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Fundamentals of Accounting, Business, and Management 2

Financial Statements

Purpose of financial statements

Financial statements are a structured representation of the financial position and financial performance of an entity. The
objective of financial statements is to provide information about the financial position, financial performance and cash
flows of an entity that is useful to a wide range of users in making economic decisions. Financial statements also show the
results of the managements stewardship of the resources entrusted to it. To meet this objective, financial statements
provide information about an entitys: (a) assets; (b) liabilities; (c) equity; (d) income and expenses, including gains and
losses; (e) contributions by and distributions to owners in their capacity as owners; and (f) cash flows.

Complete set of financial statements

A complete set of financial statements comprises:

(a) a statement of financial position as at the end of the period;

(b) a statement of comprehensive income for the period;

(c) a statement of changes in equity for the period;

(d) a statement of cash flows for the period; and

(e) notes, comprising a summary of significant accounting policies and other explanatory information.

General features

1. Going concern
2. Accrual basis of accounting
3. Materiality
4. Comparative information
5. Consistency of presentation

STATEMENT OF FINANCIAL POSITION

A. Information to be presented in the statement of financial position


As a minimum, the statement of financial position shall include line items that present the following amounts:
(a) property, plant, and equipment;
(b) investment property;
(c) intangible assets;
(d) financial assets (excluding amounts shown under (e), (h) and (i));
(e) investments accounted for using the equity method;
(f) biological assets;
(g) inventories;
(h) trade and other receivables;
(i) cash and cash equivalents;
(j) the total of assets classified as held for sale and assets included in disposal groups classified as held for sale in
accordance with IFRS 5 Non-current Assets Held for Sale and Discontinued Operations;
(k) trade and other payables;
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Financial Statements
(l) provisions;
(m) financial liabilities (excluding amounts shown under (k) and (l));
(n) liabilities and assets for current tax, as defined in IAS 12 Income Taxes;
(o) deferred tax liabilities and deferred tax assets, as defined in IAS 12;
(p) liabilities included in disposal groups classified as held for sale in accordance with IFRS 5;
(q) non-controlling interest, presented within equity; and
(r) issued capital and reserves attributable to owners of the parent.

B. Current/non-current distinction
1. Current assets
An entity shall classify an asset as current when: (a) it expects to realize the asset, or intends to sell or
consume it, in its normal operating cycle; (b) it holds the asset primarily for the purpose of trading; (c)
it expects to realize the asset within twelve months after the reporting period; or (d) the asset is cash
or a cash equivalent unless the asset is restricted from being exchanged or used to settle a liability for
at least twelve months after the reporting period. An entity shall classify all other assets as non-
current.
The operating cycle of an entity is the time between the acquisition of assets for processing and their
realization in cash or cash equivalents. When the entitys normal operating cycle is not clearly
identifiable, it is assumed to be 12 months. Current assets include assets (such as inventories and
trade receivables) that are sold, consumed, or realized as part of the normal operating cycle even
when they are not expected to be realized within 12 months after the reporting period. Current assets
also include assets held primarily for the purpose of trading and the current portion of non-current
financial assets.
2. Current liabilities
An entity shall classify a liability as current when: (a) it expects to settle the liability in its normal
operating cycle; (b) it holds the liability primarily for the purpose of trading; (c) the liability is due to
be settled within twelve months after the reporting period; or (d) it does not have an unconditional
right to defer settlement of the liability for at least twelve months after the reporting period. Terms
of a liability that could, at the option of the counterparty, result in its settlement by the issue of equity
instruments do not affect its classification. An entity shall classify all other liabilities as non-current.
Some current liabilities, such as trade payables and some accruals for employee and other operating
costs, are part of the working capital used in the entitys normal operating cycle. An entity classifies
such operating items as current liabilities even if they are due to be settled more than twelve months
after the reporting period. The same normal operating cycle applies to the classification of an entitys
assets and liabilities. When the entitys normal operating cycle is not clearly identifiable, it is assumed
to be twelve months.
Other current liabilities are not settled as part of the normal operating cycle, but are due for
settlement within 12 months after the reporting period or held primarily for the purpose of trading.
Examples are some financial liabilities classified as held for trading, bank overdrafts, and the current
portion of non-current financial liabilities, dividends payable, income taxes and other non-trade
payables. Financial liabilities that provide financing on a long-term basis (ie are not part of the working
capital used in the entitys normal operating cycle) and are not due for settlement within 12 months
after the reporting period are non-current liabilities.
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Financial Statements
C. Elements (Accounting Equation)
Every balance sheet demonstrates the fundamental accounting equation, which is "A = L + E." The total amount
of the company's assets (A) is equal to the total amount of its liabilities (L) plus the owners' equity (E) in the
company. This equation must always balance, with the same amount on each side of the "equals" sign. That's why
they're called balance sheets.

D. Classification
1. Account Form
The account form of the balance sheet provides information in an essentially horizontal format. The
account form has two columns, set side by side. The left column lists the company's assets. The final line
on the left side of the sheet provides the total value of all assets. The column on the right lists both
liabilities and equity, with liabilities coming first. The final line on the right provides the total combined
value of liabilities and equity.

2. Report Form
The report form of the balance sheet provides information in a vertical format -- essentially one column
that goes the full width of the page. The report form starts with assets, providing a total value at the end
of the assets section. It then lists liabilities and finishes with equity, with the final line of the report
providing the total combined value of liabilities and equity.
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Financial Statements
STATEMENT OF COMPREHENSIVE INCOME

A. Information to be presented in the statement of comprehensive income


As a minimum, the statement of comprehensive income shall include line items that present the following
amounts for the period:
(a) revenue;
(b) operating and administrative expenses;
(c) finance costs;
(d) tax expense;
(e) a single amount comprising the total of:
(i) the post-tax profit or loss of discontinued operations and
(ii) the post-tax gain or loss recognized on the measurement to fair value less costs to sell or on the
disposal of the assets or disposal group(s) constituting the discontinued operation;
(f) profit or loss;
(g) each component of other comprehensive income classified by nature; and
(h) total comprehensive income.

B. Presentation
An entity shall present all items of income and expense recognized in a period:
(a) in a single statement of comprehensive income, or
(b) in two statements: a statement displaying components of profit or loss (separate statement of
comprehensive income) and a second statement beginning with profit or loss and displaying components of
other comprehensive income (statement of comprehensive income).
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Financial Statements
C. Elements

D. Forms of Analysis
1. Nature of expense method
An entity aggregates expenses within profit or loss according to their nature (for example, depreciation,
purchases of materials, transport costs, employee benefits and advertising costs), and does not reallocate
them among functions within the entity. This method may be simple to apply because no allocations of
expenses to functional classifications are necessary. An example of a classification using the nature of
expense method is as follows:
Revenue X
Other income X
Changes in inventories of finished goods and work in progress X
Raw materials and consumables used X
Employee benefits expense X
Depreciation and amortization expense X
Other expenses X
Total expenses (X)
Profit before tax X

2. Function of expense or cost of sales method


Classifies expenses according to their function as part of cost of sales or, for example, the costs of
distribution or administrative activities. At a minimum, an entity discloses its cost of sales under this
method separately from other expenses. This method can provide more relevant information to users
than the classification of expenses by nature, but allocating costs to functions may require arbitrary
allocations and involve considerable judgement. An example of a classification using the function of
expense method is as follows:
Revenue X
Cost of sales (X)
Gross profit X
Other income X
Distribution costs (X)
Administrative expenses (X)
Other expenses (X)
Profit before tax X
Fundamentals of Accounting, Business, and Management 2
Financial Statements
STATEMENT OF CHANGES IN EQUITY
A Statement of Owner's Equity shows the changes in the capital account due to contributions, withdrawals, and net
income or net loss. This shows the movement in capital as a result of those four elements.
Capital is increased by owner contributions and income, and decreased by withdrawals and expenses.
Example:

Pointers:
1. A Statement of Owner's Equity (SOE) shows the owner's capital at the start of the period, the changes that
affect capital, and the resulting capital at the end of the period. It is also known as "Statement of Changes
in Owner's Equity".
2. A typical SOE starts with a heading which consists of three lines. The first line shows the name of the
company; second the title of the report; and third the period covered.
3. The title of the report is Statement of Owner's Equity. This is used for sole proprietorships. For partnerships,
the title used is "Statement of Partners' Equity" and for corporations, "Statement of Stockholders' Equity".
4. Notice that the third line is worded "For the Year Ended..." This means that the SOE presents information
for a specific span of time. In the above example, the period covers 1 year that ends on December 31, 2016.
Hence, the amounts presented pertain to changes to owner's equity from January 1, 2016 to December 31,
2016.
5. Income increases capital. Expenses decrease it. Net income is equal to income minus expenses. Hence, net
income would increase the capital account. If expenses exceed income, there is a net loss. In such case, net
loss will decrease the capital account.
6. The net income is the bottom-line amount in the company's Income Statement.
7. Good accounting form suggests that a single line is drawn every time an amount is computed (it signifies
that a mathematical operation has been completed). The bottom-line amount is double-ruled.

STATEMENT OF CASH FLOWS


The statement of cash flows is part of the financial statements issued by a business, and describes the cash flows into and
out of the organization. Its focus is on the types of activities that create and use cash, which are operations, investments,
and financing. Though the statement of cash flows is generally considered less critical than the income statement and
balance sheet, it can be used to discern trends in business performance that are not readily apparent in the rest of the
financial statements. It is especially useful when there is a divergence between the amount of profits reported and the
amount of net cash flow generated by operations.
Fundamentals of Accounting, Business, and Management 2
Financial Statements
There can be significant differences between the results shown in the income statement and the cash flows in this
statement, for the following reasons:

1. There are timing differences between the recordation of a transaction and when the related cash is expended or
received.
2. Management may be using aggressive revenue recognition to report revenue for which cash receipts are still some
time in the future.
3. The business may be asset intensive, and so requires large capital investments that do not appear in the income
statement, except on a delayed basis as depreciation.

Many investors feel that the statement of cash flows is the most transparent of the financial statements (i.e., most difficult
to fudge), and so they tend to rely upon it more than the other financial statements to discern the true performance of a
business.

Cash flows in the statement are divided into the following three areas:

1. Operating activities. These constitute the revenue-generating activities of a business. Examples of operating
activities are cash received and disbursed for product sales, royalties, commissions, fines, lawsuits, supplier and
lender invoices, and payroll.
2. Investing activities. These constitute payments made to acquire long-term assets, as well as cash received from
their sale. Examples of investing activities are the purchase of fixed assets and the purchase or sale of securities
issued by other entities.
3. Financing activities. These constitute activities that will alter the equity or borrowings of a business. Examples are
the sale of company shares, the repurchase of shares, and dividend payments.

Indirect method vs. Direct Method


Direct Method
When using the direct method, you list cash flows in the operations section of the cash flow statement. Cash flows due to
operations arise from customer collections and cash paid to suppliers, employees and others. The section also reports
cash paid for income tax and interest. The problem in trying to use the direct method is that a company might not keep
the information in the required form. For example, companies using accrual accounting lump together cash and credit
sales -- they would have to make special provision to track cash sales separately.

Indirect Method
In the indirect method, you adjust net income to convert it from an accrual to a cash basis. This requires you to add back
non-cash expenses such as depreciation, amortization, loss provision for accounts receivable and any losses on the sale of
a fixed asset. You also adjust net income for changes between the starting and ending account balances in current assets
-- excluding cash -- and current liabilities for the period. These accounts include accounts receivable, inventory, supplies,
prepaid assets, payable liabilities and unearned revenues.

Considerations
- The indirect method uses readily available information and most companies find it easier to employ.
- The only difference between the two method is how cash flows from operating activities are being calculated.
Fundamentals of Accounting, Business, and Management 2
Financial Statements

NOTES TO FINANCIAL STATEMENT


The notes shall:
(a) present information about the basis of preparation of the financial statements and the specific accounting policies
used;
(b) disclose the information required by IFRSs that is not presented elsewhere in the financial statements; and
(c) provide information that is not presented elsewhere in the financial statements, but is relevant to an understanding
of any of them.

An entity shall, as far as practicable, present notes in a systematic manner. An entity shall cross-reference each item in
the statements of financial position and of comprehensive income, in the separate statement of comprehensive income
(if presented), and in the statements of changes in equity and of cash flows to any related information in the notes.
Fundamentals of Accounting, Business, and Management 2
Financial Statements
FINANCIAL ANALYSIS
A. Horizontal Analysis or Trend Analysis
Horizontal analysis focuses on trends and changes in financial statement items over time. Along with the
dollar amounts presented in the financial statements, horizontal analysis can help a financial statement
user to see relative changes over time and identify positive or perhaps troubling trends.
In one horizontal analysis approach, a base year is selected and the dollar amount of each financial
statement item in subsequent years is converted to a percentage of the base year dollar amount.
Sample problem:

Analysis:
2008 is the base year, 2009 and 2010 revenues were 108% and 120% of the base year amount
The dollar amounts and percentages for each financial statement item increased each year, but the
trends for each item differed. For example: in 2010 when revenues were 120% of the base year
amounts, cost of goods sold was lessonly 115% of the base year amount. Perhaps the company
raised its selling prices and/or its inventory cost declined?
In addition to base year comparisons, dollar and percentage changes from one year to the next
could also be analyzed. For example: 2009 revenues increased by $8,000 or 8% over the previous
year, and 2010 revenues increased by $12,000 or 11.1% over the previous year.
B. Vertical Analysis [Common-size Analysis]
Vertical analysis sometimes is referred to as common-size analysis because all amounts for a given year are
converted into percentages of a key financial statement component. For example: on the income statement,
total revenue is 100% and each item is calculated as a percentage of total revenue. On the balance sheet,
total assets are 100% and each asset category is calculated as a percentage of total assets. In the balance
sheet equation, total assets are equal to total liabilities plus equity; thus, each liability and/or equity account
is also calculated to be a percentage of this total (i.e., total liabilities and equity are 100%).
Vertical or common-size analysis allows one to see the composition of each of the financial statements and
determine if significant changes have occurred.
Sample problem:
Fundamentals of Accounting, Business, and Management 2
Financial Statements
Analysis:
What percentage of total assets is classified as current assets? Current liabilities comprise what
percentage of total liabilities and stockholders equity?
Inventory makes up what percentage of total assets? Is this changing significantly over time? If so, is
it increasing or decreasing? [These answers could lead to additional questions such as the following:
If it is increasing, could this indicate that the company is having trouble selling its inventory? If so, is
this because of increased competition in the industry or perhaps obsolescence of this companys
inventory?
Accounts receivable makes up what percentage of total assets? Is this changing significantly over
time? If so, is it increasing or decreasing? (These answers might lead to additional questions such as
the following: If it is increasing, could this indicate that the company is having trouble collecting its
receivables? If it is decreasing, could this indicate that the company has tightened its credit policy?
If so, is it possible that the company is losing sales that it might have made with a less strict credit
policy?)
What is the composition of the capital structure? In other words, total liabilities make up what
percentage of total assets and total stockholders equity makes up what percentage of total assets?

References:

International Accounting Standard 1 - Presentation of Financial Statements

http://smallbusiness.chron.com/difference-between-report-form-account-form-balance-sheets-54993.html

http://slideplayer.com/slide/5149002/

http://www.accountingverse.com/accounting-basics/statement-of-owners-equity.html

https://www.accountingtools.com/articles/2017/5/17/statement-of-cash-flows-overview

http://smallbusiness.chron.com/direct-vs-indirect-cash-flow-method-65970.html

http://accounting-financial-tax.com/2009/10/horizontal-vs-vertical-analysis-of-financial-statements/