Whether you are an accountant, investor, business owner, having some basic knowledge of accounting and financial statements is necessary. Accounting is the language of business. Even if you are not a CPA, understanding accounting is helpful as it enables you to understand the numbers behind businesses and evaluate the financial health of companies. The typical financial report will include the balance sheet, income statement, cash flow statement and accompanying notes to accounts.
The financial report is prepared for and relied on by different external and internal users – shareholders, creditors, bankers, suppliers, so they must be prepared in line with reporting standards to ensure consistency in reporting and enable comparison of numbers across different financial statements.
Financial reports are usually either based on US GAAP or International Financial Reporting Standards (IFRS). In general, US GAAP is more rules-based while IFRS is more principles-based. It is important to understand some of the more important principles behind many of the accounting standards that we use today:
- Matching principle: Matching principle is basically the allocation of expenses to the period in which revenue is recognized, to ensure profit fairly reflects performance for that period. For example, when we purchase inventory, we do not expense the cost of inventory until the inventory is sold (instead, we recognize the inventory as an asset when we purchase the inventory). Another example is when we purchase a capital asset, we recognize the expenses when we depreciate the asset over the length of its useful life. These are example of application of the matching principle.
- Going concern assumption: When we prepare financial statements, we prepare the numbers with the assumption that the entity will continue to operate, i.e. the entity is able to meet all its debts when they are due. If an entity is facing bankruptcy, the going concern assumption will not hold, and the accountant has to prepare the financial report with the assumption that all the assets will be liquidated.
- Conservatism principle: Conservatism refers to the principle of tending towards recognising losses and expenses, if estimates are required. For example, when we record the value of inventory, we record it at the lower of acquisition cost and net realizable value (market value). This is an example of the conservatism principle in accounting.
- Relevance principle: The relevance principle states that financial information should be useful, timely and help different users make decisions about the company. Therefore, all financial statements need to follow a certain standardized format, and the numbers presented in the financial report must be current and timely to ensure that they are useful for investors and creditors.
- Reliability principle: The reliability principle is the concept of recording transactions that can be verified so that the financial report can be relied on consistently by different people, i.e. the financial statements are trustworthy. Financial information is considered verifiable when multiple, independent measures will yield the same result.
These are the main components of a financial report:
- Income statement or statement of comprehensive income
- Balance sheet or statement of financial position
- Statement of changes in equity
- Statement of cash flows
Report #1: Income Statement
The income statement or profit and loss (P&L) shows the results of transactions (summary of revenue and expenses) from the company’s operations over the reporting period. In most income statements,
- Cost of goods sold is first deducted from total revenue to get gross profit.
- Operating expenses are then deducted from gross profit to get income from operations.
- Other income and expenses are then added/deducted from income from operations to get net income before taxes.
- Finally, taxes are deducted from net income before taxes to get net income after taxes.
Report #2: Balance Sheet
The balance sheet represents a company’s financial position at a point in time. It is represented by assets, liabilities and shareholder’s equity. The relationship between assets, liabilities and shareholder’s equity is governed by this equation – the most basic and important accounting equation:
Assets = Liabilities + Shareholder’s Equity
Report #3: Statement of Changes in Equity
The statement of changes in equity shows the change in owner’s equity over an accounting period. Changes in shareholder’s equity could include net profit or loss over the accounting period (transferred to retained earnings), increase or decrease in share capital, dividend payments to shareholders, gains and losses recognized directly in equity (revaluation surplus).
Report #4: Cash Flow Statement
The statement of cash flow shows all transactions that have an effect on the cash balances a company. While the income statement is prepared on an accrual basis, the cash flow statement reflects the movement in actual cash balances, which is considered by some to be arguably more objective measure of a company’s performance (this point is debatable).
The cash flow statement is divided into three parts: cash flow from operations, cash flow from investing activities and cash flow from financing activities.
For those who are new to accounting and financial statements, preparing the cash flow statement might seem challenging at the start. However, not many know that in fact, the cash flow statement is simply a re-arrangement of the numbers in the income statement and balance sheet, presented in a format to reflect the movement of cash. In other words, if you have already prepared the balance sheet and income statement, you would already have all the information you need to prepare the cash flow statement, i.e. the numbers from the cash flow statement are derived from the balance sheet and income statement.
To determine the cash flow from operations, there are two methods – direct method and indirect method.
The direct method of calculating cash flows is intuitive, but rarely used in practice. It involves summing up the cash flows from customer receipts, supplier payments, interest received, borrowing costs, etc. to arrive at the cash flow from operations.
The indirect method is the preferred method for most companies, as it shows clearly how net income is translated to cash flow from operations in the company. It ties back the cash flow to profit by separating the non-cash transactions like depreciation from cash transactions and highlighting the effect of adopting accrual accounting over cash accounting on the P&L. For the indirect method, you should start off by:
- Add back depreciation and other non-cash charges
- Deduct any capitalised cash outlays or cash flows from gain on sale of long-term assets
- Adjust for any change in working capital
Cash flow from investing activities includes the purchasing and selling of fixed assets or any long-term investments. Cash flow from financing activities includes cash flow due to borrowings, raising capital stock and dividend payments.
When we combine the three sections – cash flow from operating activities, cash flow from investing activities and cash flow from financing activities, we can now have a better understanding of the company from a cash flow perspective.
Report #5: Notes to Financial Statements
The financial report will usually be accompanied by notes to financial statements. These are additional information and disclosures to explain the numbers in the income statement and balance sheet. The reason for having the notes is that if we were to put every single detail in the financial statements, they would be too uncluttered and unfriendly for the reader. The notes therefore serve as additional supporting for the financial statements and allows the reader to understand more detailed breakdown of the numbers in the financial statements, if he wants to.
And lastly… if the report needs to be audited,
If the financial report is audited, the auditor will issue an auditor’s report, which will state his opinion on whether the company’s financial statements have been prepared in accordance with the financial standards.
A clean or unqualified opinion is the best type of report, and means that the company has properly prepared its financial statements in accordance to GAAP.
A qualified opinion will be issued when the auditor is unable to agree that the financial statements of the company have complied fully with GAAP. This could be due to a misstatement in an account balance or the auditor’s inability to obtain audit evidence for a particular account balance. The auditor will typically add an explanatory paragraph to explain reasons for his qualification.
An adverse opinion is the worst type of opinion issued by the auditor. It means that the company has not complied with GAAP and there are major discrepancies in the financial statements.
A disclaimer of opinion is quite rare, and it means that the auditor is not able to give an opinion due to certain reasons, e.g. auditor is not independent, limitation of scope of audit.
Hope the above summary has given you a good overview of the different components of financial statements. Financial statements are normally prepared annually. For listed companies, interim financial statements will also need to be prepared, but in a condensed version, i.e. fewer disclosures are required as compared to the annual financial reports.