Chapter 2: Main Financial Statements An overview

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Aileen Morrison
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1 Chapter 2: Main Financial Statements An overview The objective of general purpose financial reporting is to provide information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions about providing resources to the entity. Those decisions involve buying, selling or holding equity and debt instruments, and providing or settling loans and other forms of credit. International Accounting Standards Board (2010), The Conceptual Framework for Financial Reporting Three main statements: i. Balance Sheet (Statement of Financial Position ) ii. Income Statement iii. Statement of Cash Flows 1

2 Balance Sheet Fundamental Structure: Resources Sources of Capital Assets Liabilities Owners Equity Asset: Resource owned or controlled by the accounting entity expected to provide future economic benefits to the accounting entity ownership or control acquired in a past transaction = Liability:= obligation to settle a past transaction by transferring resources to an outside party Owners Equity = Residual claims 2

3 The basic accounting equation Note that the following equation always holds: Assets = Liabilities + Owners Equity The effect of a transaction on the left hand side of the balance sheet always equals the one on the right hand side Examples: An increase in one asset and a decrease in another asset An increase in an asset and an increase in a liability An increase in an asset and an increase in owners equity An increase in a liability and a decrease in owners equity Each transaction affects at least two accounts 3

4 Line items on the balance sheet Assets... economic resources owned (or controlled) by a business as a result of past transactions that are expected to yield future economic benefits and eventually result in cash inflows to the business enterprise. Examples: property, plant, cash, copyrights, patents, investments Liabilities... claims of those to whom money is owed, i.e. liabilities are existing debts and obligations Examples: loans payable to a bank, salaries payable to employees Owners Equity... residual interest in the assets of a business enterprise after deducting its liabilities; also referred to as residual equity or net assets 4

5 Classification of assets Assets current cash and marketable securities Receivables Inventories Prepayments and accrued income fixed property, plant and equipment long-term financial investments intangible assets 5

6 Classification of liabilities and shareholders equity Liabilities current short-term debt and current portion of long-term debt payables accrued expenses and deferred income long-term long-term debt provisions for contingencies and charges other long-term liabilities Equity Common Stocks at par value additional paid-in capital (= capital surplus, share premium) Reserves accumulated other comprehensive income / loss retained earnings net income for the year 6

7 Understanding the basic accounting equation The story : Angie has a degree in political science and economics, and decides to start her own business Vote-Consult. Some time ago she received from a very good friend, money that she now uses to invest in her enterprise. During the first days of her new enterprise s life the following transactions occurred (in chronological order): 1. Angie deposits in a bank account in the name of Vote- Consult. 2. She purchases computers and other office equipment for Angie buys office supply for 500 on credit. 4. She pays 300 of the total amount she spent on supplies. 5. She pays the remaining 200 out of her personal pocket. 7

8 What happens to the balance sheet? 1. Angie deposits in a bank account in the name of Vote-Consult. [Extension of both assets and liabilities side] 2. She purchases computers and other office equipment for [Exchange of assets] 3. Angie buys computer paper and office supply for 500 on credit. [Extension of both assets and liabilities side] 4. She pays 300 of the total amount she spent on supplies. [Contraction of both sides] 5. She pays the remaining 200 out of her personal pocket. [Exchange on the liabilities side] 8

9 The Income Statement Income: Increase in an entity s net assets Resulting from an entity s operations Over a period of time Fundamental balance sheet equation: Assets = Liabilities + Equity Net Assets = Assets Liabilities => Net Assets = Equity Assets = Liabilities + Owner's Equity (profits) (losses) 9

10 Income Income results only from entity operations Capital transactions with owners Gains or losses from changes in exchange rates when group accounts are concerned are not operations Such transactions do not affect income but equity Income is generated over a period of time The period between two balance sheet dates The income statement provides detailed information about how income was generated It adds up revenues and deducts expenses Income is the bottom line of the income statement 10

11 Income Statement Format (funcional basis) Net Revenue Cost of goods sold (by product category) Gross margin Operating expense Operating Income (EBIT) + Financial, Investment & other revenue Financial expenses expenses from investments and other Income before Taxes Income taxes Income after Tax + Extraordinary Items Net income 11

12 Explanations of income statement items Net revenue = gross revenue discounts returns Cost of goods sold = cost of goods available for sale ending product inventory Cost of goods available for sale = beginning product inventory + cost of goods manufactured Cost of goods manufactured = direct materials + direct labour + allocated production overhead cost ending product inventory (finished and work in process) value to be determined according to an inventory valuation method, e.g. LIFO, weighted average cost 12

13 Income statement Balance sheet and income statement are interrelated 13

14 Clean vs. dirty surplus accounting Net assets (End of period) net assets (Beginning of period) contributions to equity (receipts from share issues) + dividends + amount used to redeem shares = Comprehensive income usually not equal to income according to income statement difference: change in value of assets and liabilities due to exchange rate changes and other, depending on country s accounting regulations 14

15 Revenues and Expenses Revenues gross increase in owner s equity resulting from operating the business with the objective of generating profits usually results in an increase in an asset Examples: sales; fees, commissions; interest; dividends; rents Expenses cost of assets consumed or services used resulting from business activities and are, in general, actual or expected cash outflows Examples: salaries, wages; interest on loans; insurance premiums; cost of providing fringe benefits to employees; decrease in inventory Revenues > Expenses Net profit Revenues < Expenses Net loss 15

16 Angie s business story continued transactions (in chronological order): 6. Invited speech at a regional conference, 1000, remitted to the bank account This is a revenue: Accounts affected: Bank; Revenues; Amount: First rent and utility payment due, charged to bank account, 500. This is an expense: Accounts affected: Cost of office space; Bank 8. Prepayment received for a series of invited speeches, This is not yet a revenue, this is unearned revenue Accounts affected: Bank; Unearned revenue. 9. Personal expenses (haircut, groceries, etc.), 400, paid using the EC card. This is a withdrawal Accounts affected: Owner s equity; Bank. 16

17 Cash Flow Statement Cash flow statements records cash inflows and cash outflows Cash inflows e.g., from sales Cash outflows e.g., expenses paid Easier to manipulate profit than cash flow Opening Cash Inflows Outflows Closing Cash + - = All large companies required to prepare a Statement of Cash Flows using either: (a) Direct method (b) Indirect method 17

18 Relationship Between Cash and Profit Cash and profit fundamentally different: Cash Flow = Cash Paid Cash Received Profit = Income Earned Expenses Incurred A business may make a profit, but run out of cash. This is overtrading Depreciation is an important non-cash item 18

Chapter 2. The balance sheet: a snapshot of assets and liabilities of the enterprise

Chapter 2. The balance sheet: a snapshot of assets and liabilities of the enterprise Chapter 2 The balance sheet: a snapshot of assets and liabilities of the enterprise 1 Fundamental Structure Resources Assets Claims to be satisfied Liabilities Asset: Resource owned or controlled by the