Lita Epstein - Reading Financial Reports For Dummies

Assets = Liabilities + Equities

Assets appear on the left side of a balance sheet, and liabilities and equities are on the right side. Assets are broken down into current assets (holdings that the company will use in the next 12 months, such as cash and savings) and long-term assets (holdings that the company will use longer than a 12-month period, such as buildings, land, and equipment).

Liabilities are broken down into current liabilities (payments on bills or debts that are due in the next 12 months) and long-term liabilities (payments on debt that are due after the next 12 months).

The equities portion of the balance sheet can be called owner's equity (when an individual or partners closely hold a company) or shareholders’ equity (when shares of stock have been sold to raise cash). I talk more about what information goes into a balance sheet in Chapter 6.

The income statement, also known as the profit and loss statement (P&L), gets the most attention from investors. This statement shows a summary of the financial activities of one quarter or an entire year. Many companies prepare P&Ls on a monthly basis for internal use. Investors always focus on the exciting parts of the statement: revenue, net income, and earnings per share of stock.

The income statement also tells you how much the company is spending to produce or purchase the products or services it sells, how much the company costs to operate, how much it pays in interest, and how much it pays in income tax. To find out more about the information you can find on an income statement, go to Chapter 7.

The statement of cash flows is relatively new to the financial reporting game. The SEC didn't require companies to file it with the other financial reports until 1988. Basically, the statement of cash flows is similar to the income statement, in that it reports a company's performance over time. But instead of focusing on profit or loss, it focuses on how cash flows through the business. This statement has three sections: cash from operations, cash from investing, and cash from financing. I talk more about the statement of cash flows in Chapter 8.

Every public company's internal accounting team and external audit team must answer to government entities. The primary government entity responsible for overseeing corporate reporting is the SEC. Its staff reviews reports filed with the SEC. If SEC employees have any questions or want additional information, they notify the company after reviewing the reports.

Financial statements filed with the SEC and for public consumption must adhere to the generally accepted accounting principles (GAAP) . To meet the demands of these rules, financial reporting must be relevant, reliable, consistent, and presented in a way that allows the report reader to compare the results to prior years, as well as to other companies’ financial results. To find out more about GAAP, turn to Chapter 17.

With GAAP in place, you may wonder why so many accounting scandals have hit the front pages of newspapers around the country for the past few years. Filing statements according to GAAP has become a game for many companies. Unfortunately, investors and regulators find that companies don't always engage in transactions for the economic benefit of the shareholders, but sometimes do so to make their reports look better and to meet the quarterly expectations of Wall Street. Many times, companies look financially stronger than they actually are. For example, as scandals have come to light, companies have been found to overstate income, equity, and cash flows while understating debt. I talk more about reporting problems in Chapter 22.

Chapter 2

IN THIS CHAPTER

Exploring sole proprietorships

Taking a look at partnerships

Checking out limited liability companies

Comparing different types of corporations

All businesses need to prepare key financial statements, but some businesses can prepare less formal statements than others. The way a business is legally organized greatly impacts the way it reports its financials to the public and the depth of that reporting.

For a small business, financial reporting is needed only to monitor the success or failure of operations. But as the business grows, and as more outsiders — such as investors and creditors — become involved, financial reporting becomes more formalized until the company reaches the point at which audited financial statements are required.

Each business structure also follows a different set of rules about what financial information the business must file with state, local, and federal agencies. In this chapter, I review the basics on how each type of business structure is organized, how taxation differs, which forms the business must file, and what types of financial reports are required.

The simplest business structure is the sole proprietorship — the IRS's automatic classification for any business that an individual starts. Most new businesses with only one owner start out as sole proprietorships. Some never grow into anything larger. Others start adding partners and staff and may realize that incorporating is a wise decision for legal purposes. (Check out “ Seeking Protection with Limited Liability Companies” and “ Shielding Your Assets: S and C Corporations,” later in the chapter, to find out more about incorporating.)

To start a business as a sole proprietor, you don't have to do anything official, like file government papers or register with the IRS. In fact, unless you formally incorporate — follow a process that makes the business a separate legal entity — the IRS considers the business a sole proprietorship. (I talk more about incorporation and the process of forming corporations in the upcoming section, “ Shielding Your Assets: S and C Corporations.”)

The fact that the business isn't a separate legal entity is the biggest risk of a sole proprietorship. All debts or claims against the business are filed against the sole proprietor's personal property. If a sole proprietor is sued, insurance is the only form of protection against losing everything.

Sole proprietorships aren't taxable entities, and sole proprietors don't have to fill out separate tax forms for their businesses. The only financial reporting sole proprietors must do is add a few forms about their business entity to their personal tax returns.

Most sole proprietors add Schedule C — a “Profit or Loss from Business” form — to their personal tax returns, but some choose an even simpler form, called Schedule C-EZ, “Net Profit from Business.” In addition, a sole proprietor must pay both the employer and employee sides of Social Security and Medicare taxes using Schedule SE, “Self-Employment Tax.” These taxes total 15.3 percent of net business income, or the business income after all business expenses have been subtracted.