Understanding the building blocks of financial statements will help you understand financial statements

Financial statements are made of small building blocks. To understand the financial statement and make better business decisions, you must understand how the building blocks fit.

Accounts are the smallest building blocks.

Accounts, sometimes called general ledger accounts, are the smallest building blocks. It's where your transactions are recorded. For example, when you spend money on office supplies, you'll record it in an Office Supplies account.

Accounts are grouped in broad categories and numbered:

1. Assets (1000s)

2. Liabilities (2000s)

3. Equity (3000s)

4. Revenue (4000s)

5. Expense (6000s)

A chart of accounts is a listing of accounts.

When you group a bunch of accounts, you have a chart of accounts, which is a listing of all of your accounts.

On the chart of accounts, the accounts are usually listed in this order: assets, liabilities, equity, revenue, and expenses.

Types of accounts are separated into different financial statements.

Taking the chart of accounts and reporting balances for that account (called a trial balance) isn't a useful way of looking at financial information, so the accounts are grouped and reported in different financial statements.

All the assets, liabilities, and equity accounts are reported on the balance sheet.

All the revenue and expense accounts are reported on the profit and loss statement (aka income statement).

Account categories are grouped together on the financial statements.

Now that the assets, liabilities, and equity are all on the balance sheet, they get grouped together and reported under their own sections.

The assets section of the balance sheet lists all the assets you have, usually in order of liquidity (more on that later). Assets are grouped further by current (i.e., short-term) and long-term assets.

The liabilities section of the balance sheet lists all the liabilities. It's usually split between current and long-term liabilities.

The equity section of the balance sheet lists all your equity accounts. Depending on the company's entity type (e.g., corporation or partnership), this section can look very different from one company to the next. (A topic for another day).

As you may have guessed, the profit and loss statement is grouped by revenues and expenses. Expenses can be separated into groups as well. You can have Cost of Sales (a.k.a. direct costs), a type of expense, separated. There's also a catch-all group called Other Income and Expenses for revenue and expenses that are not part of operations.

Takeaway

• Knowing the building blocks of financial statements can help you understand them better.
• The basic building block is the account (aka general ledger account)
• Accounts are grouped in the chart of accounts.
• Accounts can be categorized by type: assets, liabilities, equity, revenue, and expenses.
• The balance sheet reports all the assets, liabilities, and equity accounts.
• The profit and loss (aka income statement) reports all the revenue and expense accounts