The Balance Sheet and Income Statement on the CPA Exam

By Kenneth W. Boyd

The financial accounting and reporting (FAR) test covers the basic financial statements that most entities are required to create. The balance sheet and income statement are the first reports that a businessperson normally considers. To a non-CPA, these two financial statements are the most important.

The balance sheet information is generated as of a certain date. This report lists a company’s asset, liability, and equity balances:

  • Assets: An asset is a resource used to make money in your business. Inventory, investments, and fixed assets (trucks, equipment, buildings, and so on) are considered assets. Your accounts receivable balance is also an asset because it represents cash you’ll eventually receive from clients.

  • Liabilities: Liabilities represent debts owed to other people. If a company doesn’t pay a liability, the creditor has a claim, or ownership right, on company assets. Liabilities include accounts payable as well as long-term debts, like loans.

  • Equity: You can define equity in several ways:

    • Equity represents ownership in a business. If the equity section of the balance sheet has a balance of $100,000, that means that the owner’s investment in the business is $100,000.

    • You can also understand equity using the balance sheet formula, which is

      Equity = Assets – Liabilities

      If you were to sell all your assets and pay off all your liabilities, any funds that remained would be considered your equity balance.

An income statement is also called a profit and loss statement. This report always covers a period of time (month, quarter, or year) rather than a specific date. The income statement includes these amounts:

  • Revenue: Sales to customers are the primary source of revenue.

  • Expenses: Expenses are the spending incurred to generate revenue.

  • Net income: Net income, which is also called profit or earnings, is the difference between revenue and expenses. The income statement formula is

    Net Income = Revenue – Expenses

The FAR test will make a distinction between a subsidiary ledger and general ledger. As the name implies, a subsidiary ledger posts transactions for a portion of the activity in an account. A good example is a company that tracks many different types of inventory items.

Suppose that Sturdy Hardware has a subsidiary ledger for tools in inventory. That ledger tracks purchases and sales of the tool portion of inventory. Sturdy has other subsidiary ledgers for inventory, such as lawn equipment and painting supplies. The inventory subsidiary ledgers are combined to generate the general ledger for inventory. The general ledger accounts for all of the activity that’s needed to post the inventory balance to the financial statements.