Module 2 Financial Statements

Module 2 Financial statements 11/6/2023, 1:10 pm
Module 2 Financial statements

Site: AIB Learning Hub Printed by: Ross Jorgensen
Course: 8006FMGT Financial Management 2023 Term 3 Date: Sunday, 11 June 2023, 12:39 PM
Book: Module 2 Financial statements
https://learning.aib.edu.au/mod/book/tool/print/index.php?id=123940 Page 1 of 17
Description
 Audio version
Welcome to Week 2
Last week we looked at why it is important for managers to understand financial management principles to maximize value in their business.
Understanding the information presented in a financial statement is another essential element of sound financial management. 8006FMGT
Financial Management is an introductory finance subject so the emphasis is not on learning how to prepare financial statements but on
learning how to examine financial statements as a key source of information for effective and sound financial decision-making. In week 2, we
look at how the financial statements generated by accountants for a business can be used in different ways to discern the financial health of
that business from the perspective of various stakeholders.
What you need to do this week:
1. Work through Module 2 Financial statements. Take notes and list anything that you need further help with. You can ask questions on
the Class Forum and/or in the weekly webinar.
2. Complete the activities:
Activity 2.1 Understanding income statements
Activity 2.2 Personal balance sheet
Activity 2.3 Cash flow statements and the Cash is King principle
Activity 2.4 Earnings management
3. Find the relevant financial statements for the competitor organisation you will focus on in Assessment 1 (Hint: look for the latest annual
report).
4. Read more of the detailed information in Chapter 3 of the textbook, as signposted in the module.
5. Attend the webinar and bring questions about anything you did not understand.
This week, you will learn to:

examine and interpret the key information included in financial statements
recognise relevant formulas/calculations in financial statements
use information in financial statements to make financial decisions
analyse the implications of earnings management decisions.
Table of contents
Introduction to financial statements
Income statement
Balance sheet
Statement of cash flow

Financial statements of NFPs
Earnings management
Summary, resources and references
Introduction to financial statements
According to Titman et al. (2019, p. 43), there are four financial statements reported in a company’s annual report:
1. Income statement (formerly the profit and loss statement)

2. Balance sheet
3. Cash flow statement
4. Statement of changes in equity.
As Titman et al. (2019, p.43) explain, the statement of changes in equity provides an expanded version of "the firm’s activities in the ordinary
and preference share accounts, the retained earnings account and changes to owners’ equity". It provides details of transactions otherwise
not captured in the income statement and balance sheet, such as dividend payments and equity withdrawals. In this subject, we will focus
on the first three statements only (the income statement, balance sheet and cash flow statement) as these are most relevant to decision-
making.
Why study financial statements?

Understanding financial statements helps managers to analyse the financial performance of the business. The insights gained from such
analysis can then be used to drive decision-making by investors and other users of the financial statements.
Let’s take the example of a manager, Julia, who sees the potential to expand production by at least 20%. The CEO of the company will not
take such a decision lightly as it will entail major investment of capital and resources, so any recommendation for expansion put forward by
Julia needs to be backed up with credible analysis. By analysing the financial statements of the company, Julia can draw valuable insights
to base her recommendations for expansion on.
Income statement
Whether an entity is established to generate profits or to simply provide a service while recovering costs (e.g. a not-for-profit or charitable
organisation), an income statement indicates the entity’s profit or loss over a specified period of time. The income statement is a statement
of revenues, expenses, gains and losses showing the results of an entity’s operations in a specific period, i.e. it may be produced monthly,
quarterly or annually. The business structure, reporting and auditing requirements will often provide an indication of how often the business
needs to produce an income statement. The income statement is also called the profit and loss (P&L) statement or the statement of
comprehensive income.
Broadly speaking, profit is calculated using the equation:
Profit = Revenue (or sales) – Expenses
Accounting principles and concepts used to prepare income statements

Accounting is the process of recording, classifying, reporting and interpreting business events. The basic accounting principles and
concepts are critical to the accounting process used to prepare financial statements. Some of the principles and concepts which are relevant
to income statements are:
1. Accrual Accounting
Financial statements, like the income statement, are usually prepared based on accrual accounting rather than on cash accounting. Under
accrual accounting, revenue and expenses are recorded when a transaction occurs rather than when a payment is received or made. This
means that the reported profit figure is different from the 'cash balance'. Under a cash-based accounting system, the profit recorded will be
the difference between cash received and cash paid for expenses.
2. Revenue Recognition
The revenue recognition principle is one of the most important concepts managers need to understand and forms the basis for an accrual
accounting system. Essentially, the principle states revenue is ‘recognised’ when it is earned (not necessarily when the cash flows in).
3. The Matching Principle

If revenue is only recognised when it is earned, as per the revenue recognition principle, all expenses incurred in earning that revenue are
matched against it in determining profit.
Cash and non-cash expenses

The income statement includes both cash and non-cash expenses. A typical example of a non-cash expense is depreciation. The
depreciation expense represents a systematic allocation of the cost of an asset over its useful life and does not involve an outflow of cash.
Mini case study: Tenti Espresso Bar

The owners of Tenti Espresso Bar have purchased an espresso machine for $10,000 and this new piece of equipment will be used over the
next 10 years. Tenti Espresso Bar will depreciate this new equipment using the straight-line method of depreciation, and the annual
depreciation expense will be $1,000 per year (10,000 / 10). In year 1, the income statement will only include this $1,000 of depreciation as
an expense, and not the full cost of $10,000 which they paid from cash, and so on for years 2, 3 etc. until in year 10 the asset is fully
depreciated. In this way, the expense of purchasing the asset is spread over its useful life.
 Read
Section 3.2 'The income statement', on pages 45-49 of the textbook, is an overview of the types of items that occur in the example
income statement provided in Table 3.1 on page 49. In particular, pay attention to the use of the income statement for interpreting
the firm’s profitability.
 Watch
The LinkedIn Learning video The income statement (04:11 minutes) is the first of 3 videos using Walmart as a case study illustrating
how to analyse and interpret financial statements. This first video takes you through a breakdown of Walmart's income statement.
Stice, J & Stice, K 2019, The_income_statement, LinkedIn Learning video, viewed 20 April 2021,
https://www.linkedin.com/learning/financial-accounting-foundations/the-income-statement?auth=true .
What
Find, investigate and interpret financial statements that you will need to prepare Assessment 1.
Why
This activity relates to this week's learning outcome: examine and interpret the key information included in financial statements. One of the
requirements of Assessment 1 is to analyse and interpret the financial statements of a competitor.
How
1. Read the Assessment 1 instructions and requirements for Report on Financial Performance Analysis and Key Finance Principles. What
information and data will you need, and where will you locate it?
2. Find the relevant financial statements for the competitor organisation you will focus on in the First Assessment (Hint: look for the latest
annual report or search on IBISWorld).
3. Identify some possible reasons why the reported profit number in the income statement will be different to the cash movement in the
statement of cash flow.
4. Bring your answers, ideas and questions to the weekly webinar and/or ask them in the Class Forum.
Balance sheet
The balance sheet is a statement of assets, liabilities and owners’ equity at a specific date. It is also called the statement of financial position
and the statement of assets and liabilities. The balance sheet shows what a business owns (its assets and how it is financed), and its debt
and shareholders’ (owners’) equity, that is, what it owes. The balance sheet follows the accounting equation which is:
Total assets = Total liabilities + Total shareholders’ equity
𝐴=𝐿+𝐸
Consider your house. If you own your house, it is an asset owned by you, which may be financed partly by debt (your mortgage) and partly
by your equity. Assume that the house is worth $400,000 and you currently owe $160,000 on your mortgage, then your balance sheet for the
house would be:
𝐴($400,000) = 𝐿($160,000) + 𝐸($240,000)
We will now discuss the three variables in this fundamental accounting equation in detail.
Assets
These are the economic resources owned or controlled by an entity that are expected to have future economic benefits for that entity. An
example would be the publishing rights to all the musical compositions of John Lennon and Paul McCartney (of the Beatles) which were
purchased by Michael Jackson. Assets are obtained or controlled by an entity as a result of past transactions or events affecting the entity.
Consider also the contracts of professional sports people. A club may be able to stop its prized player from playing for the opposition, but it
cannot force the player to play for it to the best of their ability. Accordingly, you can see why accountants have been reluctant to introduce
the valuation of people as assets.
Assets can be classified as either current or non-current (long-term). Current assets are those that are expected to be converted to cash
within a year. Non-current assets are those that are considered long-term.
Liabilities
Liabilities are defined as an obligation arising from past events which will result in an outflow of economic benefits from the entity. Consider
employee leave entitlements in an organisation. Based on the employment contracts, there is an obligation for the entity to provide for
entitlements such as annual leave, and this will result in future payments. Therefore, employee leave is considered a liability on the balance
sheet. Similar to assets, liabilities can be classified as current or non-current.
Shareholders’ equity
This represents the interests of shareholders or other owners in the assets of an entity, and is often referred to as ‘share capital’. Three main
components of shareholders’ equity are the amount received from selling shares, retained earnings and reserves. From an owner's view, the
fundamental equation can be represented as:
𝐸 = Total assets (𝐴) − Total liabilities (𝐿)
Where 𝐴 − 𝐿 is sometimes referred to as ‘net assets’.
 Read
Section 3.4 'The balance sheet', on pages 57-63 of the textbook, has details of different items included in the balance sheet. An
example of the balance sheet is provided in Table 3.5 on page 58.
 Watch
The LinkedIn Learning video The_balance_sheet (04:26 minutes) continues to explore the case study of Walmart, this time focusing
on analysing and interpreting its balance sheet.
Stice, J & Stice, K 2019, The_balance_sheet, LinkedIn Learning video, viewed 20 April 2021,
https://www.linkedin.com/learning/financial-accounting-foundations/the-balance-sheet?auth=true.
Mini case study: Tenti Espresso Bar

The owners of Tenti Espresso Bar are planning to expand by opening up a second café and have purchased new fittings and equipment for
their new shop using cash. Their current assets would include their existing inventory (e.g. coffee beans, milk, etc.), and their non-current
(fixed) assets would include the new equipment and fittings for the new shop. Their current liabilities would include any creditors, that is,
suppliers which Tenti Espresso Bar owes money to. An example of a non-current liability would be the long-term loan that Tenti Espresso
Bar took out to fund the first café.
 Interact
Tenti Espresso Bar is investing $200,000 in cash on fittings and equipment to open a second café. It started with a fixed asset value
of $100,000, current assets of $300,000 and current liabilities of $100,000. If we ignore the impact of depreciation for this exercise,
what will be the value of the fixed asset, current asset and current liabilities after the transaction?
Write your answer in the space provided. Select Check and then Show solution for feedback.
Feedback
Fixed Asset = 100,000 + 200,000 = $300,000.
Current Asset = 300,000 – 200,000 = $100,000 (this is because the second café is being bought using cash, so the current asset will be
reduced by the $200,000 of cash being used to buy the second café).
 Check
What
Apply key concepts related to financial statements to your personal finances by completing an activity in the textbook.
Why
This activity relates to this week's learning outcomes:
recognise relevant formulas/calculations in financial statements

use information in financial statements to make financial decisions.
Applying the concepts related to financial statements to your own money can support your understanding and development of financial
management skills.
How
Complete the personal financial statements provided in the 'Your personal balance sheet and income statement' section on pages 64-65 of
the textbook in order to gain a working knowledge of how balance sheets and income statements are prepared.
Check that your fundamental equation 𝐴 = 𝐿 + 𝐸 balances.
Statement of cash flow
The statement of cash flow is a very important financial record—it summarises the flows of cash for a period and the level of cash on hand at
the end of it. The cash flow statement reports where the business got its cash from (the sources of cash), and where it went (the uses of
cash). It typically has three sections:
Operating Activities
Investing Activities
Financing Activities.
The Operating Activities section reports the ‘normal’ activities of the business, which typically relates to the provision of goods and
services. This section will include receipts from customers, payments to suppliers, governments and employees, income tax paid and so on.
In the Investing Activities section, we typically report the acquisition and disposal of non-current assets, including property, plant and
equipment (PPE), payments for the acquisition of investments and proceeds from the sale of an investment.
The Financing Activities section shows the different cash movements relating to changes in the size or composition of the finance structure,
including equity and debt. This section may include dividends paid, proceeds from borrowings, proceeds from the issue of shares and so on.
 Read
Section 3.5 'The cash flow statement', on pages 65-75 of the textbook, illustrates the items typically reported in cash flow
statements.
 Watch
The LinkedIn Learning video The statement of cash flows (04:32 minutes) is the final video in the Walmart case study series. It takes
you through an analysis of Walmart's statement of cash flows.
Stice, J & Stice, K 2019, The statement of cash flows, LinkedIn Learning video, viewed 20 April 2021,
https://www.linkedin.com/learning/financial-accounting-foundations/the-statement-of-cash-flows?auth=true.
What
Reflect on cash flow statements in relation to the 'cash is king' financial principle.
Why
This activity relates to this week's learning outcomes:
examine and interpret the key information included in financial statements

analyse the implications of earnings management decisions.
This activity is relevant to the preparation of Assessment 1.
How
1. The acquisition of an asset is typically not reported in the profit numbers in the income statement. The cash flow statement reports such
numbers in the ‘Investing Activities’ section. Considering one of the key principles in finance is 'cash is king' (covered in Module 1), there is
the argument that the only useful financial statement is the statement of cash flow. Do you agree or disagree with this argument and why?
2. Share your point of view and a brief explanation by contributing to the Activity 2.3 feedback on cash flow statements and the cash is king
principle.
3. Once you have added your response, you can read the answers submitted by other students. How do your ideas differ? How similar are
they?
4. Prepare any follow-up questions for the weekly webinar and/or ask them in the Class Forum.
Financial statements of NFPs
Like their profit-seeking counterparts, NFPs must prepare regular audited financial statements. As we have discussed in detail for-profit
organisations, essential steps in ensuring effective financial reporting involve accurate record-keeping of all expenses, revenue, assets,
liabilities, cash inflows, cash outflows, and movement of equity capital. These records are then combined with regulator-approved
accounting and reporting standards to generate financial statements that present information about the NFP’s financial performance over the
reporting period (typically a financial year) and the assets, liabilities, and equity capital at the end of that period of time. Other summary
information, such as cash flow movements during the year, is also presented.
 Read
CPA Australia 2015, A guide to understanding the financial reports of not-for-profit entities (New Zealand), viewed 17 November
2022, https://www.cpaaustralia.com.au/-/media/project/cpa/corporate/documents/tools-and-resources/financial-
reporting/understanding-financial-reports-nz.pdf?la=en.
Earnings management
Those responsible for preparing financial statements are afforded some discretion with respect to accounting policies and estimation.
Consequently, the quality of reported earnings or financial information is often questioned by a range of stakeholders looking for any
irregularities or patterns in the numbers that might need further investigation. Earnings Management refers to how accounting discretion via
accounting policies and/or estimation is used to portray a desired level of earnings in a particular reporting period.
Considering one of the basic principles we learned about in Module 1 is that individuals respond to incentives, imagine that a manager has
their bonus tied to the company's reported profit. Could there be a risk that the profit numbers are smoothed over through the accrual
process?
Earnings management applied to the extreme can be risky. Two excellent examples in the Australian corporate world are the collapse of HIH
Insurance and OneTel. Similarly, in Canada, examples include the Livent, CINA and Nortel cases. The demise of these organisations was
attributed to earnings management practices and the lack of proper governance and controls.
As a result of some of these large collapses, several regulatory changes have been made. In Australia, for example, several changes around
auditor responsibilities, disclosure requirements and the quality of financial reporting have been implemented following the Corporate Law
Economic Reform Program (CLERP). In New Zealand, the Financial Markets Authority Act and KiwiSaver Amendment Act of 2011 imposed a
tighter reporting, auditing and surveillance regime. Similarly, the US passed similar reform in the Sarbanes-Oxley Act (SOX). Reforms such as
these are examined extensively in the Corporate Governance subject you will undertake as part of your AIB MBA.
 Read
The section 'IFRS and earnings management' on page 48 of the textbook expands on earnings management.
 Optional reading
This article summarises some of the key literature behind earnings management, and the authors argue that accrual accounting
can be misused to manage earnings that are often linked to executive remuneration:
Bergstresser, D & Philippon, T 2006, ‘CEO incentives and earnings management’, Journal of Financial Economics, vol. 80, no.
3, pp. 511–529.
 Tool
If you are interested in reading further about CEO incentives and earnings management, our librarians have created a ‘saved
search’ that will return the full-text for the most recent and relevant peer-reviewed academic material from the library’s collection.
Click the linked search string below to view these materials.
CEO AND "earnings management"
 Optional video
In June 2020, Wirecard, a large German payment processor and financial services provider, went bankrupt following the
announcement that 1.9 billion Euros were missing from their accounts. Top management and some board members were arrested
on fraud charges.
Ernst & Young (EY) was the external auditor for Wirecard for many years but failed to identify this problem. The video below (Wall
Street Journal 2020) (05:42 minutes) provides more insights into the scandal.
Wirecard and the Curious Case of the Missing $2 Billion | WSJ
What
Apply earnings management concepts to your own professional experience. Share your experiences on a discussion forum.
Why
This activity relates to this week's learning outcome: analyse the implications of earnings management decisions.
This activity asks you to reflect on why it is essential for organisations to have robust accounting systems and controls that allow for the early
detection of potentially unethical and fraudulent practices. The implications of earnings management decisions will be relevant to
Assessment 1.
How
1. Consider the organisation you work for or any organisation you are familiar with. You do not need to name or identify the organisation itself
but only indicate the industry/sector in which it operates.
2. Recommend an action the organisation can undertake to minimise the potential for unethical behaviour and fraud in earnings
management. For example, the segregation of duties, the delegation of authority and audit processes (both external and internal). Provide a
brief justification for your recommendation.
3. Share your experiences on the Activity 2.4 forum on earnings management. Remember that you do not need to name the organisation,
just the industry/sector.
4. To maximise the learning value of this activity, we invite you to respond to at least one post from another student. You should also bring
your questions to the weekly webinar.
Summary, resources and references
In this module, we learned about financial statements. We went through income statements, balance sheets and statements of cash flow,
and examined the different components of each of these statements in detail. In this module, we also learned why it is important to have
robust financial systems and controls to ensure proper earnings management practices are adhered to. Leveraging off what we covered in
Module 2, in Module 3, we expand on analysing financial performance using ratios.
Resources and references

8006FMGT Required and optional resources
8006FMGT References

Module 2 Financial Statements

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Module 2 Financial statements 11/6/2023, 1:10 pm

Module 2 Financial statements

What you need to do this week:

This week, you will learn to:

Introduction to financial statements

Statement of cash flow

Financial statements of NFPs

Summary, resources and references

Introduction to financial statements

1. Income statement (formerly the profit and loss statement)

Why study financial statements?

Broadly speaking, profit is calculated using the equation:

Profit = Revenue (or sales) – Expenses

Accounting principles and concepts used to prepare income statements

3. The Matching Principle

Cash and non-cash expenses

Mini case study: Tenti Espresso Bar

Activity 2.1 Understanding income statements

Total assets = Total liabilities + Total shareholders’ equity

𝐴($400,000) = 𝐿($160,000) + 𝐸($240,000)

𝐸 = Total assets (𝐴) − Total liabilities (𝐿)

Where 𝐴 − 𝐿 is sometimes referred to as ‘net assets’.

Mini case study: Tenti Espresso Bar

Activity 2.2 Personal balance sheet

recognise relevant formulas/calculations in financial statements

Check that your fundamental equation 𝐴 = 𝐿 + 𝐸 balances.

Statement of cash flow

examine and interpret the key information included in financial statements

This activity is relevant to the preparation of Assessment 1.

Financial statements of NFPs

CEO AND "earnings management"

Wirecard and the Curious Case of the Missing $2 Billion | WSJ

Activity 2.4 Earnings management

Summary, resources and references

Resources and references

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