Financial Statements
I. A variety of users depend on financial statements to determine the financial position and health of organizations.

A. Managers use financial statements to determine whether the organization is utilizing resources in the most cost-effective manner and to make key investment and financing decisions.
B. Shareholders and prospective investors use financial statements to determine whether they can receive an appropriate return on investment.
C. Financial institutions assess the ability of borrowers to repay loans and other debt through financial statement analysis.
D. Suppliers use financial statements to assess the ability of their customers to pay bills on time.
E. Customers use financial statements to assess whether their suppliers will remain in business to provide an ongoing supply of goods and services.
F. Employees analyze financial statements for their own job security and to determine the impact of profit-based compensation.
G. Competitors compare their performance to others in their industry or area using financial statements.
II. There are four financial statements businesses use to communicate financial information to stakeholders.

A. The balance sheet shows the organization’s classification of assets, liabilities, and owner’s equity as of a particular date.

1. A balance sheet is a “snapshot in time” of an organization’s financial position.
2. The balance sheet is not indicative of movement over a particular time period.
3. The balance sheet contains three specific types of accounts.

a. Assets are resources the organization owns to produce future economic benefit.
b. Liabilities are the obligations an organization has to transfer economic benefit (primarily money and other resources) to third parties.
c. Equity consists of the funds owners contribute to the organization plus any profits retained instead of being distributed to owners.
d. The classic accounting definition is assets = liabilities + equity.

i. This means that the organization’s resources under ownership equal the amount of obligations to pay third parties plus the amount of funds related to ownership in the business.
ii. More simply stated, the accounting equation is “Uses of cash (Assets) = Sources of cash (Liabilities + Equity)”
e. Contra accounts are accounts which reduce or offset a related account. Two examples illustrate contra accounts below.

i. Fixed assets generally have a related contra-asset account called “Accumulated depreciation” to reduce the amount of fixed assets on the balance sheet.
ii. Paid-in-capital (an equity account) may have a contra-equity account called “Treasury stock” to record the cost of stock repurchased by the organization.
B. The income statement shows the organization’s sources of revenue, causes of expenses, and net income of operations for a given period of time.

1. The income statement can be shown in one of two methods.

a. The single-step method shows the organization’s total revenues and gains compared to total expenses and losses. An example of a single-step income statement is shown below.

 
b. A multi-step income statement shows how an organization’s revenue, gains, expenses, and losses are split into operating and nonoperating activities. This type of income statement provides a more detailed look at how an organization’s primary business operations are performing compared to nonprimary activities.
 
C. The statement of cash flows shows the changes to the organization’s cash position over the course of a period of time.

1. The income statement records revenues and expenses on an accrual basis, so the cash flow statement presents a clearer picture of the organization’s sources and uses of cash.
2. The cash flow statement also reconciles the organization’s cash position from the beginning to the end of the year.
3. The statement of cash flows is separated into three sections.

a. Operating activities — Cash generated and spent as a part of an organization’s regular and ongoing operations.

i. Example — McDonald’s cash flow from operating activities will show how the company uses and receives cash from preparing and selling food and beverages.

(1). There are two methods to prepare the operating method of the statement of cash flows.

(a). Direct method — The specific sources and uses of cash are listed to show how an organization spends and generates cash flows.
(b). Indirect method — This statement begins with net income and reconciles
D. The statement of changes in equity shows how the organization’s equity position has changed over the course of the year, including the following items.1

1. The amount of new share capital issued
2. Any contributions of individual owners into the business
3. Any withdrawals of capital by individual owners
4. The amount of dividend paid during the year to shareholders
5. The amount by which PPE is valued up or valued down
6. The amount of net income earned during the year
7. The amount of net income retained during the year
8. Any movement in the unrealized loss or gain reserve and reserve for changes in foreign exchange gain or loss, etc.
9. The following example of a statement of shareholders’ (owners’) equity comes from Deere & Company’s 2013 annual report.
III. Each financial statement has advantages and limitations to the information it provides, which is why the four statements work together to show the organization’s financial position.

A. Balance sheet advantages

1. Shows the organization’s assets, obligations to pay, and owner’s equity at a particular point in time.
2. Shows the timing of sources and uses of resources (short-term compared to long-term).
B. Balance sheet disadvantages

1. Only shows a snapshot of the organization’s position. Does not show activity over a period of time.
2. Accounting principles such as first in-first out vs. last in-first out can differ among organizations, making comparison difficult.
3. Different organizations can use different estimates for the same type of activity, making comparison among different companies difficult.
C. Income statement advantages

1. Shows the results of an organization’s ongoing operations.
2. Provides a picture of whether the organization is generating the resources to continue operating as a going-concern entity.
D. Income statement disadvantages

1. Many income statement items rely on management judgments and estimates. This can hinder the ability to compare income statements of different organizations.

a. Example — One organization may use a straight-line depreciation method, while another organization may record depreciation using an accelerated method.
b. Example — One organization may use First In, First Out (FIFO) to value inventory and record cost of sales, while another organization uses Last In, First Out (LIFO). If prices are rising (i.e. inflation), the second organization will record higher cost of sales on the same inventory.
2. The accrual method of accounting means an income statement is not necessarily a good representation of an organization’s cash flows.
E. Cash flow statement advantages

1. Provides an analysis of how organizations receive and use cash. This is important because suppliers, employees, and lending sources are paid in cash, not profits.
2. Separates cash activity into operating, investing, and financing activities, allowing investors to identify how an organization is obtaining and using cash.
F. Cash flow statement disadvantages

1. Cash flow statements only show historical information. Investors and other users must infer future cash flows based on historical information.
2. Cash flow statements do not consider the accrual method of accounting.
3. Noncash expenses are ignored when preparing the operating section of a cash flow statement.
IV. All four financial statements relate to one another to present an integrated picture of the organization’s financial health.

A. Double-entry bookkeeping requires that debits and credits match for any journal entry reflecting an event.

1. Debits and credits equaling means a particular transaction may impact different financial statements in a number of ways.
2. The following table illustrates how several common transactions will impact the balance sheet, income statement, and statement of cash flows.
B. The relationship between the various financial statements is reflected in the figure below.

1. Income becomes a part of retained earnings.
2. Additional capital raised appears in the statement of cash flows as a financing activity and in the balance sheet as an increase in owner’s equity.
3. Dividends received are reflected in the statement of cash flows as a financing activity and reduce retained earnings and cash.
4. Fixed asset purchases appear as increases in the balance sheet’s fixed assets and in the statement of cash flows as investing activities.
5. The following table shows the relationship between the various financial statements
V. In addition to the four key financial statements, financial statements also include additional disclosures to help investors understand statements.

A. Disclosures are key explanations helping investors understand key assumptions and methods of accounting to help compare prior periods and assist with comparisons with other companies.
B. Key disclosures include the following items.

1. Significant accounting policies, including the following:

a. Method of depreciation
b. Inventory valuation method
c. Revenue recognition policies
d. Securities classified as cash equivalents
2. Related party transactions
3. Whether the business is in the development stage of operations and may not have adequate current profitability
4. Amounts and nature of maturing debt for the financial statement period
5. Sinking fund provisions
C. Supplemental schedules allow an organization to provide additional numerical detail to support the figures in financial statements.

1. Supplemental schedules allow organizations to provide more detailed information to help users understand or interpret financial statements in more detailed.
2. Organizations can use supplemental schedules for instances such as the following:

a. Additional detail of fixed assets, such as types of fixed assets or length of service.
b. Business unit or segment revenues and expenses.
c. Additional detail of debt maturity levels or debt subordination levels.
D. Management’s Discussion and Analysis (MD&A), which provides management commentary on the financial condition of the organization, including forward-looking information.

1. MD&A provides additional depth to the numbers provided in the financial statements.
2. MD&A also gives management the opportunity to communicate about events impacting the business, including but not limited to the following.2

a. Strategy and growth opportunities
b. Risk management and opportunities
c. Business results and outlook
d. Investment and financing decisions
VI. Most organizations prepare the statement of cash flow’s operating section using the indirect method.

A. When an organization uses the indirect method to prepare the operating section of a statement of cash flows, it does NOT directly identify sources and uses of cash like in the direct method. The indirect method computes cash flow by reconciling net income to the changes in noncash gains, losses, and expenses and by adjusting for the changes in current asset and current liability accounts.
B. Cash flow from operating activities (indirect method) — The following Excel file shows an example of a cash flow from operating activities using the indirect method. This example is also part of a Deep Dive as part of this lesson.
Cash flow Statement – Company XYZ, Year 2
Cash flow from Operating Activities
Net income 73,500
Depreciation 20,000
(Gain)/Loss (20,000)
Marketable securities (2,500)
Accounts Receivable 2,000
Inventory (3,000)
Other Current Assets (1,000)
Accounts Payable 3,000
Accrued Expenses 500
Other Current Liabilities 500
Cash flow from Operating Activities 73,000
C. Cash flow from investing activities
D. Cash flow from financing activities
E. The indirect method of preparing a cash flow statement reconciles net income to cash flow from operations by the following method.

1. Net income, PLUS
2. Depreciation expense, PLUS/MINUS
3. Non-operating losses (PLUS) or Non-operating gains (MINUS)
4. MINUS increases in current assets or PLUS decreases in current assets.
5. PLUS increases in current liabilities or MINUS decreases in current liabilities.
6. The following table shows the relationship between cash flows and changes in current assets and current liabilities.
Increase Decrease
Current Assets Cash decreases Cash increases
Current Liabilities Cash increases Cash decreases