2238 Financial Reporting | 2021/2022 T1

Introduction to Financial
Statements

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Types of corporate information

• Accounting is the process of identifying, recording,
Financial Markets measuring and communicating economic events in
History value terms, to provide information for decision-making
Information
purposes
Company
mission Corporate Accounting
Economic Accounting Process
and information Information
strategy Activities

Social
Governance Accounting
responsibility
Decision-Making Information

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Users of accounting information

• Equity Investors • Management • Governments
– Investment analysis – Strategic planning – Policy making
– Management – Investment in operations – Regulation
performance evaluation – Evaluation of subordinates – Taxation
– Government contracting
• Debt Investors • Employees
– Probability of default – Security and remuneration • Customers
– Determination of –Security of supply
lending rates • Litigants
– Covenant violations – Disputes over value in the firm • Business Partners and Competitors

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Focus of this course

Types of accounting information

Management Process of preparing management reports and accounts that provide financial and
Accounting statistical information required by managers to make day-to-day and short-term decisions

Field of accounting concerned with the summary, analysis and reporting

Financial of financial transactions pertaining to a business. This involves the preparation
Accounting
of financial statements available for public consumption/ decision makers outside the firm

Consists of accounting methods that focus on taxes rather than the appearance of public
Tax Accounting
financial statements.

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Accounting issues
WHAT TYPES OF QUESTIONS DOES ACCOUNTING ANSWER?

• What events should be recorded? • What information should be disclosed?

• When should an event be recorded? • How should information be aggregated?

• How much should be recorded? What measurement unit • Where should the information be disclosed? In
should be used? financial statements or just in the footnotes?
Separate item or aggregated with other items?
• How should a transaction be classified?

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Accounting Standards
• There are accounting standards and legal frameworks that rule accounting processes and reporting.

• Accounting standards are common set of principles, rules and procedures that define the basis of financial accounting
policies and practices

• Two main accounting standards in the world

– U.S. Generally Accepted Accounting Principles (GAAP): set by the Financial Accounting Standards Board
(FASB) together with the Securities Exchange Commission (SEC) in the United States.

– International Financial Reporting Standards (IFRS): set by the International Accounting Standards Board (IASB)
and is being applied in more than 100 countries worldwide (US is the largest of the few remaining hold-outs).

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Accounting Standards

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Accounting Standards
• European Union adopted the IFRS in 2005 for listed companies. Each country adapts its regulatory
system to accommodate the IFRS standards

• The US is expected to move completely from GAAP to the IFRS, as intended by the SEC. There are
still some significant differences between the two

• Cross listed firms in the US may apply the IFRS since 2007.

• Convergence is inevitable, the question no longer is “if” but “when”:

– Globalization rules
– Complexity of current US standards

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Accounting principles and guidelines

Monetary Unit Economic activity is measured in one currency

Economic Entity The company is separate from the owner

Going concern The company will continue in the foreseeable future

Historical cost Reported financial values are based on historical cost

Revenue
Revenues are recognized when a product or service is sold
recognition

Matching Expenses should match revenues in timing

Full disclosure All pertinent information must be visible and clear on financial statements

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Accounting principles and guidelines

Objetivity Use unbiased and verifiable information

Materiality significance
The company of an item/transaction
is separate from the owner determines its degree of relevance

Conservatism In doubtful cases, one should choose the option with lower value/net income

Consistency Reports must be consistent throughout time

Comparability Reports must be comparable across firms

Time Period Business activities are reported in a given period

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INTRODUCTION TO FINANCIAL STATEMENTS

The Financial Statements

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Accounting definitions
• Journal: a chronological record of a company´s transactions

• Journal entry: a record of an individual transaction in the journal

• Account: a record that contains all the information about changes in a specific asset, liability or
in an element of owner’s equity

• Ledger: a file of accounts

• T account: a ledger account that takes the shape of the capital letter T

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The accounting cycle

The accounting cycle: the sequence of accounting procedures used to record, classify and summarize information in financial reports

Post the journal Prepare the

Create journal entry Prepare a trial
entry in ledger financial
for transaction balance
accounts statements

• At the end of each

• During the period • When
period
necessary
• Happens each time a
• Requires
transaction occurs
iterations/adjustments

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Financial Reports
STRUCTURE OF FINANCIAL REPORTS: FREQUENCY OF REPORTS:

• Management Discussion and Analysis • Annual reports: 10-K (U.S.)

• The Four Financial Statements • Quarterly reports: 10-Q (U.S.)

– Statement of Financial Position
– Statement of Comprehensive Income • Unscheduled reports: 8-K (U.S.)
– Statement of Cash Flows
– Statement of Changes in Equity
Example

• Footnotes to the Financial Statements

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INTRODUCTION TO FINANCIAL STATEMENTS

Statement of Financial Position

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Statement of Financial Position

– The statement of financial position reflects the resources the firm controls at a point in time. It is a
detailed description of the firm’s assets, and the claims against them.
• Assets are the economic resources owned by the company
• Liabilities are the company´s debt and obligations
• Shareholders´ equity indicates the amount of financing provided by the owners of the business and
the earnings

– Assets are sorted by decreasing liquidity, while liabilities are sorted by increasing maturity.

– Assets = Liabilities + Shareholders’ Equity

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Statement of Financial Position

Balance Sheet
Assets 8900 Liabilities 4800
Current 6800 Current 2950
Cash 1300 Accounts Payable 2000
Accounts Receivable 2000 Wages Payable 300
Inventories 3000 Taxes Payable 350
Other Current Assets 500 Other Current Liabilities 300
Non-current 2100 Non-current 1850
Property Plant and Equipment 1500 Deferred taxes 350
Intangible Assets 500 Long-term debt 1500
Other Non-Current Assets 100 Owners' Equity 4100
Capital (common) stock 300
Retained Earnings 3800

Example

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INTRODUCTION TO FINANCIAL STATEMENTS

Statement of Comprehensive Income

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Statement of Comprehensive Income

• The statement of comprehensive income reports revenues less expenses (i.e., net
income) that increase owners' equity between two balance sheet dates (not exclusively).

– Operating expenses can be presented

• By function (e.g., cost of sales, distribution costs etc)
• By nature (e.g., raw materials, employee benefit expenses etc)

• Exceptional items (i.e., operating items that are material and non-recurring) should be
disclosed as a separate line item (e.g., losses on sale of PPE)

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Statement of Comprehensive Income

Statement of Comprehensive Income
Net Revenue 15000
- Cost of Goods Sold 8500
= Gross Margin 6500
- Operating Expenses 1000
= Operating Income 5500
- Net interest expense 100
= Income before taxes 5400
- Income Taxes 1836
= Net Income 3564
+ Other comprehensive income 50
= Total comprehensive income 3614
Example

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Statement of Comprehensive Income

WHAT GOES TO OTHER COMPREHENSIVE INCOME?

• Other comprehensive income includes those revenues, expenses, gains, and losses that are
excluded from net income on the income statement. This means that they are instead listed
after net income on the income statement.

• Revenues, expenses, gains and losses appear in other comprehensive income when they have
not yet been realized; to avoid net income unnecessary fluctuations. Some examples:
– Unrealized gains and losses resulting from changes in fair values of assets and liabilities,
– Actuarial gains and losses on defined benefit plans
– Losses from translating financial statements of a foreign operation

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INTRODUCTION TO FINANCIAL STATEMENTS

Statement of Cash Flows

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Statement of Cash Flows

• The statement of cash flows explains the change in cash during the period in terms of cash
provided by or used for operating, investing and financing activities.

• The primary purpose of a statement of cash flows is to provide relevant information about
the cash inflows and outflows of an enterprise during the period. The statement has three
main sections: Cash Flows from Operating Activities, Cash Flows from Investing Activities,
and Cash Flows from Financing Activities

• Change in Cash = Cash from Operations + Cash from Investing + Cash from Financing

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Statement of Cash Flows

• Cash Flows from Investing Activities - Investing activities involve acquiring and disposing of debt or equity
investments, property, plant and equipment and other productive assets used in the production of goods or
services by the enterprise (other than materials that are part of the enterprise's inventory).

• Cash Flows from Financing Activities - Financing activities involve obtaining resources from owners and
providing them with a return on their investment; borrowing money and repaying amounts borrowed and
obtaining and paying for other resources obtained from creditors on long-term credit.

• Cash Flows from Operating Activities - Operating activities involve all transactions and other events that
are not defined as investing or financing. Operating activities generally involve producing and delivering goods
and providing services. Cash flows from operating activities are generally the cash effects of transactions and
other events that enter into the determination of net income.

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Statement of Cash Flows

Statement of Cash Flows
Cash flow from operating activities 1100.00
Cash flow from investing activities (500.00)
Cash flow from financing activities 400.00
Increase (decrease) in cash and cash equivalents 1000.00
Cash and cash equivalents - begining period 300.00
Cash and cash equivalents - ending period 1300.00

Example

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Statement of Cash Flows

• Two methods for presentation of cash flows from operations:

– Indirect method: start from net income and adjust for accruals to arrive at cash flows
from operations
– Direct method: present each cash flow item separately

• The direct method of presentation is encouraged, but the indirect method is acceptable

• Most U.S. corporations prepare the statement of cash flows using the indirect method.

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INTRODUCTION TO FINANCIAL STATEMENTS

Statement of Changes in Equity

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Statement of Changes in Equity

• The statement of changes in equity has two primary components:
Total comprehensive income
Net payout to shareholders

• Total comprehensive income = Net income + Other comprehensive income

• Net payout to shareholders (or capital transactions) = Dividends + Share repurchases – Share issues

Ending equity = Beginning equity + Total comprehensive income – Net payout to shareholders

Example

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INTRODUCTION TO FINANCIAL STATEMENTS

The accounting equation

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Accounting equation
ASSET (A) = LIABITITIES (L) + OWNERS EQUITY (OE)
From the statement of
financial position
ΔA = ΔL + ΔOE

ΔA = ΔL + Total Comprehensive Income – Net Payout to Shareholders (NPS)

Using statement of changes
in equity
ΔA = ΔL + NET INCOME + OCI - NPS

Using statement of ΔA = ΔL + Revenues – Expenses - NPS

comprehensive income
(simplified) ΔA + Expenses = ΔL + Revenues - NPS

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Accounting equation
ASSET (A) = LIABITITIES (L) + OWNERS EQUITY (OE)

ΔA + Expenses = ΔL + Revenues - NPS

• An increase in the left-hand side requires either a decrease on

the same side or an increase on the right-hand side

• Left-hand side accounts increase through debits and right-

hand side accounts through credits

• This implies that to keep this equality, every debit generates a

credit and vice versa (double-entry system)

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Accounting equation
Type of Account Increase with debit or
Account name
(Asset/Liability/IncomeStatement) credit?
Accounts Receivable
Accounts Payable
Cash
Property Plant and Equipment
Cost of goods sold
Wages payable
Revenue

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Accounting equation
Type of Account Increase with debit or
Account name
(Asset/Liability/IncomeStatement) credit?
Accounts Receivable ASSET DEBIT
Accounts Payable LIABILITY CREDIT
Cash ASSET DEBIT
Property Plant and Equipment ASSET DEBIT
Cost of goods sold INCOME STATEMENT DEBIT
Wages payable LIABILITY CREDIT
Revenue INCOME STATEMENT CREDIT

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Accounting equation //
Examples
Example 1: The firm purchases a machine for $57, payment is due next month

Example 2: The firm pays a supplier $16, in cash

Example 3: The firm renders $400 of services, to be received in 3-months

Example 4: The owner invests $100 in cash in the company

Provide the journal entries for the examples above

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Accounting equation //
Examples
Example 1: The firm purchases a machine for $57, payment is due next month
Dr PPE $57
Cr Accounts Payable $57

Example 2: The firm pays a supplier $16, in cash

Dr Accounts Payable $16
Cr Cash $16

Example 3: The firm renders $400 of services, to be received in 3-months

Dr Accounts Receivable $400
Cr Revenues $400

Example 4: The owner invests $100 in cash in the company

Dr Cash $100
Cr Paid-in-capital $100

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