Hi, Else here.
And in this video, we'll be exploring financial statements,
what they look like, and how they interconnect.
Why are financial statements necessary?
Financial statements tell a business' story, what it does,
and how well it does it.
They provide a business' financial performance,
its current financial position, and its cash flows.
Both internal and external stakeholders
use the financial statements to analyze the business and answer
questions.
That allows them to make decisions
and meet their objectives.
A business will produce the following financial statements,
income statement, statement of retained earnings,
balance sheet, and the statement of cash flows.
Statements must be completed in a specific order.
And we'll start with the income statement.
An income statement reports the results
of a business' day-to-day operations,
the revenues, less expenses incurred
to generate that revenue, to obtain a total profit.
The income statement measures a business' 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 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,
that is not earned revenue today because they have not
done their job 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 their 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 a good is provided.
Revenue, earned by providing services or goods.
Expenses are 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 mow a customer's lawn,
then the gas that was consumed during the mowing of the lawn
would be an expense, a cost of earning 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 to help earn revenue.
Costs or expenses must be matched to the revenue
they help to generate.
Expenses, costs that have been 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 business 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 are always placed in order of magnitude.
That means from the highest amount to the lowest amount.
Why?
Remember the purpose of financial reporting,
to provide information for external stakeholders
to make resource allocation decisions.
Therefore, highlighting the largest sources of revenue
first helps to make the information more understandable
and to increase clarity.
Expenses are listed next, with a heading
called Operating Expenses.
The order of expenses, similar to revenues,
is always from largest to smallest.
After listing all the expenses, the statement
provides a total for all the expenses,
excluding income tax expense.
Next is the subtotal profit before income tax expense,
calculated as total revenues minus total operating expenses,
then income tax expense as a separate line
item before listing the final profit amount.
Often students place income tax expense in the same listing
as operating expenses.
However, this is incorrect.
Operating expenses are the costs of running a business
and are controllable, for the most part, by the business.
Income tax expense is prescribed by the CRA, the Canada Revenue
Agency, and is not controllable by the business.
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 at the bottom
of the income statement.
The statement we have just developed
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.
Bankers are interested in a business' 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, as the current value of a business'
property, plant, and equipment is not
available on any financial statement that is produced.
The answer is definitely not D either,
determining if a business is profitable enough
to pay dividends is what owners will use the income
statement for, not bankers.
The correct answer is C, as banks
are interested in determining the future profitability
of the business.
Why is this?
Because it will help banks predict
if the business will repay the loan plus interest
in the future.
Owners use the income statement to determine
if the business is profitable and if they will be
paid dividends in the future.
Banks, also called lenders, use the income statement
to help them determine if they will
fund the business with loans and if the business will,
in the future, repay the loan plus interest.
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.
The income statement, which shows past performance,
is used by both internal and external stakeholders
to predict how profitable the business will be in the future.
The income statement is a statement
that is connected to one other financial statement.
The profit or net loss from the income statement
is used in the statement of retained earnings.
Since the profit from the income statement
is used in another statement, it is always
the first financial statement to be completed.
The next statement produced is the statement
of retained earnings.
We'll be covering that statement in our next video.