Hi, Else here.
And in this video, we'll start exploring financial statements,
what they look like, and how they're interconnected.
We'll be using ASPE, Accounting Standards
for Private Enterprises, to produce our statements.
Why are financial statements necessary?
Remember that external stakeholders, mainly investors,
lenders, and other creditors, have
to make decisions about resource allocations--
where to put their money.
They use financial statements to answer questions
that they may have about a business.
From the video on business organization,
we know that corporations can be either public or private.
Public corporations must follow IFRS.
Private corporations can follow either IFRS or ASPE.
A private corporation that follows ASPE
will produce the following financial statements-- income
statement, statement if retained earnings,
balance sheet, and the statement of cash flows.
Corporations who follow IFRS, whether public or private,
must produce the following statements-- income statement,
statement of comprehensive income,
statement of changes in equity, statement
of financial position, and finally, the statement of cash
flows.
If you wish to learn more about these statements,
go to my video on IFRS financial statements.
In these videos, we'll only be covering ASPE.
Statements must be completed in a specific order
and we'll start with the income statement.
An income statement reports the results
of a businesses day-to-day operations-- the revenues,
less the expenses incurred to generate that revenue,
to obtain a profit figure called net income.
The income statement measures the business's performance
within a period of time either annually, quarterly,
or monthly.
To better understand the income statement,
we have to understand the two main elements-- revenues
and expenses.
Revenues are the income that a business earns.
There are only two ways to earn revenue.
Businesses either provide a service or a good.
The key to revenue is that it must be earned.
What does that mean?
It means that the business has done their job--
past tense.
For example, if a lawn care business
plans to mow a customer's lawn tomorrow,
it has not earned revenue today, because they have not
done their job as yet.
After they've finished mowing the customer's lawn,
they have earned their revenue.
If a retail store plans to sell a product to a customer
tomorrow, revenue is not earned because, again, the business
has not as yet done their job.
Revenues can only be recognized when the business has
finished the job, provided the service, or delivered the good.
Notice the past tense--
that's very important with regards to the element revenue.
To summarize, revenue is income earned
through the day-to-day activities of a business
when a service or good is provided.
Revenue-- earned by providing services or goods.
Expenses or the cost of the resources
that have been used, consumed, or incurred to help
generate revenue.
Expenses are best described through an example.
If you use gas in a lawnmower when you move a customer's
lawn, then the gas that was consumed during the moving
of the lawn is an expense--
a cost to earn the revenue.
Why?
Because the gas was consumed in order to help
generate service revenue.
Note that the concept of used, consumed, or incurred
is important, but so is the fact that these things must
have happened in order to earn revenue.
Costs or expenses must be matched to the revenue
they helped to generate.
Expenses-- cost of what is used, consumed, or incurred to help
generate revenue.
Now that you understand the elements
that make up the income statement,
let's look at the format.
The format of an income statement is important.
Note that the heading must always
include the company name, the title
of the financial statement, and the time period covered.
Then revenues are listed first.
If there are multiple revenues, you
must list each different type of revenue
individually, and then show a subtotal called total revenues.
Is there a correct order for revenues?
Generally, they're placed in the order of magnitude-- meaning
from the highest amount to the lowest.
Why?
Because remember the purpose of financial reporting--
provide information for external users
to make resource allocation decisions.
Therefore, highlighting the larger sources of revenue
first help to make the information more understandable
and increases clarity.
Expenses are listed next with the heading called
operating expenses.
The order of expenses, similar to revenues,
are from the largest to the smallest.
After listing all the expenses, this statement
provides a total of all the expenses,
excluding income tax expense.
Next is the subtotal-- income before income tax expense
calculated as total revenue minus total expenses.
Then, income tax expense is a separate expense item
before listing a final net income amount.
Often, textbooks show income tax expense in the same listing
as operating expenses.
However, this is incorrect.
Operating expenses are the costs of operating the business
and are controllable, for the most part, by the business.
Income tax expense is prescribed by this CRA--
Canada Revenue Agency-- and is not at all controllable.
As a consequence, income tax expense
must be listed separately.
What happens if expenses are greater than revenues?
Then a net loss amount is provided that the bottom
of the income statement.
The statement we have developed here
is called the single step income statement.
We'll be covering a multiple step income
statement in a future video.
Remember to pause the video to determine
your answer to this check your understanding
question about the uses of the income statement.
Investors are interested in a business's past performance
because it helps them.
The answer is not A--
determining the amount of debt a business currently
has is answered by reviewing the balance sheet.
The answer is not B either--
as the current value of a businesses property, plant,
and equipment is not available on any financial statement
that is produced under ASPE.
The answer is not D either.
Determining if a business is profitable enough
to repay its debt is what lenders and creditors
will use the income statement for, not investors.
The correct answer is C as investors
are interested in determining the future profitability
of the business.
Why is this?
Because it will help investors determine
if they will get the return on their investment
that they want in the future.
Investors also use the income statement
to determine if the business will be in a position
to pay dividends.
Lenders use the income statement to help them determine
if they want to fund a business with loans
and if the business will be in a position to repay the loan
plus interest in the future.
Other creditors use this statement
to figure out if the business will be profitable enough
to repay their debts as they come due.
The long-term survival of any business
depends on its ability to produce revenues that are
greater than their expenses.
Profit allows a business to fund their financing activities
by paying dividends to shareholders and interest
to lenders.
It also allows the business to pay for investing activities,
like buying new equipment.
Investors and creditors base their decisions
on their beliefs about a business's future performance.
Income statements, which show past performance,
give stakeholders information to help them make predictions
about future profitability.
The income statement is a statement
that is connected to two other financial statements.
The net income or net loss from the income statement
is used in both the statement of retained earnings
and the statement of cash flows under the indirect method.
Since the net income from the income statement
is used in other statements, it's
always the first financial statement completed.
The next statement produced is the statement
of retained earnings.
We'll be covering that statement in our next video.