Ch 15 Mini Sim on Accounting and Accounting Information

You tell Alex that you're almost done with the balance sheet. Because his restaurant is a sole proprietorship, there's only one section that still needs to be completed: owners' equity. He asks what that is and how you calculate it. How should you respond to Alex?

Assets = Liabilities + Owners' Equity

Alex seems to be catching on faster than you thought he would, so you go on to try to explain the last major financial statement to him -- the statement of cash flows. You tell Alex that the statement of cash flows shows the effect of cash on three aspects of a business. Which three aspects are they?

You chose operating, investing, and financing. That was the best choice. The statement of cash flows shows the effects of cash on a business's operating, investing, and financing activities.

It doesn't surprise you at all that Alex is a bit confused by what these activities mean. You explain the following: Cash flows from operations are cash inflows and outflows caused by the restaurant's main business -- selling food and beverages and catering. Cash flows from investing are payments made to acquire long-term assets or cash received from the sale of long-term assets. Cash flows from financing reflect changes in debt, loans, or dividends. You're still getting a blank look from Alex, so you give him a series of examples to help him understand the different categories.

When asked to categorize items as cash inflows or outflows as a result of operating, investing, or financing activities, you correctly identified most of the items. Good job!.

You explain the basic format of the income statement to Alex. When he sells a meal or a drink in his restaurant, he receives revenues -- funds that flow into his business from the sale of goods or services. On the income statement, he then needs to subtract the cost of revenues (or cost of goods sold) -- the cost to his restaurant of the food and beverages it sells. When he subtracts the cost of revenues from revenues, the result is his gross profit. He then needs to subtract his operating expenses. These are expenses incurred in running the restaurant, such as utilities, insurance, payroll, cleaning supplies, and the like. Alex also needs to then subtract approximated taxes in order to arrive at his net income.

When asked to categorize items as either revenues, cost of revenues, or operating expenses, you correctly identified most of the items. Good job!

"Let's start out slowly," you suggest to Alex. "We'll put together a balance sheet first and see where we stand. The first section of the balance sheet lists your assets, so let's start with those. Assets are things that the restaurant owns. Do you have that information?" Alex tells you that he had to prepare a list of equipment for his insurance agent, and he has a pretty good idea of his inventory. "That's a good start," you tell Alex, "but don't forget about the cash you have on hand, how much you have in checking or savings accounts, and any accounts receivable -- money you're owed from customers." Alex turns to his computer and after a few minutes, he hands you a list. "This is exactly what I need," you tell him. "Now we're going to list these assets as current assets or fixed assets, and we'll put the current assets in the order of liquidity -- in other words, how easily they can be converted into cash. Then we'll have the first part of our balance sheet."

When asked to list current and fixed assets for Alex's Ristorante, you correctly categorized all items. Great job!

You explain to Alex that the second part of the balance sheet lists his liabilities -- amounts that the restaurant owes to other parties. After some digging, Alex puts together a list of what he owes. You look over the list and tell Alex, "Now we're going to separate these liabilities into two categories -- current liabilities, which need to be paid within a year, and long-term liabilities."

When asked to list current and long-term liabilities for Alex's Ristorante, you correctly categorized all the items. Great job!

You tell Alex that the two of you are off to a great start. The balance sheet is completed, and it's time to start putting together an income statement for the restaurant. Alex doesn't understand why you need to put together both an income statement and a balance sheet. What's the difference between them? What's the best way to respond to him?

You chose that the income statement provides detail on how the restaurant generates and uses cash, and the balance sheet shows the restaurant's financial condition at a specific point in time. That was an incorrect choice. The income statement, sometimes called a profit-and-loss statement, reveals whether the business is making a profit. The balance sheet, also known as a statement of financial position, reveals the business's assets, liabilities, and owners' or shareholders' equity.

At your first meeting with Alex, you ask to see his most recent financial statements so that you can get an overall assessment of the restaurant's financial health. Alex looks at you blankly and says, "I'm a chef, not an accountant, and I don't know what financial statements you're talking about. Can you explain to me?" What should your response be?

You chose that the three most important statements are the balance sheet, the statement of cash flows, and the income statement. That was the best choice. The restaurant's financial statements summarize its financial information for a given period of time, and the three most important statements are the balance sheet, the income statement, and the statement of cash flows.