Introducing Financial Statements

1. Defining Financial Statements

A financial statement is a formal report of the financial activities of a business, person, or other entity. These statements are a key component of accounting; they represent the process of communicating information about a financial entity. They are presented in a structured manner with conventions accepted by accounting and regulatory personnel.

An entity’s financial statement typically includes four basic components:

• Income statement: This reports on a company’s expenses and profits to show whether the company made or lost money. It also displays the revenues of a specific period and the costs and expenses charged against these revenues. In contrast with the balance sheet, which represents a single moment in time, the income statement represents a period of time
• Statement of changes in stockholders’ equity: This explains the company’s equity throughout the reporting period. The statement breaks down changes in the owners’ interest in the organization and in the application of retained profit or surplus from one accounting period to the next. The line items typically include profits or losses, dividends paid, redemption of stock, and any other items credited to retained earnings.
• Balance sheet: This reports on a company’s assets, liabilities, and ownership equity. A balance sheet is often described as a “snapshot of a company’s financial condition” at a single point in time. It is usually presented with assets in one section and liabilities and net worth in the other.
• Cash flow statement: This shows how changes in income affect cash and cash equivalents, breaking the analysis down to operating, investing, and financing. Essentially, the cash flow statement is concerned with the flow of cash in and out of the business. As an analytical tool, it is useful in determining the short-term viability of a company.

hint

For complex entities, financial statements often include an extensive set of notes as an explanation of financial policies. The notes typically describe each item in detail.

EXAMPLE

The notes may explain financial figures or the accounting methods used to prepare the statement.

terms to know

Assets

Something or someone of any value; economic resources that represent the value of ownership that can be converted into cash.

Liability

An obligation, debt, or responsibility owed to someone.

Equity

The residual claim or interest to investors in assets after all liabilities are paid.

2. Uses of Financial Statements

Readers of financial statements seek to understand key facts about the performance and disposition of a business. They make decisions about the business based on their interpretations of the statements. Because financial statements are widely relied upon, they must be straightforward and easy to understand.

For large corporations, these statements are often complex and may include an extensive set of notes and explanations of financial policies and management discussion and analysis. The notes typically describe each item on the balance sheet, income statement, and cash flow statement in further detail. Notes to financial statements are considered an integral part of the financial statements.

Owners and managers frequently use financial statements to make important business decisions, for instance:

• Whether or not to continue or discontinue part of the business
• Whether to make or purchase certain materials
• Whether to acquire or rent/lease certain equipment in the production of goods

Other individuals and entities use financial statements, for instance:

• Prospective investors use financial statements to perform financial analysis, which is a key component in making investment decisions.
• A lending institution will examine the financial health of a person or organization and use the financial statement to decide whether or not to lend funds.
• Philanthropies may use the financial statements of a nonprofit as a component in determining where to donate funds.
• Government entities (tax authorities) need financial statements to ascertain the propriety and accuracy of taxes and other duties declared and paid by a company.
• Vendors who extend credit may use financial statements to assess the creditworthiness of a business.
• Employees also may use reports in making collective bargaining agreements.

think about it

All publicly traded companies must annually disclose their financial status to the Securities and Exchange Commission in what is called a 10K report. You can access these 10K reports via the SEC Search Filings.

Below is a balance sheet from Amazon, derived from its 2022 10K report. What does this balance sheet tell you about Amazon? What questions do you still have?

term to know

Financial Analysis

Also referred to as financial statement analysis; an assessment of the viability, stability, and profitability of an organization or project.

3. Limitations of Financial Statements

The limitations of financial statements include inaccuracies due to intentional manipulation of figures; cross-time or cross-company comparison difficulties if statements are prepared with different accounting methods; and an incomplete record of a firm’s economic prospects, some argue, due to a sole focus on financial measures.

3a. Intentional Manipulation of Figures

One limitation of financial statements is that they are open to human interpretation and error, in some cases even intentional manipulation of figures. Due to the events that transpired in the Enron scandal, there has been some mistrust regarding the validity of the content of financial statements. High-profile cases in which management manipulated figures in financial statements to indicate inflated economic performance highlighted the need to review the effectiveness of accounting standards, auditing regulations, and corporate governance principles.

As a result, there has been a renewed focus on the objectivity and independence of auditing firms. An audit of the financial statements of a public company is usually required for investment, financing, and tax purposes, and these are usually performed by independent accountants or auditing firms and included in the annual report. Additionally, in terms of corporate governance, managing officials like the CEO and CFO are personally liable for attesting that financial statements are not untrue or misleading, and making or certifying misleading financial statements exposes the people involved to substantial civil and criminal liability.

terms to know

Audit

The verification of the financial statements of a legal entity intended to enhance the degree of confidence of intended users in the financial statements by providing reasonable assurance that the financial statements are presented fairly.

Corporate Governance

The roles and relationships between a company’s management, its board, its shareholders and other stakeholders, and the goals for which the corporation is governed. Much of the contemporary interest in corporate governance is concerned with the mitigation of conflicts of interest and the nature and extent of the accountability of people in the business.

3b. Different Accounting Methods

Another set of limitations of financial statements arises from different ways of accounting for activities across time periods and across companies. This can make it difficult to compare a company’s finances across time or to compare finances across companies. Different countries have developed their own accounting principles, making international comparisons of companies difficult. However, the Generally Accepted Accounting Principles (GAAP), a set of guidelines and rules set by the Financial Accounting Standards Board (FASB), are one means by which the uniformity and comparability between financial statements is improved. GAAP principles are only used in the United States.

Recently, there has been a push toward worldwide standardization of accounting rules made by the International Accounting Standards Board (IASB). The IASB oversees the International Financial Reporting Standards (IFRS). IFRS are accounting standards that have been adopted by 144 countries around the world.

big idea

GAAP	IFRS
Stand for Generally Accepted Accounting Principles	Stand for International Financial Reporting Standards
Adopted by the United States only	Adopted by 144 countries around the world
Issued by the FASB	Issued by the IASB
Relatively less transparent, flexible, comprehensive, and consistent	More transparent, flexible, comprehensive, and consistent
Use the LIFO (last in, first out) method for inventory estimates	Do not allow the LIFO method for inventory
The required financial statements include a balance sheet, income statement, statement of comprehensive income, changes in equity, cash flow statement, and footnotes	The required financial statements include a balance sheet, income statement, changes in equity, cash flow statement, and footnotes
Rule based	Principal based
Inventory reversal is prohibited	Inventory reversal is permitted under certain conditions
Source: Khan, M. (2022, June 24). Difference between IFRS and GAAP. Invyce. invyce.com/difference-between-ifrs-and-gaap/

terms to know

GAAP

Generally Accepted Accounting Principles; refer to the standard framework of guidelines, conventions, and rules accountants are expected to follow in recording, summarizing, and preparing financial statements in any given jurisdiction.

FASB

Financial Accounting Standards Board; a private standard-setting body whose primary purpose is to establish and improve Generally Accepted Accounting Principles within the United States.

IASB

International Accounting Standards Board; the independent accounting standard-setting body of the IFRS.

IFRS

International Financial Reporting Standards; the major accounting standards system used outside of the United States.

3c. Focus on Financial Measures

Another limit to financial statements as a window into the creditworthiness or investment attractiveness of an entity is that they focus solely on financial measures of health. Even traditional investment analysis incorporates information outside of the financial statements to make organizational assessments. However, other methods, such as full cost accounting (FCA) or true cost accounting (TCA), argue that an organization’s health cannot just be determined by its economic characteristics. Therefore, one needs to collect and present information about environmental, social, and economic costs and benefits (collectively known as the “triple bottom line”) to make an accurate evaluation.

reflect

Accounting standards are varied across the globe. If you had an accounting magic wand (and who wouldn’t want that), what would you do to solve this problem?