The first thing to note about the income statement shown in Table 1-3 is the sales revenue figure of $13,000. This sales revenue figure shows the sales generated for a particular period of time. The $13,000 figure shown in Table 1-3 comes directly from the Sales Journal shown in Table 1-1.

      One important thing to recognize about accounting for sales revenue is that revenue gets counted when goods or services are provided, not when a customer pays for the goods or services. If you look at the list of sales shown in Table 1-1, for example, Joe (the first customer listed) may have paid $1,000 in cash, but Bob, Frank, and Abdul (the second, third, and fourth customers) may have paid for their purchases with a credit card. Yoshio, Marie, and Jeremy (the fifth, sixth, and seventh customers listed) may not have even paid for their purchases at the time the goods or services were provided. These customers may have simply promised to pay for the purchases at some later date. However, this timing of the payment for goods or services doesn’t matter. Accountants have figured out that you count revenue when goods or services are provided. Information about when customers pay for those goods or services, if you want that information, can come from lists of customer payments.

      Cost of goods sold and gross margins are two other values that you commonly see on income statements. Before I discuss cost of goods sold and gross margins, however, let me add a little more detail to this example. Suppose that the financial information in Tables 1-1, 1-2, and 1-3 shows the financial results from your business: the hot dog stand that you operate for one day at the major sporting event in the city where you live. Table 1-1 describes sales to hungry customers. Table 1-2 summarizes the one-day expenses of operating your super-duper hot dog stand.

      In this case, the actual items that you sell – hot dogs and buns – are shown separately on the income statement as cost of goods sold. By separately showing the cost of the goods sold, the income statement can show what is called a gross margin. The gross margin is the amount of revenue left over after paying for the cost of goods. In Table 1-3, the cost of goods sold equals $3,000 for purchases of dogs and buns. The difference between the $13,000 of sales revenue and the $3,000 of cost of goods sold equals $10,000, which is the gross margin.

      

Knowing how to calculate gross margin allows you to estimate firm break-even points and to perform profit, volume, and cost analyses. All these techniques are extremely useful for thinking about the financial affairs of your business. In fact, Book VI, Chapter 1 describes how you can perform these analyses.

      The operating expenses portion of the simple income statement shown in Table 1-3 repeats the other information listed in the Expenses Journal. The $1,000 of rent, the $4,000 of wages, and the $1,000 of supplies get totaled. These operating expenses are then subtracted from the gross.

      Do you see, then, what an income statement does? An income statement reports on the revenues that a firm has generated. It shows the cost of goods sold and calculates the gross margin. It identifies and shows operating expenses, and finally shows the profits of the business.

      One other important point: Income statements summarize revenues, expenses, and profits for a particular period of time. Some managers and entrepreneurs, for example, may want to prepare income statements on a daily basis. Public companies are required to prepare income statements on a quarterly and annual basis. And taxing authorities, such as the Internal Revenue Service (IRS), require tax return preparation both quarterly and annually.

      

Technically speaking, the quarterly statements required by the IRS don’t need to report revenue. The IRS requires quarterly statements only of wages paid to employees. Only the annual income statements required by the IRS report both revenue and expenses. These are the income statements produced to prepare an annual income tax return.

       Balance sheet

      The second most important financial statement that an accounting system produces is a balance sheet. A balance sheet reports on a business’s assets, liabilities, and owner contributions of capital at a particular point in time:

      ✔ The assets shown on a balance sheet are those items that are owned by the business, which have value and for which money was paid.

      ✔ The liabilities shown on a balance sheet are those amounts that a business owes to other people, businesses, and government agencies.

      ✔ The owner contributions of capital are the amounts that owners, partners, or shareholders have paid into the business in the form of investment or have reinvested in the business by leaving profits inside the company.

      As long as you understand what assets and liabilities are, a balance sheet is easy to understand and interpret. Table 1-4, for example, shows a simple balance sheet. Pretend that this balance sheet shows the condition of the hot dog stand at the beginning of the day, before any hot dogs have been sold. The first portion of the balance sheet shows and totals the two assets of the hot dog stand business: the $1,000 cash in the cash register in a box under the counter and the $3,000 worth of hot dogs and buns that you’ve purchased to sell during the day.

Table 1-4 A Simple Balance Sheet

Balance sheets can use several other categories to report assets: accounts receivable (these are amounts that customers owe), investments, fixtures, equipment, and long-term investments. In the case of a small owner-operated business, not all these asset categories show up. But if you look at the balance sheet of a very large business – say, one of the 100 largest businesses in the United States – you see these other categories.

      The liabilities section of the balance sheet shows the amounts that the firm owes to other people and businesses. For example, the balance sheet in Table 1-4 shows $2,000 of accounts payable and a $1,000 loan payable. Presumably, the $2,000 of accounts payable is the money that you owe to the vendors who have supplied your hot dogs and buns. The $1,000 loan payable represents some loan you’ve taken out – perhaps from some well-meaning and naive relative.

      The owner’s equity section shows the amount that the owner, the partners, or shareholders have contributed to the business in the form of original funds invested or profits reinvested. One important point about the balance sheet shown in Table 1-4: This balance sheet shows how owner’s equity looks when the business is a sole proprietorship. In the case of a sole proprietor, only one line is reported in the owner’s equity section of the balance sheet. This line combines all contributions made by the proprietor – both amounts originally invested and amounts reinvested.

      I talk a bit more about owner’s equity accounting later in this chapter because the owner’s equity sections look different for partnerships and corporations. Before I get into that, however, let me make two important observations about the balance sheet shown in Table 1-4:

      ✔ A balance sheet needs to balance. This means that the total assets must equal the total liabilities and owner’s equity. In the balance sheet shown in Table 1-4, for example, total assets show as $4,000. Total liabilities and owner’s equity also show

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