Investors, bankers, businessmen, and capital markets have come to realize that accurate financial statements are a highly important, if not an indispensable aid, to running a successful business.
Limits of a Single Entry System
Not so long ago, companies used mere a single entry accounting systems for bookkeeping and depended upon an inventory of assets and liabilities at the end of the year in order to determine their financial condition. From such an inventory there was compiled a list of accounts separated as to assets and liabilities which was called a balance sheet and which showed the surplus or deficit. The profit or loss was determined by a comparison of the surplus or deficit at the end of the period with that at the beginning. All that could be established was the fact that a gain had been made or a loss sustained and the extent in either case. Such information was not very useful to a company, as the different types of gain and loss are important for measuring the financial success of a business.
Where is the P&L?
The big question, which began to arise as a result of this was, “What was the cause from which the profits have resulted?” With the aid of double entry bookkeeping and the accompanying nominal accounts a profit and loss account became possible. This summary, which was a transcript of the corresponding accounts in the books, was crude at first, and while nothing more than a classified list of debits and credits, did explain in a measure the increase or decrease in the surplus or the deficit.
The Need for a Detailed P&L
This statement, being crude as it was, wasn’t enough. The account might have been called a hodgepodge of information accounting arithmetically for, and to a certain extent explaining in general terms the causes of, profits and loss. But the business man began to ask for something more definite; something more concrete; something which would tell him with more precision just why a profit had been made. He was also dissatisfied at having to wait until the end of a year before obtaining this information.
Quite naturally he began to ask, if he happened to be engaged in manufacturing, “How much do I make on my goods without taking into consideration the expenses of selling them, or the expense of conducting the business?” To satisfy this want on the part of the proprietor, the accountant presumably prepared a more elaborate statement of the profit and loss for the period, which divided the total expense of conducting the business into three classes; namely, manufacturing, selling, administrative and general. He arranged to show the profit after each class of expense had been deducted. His statement was in account form and was known as the trading and profit and loss account, or as the manufacturing, trading and profit and loss account. This latter statement probably attained greater popularity than the former. It was divided into three sections, entitled respectively, manufacturing, trading, and profit and loss. The first section had as its object the gathering together of all the items of cost or expense affecting the manufactured goods sold. These, of course, comprised the stock at the beginning of the year, whether in the shape of raw material, goods in process, or finished goods, to which was applied the respective inventories at the end of the period. It also included wages, rent and taxes of factory, depreciation on machinery and all incidental items of expense affecting the manufacturing. When this cost of manufactured goods sold had been ascertained, the section was closed out by being balanced and the balance was brought down to the second section, or that called trading. This section showed on the credit side the sales, and on the debit side the cost of sales plus salesmen’s salaries and expenses, together with discounts on sales. It was balanced in a manner similar to the first section, and the balance carried down to the profit and loss group. In this section the gross profit on trading appeared on the credit side and was offset by such items as the rent of warehouse, salaries of clerks, depreciation on factory, office expenses, reserve for bad debts, interest, dividends, etc.
This statement, while quite obviously an improvement over the original profit and loss account, still left something to be desired. While intended to allocate profits to a certain extent, it possessed to such a degree the features of a ledger account, that it was generally condemned by the proprietor, who as a rule understood little. about bookkeeping, as being too intricate for his interpretation. It worked its way into favor with bookkeepers in this country at a time when very little attention had been given by them to financial statements. It is supposed to have come from England, where it originated. It has now been largely discarded in favor of a statement which is known as the statement of income and profit and loss.
This statement presumably came in response to the persistent demands on the part of the proprietor for financial statements which would be of use to him in running his business, so to speak. Many such men have been heard to say, “What I want is a statement which I can understand and which will help me to run my business and make more money.” “What I want is an income statement which will tell me whether I am making money through proper and consistent manufacturing cost, or whether I am losing money because my selling or administrative expense or my fixed charges or any one of them is too high. If I lose money, I want to know whether my selling price is too low or my cost and expense items too high, and above all, I want a statement which I can understand. I know nothing of bookkeeping or accounting, and I do not wish to be bothered with highly technical and involved statements.”
The Modern Day Income Statement Emerges
The statement of income and profit and loss is the latest device for supplying the wants of the business man with information as to his operations. While it has developed into a somewhat elaborate statement, it is so arranged as to present to the business man in a simple and logical manner that which he desires. It does away with all bookkeeping features; there is no such thing as debts and credits. It deducts one item from another in the same way that the layman would do it, “if he were figuring up his profits.” It seems to appeal to him and be possible of interpretation by him for this reason. It is constructed in accordance with the divisions of organization. It sets out clearly the cost incident to manufacturing, selling and administration. It separates from these departments, which comprise the operations, all such items as secondary income or deductions therefrom. It complies with the economic theories with regard to interest, rent, taxes, etc. It allocates the profits to the respective division of organization showing gross profit, selling profit and net profit. It shows the income from operations and the income from sources other than operations. It gives the business man a statement from which to form his judgments and to administer.
The balance sheet of to-day has also undergone some remarkable changes. From an intricate mixture of accounts, classified only as to debit and credit, it has become a statement of great refinement, showing not only the true financial condition but carrying with it information which is of inestimable value to the proprietor or administrative officer. It now enables him to determine the manner in which his capital is invested; the extent to which his equity in the organization exists; to separate his fixed capital from his working capital; to determine which assets have an intrinsic value and those which are carried merely as a matter of courtesy for accounting purposes.
The fact that scientifically prepared financial statements are desirable and, in fact, needed by the business man who hopes to become successful would appear to pass unchallenged. That great corporations are in effect magnified individuals, the power of observation of whose officers is limited, will also probably be unquestioned. That such officers must have some artificial means of transcending such limits is also quite evident. Financial statements, with their accompanying statistical data, furnish such a means.
The duty which confronts the accountant is that of presenting such financial statements and presenting them when needed. Some concerns require statements showing daily profits, others what might be termed perpetual balance sheets, while the great majority probably close their books either semi-annually, quarterly or monthly. These statements will not prepare themselves. They will not permit of successful preparation unless some arrangement has been made to secure the facts and figures essential to their preparation. In order that this may be accomplished it is necessary that the accountant should thoroughly understand books, the object in keeping them, their classification, their form and ruling; methods of bookkeeping; of accounts, their philosophy, classification, and arrangement in books; the relation which each account bears to allied subjects, such as economics, law and finance; the peculiar effect which the various economic and legal types of organization and various lines of business have upon the accounts and the accounting technique.
The accountant having in mind the results which he wishes to attain, plans his work accordingly. He begins with the selection of proper books. He proceeds by choosing such accounts as will, when properly arranged, reveal, in accordance with economic principles, a complete record of the financial transactions of the particular type of organization involved and facilitate the preparation of comprehensive financial statements. Not alone arithmetical statements which are mathematically correct and accurate with regard to the facts, but statements which set forth such facts in a manner which can be readily understood. A balance sheet may set forth all the real accounts. It may show the financial condition of the organization. An income statement may disclose all the nominal accounts and show the results of operation during the period just past. If the arrangement is disregarded, the statements will have little meaning. Properly arranged, they may be of immense value to the proprietor or administrative officer. They may show not only the financial condition and the results of operation in the past, but light the way to improvement in the future. A properly constructed balance sheet may be a most important factor in guiding the financial policies. A statement of income and profit and loss, wherein items of cost are grouped around units of production and items of expense around units of service, may be most helpful as an index to efficiency and honesty or as a warning of weakness or impending danger.
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