This formula is intuitive: a company has to pay for all the things it owns assets by either borrowing money taking on liabilities or taking it from investors issuing shareholders' equity. All revenues the company generates in excess of its liabilities will go into the shareholders' equity account, representing the net assets held by the owners. These revenues will be balanced on the assets side, appearing as cash, investments, inventory, or some other asset.
Assets, liabilities and shareholders' equity each consist of several smaller accounts that break down the specifics of a company's finances. These accounts vary widely by industry, and the same terms can have different implications depending on the nature of the business. Broadly, however, there are a few common components investors are likely to come across.
The balance sheet is a snapshot representing the state of a company's finances at a moment in time. By itself, it cannot give a sense of the trends that are playing out over a longer period. For this reason, the balance sheet should be compared with those of previous periods. It should also be compared with those of other businesses in the same industry since different industries have unique approaches to financing. A number of ratios can be derived from the balance sheet, helping investors get a sense of how healthy a company is. These include the debt-to-equity ratio and the acid-test ratio , along with many others.
The income statement and statement of cash flows also provide valuable context for assessing a company's finances, as do any notes or addenda in an earnings report that might refer back to the balance sheet. They are divided into current assets, which can be converted to cash in one year or less; and non-current or long-term assets, which cannot.
MAJOR FINANCIAL STATEMENTS
Here is the general order of accounts within current assets:. Liabilities are the money that a company owes to outside parties, from bills it has to pay to suppliers to interest on bonds it has issued to creditors to rent, utilities and salaries. Current liabilities are those that are due within one year and are listed in order of their due date.
Long-term liabilities are due at any point after one year. Some liabilities are considered off the balance sheet, meaning that they will not appear on the balance sheet. Shareholders' equity is the money attributable to a business' owners, meaning its shareholders. It is also known as "net assets," since it is equivalent to the total assets of a company minus its liabilities, that is, the debt it owes to non-shareholders. Retained earnings are the net earnings a company either reinvests in the business or use to pay off debt; the rest is distributed to shareholders in the form of dividends.
Treasury stock is the stock a company has either repurchased or never issued in the first place.
It can be sold at a later date to raise cash or reserved to repel a hostile takeover. Some companies issue preferred stock , which will be listed separately from common stock under shareholders' equity. The "common stock" and "preferred stock" accounts are calculated by multiplying the par value by the number of shares issued. Additional paid-in capital or capital surplus represents the amount shareholders have invested in excess of the "common stock" or "preferred stock" accounts, which are based on par value rather than market price.
Shareholders' equity is not directly related to a company's market capitalization: the latter is based on the current price of a stock, while paid-in capital is the sum of the equity that has been purchased at any price. The balance sheet is an invaluable piece of information for investors and analysts; however, it does have some drawbacks. Info Print Cite. Submit Feedback. Thank you for your feedback. See Article History. You can learn more about this topic in the related articles below.
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Read More on This Topic. During the first period of normal operations, the enterprise must disclose its former developmental stage status in the notes section of its financial statements. Fraudulent financial reporting is defined as intentional or reckless reporting, whether by act or by omission, that results in materially misleading financial statements. Fraudulent financial reporting can usually be traced to the existence of conditions in either the internal environment of the firm e.
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Excessive pressure on management, such as unrealistic profit or other performance goals, can also lead to fraudulent financial reporting. The legal requirements for a publicly traded company when it comes to financial reporting are, not surprisingly, much more rigorous than for privately held firms. And they became even more rigorous in with the passage of the Sarbanes-Oxley Act. This legislation was passed in the wake of the stunning bankruptcy filing in by Enron, and subsequent revelations about fraudulent accounting practices within the company. Enron was only the first in a string of high-profile bankruptcies.
Serious allegations of accounting fraud followed and extended beyond the bankrupt firms to their accounting firms. The legislature acted quickly to fortify financial reporting requirements and stem the decline in confidence that resulted from the wave of bankruptcies. Without confidence in the financial reports of publicly traded firms, no stock exchange can exist for long.
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The Sarbanes-Oxley Act is a complex law that imposes heavy reporting requirements on all publicly traded companies. Meeting the requirements of this law has increased the workload of auditing firms. In particular, Section of the Sarbanes-Oxley Act requires that a company's financial statements and annual report include an official write-up by management about the effectiveness of the company's internal controls. This section also requires that outside auditors attest to management's report on internal controls.
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An external audit is required in order to attest to the management report. Private companies are not covered by the Sarbanes-Oxley Act. However, analysts suggest that even private firms should be aware of the law as it has influenced accounting practices and business expectations generally.
The preparation and presentation of a company's financial statements are the responsibility of the management of the company. Published financial statements may be audited by an independent certified public accountant. In the case of publicly traded firms, an audit is required by law. For private firms it is not, although banks and other lenders often require such an independent check as a part of lending agreements.
During an audit, the auditor conducts an examination of the accounting system, records, internal controls, and financial statements in accordance with generally accepted auditing standards. The auditor then expresses an opinion concerning the fairness of the financial statements in conformity with generally accepted accounting principles. Four standard opinions are possible:.
The financial statements are the responsibility of the company's management; the audit was conducted according to generally accepted auditing standards; the audit was planned and performed to obtain reasonable assurance that the statements are free of material misstatements, and the audit provided a reasonable basis for an expression of an opinion concerning the fair presentation of the audit. The audit report is then signed by the auditor and a principal of the firm and dated.
May-June Kwok, Benny K. Accounting Irregularities in Financial Statements. Gower Publishing, Ltd. Taulli, Tom. Ross Publishing, Taylor, Peter.
Assets are probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events. Comprehensive income is the change in equity net assets of an entity during a period from transactions and other events and circumstances from nonowner sources. It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners.
Distributions to owners are decreases in net assets of a particular enterprise resulting from transferring assets, rendering services, or incurring liabilities to owners. Distributions to owners decrease ownership interest or equity in an enterprise. Equity is the residual interest in the assets of an entity that remains after deducting its liabilities. In a business entity, equity is the ownership interest.
Expenses are outflows or other uses of assets or incurring of liabilities during a period from delivering or producing goods or rendering services, or carrying out other activities that constitute the entity's ongoing major or central operation. Gains are increases in equity net assets from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity during a period except those that result from revenues or investments by owner.
Investments by owners are increases in net assets of a particular enterprise resulting from transfers to it from other entities of something of value to obtain or increase ownership interest or equity in it. Liabilities are probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.