Topic Overview 9: Financial Statements

Contents:
1. Introduction

2. The annual reports under the International Financial Reporting Standards (IFRS)

3. Balance sheet: its contents and informational aims

3.1 Assets: definition and classification

3.2 Liabilities: definition, classification

3.3 Equity: value-meaning and components

3.4 Overall informational value of the balance sheet

By the end of this week, you will be able to:

• Understand what the IFRSs are

• Understand the main components of Balance-Sheet

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1. Introduction

It is important to estimate the informational value of the annual report under the International
Financial Reporting Standards’ (IFRS) provisions. The annual report is a publication that fulfils
the regulatory requirements of reporting the financial performance and situation of a reporting
entity and, at the same time, is also used for wider corporate communication purposes.

Any corporation either is a single company or a group (Group means more than one organisaiton
belongs to the same owner who make the decisions or governed by the same board of directors) is
called a reporting entity (Mongiello, 2009). Chang and Hong (2000) defines as a business group
any combination of single firms that could operate independently that are controlled
administratively and financially by the same person(s).

As Mongiello (2009) explains, what is included in the annual reports of companies is not constant
and the same, but there are several required sections. There are laws (that may differ from country
to country) requiring specific items and statements to be included in the annual reports. While, the
countries adopted the IFRS have very similar regulation, there are still differences for many
reasons, that are listed below:

1. The flexibility provided by the IFRS, allowing the firms to choose what concerns the
formats of the financial statements. Based on the cultural background and past experience
of the preparers of the accounts, the interpretation to be adopted, varies as there are several
subjects under controversy between the professionals.
2. The recent grate enhancement of the IFRS, especially the last 10 years; normally the
amendments are applied, with the companies’ end of the financial year falling on either
sides of the enforcement date of the revised standards, and often allowing the possibility to
comply with the revised standard before the official date of the changes to be enforced.
3. As the annual reports are used widely to communicate information to the users, the
preparers are trying to show that their reports are unique, following the directors’
suggestions for different and non-common documentation with the competitors.
4. Other reasons lie on the different versions of the standards endorsed in different world
regions; chiefly the European Union’s (EU) ‘carve outs’ of the IAS 39, whereby certain
provisions that refer to the treatment and reporting of certain financial instruments is
different in the EU than in the rest of the world.

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 5. The fact that the information published through the reports is used by technological tools,
affects what format is chosen for the annual reports. Mongiello (2009) suggests some
examples of how this affects the reporting, that can be easily found on the internet
suggesting to visit the BMW’s and Marks & Spencer’s official web pages’ investor
relations areas. The ‘technological’ interpretation of the principle of fairness in the
presentation of the financial statements can be observed, as the hyperlink to Excel allows
us to analyze quickly and easy the respective information in our own spreadsheets. It would
be more difficult to do the same exercise using printed documents.

Now let see what “IFRS” and “IAS” are. International Accounting Standards (IAS) and the newer
International Financial Reporting Standards (IFRS). The IFRS have replaced the majority of IAS,
while some are still in effect.

Mongiello (2009) explains that the intervention of the International Accounting Standard Board in
the body of accounting standards can have the following natures:

• modifies existing IAS or IFRS

• or issue new standards (IFRS), which are added to the existing list of standards superseding
existing IAS, which are then no longer used
• or issues new standards (IFRS), which address completely new areas of accounting.

Kieso et al. (2020) argue that the effort for a common global framework is continuously enhanced
minimizing the differences and as a result, the regular readers of the financial statements will
benefit through the better decision-making process, having comparable statements of companies
reporting in different jurisdictions.

2. The annual reports under the International Financial Reporting Standards (IFRS)

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According to Mongiello (2009) the Annual reports we have discussed above must have the
following sections and documents:

• Chairman’s letter to the shareholders

• Operational review
• Directors’ report: business review
• Directors’ report: corporate governance
• Financial statements:
o Accounting policies
o Income statement
o Balance sheet
o Cash flow statement
o Statement of changes in equity
o Notes to the accounts
o Auditors’ report

While the above could be “independent” documents, must be used together for the decisions the
stakeholders intend to take. As Mongiello (2009) explains , the financial statements alone, could
inform the users up to a specific point; even considering the amount of disclosure included in the
‘accounting policies’ and the ‘notes to the accounts’, the conclusions and the interpretation of the
figures published need to be supported by what the directors intended to do and how, while the
opinion of them, regarding the going concern of the corporation cannot be ignored.

The following example, presented by Mongiello (2009) facilitate the understanding of the above:
The operational review should normally enlighten the reader of the accounts on the reasons behind
certain capital expenditures, i.e. investments for maintaining or improving the production and
distribution capacity of the entity. These expenses could, for example, seem inexplicably high, in
comparison with sector’s or competitors’ benchmarks, if not seen in the context provided by an
operational review, where the directors explain that they are undertaking a business reengineering
process aimed at reducing areas of inefficiency in production or distribution.

3. Balance sheet: its contents and informational aims

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An example:

ABC Corporation
Balance Sheet December 31, 2000
Assets Liabilities and Owners’ Equity
Cash 5,000 Accounts payable 8,000
Accounts receivable 7,000 Notes payable 2,000
Inventory 10,000 Total liabilities 10,000
Equipment 7,000 Owners’ equity 19,000
Total assets 29,000 Total liabilities 29,000
and owners’ equity

The balance sheet, or statement of financial position, reports the financial situation of a company,
presenting its assets, liabilities and equity. Equity equals the difference between total assets and
total liabilities, as illustrated below (ASSETS = LIABILITIES + EQUITY).

(Mongiello, 2009)

3.1 Assets: definition and classification

Definition

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As a general rule, the assets are all those items over which the entity exercises enough control to
enable it to receive the benefits emanating from them. A more technical definition goes along the
lines of assets being entity’s rights to future economic benefits. In addition, for the assets to be
reported in the balance sheet, they must be measurable in a fairly objective way.

Alexander and Nobes (2004) explain that the companies must classify as current assets, those
intends to be recovered or settled before 1 year, while the rest are to be observed as the fixed assets.
The authors, mentioning the IAS 1, suggest classifying as current assets those meeting the
following criteria:

✓ is expected to be realized in, or is held for sale or consumption in, the normal course of the
entity’s operating cycle;
✓ is held primarily for trading purposes;
✓ is expected to be realized within twelve months of the balance sheet date; or
✓ is cash or a cash equivalent that is not restricted in its use.

The following asset items, in the cases that are observes as material must be presented separately,
in different lines of the statement of financial position (Alexander and Nobes, 2004):

o property, plant and equipment

o investment property
o intangible assets
o financial assets (unless included under other headings below)
o investments accounted for using the equity method (see chapter 14)
o biological assets
o inventories
o trade and other receivables
o cash and cash equivalents

An example of assets, disclosed by Alexander and Nobes (2004), follows:

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3.2 Liabilities: definition, classification

Definition

Liabilities are entity’s obligations to transfer future economic benefits to third parties. They
comprise: all debentures, borrowings from lenders, received bills and unpaid invoices, which are
actual obligations; but also, accruals, which are obligations not yet substantiated by third parties’
invoices or bills; and provisions for future expenses, which are not yet obligations, but will be in
the future for facts that have happened in the past.

According to Alexander and Nobes (2004), the liabilities are classified -based on IAS 1- as current
liabilities when the following criteria are met:

i. expected to be settled in the normal course of the entity’s operating cycle; or

ii. due to be settled within twelve months of the balance sheet date.

The authors list the following items to be presented separately in the cases of materiality:

o trade and other payables

o provisions
o financial liabilities (unless included under other headings)
o tax liabilities

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An example of the statement of financial position liabilities’ side would be the following (with the
Equity):

Balance sheet of ABCD Ltd

as at 30 December 2020
Capital 13,500
Retained Earnings 14,000
Net profit 5,700

Bank overdraft 3,300

Creditors 5,000
Rent payable 600
Salaries Payable 20,500
62,600

3.3 Equity: value-meaning and components

Value and its meaning

The value of the equity is the result of total assets less total liabilities. It represents the ‘book value’
of the entity, i.e. its value according to the accounting books, which has a very weak link with the
value attributed to it by actual and potential investors.

The equity is normally a positive value. A negative equity is not sustainable in the long run, hence,
in such case, an entity’s management will have to either raise more capital by issuing new shares
or wind up the entity.

Horngren et al. (2002) explains that the accounting equation must balance, in a sense that by
deduction liabilities from assets, the residual is the value of what the owners receive, that is capital,
the shareholders’ claims. As the authors explain, the owners of a company’s stocks have the
following rights:

1. Vote
2. Share the corporate profits

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 3. Share any assets left
4. Acquire more shares of subsequent issues

In addition, their power depends on the volume of shares they have.

Regarding the shares, the following 4 categories are identified by Horngren et al. (2002):

Authorized shares:

The total number of shares that may legally be issued under articles of incorporation

Issued shares:

The aggregate number of shares sold to the public

Outstanding shares:

Shares remaining in the hands of the shareholders

Treasury stock:

The stocks of the company that have been repurchased by the company and not retired

Example:

Number of share (000)

Authorized 10,200
Unissued (9,076)
Issued 1,124
Shares held in treasury (1)
Total shares outstanding 1,123

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Components

Not only the total value of the equity, but also its components convey valuable information for the
readers of the accounts.

Typically the equity includes the following:

• Share capital
• Share premium reserve
• Retained profits, or reserve of profits (= accumulated profits that have been retained)
• Retained profit or loss (current year)
• Revaluation reserve
• Gains and losses that have been accounted for directly in the equity

3.4 Overall informational value of the balance sheet

The balance sheet provides you with an insight about how much capital the entity’s management
can count on or, in more appropriate terms, the total value of the assets, which the management
can employ to operate the business, and what these assets are. On the other hand, the balance sheet
also indicates where the capital to finance these assets has come from; liabilities represent capital
that is borrowed by the entity and equity represents capital that is owned by the entity. The capital
coming from both liabilities and equity is invested in the entity’s assets.

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The following, is a Balance sheet example, extracted from Alexander and Nobes (2004):

Summarizing - Find the missing elements in the following (independent) cases:

ASSETS LIABILITIES SHAREHOLDERS’ EQUITY

$100,000 30,000 ?
? 450,000 200,000
350,000 450,000 ?
675,000 ? 310,000

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References

Alexander, D., & Nobes, C., 2004. Financial accounting: an international introduction. Pearson
Education.

Chang, S.J. and Hong, J., 2000. Economic performance of group-affiliated companies in Korea:
Intragroup resource sharing and internal business transactions. Academy of Management journal,
43(3), pp.429-448.

Horngren, C.T., Sundem, G.L., Elliott, J.A. and Philbrick, D.R., 2002. Introduction to financial
accounting. Prentice Hall.

Kieso, D.E., Weygandt, J.J. and Warfield, T.D., 2020. Intermediate accounting IFRS. John Wiley
& Sons.

Mongiello, M., 2009. International Financial Reporting. BookBoon.

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