12.2: Understanding Financial Statements

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Learning Objectives

Understand the function of the income statement.
Understand the function of the balance sheet.
Understand the function of the statement of owner’s equity.

We hope that, so far, we’ve made at least one thing clear: If you’re in business, you need to understand financial statements. For one thing, the law no longer allows high-ranking executives to plead ignorance or fall back on delegation of authority when it comes to taking responsibility for a firm’s financial reporting. In a business environment tainted by episodes of fraudulent financial reporting and other corporate misdeeds, top managers are now being held accountable (so to speak) for the financial statements issued by the people who report to them. For another thing, top managers need to know if the company is hitting on all cylinders or sputtering down the road to bankruptcy. To put it another way (and to switch metaphors): if he didn’t understand the financial statements issued by the company’s accountants, an executive would be like an airplane pilot who doesn’t know how to read the instrument in the cockpit—he might be able keep the plane in the air for a while, but he wouldn’t recognize any signs of impending trouble until it was too late.