Financial Statements and Reports

SESSION 1: FINANCIAL STATEMENTS AND REPORTS

Revision:

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Financial acc → specific rules / past / external users

Management acc→ no rules / futur / mainly internal users

Accounting concepts’ refers to the axioms or basic assumptions underlying the financial accounts. Those concepts are:

• Going concern → company will continue to trade for the foreseeable future + fixed assets and stock will be used in the normal course
• Accruals → revenues and costs recognised as earned or incurred and matched with one another, profit measurement based on accruals and matching, not when cash is received
• Consistency →  accounting treatment of similar items within each accounting period and from one period to the next + enables comparability
• Prudence → revenues and profits are only recognised when realised, expenses and losses are recognised whether amount is known with certainty +ensures that revenues profits and assets (losses and liabilities) not overstated (understated)
• Separate Valuation → value of each item on financial statements should be estimated independently + one item should not be offset against another

Four objectives to be met by acc practice:

• Relevance → important to users in predicting future or confirming present/past
• Reliability → transactions represented faithfully, info neutral, free from errors, complete

CAN’T HAVE BOTH → FI ACC = MORE RELIABILITY / MA ACC = MORE RELEVANCE

• Comparability → facilitates cross section comparison (disclosure, consistency)
• Understandability → ability to understand content of financial statements

The Balance Sheet = snapshot of what company finance look like at a certain time

Presents financial position of a company at a certain point in time + summarizes assets and liabilities of the company

ASSETS = what company owns / controlled by business activity / short term assets or long term

Following characteristics:

• Probable future benefit
• Benefit should be result of past event or transaction
• Business must have right to control the resource
• Asset should be measurable in monetary terms

Examples of short term assets (current assets) : inventories, trade receivables (debt), cash/bank deposit, investments, prepayments

Operating cycle

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Examples of non-current assets (long-term/fixed assets): tangibles fixed assets (property, plant and equipment, depreciation), intangibles assets (goodwill, patents, trademarks), investm

LIABILITIES = what company owes / obligation to owners and third parties / short-term or long

Examples of current liabilities: trade payables (creditors), accruals (service received but not paid yet), VAT and taxes payables, bank overdrafts

Examples of non-current liabilities: long-term loans, bonds and debentures, mortgages

EQUITY = owner’s interest in the business

• Shareholders’ equity (equity, capital, net worth) / amount invested in firm / par value of shares
• Share premium → excess paid over the par value of shares
• Retained profits → portion of profits reinvested in the business / residual amount after paying dividends

Assets, liabilities & equity: relationship

Accounting definition: liabilities represent obligations to owners and third parties + assets represent what company owns

Finance definition: liabilities represent source of financing + assets represent uses of financing

Balance sheet equation

Uses of funds = sources of funds (amount invested should be reflected in value of assets)

→ Sources = Liabilities + Shareholders’ equity

→ Uses = Total Assets

Assets = Liabilities + Shareholders’ equity → value of assets a company owns cannot exceed amount of money invested

Assets – Liabilities = Shareholders’ equity → value of a company can be found if we deduct

liabilities from total assets

Balance sheet and profit

Profit figure can be derived from balance sheet:

• Revenue from sales increase assets and increase equity
• Expenses decrease assets
• Successful businesses show increases in equity
• Change in equity is called profit or income

Profit can also be calculated using balance sheet as follows:

• Increase in equity (net asset year 2 - net asset year 1)
• Minus proceeds of share issue
• Plus any dividends paid
• Minus any amount resulting from revaluation of assets

Balance sheet: Uses

• Can be used to analyse company performance
• Asset/Capital management → analysis of relationship between assets and liabilities
• Liquidity → analysis of relationship between current assets and current liabilities
• Profitability/Efficiency → analysis of relationship between output and resources
• Cross section and time series comparison
• Ratio analysis

Balance sheet: Limitations

• Limited usefulness → it reflects the financial position of the company at certain point in time
• Balance sheet figures are at historical prices → no adjustments for inflation
• Off-balance sheet activities → derivative instruments
• Real value of business depends on its ability to generate income and not on the individuals asset and liability values

The Profit and Loss Account

Income statement: Overview

• Presents activities of a company for a given period → states revenue, expenses and profit
• Summarises financial performance for a defined period
• Presents amount of: revenues earned, expenses incurred, tax to be paid, distribution of profit
• Preparation and content underpinned by accounting standards and principles
• Reminder = profit is not the same as cash receipts
• It follows a general form

Income statement: Structure & Terminology

• Revenues → total amount of sales for the period / also known as turnover or sales
• Cost of sales → also known as COGS
• Gross profit → difference between sales figure and cost of goods that have been sold / excludes inventory
• Distribution costs → cost related to distribution of products
• Administration expenses → not directly tied to manufacturing or sales
• Depreciation
• Operating profit → difference between gross profit and sum of OPEX /  shows profit from operations / earnings before interest and tax / allows comparison of companies with /=/ capital
• Finance income → interest received
• Financing costs → interest paid
• Profit bef tax → Operating profit + finance income-finance expenses / comparison in /=/ tax env
• Tax
• Profit after tax → profit for the period / difference between EBT and tax payable
• Determines → earnings per share / amount of dividend / retained earnings / changes in equity

Detailed items: Revenues

• Sales: how much is earned for goods sold → sales revenue; Turnover
• Income for service rendered → rent revenues, fees, subscriptions
• Underlying principles: “Realisation concept” → invoice sent / incentive to bring sales forward
• Has the service been provided during the period → cash may be received earlier or later / sales include “credit sales”

Detailed items: Expenses

• Amounts used in providing sale or service during period
• Accruals concept → (wages, electricity…) not amount paid during period / incurred in earning
• Trading businesses have significant “Cost of Sales” or “COGS” expenses
• COGS = Opening inventory + Purchases - Closing inventory / overstating closing = good
• Depreciation → purchase of non-current assets not immediately treated as expense / cost allocation - not asset valuation / less obvious in standardised income statements
  Depreciation method: Straight line method → takes into account initial cost, useful life and salvage price / Diminishing balance method → takes into account initial cost, percentage of yearly depreciation + leads to higher depreciation in early years and lower in later years
• Impairment of goodwill → non-current asset / does not last indefinitely / difficult to assess its useful life / grey area in acc

Problem Areas and Items

• Capital and revenue expenditures → cap exp = purchase of asset / rev exp = maintenance + cost of usage
• Depreciation
• Valuation of inventories…
• Timing and recognition of revenue....

⇒ all impact on the level of reported profit

Income statement: Role and Limitations

Role → summarises financial performance / reveals areas for profit improvement / facilitates financial control, comparison (monitoring and budgetary control / time series and cross sections)

Limitations → performance differs across firms (/=/ acc policies) / profit not same as cash flows / Profit not enough (consider profit in relation to investment)