In the first of a series of articles about financial reports, Mahmood Reza distinguishes between the roles of the balance sheet and the income statement.
Financial statements: what, why and how
Financial statements are the culmination of a process of summarising, classifying and structuring large quantities of data. Financial statements present useful information that helps in the efficient running of an organisation, indicate how its management is performing and provide users with information about its resources and activities.
This article will focus on the main financial statements, looking at what these statements are, introducing key terms and discussing the basis of their preparation and how one should interpret them. Accounting has developed over a number of centuries and with it has evolved a framework with accepted guidance and rules as to how accounts should be prepared. The accounting framework allows for flexibility of interpretation and judgement, permitting accountants to be ‘creative’, albeit not in an artistic sense.
Two of the main financial statements produced by arts organisations are a balance sheet and a profit (or income) statement. The balance sheet lists all assets owned or controlled by an organisation and all of its debts (liabilities) at the same point in time. The profit statement shows income generated and the costs incurred in generating that income. Examples of assets might include office furniture, computer equipment, money owed by customers, scenery, cash and grant monies not yet received; examples of liabilities include bank overdrafts, PAYE and money owed to suppliers for goods or services. Accounting statements are presented in monetary terms and therefore only include items that can be measured reliably and with certainty. In this way, while a monetary value can be placed on the purchase of a computer, skilled and loyal members of staff cannot be valued reliably and consequently would not appear in a set of financial accounts.
Assets are items of value and can be sub-divided into categories. Fixed assets are those that have been acquired for long-term use by an organisation to help it earn its income and carry out its work. Current assets include cash or items that an organisation intends to turn into cash within one year. For example, a theatre will have stage scenery, lighting rigs and costumes that it may use for a number of productions. These will all be examples of fixed assets. If that same theatre runs a café, then all its food and drink stock will be classified as current assets.
Another important classification and distinction is that between capital and revenue costs. If an item is classified as capital it will appear in the balance sheet; if it is classified as a revenue cost, it appears in the income statement and is used to calculate profit. Capital costs are those that result in acquiring fixed assets or in improving them; revenue costs are those incurred in:
• obtaining assets for turning into cash
• the day to day running costs of an organisation, for example wages and rent
• maintaining fixed assets.
Capital costs usually have associated revenue costs. For example, a van used by a theatre company for touring would be classified as a fixed asset (balance sheet), the associated revenue costs would be the fuel, repairs, insurance and road tax (profit statement). While the building housing a gallery would be classified as a fixed asset (balance sheet), if the gallery were to be painted or a broken window replaced, then this would normally be classified as revenue (profit statement). However, if the gallery were to have an extension then this would be classified as capital (balance sheet).
A profitable organisation is not necessarily cash rich. It is not that unusual for an organisation to be profitable for a period of time and have a shortage of cash. My next article will explain how profit is calculated, explain depreciation, introduce cash flow and discuss the strengths and limitations of financial statements.
Mahmood Reza is Proprietor of the accountancy practice Pro Active Accounting.
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