Fundamental Concepts Related To Financial Statements

Part 1: Financial Reporting #

1. Objectives of Financial Statements

• Financial statements serve to provide information about:
  • Financial position: Assets, liabilities, and equity as of a specific date (Balance Sheet).
  • Performance: Results of operations and net income for a period (Income Statement).
• They also disclose information about changes in financial position and cash flows (Statement of Cash Flows).
• Objective: To aid users (investors, creditors, management, etc.) in making economic decisions.

2. Enhancing Qualitative Characteristics of Financial Information

• Relevance: Information influences decisions by users.
• Faithful Representation: Information is complete, neutral, and free from error.
• Comparability: Information can be compared with similar information from other entities.
• Understandability: Information is understandable to users with reasonable knowledge of business and economic activities.

3. Constraints on Financial Statements

• Cost vs. Benefit: The cost of providing information should not outweigh its benefits to users.
• Materiality: Information should be material enough to influence the decisions of users.

4. Assumptions of Financial Statements

• Going Concern: Assumes the entity will continue operations in the foreseeable future.
• Accrual Basis: Transactions are recorded when they occur, not when cash is exchanged.

5. Measurement of Financial Statement Elements

• Historical Cost: Assets are recorded at the amount paid or fair value of consideration given at acquisition.
• Realizable Value: Assets are recorded at the amount that would be received in an orderly disposal.

6. Qualitative Characteristics and Elements of Financial Statements

• Performance Measurement: Primarily evaluated through the income statement, which shows revenues and expenses over a period.
• Financial Position: Assessed through the balance sheet, detailing assets, liabilities, and equity at a specific date.
• Shareholder’s Residual Claim: Reflects owners’ equity, the residual interest in assets after deducting liabilities, presented on the balance sheet.

7. Role of Financial Reporting

• Purpose: Provide information about the financial position, performance, and changes in financial position of an entity.
• Users: Aid users in making economic decisions based on the financial information presented.

8. Evaluation Tools in Financial Statements

• Income Statement: Used to assess profitability and financial results from business activities over a period.
• Balance Sheet: Evaluates the financial position by showing assets, liabilities, and equity at a specific date.
• Cash Flow Statement: Analyzes the sources and uses of cash flows during a period.

Part 2: Income Statement #

1. Expenses on the Income Statement: #

Classification:

• Expenses on the income statement can be grouped by either nature or function.
• Nature: Classifies expenses based on what they are (e.g., salaries, rent, depreciation).
• Function: Classifies expenses based on their purpose or role in the operation (e.g., cost of goods sold, selling expenses, administrative expenses).

2. Expense Classification by Function: #

Examples:

• Cost of Goods Sold (COGS): Represents the direct costs incurred in producing goods sold by the company.
• Other Examples: Manufacturing costs, production overheads, and costs associated with sales and marketing.

3. Calculation of Gross Profit: #

Formula:

• Gross Profit = Revenue – Cost of Goods Sold (COGS)
• Example Calculation:
  • Revenue: $4,000,000
  • COGS: $3,000,000
  • Gross Profit = $4,000,000 – $3,000,000 = $1,000,000

4. Common Size Income Statement: #

Definition:

• A common size income statement presents each line item as a percentage of revenue.
• Facilitates comparison across time periods (time-series analysis) and across companies (cross-sectional analysis).

5. Comprehensive Income Calculation: #

Components:

• Net Income: The profit earned during the period from primary business activities.
• Other Comprehensive Income (OCI): Includes items that affect shareholders’ equity but are not part of net income.
• Example Calculation:
  • Net Income: $15 million
  • OCI Components: Unrealized gain on available-for-sale securities ($5 million), Unrealized loss on derivatives accounted for as hedges (-$3 million), Foreign currency translation gain on consolidation ($2 million)
  • Comprehensive Income = Net Income + OCI
  • Comprehensive Income = $15 million + $4 million = $19 million

6. Other Comprehensive Income (OCI): #

Examples:

• Foreign Currency Translation Adjustment: Reflects gains or losses from translating financial statements of foreign subsidiaries.
• Unrealized Gain on Available-for-Sale Securities: Unrealized gains or losses on investments classified as available-for-sale.

7. Items Classified as Other Comprehensive Income: #

Criteria:

• Items that affect shareholders’ equity but are not included in net income.
• Examples: Foreign currency translation adjustments, unrealized gains or losses on available-for-sale securities.

Part 3: Balance Sheet #

Equity is referred to as “Book Value”. – NOT market or intrinsic value.

B/S has mixed model with respect to measurement. Some assets and liabilities are measured based on historical cost, sometimes with adjustments, whereas other assets and liabilities are measured based on a fair value, which represents its current value as of the balance sheet date.

• Assets or liabilities on the balance sheet are valued at their fair market value as of the reporting date.
• However, these values can fluctuate post-reporting period due to changing economic conditions or market dynamics.
• Thus, while the balance sheet provides a snapshot of a company’s financial position at a specific moment, the actual value of these items may change after the reporting date.

Some Company Valuation Factors not included in B/S:

• Future cash flows projected by the company.
• Current market conditions impacting demand and pricing.
• However, crucial aspects affecting future cash flow generation, like reputation and management expertise, are not quantified in the balance sheet.

Current Liability: Payments due within one operating cycle of the business, even if they will be settled more than one year after the balance sheet date, are classified as current liabilities.

Revenue Received in Advance:

• When a company receives money from customers for products to be delivered in the future – Recorded as both an asset and a liability. Ex. Cash as asset and Unearned revenue as the liability. As the product is delivered, revenue will be recognized and the liability will be reduced.

Resources Controlled by a Company:

• Assets are resources controlled by a company.

Equity Calculation:

• Equity equals Assets minus Liabilities.

Difference Between Reported and Market Value of Shareholders’ Equity:

• Market value differs due to factors not reflected in the balance sheet, such as reputation and management skills.
• The balance sheet measures some assets and liabilities based on historical cost and measures others based on current value. Whereas, Market value of shareholders’ equity is updated continuously.
• Shareholders’ equity reported on the balance sheet is updated for reporting purposes and represents the value that was current at the end of the reporting period. not the current one.

Classified Balance Sheet:

• Distinguishes between current and non-current items.

Liquidity-Based Balance Sheet Presentation:

• Used by banks to list assets and liabilities by liquidity.

Contra Asset Account:

• Offsets the balance of a related asset account, such as allowance for doubtful accounts.

Current Liability Definition:

• Obligations due within one year or the operating cycle. Ex. payment due at least one year after the balance sheet date but still within a normal operating cycle.

Accrued Expenses (Accrued Liabilities):

• Expenses recognized on the income statement but not yet paid.

Debt Due Within One Year:

• Classified as a current liability.

Non-Controlling Interest in Consolidated Subsidiaries:

• Shown separately as part of shareholders’ equity.

Retained Earnings:

• Component of shareholders’ equity.

Treasury Stock Transactions:

• Reduces both assets and shareholders’ equity.

Share Repurchases Impact:

• When a company repurchases its own shares from the market, it uses cash to buy back these shares.
• This reduces the company’s cash balance, which is categorized as an asset on the balance sheet.
• Additionally, the number of shares outstanding decreases because the company holds these repurchased shares as treasury stock.
• Treasury stock represents shares that the company buys back and holds in its treasury, effectively reducing the total number of shares available to the public.
• Effect on Shareholders’ Equity:
  • Shareholders’ equity decreases because there are fewer outstanding shares.
  • Treasury stock is subtracted from the total equity (owners’ equity) on the balance sheet, acting as a contra-equity account.
  • The reduction in shareholders’ equity reflects the decrease in the company’s ownership interest held by shareholders due to the share repurchase.

Part 4: Cash Flow Statement #

Converts the accrual-based income statement to a cash-based statement and provides a reconciliation between beginning an ending cash balances.

Components:

1. Operating Activities
   • Inflows
     • Cash Sales – Revenue generated from sales where payment is received immediately in cash. To generate revenue, companies undertake such activities as manufacturing inventory, purchasing inventory from suppliers, and paying employees. If we are in the business of trading securities – Sales of dealing securities or trading securities can be considered cash inflow, and if we are in a different business, that would be considered an investing activity.
     • Decreases in Assets – a collection of accounts receivable
     • Increases in liabilities – Increases in the bank line of credit means we have more.
2. Investing activities
   • purchasing and selling
     • Long term assets – PPE, Factory/Infrastructure (LT), Intangible assets, other LTA. Investment in both short-term (cash equivalents) And long-term assets is equity and debt (bonds and loans) issued by other companies.
     • non-trading securities
     • Almost any non current assets.
     • When doing calculations for NET CASH FLOW – you might see an item as “Loss on sale“. That would be a loss from selling the item at an amount less than the book value, and that is a NON-CASH item. Our only concern should be the Purchase of the Item & Proceeds from the sale. The difference between the two would be our NET CASH FLOW.
3. Financing Activities
   • obtaining or repaying capital,
   • Sources
     • Shareholders – Equity
     • Creditors – Long term debt
   • Cash Inflows: Include proceeds from issuing stock (common or preferred) or bonds, and cash received from borrowing.
   • Cash Outflows: Include payments for repurchasing stock (e.g., treasury stock), and for repaying bonds and other borrowings.

Noncash financing activities

• No cash, no cash flow reporting.
• Examples:
  • Barter,
  • Stock Dividends ( a way to distribute earnings or capitalize retained earnings while conserving cash, basically giving additional shares instead of cash ),
  • conversion of convertible securities.