Inštitut za ekonomsko demokracijo

Some accounting fundamentals: Balance sheets, income statements, and cashflow statements

Author: David Ellerman, President IED

27 Day Cash Buffer

There are some accounting fundamentals that are common to companies, organizations, and even individual households—and that hold across different countries and national standards.

A balance sheet (BS) gives the amounts or balances for the accounts of an organization or individual at a point in time, e.g., end of the year (and the start of next year). Two of the most important accounts on the balance sheet are cash and equity, particularly the equity due to the profits or earnings from business operations retained in the company. Thus a balance sheet might have the following form.

Balance Sheet at end of the time period (e.g., month or year)

Assets Liabilities and Equity

Land

Buildings

Fixed equipment

Equity due to retained earnings

Equity due to paid-in capital from shareholders.

Inventory

Cash

Liabilities: Long-term

Liabilities: Short-term

 

The sum of the Asset accounts has to equal the sum of the Liability and Equity accounts. The Balance sheet has to ‘balance.’

The balances in the accounts change over the year or whatever the time period is between balance sheets. There is another type of accounting statement that lists those changes, the inflows, outflows, and netflows (inflows minus outflows) over the time period. That accounting statement, a netflow statement, covering a period of time is associated with some account on the balance sheet.

• If the account is the Equity due to retained earnings or just Retained earnings, then the flow statement is the Income Statement, also called the Profit and Loss statement (P&L).

• If the balance sheet account is Cash, then the flow statement is called the Net cashflow statement or just Cashflow statement.

The BS accounts are sometimes called “stock” accounts (nothing to do with shares of stock) with a value at a point in time as opposed to the “flow” accounts on the flow statement which cover the flows over a period of time. There is a basic arithmetic equation that connects the flow statements over a time period to the beginning and ending balance sheet accounts.

Beginning BS account + Inflow – Outflow = Ending BS account.

Basic Stock-Flow Equation

If Cash starts off at 10000 € and the Net cashflow is 5000 – 3000 = 2000 € over the time period, then the ending Cash balance had better be 12000€, otherwise something is wrong.

Cashflow statement for time period
Cash Inflows:

Cash sales

+ Payments on receivables

+ Sales of assets

+ Cash paid in from shareholders

= Total Cash Inflows
Cash Outflows:

Cash expenses (wages, raw materials, etc.)

+ Cash Purchase of assets

+ Payments on loans and other liabilities

+ Taxes

+ Cash dividends

= Total Cash Outflows
Net Cashflow

 

The Income Statement or P&L has the same form of Inflows called “Revenues” and outflows called “Expenses” and then the Net Income = Profit = Revenues minus Expenses. Then Taxes and Dividends are subtracted to get the Retained Earnings for the time period.

Net Income statement for time period
Revenues:

Cash Sales

+ New receivables

= Total Revenues
Expenses:

Cash expenses (wages, raw materials, etc.)

+ Inputs purchased on credits

+ Depreciation

+ Interest portion of loan payments

= Total Expenses
Pretax Net Income = Revenues – Expenses
– Taxes
= After-tax Net Income
– Dividends
= Retained Earnings for the period

 

There is no assumption that the revenues or expenses are in terms of cash. For instance, revenues might be for sales of the product to a trusted customer who gave in return a “receivable” or I.O.U. to be paid off in cash in the next or a later time period. Or an expense might be depreciation on a fixed asset which is not a cash expense. The expense represents the services of the asset (e.g., the rental for the time period if the company had rented the asset instead of purchasing it).

The basic stock-flow equation has to hold for the time period in both flow statements:

• Beginning Retained earnings + Retained earnings for the period (from the Income statement) = Ending Retained Earnings, and

• Beginning Cash + Net Cashflow (from the Cashflow statement) = Ending Cash.

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