Basic Accounting

Balance Sheet

A balance sheet is simply a list of all the balance of the assets and
the liabilities and the investments of the business. In a traditional
way the assets are shown on the left-hand side of the page and
liabilities on the right-hand side of the page. There are always two
aspects to every event, which enable the balance sheet to balance;
this is because the balance sheet is actually constructed from the
accounting equation.

There are numerous problems inherent in the balance sheet presentation
and may cause difficulty in analysis. First, most assets are valued at
cost; thus, one cannot determine the market value or replacement cost
of many assets and should not assume that their balance sheet value
approximates this current valuation. Secondly, varying methods are
used for valuation of assets both in short and long-term asset
valuation. A third and different type of problems exists in that not
all items of value to the firm are included as assets. For example,
such characteristics as good employees, outstanding management, and a
well-chosen location do not appear on the balance sheet. In the same
vein, liabilities relate to pensions and contingencies may also appear
on the balance sheet. These problems do not make statement analysis
impossible. They merely imply that qualitative judgement must be
applied to quantitative ratio and trend analyses, in order to
incorporate the impact of these problem areas.

Profit & Loss statement

This is a statement that records the income of the business (whether
all received or not), as well as the expenses of the business (whether
all paid or not). It determines what the profit or the loss of the
operation is for a particular period, by deducting all costs from
income.

The problem with the P&L is that at the end of the year the profit is
not actually cash. This is because parts of the profit & loss account
are made up by assumptions.

Cash-flow statement

Unlike the P&L the cashflow statement has nothing to do with income
and expenses, but has everything to do with cash flowing in and out of
the business. Cashflow has nothing to do with profit; they are two
different types of concepts. Cashflow is mainly concerned with cash
balance at the end of a particular period, for example every month.

There is an argument that cashflow statements are more useful then the
other two financial statements (Balance sheet and Profit & Loss). I
can understand why a person may argue that; this is due to numerous
reasons, such as:

A P&L statement may show a positive figure at the end of a
particular period, but that does not mean the business has made a
profit in terms of cash due to the fact that parts of the P&L account
is made up by assumptions. For example, the business is assuming that
they have paid insurance, when they haven’t. But in the P&L account it
will show that the business has paid the insurance, hence the profit
figure will be different. Where as in the cashflow statement, the
transaction is recorded after the event has taken place. The bottom
line is that, regardless of the transaction taking place or not the
P&L statement will state that the transaction has or will take place.

Like the P&L statement, the balance sheet also makes assumptions.
For example, as discussed earlier, assets are valued at cost, and one
may not be able to determine the value of the assets in the future,
hence assumptions are made for valuation of assets.

Unlike the P&L and balance sheet, the cashflow statement intended’s
to include information that represent an adequate picture of the
business’s liquidity and financial adaptability.

The balance sheet and the P&L are used to assess the financial
situation of the business but this may be misleading due to only parts
of the financial activities are recorded, where as the cashflow
statement presents the reader with additional information that can be
useful.

As both balance sheet and P&L statements use the accruals concept it
is difficult for the user of the accounts to investigate whether a
business has a good cash management system, which is very important to
the success of the entity.

It may be that the cashflow statement presents transactions that have
occurred, compared with the P&L and the balance sheet where
transactions are assumed to take place. It is better to use all
statements together to present a fuller picture of the business to the
user of the accounts. Like the P&L and balance sheet, the cashflow
statement has few deficiencies. For example, cash can be manipulated,
as a business you are bound to juggle around with payments if there is
a problem in order to make the cashflow available, and therefore
manipulation can take place. Also the technical side of cashflow
statements has room for improvement. The requirements to include both
receipts and payments under the same heading frequently results in a
statement which is riddled with brackets and therefore difficult to
understand.

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