Balance Sheet and Income Statement

INTRODUCTION

BALANCE SHEET AND INCOME STATEMENT

The current presentation will provide an introduction to two of the most important financial statements. We will begin by looking at an individual’s set of accounts for the month of August and on how things stand of the first day of September. The individual – Charlie – wants to understand how he did financially the previous month and where he stands now. The next slide is a list of accounts that Charlie has provided us. We need to organize this information in a useful way.

Charlie's accounts during August and on the first day of September
Account / Amount
Balance on Car Loan on Sept. 1 / 9,000
Balance on Student Loan on Sept. 1 / 18,000
Value of Car on Sept. 1 / 21,700
Cash on Hand on Sept. 1 / $1,275
Dividends earned on Stock Holdings for the month / 175
Food & Entertainment for the month / 500
Gas for the month / 275
Interest Earned on Savings Deposit / 25
Interest Paid on Car Loan during month / 50
Interest Paid on Student Loan during month / 100
Monthly Rent / 1,800
Monthly Salary / $4,000
Monthly Taxes / 200
Savings Account Balance on Sept. 1 / 5,025
Value of Stocks on Sept. 1 / 4,000
Work Related Luncheons during month / 325

Begin by organizing the accounts not by alphabetical order or magnitude, but rather by whether the account describes (1) what happened during the month of August and (2) accounts being recognized on the particular day of September 1st.

The accounts describing the time period of the month of August will go onto the income statement. Once you have identified these accounts, then separate them into revenue (or, income) and expenses. The income statement takes the following general form – though we shall see variations on this shortly.

REVENUE

-EXPENSES

NET INCOME

revenue may also be termed income or gross earnings

Net income is also termed profit, net profit, or earnings

The accounts describing the point in time of September 1st will go onto the balance sheet. Consider which of these accounts represent things that Charlie has (i.e., assets) and what he owes (i.e., liabilities). The balance sheet takes the following general form – again, we’ll see cases where a slight rearrangement may prove useful for a particular purpose. We will usually use a vertical layout for the balance sheet, though when doing individual transactions the horizontal layout will save us space.

ASSETS=LIABILITIES+EQUITY

Equity goes under various labels depending upon the type of entity. For example, equity would typically be termed “net worth” for an individual’s balance sheet. Equity would be termed “shareholder equity” for a corporation. A small business might use the term “owner’s equity”. Nonprofit organizations normally use the term “net assets” for equity. Often, the nonprofit and the individual mentally (but not for presentation) rearrange the balance to solve for equity.

Equity (net worth, net assets) = Assets – Liabilities

Let’s organize the Charlie’s accounts to form a simple income statement for the month of August.

Charlie's Income Statement for the Month of August
Revenue
Monthly Salary / $4,000
Interest Earned on Savings Deposit / 25
Dividends earned on Stock Holdings / 175
Total revenue / 4,200
Expenses
Food & Entertainment / 500
Gas / 275
Interest Paid on Car Loan / 50
Interest Paid on Student Loan / 100
Monthly Rent / 1,800
Monthly Taxes / 200
Work Related Luncheons / 325
Total expenses / 3,250
Net Income / 950

Notice how the income statement allows us to easily see Charlie’s income (revenue) for the month, his expenses, and what he had left over (net income). At the very least we can say that Charlie was able to save $950 during the month.

We might be interested in a slightly more complicated way to structure the income statement. For example, we might want to group revenue/expenses associated with the same activities.

Charlie's Income Statement for the Month of August
Work Related Income
Monthly Salary / $4,000
Work Related Expenses
Work Related Luncheons / 325
Work Related Earnings / 3,675
Ordinary Living Expenses
Food & Entertainment / 500
Gas / 275
Monthly Rent / 1,800
total / 2,575
Earnings before Other Income and Taxes / 1,100
Other Income
Interest Earned on Savings Deposit / 25
Dividends earned on Stock Holdings / 175
total / 200
Interest Expense
Interest Paid on Student Loan / 100
Interest Paid on Car Loan / 50
total / 150
Non-Work Related Income / 50
Earnings before Taxes / 1,150
Monthly Taxes / 200
Net Income / 950

The previous income statement looks more like most corporate income statements. Below is the income statement for Proctor & Gamble. Notice how the activities of Proctor & Gamble have been grouped together. I have also included income statements for several years, this allows for ease of comparison. Over the course of the semester we will see many income statements in various forms. Though normally, they will be organized along similar lines as the following.

Proctor & Gamble
Income Statement
For the Years Ended June 30, 2001 to 2005
Jun-01 / Jun-02 / Jun-03 / Jun-04 / Jun-05
Sales / 39,244 / 40,238 / 43,377 / 51,407 / 56,741
Cost of Sales / 19,831 / 19,296 / 20,438 / 23,343 / 25,920
Gross Operating Profit / 19,413 / 20,942 / 22,939 / 28,064 / 30,821
Selling, General & Admin. Expense / 12,406 / 12,571 / 13,383 / 16,504 / 18,010
Depreciation & Amortization / 2,271 / 1,693 / 1,703 / 1,733 / 1,884
EBIT / 4,736 / 6,678 / 7,853 / 9,827 / 10,927
Other Income, Net / 674 / 308 / 238 / 152 / 346
Interest Expense / 794 / 603 / 561 / 629 / 834
Pre-tax Income / 4,616 / 6,383 / 7,530 / 9,350 / 10,439
Income Taxes / 1,694 / 2,031 / 2,344 / 2,869 / 3,182
Total Net Income / 2,922 / 4,352 / 5,186 / 6,481 / 7,257

EBIT stands for Earnings Before Interest and Taxes

Now, let’s return to Charlie’s accounts – specifically those that indicate measure amounts at the point in time of Sept. 1 – to construct his balance sheet.

Charlie's Balance Sheet on September 1
ASSETS
Cash / $1,275
Savings Account / 5,025
Stocks / 4,000
Car / 21,700
Total Assets / 32,000
LIABILITIES
Balance on Car Loan / 9,000
Balance on Student Loan / 18,000
Total Liabilities / 27,000
EQUITY
Net Worth / 5,000

Notice that ASSETS = LIABILITIES + EQUITY (this must always be the case!!!)
Notice how the assets are listed from the most liquid (i.e., cash) to the least liquid (the car). The assets and liabilities on a balance sheet are always listed in this order. In fact, we see that most balance sheets will make this quite explicit. Take a look at Proctor & Gamble.

Proctor & Gamble
Balance Sheet (in Millions) as of June 30
Jun-01 / Jun-02 / Jun-03 / Jun-04 / Jun-05
Cash and Equivalents / 2,306 / 3,427 / 5,912 / 5,469 / 6,389
Receivables / 2,931 / 3,090 / 3,038 / 4,062 / 4,185
Inventories / 3,384 / 3,456 / 3,640 / 4,400 / 5,006
Other Current Assets / 2,268 / 2,193 / 2,630 / 3,184 / 4,749
Total Current Assets / 10,889 / 12,166 / 15,220 / 17,115 / 20,329
Property, Plant & Equipment, Net / 13,095 / 13,349 / 13,104 / 14,108 / 14,332
Intangibles / 8,300 / 13,430 / 13,507 / 23,900 / 24,163
Other Non-Current Assets / 2,103 / 1,831 / 1,875 / 1,925 / 2,703
Total Non-Current Assets / 23,498 / 28,610 / 28,486 / 39,933 / 41,198
Total Assets / 34,387 / 40,776 / 43,706 / 57,048 / 61,527
Accounts Payable / 2,075 / 2,205 / 2,795 / 3,617 / 3,802
Short Term Debt / 2,233 / 3,731 / 2,172 / 8,287 / 11,441
Other Current Liabilities / 5,538 / 6,768 / 7,391 / 10,243 / 9,796
Total Current Liabilities / 9,846 / 12,704 / 12,358 / 22,147 / 25,039
Long Term Debt / 9,792 / 11,201 / 11,475 / 12,554 / 12,887
Deferred Income Taxes / 894 / 1,077 / 1,396 / 2,261 / 2,894
Other Non-Current Liabilities / 1,845 / 2,088 / 2,291 / 2,808 / 3,230
Total Non-Current Liabilities / 12,531 / 14,366 / 15,162 / 17,623 / 19,011
Total Liabilities / 22,377 / 27,070 / 27,520 / 39,770 / 44,050
Preferred Stock Equity / 1,701 / 1,634 / 1,580 / 1,526 / 1,483
Common Stock Equity / 1,559 / 1,726 / 2,494 / 3,667 / 4,273
Retained Earnings / 10,451 / 11,980 / 13,692 / 13,611 / 13,204
Total Shareholder Equity / 12,010 / 13,706 / 16,186 / 17,278 / 17,477
Total Liabilities & Shareholder Equity / 34,387 / 40,776 / 43,706 / 57,048 / 61,527

The balance sheet for P&G looks more complicated than Charlie’s, but notice how it has the same basic structure.
Again, Assets = Liabilities + (Shareholder) Equity
Several years of balance sheets have been included for comparison purposes.
Assets and Liabilities are listed from the most liquid (near cash) to the least liquid. This can be helpful when you don’t recognize an account title (e.g., tangibles). You will at least have an idea what that account must refer to based on where it is listed on the balance sheet.
Balance sheets typically make a distinction between Current and Non-Current (or, Long-Term) accounts. For example,
Current Assets are assets that will be turned into cash (or, live) within 1 year
Non-Current (or, Long-Term) Assets will typically last longer than 1 year

The same will be true for current and non-current liabilities.

Relationship between the Income Statement and Balance Sheet

The income statement stands between two consecutive balance sheets. Changes in the income statement will almost always cause a change in the balance sheet. Typically, there will be a change in assets and corresponding change in equity brought about by the income statement.

As a simple example, suppose that Charlie receives a $1,000 paycheck (revenue or income) from his job and spends $200 (cash) on food (expense) during the first week of September. Just to keep things as simple as possible, we will suppose that nothing else occurred. How would Charlie’s balance sheet change?

Charlie's Balance Sheet on Sept. 1 / Charlie's Income Statement for Sept. 1 - Sept. 7 / Charlie's Balance Sheet on Sept. 7
ASSETS / Revenue / ASSETS
Cash / $1,275 / Salary for the Week / $1,000 / Cash / $2,075
Savings Account / 5,025 / Expenses / Savings Account / 5,025
Stocks / 4,000 / Food for the Week / 200 / Stocks / 4,000
Car / 21,700 / Net Income / 800 / Car / 21,700
Total Assets / 32,000 / Total Assets / 32,800
LIABILITIES / LIABILITIES
Balance on Car Loan / 9,000 / Balance on Car Loan / 9,000
Balance on Student Loan / 18,000 / Balance on Student Loan / 18,000
Total Liabilities / 27,000 / Total Liabilities / 27,000
EQUITY / EQUITY
Net Worth / 5,000 / Net Worth / 5,800

We see that by receiving cash (his paycheck) and paying cash for food changed the amount of cash and total assets by the $800. Moreover, and this is important, we see that the positive net income of $800 increased the equity portion (net worth) of Charlie’s balance sheet. A corporation will look much the same. The only difference will be if the corporation chooses to pay out some of their net income (or, profits) to their shareholders in the form of dividends.

BALANCE SHEET BALANCE SHEET

1/1/2008 1/1/2009

INCOME STATEMENT

1/1/2008 – 12/31/2008

Revenue

- Expenses

Net Income

EQUITY

Dividends to Shareholders

The Equity Portion of the Balance Sheet

Unlike for an individual, the equity portion of a balance sheet for an organization is composed of at least two accounts.
One account will measure how much has been invested into the organization by its owners. This account has various labels: capital stock, paid-in capital, common stock equity, etc.
The other account will measure the retained earnings of the organization. That is, retained earnings will keep track of net income earned over the life of the organization that has not been paid out to the owners – thus, earnings that have been retained within the organization.
In general terms the equity portion of a balance sheet will look something like the following.

Capital Stock$16,000

Retained Earnings$14,000

Total Equity$30,000

When we say that the income statement stands between two consecutive balance sheets, it is really the retained earnings account within the equity portion of the balance sheet that is being impacted. We can see this with the following relationship (sometimes called the statement of equity).

Ending Retained Earnings = Beginning Retained Earnings + Net Income - Dividends

This is an important relationship when constructing balance sheets and thinking about the impact of individual transactions.

Another Example

Jane has the following accounts. Organize the accounts into a simple income statement and balance sheet.

Jane's Accounts during the year and on Jan. 1
Account / Amount
Interest Earned on Savings account / 150
Interest Paid on Car Loans / 1,200
Insurance premiums paid / 1,500
Credit Card Balance / 2,050
Savings Account / 3,000
Miscellaneous Expenses for the year / 3,075
Utility bills for the year / 5,025
Checking Account (Cash) / $6,000
Interest Paid on Mortgage / 8,000
Taxes Incurred / $8,900
Value of Cars / 18,000
Food, Entertainment, and Clothing / 22,500
Value of Retirement Account / 35,000
Wages Earned / 60,000
Mortgage (loan) remaining on the home / 70,000
Value of Home / 110,000
Jane's Income Statement for the Year
Revenue
Wages Earned / 60,000
Interest Earned on Savings account / 150
Total revenue / 60,150
Expenses
Interest Paid on Car Loans / 1,200
Insurance premiums paid / 1,500
Food, Entertainment, and Clothing / 22,500
Utility bills for the year / 5,025
Interest Paid on Mortgage / 8,000
Taxes Incurred / $8,900
Miscellaneous Expenses for the year / 3,075
Total expenses / 50,200
Net Income / 9,950
Jane's Balance Sheet as of January 1
ASSETS
Checking Account (Cash) / $6,000
Savings Account / 3,000
Value of Retirement Account / 35,000
Value of Cars / 18,000
Value of Home / 110,000
Total Assets / 172,000
LIABILITIES
Credit Card Balance / 2,050
Mortgage (loan) remaining on the home / 70,000
Total Liabilities / 72,050
EQUITY
Net Worth / 99,950
Liabilities & Net Worth / 172,000

Suppose Jane earned $5,000 during the first month of January. In addition, suppose Jane had expenses of $3,500 during the first month of January. What would Jane’s new Net Worth be on February 1st?

Net Worth = Net Worth on+Net Income during January

On Feb. 1stJan. 1st

$101, 450=$99,950+$1,500 (i.e., $5,000 - $3,500)

Note, for a corporation we would calculate Retained Earnings instead of New Worth and take into account (by subtracting) any dividends the corporation pays out to its shareholders (i.e., owners)