Introduction to financial statements
In Titman et al. (2019, p. 43)[1], they state that four financial statements are included in a company’s annual report. These are:-
- Income Statement (Formerly known as a Profit and Loss)
- Balance Sheet
- Cash Flow Statement
- Statement of Changes in Equity
Titman et al. (2019, p.43)[1] go on to further explain that the Statement of Changes in Equity details changes in ordinary and preference shares, retained earnings and any changes to owners’ equity. The statement discloses items such as dividend payments and equity withdrawals that are not detailed in the Balance Sheet or Income Statement.
Why study financial statements?
Understanding financial statements is essential for managers. They provide valuable information on which to base management and investment decisions and also on the performance of the organisation. Financial statements also allow other potential stakeholders such as lenders and investors valuable information about the viability and sustainability of the organisation [2].
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Income statement
Irrespective of whether or not an organisation is focused on creating profit or delivering services as a not-for-profit, the Income Statement provides valuable detail about the income and expenses of the organisation for a specific time period. Income Statements include information from a particular date up to a particular date. They can be monthly, quarterly or annual. Income Statement is a better term than Profit and Loss, mainly when applied to a not-for-profit that would traditionally generate surpluses or deficits.
Profit = Revenue(Sales) – Expenses
Accounting principles and concepts used to prepare income statements
There are specific principles and concepts applied to the preparation of financial statements
1. Accrual Accounting
Financial Statements are normally prepared using the concept of accrual accounting and not cash accounting. Accrual accounting refers to the concept of recognising a transaction, be it income or expense, when that transaction occurs and not when payments are received or made. This results in the profit or loss being different to the cash balance.
2. Revenue Recognition
The concept of revenue recognition refers to the principle that income is recognised when it is earned and not when payment is received.
3. The Matching Principle
The concept of matching means that if income is recognised when it is earned and not when cash is received, then all expenses involved in earning that income are also recognised in the same period. In other words, expenses are recognised when they are incurred and not when payments are made.
Cash and non-cash expenses
The Income Statement records both cash and non cash expenses. A non cash expense is one such as depreciation where the cost of an asset is allocated on a periodic basis over the term of its expected life.
Statement of Cash Flows
A very important document as is details in summary form the flow of cash for the period of the report and the cash available at the end of the period. The report essentially provides detail on where the organisation got its cash and where it went. The Statement of Cash Flows looks at three areas.
- Operating Activities
- Investment Activities
- Finance Activities
Operating Activities
These would be the organisation’s normal operations and include cash received from customers, payments for goods and services and taxes to the government.
Investment Activities
These would include items around non-current assets such as property plant and equipment. The report would show what was expended on fixed assets, any income from the sale of fixed assets and the purchase and disposal of other investments.
Finance Activities
This area shows movement in debt and equity. The organisation could of borrowed more funds or paid off debt. The payment of dividends is also recognised in this area.
Earnings Management
Earnings management refers to how the application of accounting policies are used to show a particular or more favourable position to stakeholders. This may be in the interest of a CEO for bonus purposes or not writing off bad debts or worthless assets to hold profit levels at a high level.
The above video tells the story of One.Tel who went into liquidation because of poor financial management.
Assessment 1
Assessment 1 looks at ratio analysis and the comparison of two public companies. I find this to be a huge jump in skill sets for people without a background in finance to have a single module on financial statements and then be expected to conduct a critical review of public companies using ratio analysis. It will be very interesting to see how this evolves in the student chat area.
Summary
This module has covered the basic financial statements produced by an organisation. There has been some insight into the purpose for each one. However, the big takeaway is Earnings Management where organisations and managers can manipulate the results through the application of accounting policies.
References- Titman, S, Martin, T, Keown, AJ & Martin, J 2019, Financial management: Principles and applications, 8th edn, Pearson, Melbourne.[↩][↩]
- Module 2 Financial statements: Introduction to financial statements 2022, Aib.edu.au, viewed 4 September 2022, <https://learning.aib.edu.au/mod/book/view.php?id=113080&chapterid=41249>.[↩]
