I usually ask my readers. Do we need to know how to prepare a Financial Statement in order to read it? Some may say Yes and some No. My answer is you do not need to have the knowledge of preparing a financial statement in order to read it. However having an understanding about how to prepare a financial statement will always help us to read it better. Definitely, I do not want to make you a book-keeper or an accountant. The next few paragraphs I am going to make you understand how to prepare a financial statement from a layman’s perspective. Let’s get started.
W e have understood so far that in any transaction where –
- Money comes in
- Money goes out
- Money supposed to come in
- And money supposed to go out is called a financial transaction.
Let us imagine in front of A & M Furniture’s office(An imaginary company) I keep a big box. Whenever a financial transaction happens, that is whenever money comes in, goes out, is supposed to come in or is supposed to go out I write it on a piece of paper. Then I drop it inside the box. After some time the box will be filled with piles of paper which will contain financial transactions. I am going to take out each and every paper and read the financial transaction. I would like you to tell me whether the financial transaction is an expense, an income, a liability or an asset. Let me take out the first paper.
- It reads Salaries and wages paid. Is it an expense or an income or a liability or an Asset? Of course it is money going out of the business and it is an Expense.
- The second financial transaction is Electricity and Telephone bills paid. Again it is money going out of the business, so it is an Expense.
- The next transaction is Owner invests money. It got you confusing. Is it not? It is confusing because you have tried to look from an owner’s perspective. Let me remind you that when it comes to financial statement owner and business are treated separately. We are preparing this financial statement from business perspective. So, looking from business perspective business has borrowed money. This means it is liable to pay back. So when owner invest money it becomes a Liability.
- Next transaction is Payment received from sale of furniture. Her money comes in the business so it is Income.
- Loan taken from Bank. It is borrowed money so it is a Liability.
- Equipment purchased. The business has purchased equipment and it has got a Fixed Asset. So it is an Asset.
- Interest paid on loan. Money is going out of business. So, it is an Expense.
- Purchase of Raw materials on credit. The business has bought something, so money is supposed to go out of business. This means the business is liable to pay someone. Hence it would get listed under Current Liabilities.
- Credit Sales to customer. In this case business has given credit to a customer. This means money is supposed to come in to the business. So, it will get listed as Current Asset.
- Land and Building purchased. It is a Fixed Asset.
If you got all the above ten right then you have just prepared a financial statement from a layman’s perspective. You are surprised right. You will have a few questions. Is that it? Is this what my book-keeper is doing? Is this what my accountant is approving? Is this what happens in finance department? Well pretty much Yes. However in a real life scenario, it will not be just ten or twenty financial transactions. It will be few hundred or thousand at a given point of time. But it does not matter what is the number of financial transactions. It may be millions, but it has to be an Expense, an Income, a Liability or an Asset.