Revision Notes: Financial Statements

1.  Understand WHO reads the financial statement

        Equity Investor group, loan creditor group, employee group, analyst-adviser group, business contact group, government and public group

2. Understand the users’ PURPOSE of reading the financial statement

        Assess the stewardship of management on the use of the economic resources controlled by the enterprise.

        Assess the stewardship of management as a basis for assessing past and anticipated performance.

        Assess the enterprise’s capacity to generate cash flows from its existing resource base and in forming judgments on the effectiveness the enterprise employed its resources and might employ additional resources.

        Assess how future cash flows will be distributed, its ability to raise further finance and its requirement for future finance.

        Assess the business liquidity and solvency to meet its financial commitments as they fall due.

        Assess its risk profile and risk management approach.

        Evaluate its current performance, financial adaptability and its ability to generate cash in future.

        Provides investors information on the enterprise’s capacity to adapt to changes in the environment in which it operates – to raise new capital, repay capital or debt at short notice, mitigate the risks associated with operations.

3. Remember FOUR (4) types of financial statements:

        Income Statement – show whether a business is earning profit/loss during a particular period(accounting period) and how much profit/(loss) achieved.

Balance Sheet– show the assets, liabilities and equities of a

business at a particular date.

        Statement Of Changes in Equity– explain the changes in owners’ equity in during the period that is, from the end of the previous year to date. Show what causes the change-“increase/(decrease) in current profit/(loss), increase in paid up capital, increase in revaluation properties / foreign exchange rates,etc.

        Cash Flow Statement-show how the cash being used during certain period of time between the previous balance sheet and the current balance sheet. Show the cash inflow and outflow, sources of cash inflow and purposes for which cash was spent.

4. The four financial statements are presented in the ANNUAL REPORT.

        The purpose of the Annual Report is to provide information to make investment and credit decisions, analyse the prospect of future cash flows, economic resources and claims against the resources and showing the changes in owners’ equity.

5. Main QUALITATIVE Characteristics of Financial Statements:

        Understandable, useful, relevant, reliable, timely, verifiable by other parties, neutral, gives a true picture (representational faithfulness),comparable and consistent

6.  Remember the ACCOUNTING EQUATION :

 Assets = Liabilities + Owners’ Equity

6a ASSETS= Current Assets + Long-Term Investment + Property, Plant & Equipment + Intangible Assets

CURRENT ASSETS are assets:

• that are expected to be realised in, or is held for sale or consumption in, the normal course of the enterprise’s operating cycle ; or

• is held primarily for trading purposes or for the short term and expected to be realised with twelve months of the balance sheet date ; or

• Is cash or a cash equivalent asset which is not restricted in its use

Examples of Current Assets :Cash, short term investments, accounts receivable, notes receivables, inventories, prepayments

LONG-TERM investments are:

• investments a company intends to hold for more than one year. Consist of stocks and bonds of other companies, real estate, and cash that has been set aside for a specific purpose or project.

The difference between Short Term and Long Term investments lie in the company’s motive for owning them.

Short term investments consist of stocks, bonds, etc. a company has bought and will sell shortly.The investments made under long term investments may never be sold

Examples of Long-term investments -investment in subsidiaries, associates,buildings under construction, etc

PROPERTY, PLANT & EQUIPMENT-land and building, factory machinery, office equipment, etc

INTANGIBLE ASSETS = no physical existence like trademark, patents, goodwill

6b. LIABILITIES = Current + Long Term Liabilities

Current liabilities are obligations/liabilities:

• that is expected to be settled in the normal course of the enterprise’s operating cycle; or

• Is due to be settled within twelve months of the balance sheet date

Examples of Current liabilities are Accounts Payable, Bank Overdraft, short term loans, other creditors, accruals, deferred revenue,etc.

Long Term Liabilities:

• Is opposite of current liabilities which are more than 12 months from the date of the balance sheet.

Examples of Long term liabilities are Long term debts /fixed term loan.

Remember that we need to classify the total debts into two(2) parts:

• Current portion of long-term debts( amount owing within 12 months of balance sheet date;

     Non-current portion namely More than 12 months of balance sheet date and

      Also, the current portion of the long term debts is to be classify as Current Liabilities whilst the non-current portion is in the Long Term Liabilities

6c  OWNERS EQUITY/SHAREHOLDERS FUND

= Owners Equity =Assets-Liabilities

  (Assets=what the entity owns & Liabilities=what the entity owes)

Therefore, owners equity = the residual after total assets minus the liabilities relating to the acquiring the assets

Owners equity is the paid-up capital plus free reserves and retained earnings or undistributed profits

Owners equity also called the NET WORTH of the business namely whatever belonging to the owners of the business.

Owners Equity =Paid Up Capital + Capital Reserves or Non-Distributable Reserves + General Reserves or Distributable Reserve

RESERVES:-

– Appropriations of profit namely when profits have been ascertained after deducting all expenses which includes provision and others. Are residual earnings after all expenses and taxation which belongs to the owners namely the shareholders.

Essentially two(2) types of Reserves:

• Capital Reserves
• Revenue Reserves

Capital Reserves:

• Are appropriation from profits ( refer above) which cannot be distributed by way of cash dividends;

• Arises mainly from (i) equity transactions between the enterprise and its shareholders; (ii) from adjustments arising in accounting for business combinations; (iii) from differences arising on translation of foreign currency operations; (iv) from surpluses arising from asset revaluation; (iv) any unrealized gain which has not been included in income.

Examples of capital reserves are share premium, capital redemption reserves, capital reserves arising on merger and acquisition, statutory reserves, asset revaluation reserve and exchange fluctuation reserves.

Revenue Reserves are:

• Are appropriation from profit ( refer above) which can be distributed by way of cash dividends although some may be set aside for other purposes.

Examples of Revenue Reserves – Retained profits and general reserves.

7.0 What are the LIMITATIONS of Financial Statements?

• Financial statements are essentially statements reflecting historical facts. It ignore inflationary trend and does not reflect the true current worth of the enterprise;
• Certain important qualitative elements are omitted from the financial statements;
• Some items in the assets side of the balance sheet which has no real value and are merely deferred charges to future incomes like preliminary / pre-incorporation expenses and other:

• There are still the following issues or challenges in preparing the financial statements which may amount to overstatement of the accounting profit of an entity:

       When to and how much to recognize revenue in the Income statement;

       When to expense or to capitalize the expenses.

       Method of depreciations and the rates to depreciate into the income statement are selected by management to suit their business needs;

       Adequacy of provisions and method of providing for doubtful debts;

       Basis of valuation of assets-when can costs change to reflect current values? Using replacement or current costs;

       Consolidation challenges-what to eliminates to reflects the overall group performance. Some items might be omitted to show a higher accounting profits.

8.0 INCOME STATEMENT = Revenues (net)- Cost of Goods Sold/Cost of Sales Operating Expenses = Profit Before Tax

NET REVENUE are the list prices of the goods and/services less any discounts offered to the customer to induce purchase.

Revenue is recognized in the period in which goods and services are sold, not necessarily the period in which cash is received which follow strictly to the matching and accrual accounting concept.

COST OF GOODS comprise the TOTAL COST OF THE PRODUCT BEING SOLD.

Originally, when the manufacturer made the product, all the cost related to the product are added to the value of the inventory. When the product is sold, these costs of inventory are then expensed through the Income Statement as cost of goods sold.

GROSS MARGIN is simply Net Revenues less Cost of Goods Sold

The higher the gross margin, it means that there is a higher MARK-UP on the costs of Goods Sold .

For Details, Please Refer to the individual articles in the Section on FINANCIAL STATEMENTS