said, let's launch into our first topic on the big three financial statements, as there is no better place to start, making sure you have a clear understanding of the role and importance of the balance sheet, income statement (aka profit-and-loss, or P&L), and statement of cash flows. Large or small, for-profit or non-profit, corporations, LLCs, partnerships, or sole proprietorships, governments, or private businesses, legal or illegal, it doesn't really matter, as this basic concept is always present. That is, all operating entities need to produce complete, accurate, reliable, and timely financial statements on which to base sound business decision-making.

THE FINANCIAL REPORTING BEDROCK

It should go without saying that business managers, company lenders and investors, regulatory agencies, and countless other parties need to clearly and concisely understand an organization's financial performance and results in a timely manner. This is common sense, no doubt, but you would be absolutely amazed at how often this basic concept is overlooked or, for lack of a better term, neglected, by even the senior-most executive management teams. Maybe it is a result of ignorance, not having enough time, or just being lazy, but as we start our discussion on the big three financial statements, it should become abundantly clear just how important all three primary financial statements are and the key role each one plays.

Before we dive into a more detailed analysis of each of the big three financial statements, a quick overview of each financial statement and the related purpose is warranted:

• The balance sheet: The financial condition of a business is communicated in an accounting report called the balance sheet. In its simplest form, the balance sheet reports the assets owned by a business, the liabilities owed by the business (to third parties), and the net ownership equity (assets minus liabilities), all at a point in time.
• The income statement (AKA the Profit & Loss or just the P&L): The financial performance of a business that reports and measures its profit- or loss-making activities is presented in an accounting report called the income statement. In its simplest form, the income statement reports sales, costs of goods sold, operating expenses, other expenses or income, and finally, whether a net profit or loss was generated and covers a period of time (e.g., 12-month period of 1/1/20 through 12/31/20).
• The statement of cash flows: Finally, the last of the big three financial statements, and often the most important (but least understood), is the statement of cash flows. In its simplest form, this financial statement reports a business's sources (i.e., how a business generates cash), uses (i.e., how a company consumes cash), and net change in cash. Similar to the income statement, the statement of cash flows covers a time period which is almost always consistent with the time period reported in the income statement.

It should be noted that alternative titles for these financial statements are common. For the balance sheet, alternatives include "statement of financial condition" or "statement of financial position." An income statement may be titled "statement of operations" or "earnings statement" as well as the profit & loss or, more simply, the P&L. For ease of presentation, we stick with the names balance sheet and income statement to be consistent throughout the book. The statement of cash flows is almost always called just that (but sometimes referred to as just a cash flow statement).

Finally, as you work your way through the book, please remember these definitions for frequently used terms and concepts:

• Financial information: The term financial information is used throughout the entire book and in its broadest sense includes basically all types of financial reports, financial statements, data, analyses, evaluations, assessments, and so on. For ease of reference and consistency, we simply use the term financial information in an all-encompassing meaning, apart from Chapter 2, where we present a discussion on the role and importance of preparing external financial reports and statements (which represent a selection or fraction of internally generated financial information).
• Businesses: As previously noted, all types of businesses, organizations, not-for-profits, government entities, and so on should produce financial statements on a periodic basis. Again, for ease of reference and consistency, when we refer to a business throughout the book, it is assumed to include any one of the entities identified.
• Financial statements: The term financial statements, in the plural, generally refers to a complete set that includes a balance sheet, an income statement, and a statement of cash flows as well as often implying that multiple years of financial statements will be presented. Informally, financial statements are called just "financials." In almost all cases the financial statements need to be supplemented with additional information, which is presented in footnotes and supporting schedules. One supporting schedule is very common - the statement of changes in stockholders' (owners') equity.

THE INCOME STATEMENT, AKA PROFIT AND LOSS (P&L)

First up, we will begin with the income statement, as, for most parties, this is the financial statement that is not only looked to first to quickly assess total sales generated (which is a common measurement of the "size" of a business) and whether a business made any money (i.e., a profit), but, maybe more importantly, is the financial statement that tends to be the most easily understood. Exhibit 1.1 provides an example of a standard externally presented income statement.

The income statement is read in a step-down manner, like walking down a set of stairs. At the top of the staircase, sales revenue is reported first. Then, as you proceed down each step, a deduction of one or more expenses is reported. The first step deducts the cost of goods (products) sold from the sales revenue of goods sold, which gives gross profit (also called gross margin - one of the few places you see the term profit in income statements). This measure of profit is called gross because many other expenses are not yet deducted.

EXHIBIT 1.1 Audited Income Statement

Next, a broad category of general business expenses, often referred to as operating expenses or selling, general, and administrative expenses, are reported in the P&L. In our income statement example (Exhibit 1.1) you see four different operating expenses...