Lecture Note 2.

Financial Statements

Financial Management
Main Contents

Disclosure of Financial Information

Balance Sheet or Statement of Financial Position

Income Statement or Statement of Comprehensive Income

Statement of Cash Flows

Other Financial Statement Information

Financial Reporting in Practice

Financial Management 2 Lecture Note 2. Financial Statements

Learning Objectives

Know why the disclosure of financial information through financial

statements is critical to investors

Understand the function of the balance sheet

Use the balance sheet to analyze a firm

Understand how the income statement is used

Interpret a statement of cash flows

Know what management’s discussion and analysis and the statement of

stockholders equity are

Financial Management 3 Lecture Note 2. Financial Statements

1. Disclosure of Financial Information

Financial statements
They are accounting reports issued periodically to present the past performance and a
snapshot of the firm’s assets, cash flows and the financing of those assets, etc.

Financial statements are important tools as information sources

Managers as well as interested outside parties such as investors, financial analysts, creditors,
labor unions, and so on rely on financial statements to obtain reliable information about a
corporation

They provide the information of corporate cash inflows and outflows from company
activities
The company activities are classified by business and financial activities
 Business activities: the transaction of goods and services such as purchasing raw material,
production and sales, etc.
 Financial activities: the transaction of capital such as financing funds from inside or outside,
distribution of profits, etc.

Financial Management 4 Lecture Note 2. Financial Statements

1. Disclosure of Fin. Information (Cont.)

The company activities and funds flows

Financing Investment Operation Distribution

Capital Asset Business

Investors Distribution
Structure Structure Activities

Liabilities Current Sales Interests

Assets Sales of
goods sold Taxes
Stockholder Equities Long-term Other costs
Assets Retained
--------------- --------------- --------------- Earnings
Bondholder Total Total Assets Operating
Liabilities Income Dividends
and Equities

Financial Management 5 Lecture Note 2. Financial Statements

1. Disclosure of Fin. Information (Cont.)

Preparation of financial statements

Accounting Reports about a company’s performance and financial position must be
understandable and accurate
So, they are written based on a common set of rules and a standard format

Generally Accepted Accounting Principles (GAAP) and International Financial

Reporting Standards (IFRS) issued by the IASB provide a standards for financial
statements
This standardization also makes it easier to compare the financial results of different firms

Corporations are required to hire an auditor to check the annual financial statements
To ensure they are prepared according to the adopted accounting principles
To provide evidence that the information is reliable

Financial Management 6 Lecture Note 2. Financial Statements

1. Disclosure of Fin. Information (Cont.)

International Financial Reporting Standards

Suggested by International Accounting Standards Board (IASB)
Established in 2001 by representatives from 10 countries, including the U.S.

Since 2005 all publicly traded European Union companies are required to follow IFRS
Now, used by many other countries, including Korea, Australia, several countries in Latin
America and Africa
Accepted by all major stock exchanges around the world except U.S. and Japan

Korea has adopted IFRS from 2011

Financial Management 7 Lecture Note 2. Financial Statements

1. Disclosure of Fin. Information (Cont.)

The basic financial statements under IFRS adopted in Korea

1) Statement of financial position or Balance sheet (재무상태표)

2) Comprehensive income statement (포괄손익계산서)

3) Statement of cash flows (현금흐름표)

4) Statement of change in equity (in Korea, 자본변동표)

Statement of stockholders’ equity (in US)

Financial Management 8 Lecture Note 2. Financial Statements

1. Disclosure of Fin. Information (Cont.)

The company activities and financial statements

Income
Balance Sheet
Statement

Capital Asset Business

Investors Distribution
Structure Structure Activities

Liabilities Current Sales Interests

Assets Sales of
goods sold Taxes
Stockholder Equities Long-term Other costs
Assets Retained
--------------- --------------- --------------- Earnings
Bondholder Total Total Assets Operating
Liabilities Income Dividends
and Equities

Statement of Statement of
Cash Flows Change in Equity
Financial Management 9 Lecture Note 2. Financial Statements
2. Balance Sheet

Balance sheet or Statement of financial position

Lists the firm’s assets and liabilities
Provides a snapshot of the firm’s financial position at a given point in time  A static report
Example: Table 2.1 Nokia Consolidated Statements of Financial Position in € millions

Financial Management 10 Lecture Note 2. Financial Statements

2. Balance Sheet (Cont.)

The balance sheet identity

The two sides of the balance sheet must balance
Total assets = total liabilities + shareholder’s equity

Current assets
Cash and other marketable securities
Short-term, low-risk investments (Eq.
Easily sold and converted to cash
Accounts receivable 2.1)
Amounts owed to the firm by customers who have purchased on credit
Inventories
Raw materials, work-in-progress and finished goods
Other current assets
Includes items such as prepaid expenses

Financial Management 11 Lecture Note 2. Financial Statements

2. Balance Sheet (Cont.)

Long-term assets or non-current assets

Assets that produce benefits for more than one year

Reduced through a yearly deduction called depreciation according to a schedule that

depends on an asset’s life
Depreciation is not an actual expense, but a way of recognizing that fixed assets wear out and
become less valuable as they get older

The book value of an asset = its acquisition cost - its accumulated depreciation

Goodwill as an intangible asset

The difference between the price paid for the company and the book value assigned to its
tangible assets

Other long-term assets

Including such items as property not used in business operations, start-up costs in connection
with a new business, trademarks and patents, and property held for sale

Financial Management 12 Lecture Note 2. Financial Statements

2. Balance Sheet (Cont.)

Current Liabilities
Accounts payable
The amounts owed to suppliers purchases made on credit
Notes payable
Loans that must be repaid in the next year
Repayment of long-term debt that will occur within the next year
Accrual items
Items such as salary or taxes that are owed but have not yet been paid, and deferred or unearned
revenue
Net working capital = current assets – current liabilities
The capital available in the short term to run the business

Long-Term Liabilities
Long-term debt
A loan or debt obligation maturing in more than a year

Financial Management 13 Lecture Note 2. Financial Statements

2. Balance Sheet (Cont.)

Stockholders’ Equity
The book value of equity
Net worth from an accounting perspective
Equity = total assets – liabilities
The book value of equity is an inaccurate assessment of the actual value of the firm’s
equity value
Ideally, the balance sheet would provide us with an accurate assessment of the true value of the
firm’s equity
Unfortunately, this is unlikely to be the case
 Many assets are valued based on their historical value rather than their market value today
 Many of the firm’s valuable assets are not captured on the balance sheet
Market capitalization as the true value of firm’s equity
Market price per share times number of shares
It does not depend on historical cost of assets, instead, it depends on what investors expect
those assets to produce in the future
The book value of equity can be negative  encroachment of capital
A negative book value of equity is not necessarily an indication of poor performance
Financial Management 14 Lecture Note 2. Financial Statements
2. Balance Sheet (Cont.)

Usefulness of the balance sheet

We can learn a great deal from a firm’s balance sheet

It provides a lot of information about firm’s asset and capital structure at a certain time
The information of balance sheet can be used such as
 Evaluation of financial soundness
 Evaluation of ability generating the future cash flows
 Evaluation of ability to finance additional funds in the future

Book value of equity is sometimes used to estimate liquidation value of the firm
It is also very useful to assess i) the firm’s value, ii) its leverage, and iii) its short-term cash
needs, etc.

Financial Management 15 Lecture Note 2. Financial Statements

3. Income Statement

The income statement or statement of comprehensive income

It lists the firm’s revenues and expenses over a period of time  A dynamic report
Sometimes called the profit and loss statement, or “P&L.”

Financial Management 17 Lecture Note 2. Financial Statements

3. Income Statement (Cont.)

The last or “bottom” line of the income statement shows net income
The net income is a measure of its profitability during given accounting year and also
referred to as the firm’s earnings
It provides useful information regarding the profitability of a firm’s business and how
it relates to the value of the firm’s shares

The principle of matching costs with revenues

There are two separate account reporting system
Accrual-based accounting and Cash-based accounting
The most GAAPs and IFRS adopt the accrual-based accounting
Accounting profit = revenues - costs
In accrual accounting, accounting profits are calculated under the principle of matching costs
with revenues
That means a cost is recognized only when the revenue related to the cost is recognized
 If a related revenue does not take place then any cost is not accounted as a cost
This principle causes the difference between accounting profits of a firm and the actual cash-
flows in the firm
Financial Management 18 Lecture Note 2. Financial Statements
4. Statement of Cash Flows

The statement of cash flows

It uses the information from the income statement and balance sheet to determine
how much cash the firm has generated
how that cash has been allocated during a set period

It is also a dynamic report just like income statement

Cash is important because it is needed to pay bills and maintain operations and is the
source of any return of investment for investors

The statement of cash flows is divided into three sections which roughly correspond to
the three major jobs of the financial manager
Operating activities
Investment activities
Financing activities

Financial Management 19 Lecture Note 2. Financial Statements

4. Statement of Cash Flows (Cont.)

Example of the statement of cash flows

Financial Management 20 Lecture Note 2. Financial Statements

4. Statement of Cash Flows (Cont.)

Operating activity
Use the following guidelines to adjust for changes in working capital
Accounts receivable
 When a sale is recorded as part of net income, but the cash has not yet been received from the
customer, adjust the cash flows by deducting the increases in accounts receivable
 This increase represents additional lending by the firm to its customers and it reduces the
cash available to the firm
Accounts payable
 Similarly, we add increases in accounts payable
 Accounts payable represents borrowing by the firm from its suppliers
 This borrowing increases the cash available to the firm
Inventory
 Finally, we deduct increases to inventory
 Increases to inventory are not recorded as an expense and do not contribute to net income
 However, the cost of increasing inventory is a cash expense for the firm and must be
deducted
We also add depreciation to net income, since it is not a cash outflow

Financial Management 21 Lecture Note 2. Financial Statements

4. Statement of Cash Flows (Cont.)

Investment activity
Subtract the actual capital expenditure that the firm made
Also deduct other assets purchased or investments made by the firm, such as acquisitions

Financing activity
The last section of the statement of cash flows shows the cash flows from financing
activities
Dividends paid
Cash received from sale of stock or spent repurchasing its own stock
Changes to short-term and long-term borrowing
Retained earnings = Net Income – Dividends
Payout ratio = Dividends / Net Income

The last line of the Statement of Cash Flows

Combines the cash flows from these three activities to calculate the overall change in
the firm’s cash balance over the time period
Financial Management 22 Lecture Note 2. Financial Statements
5. Other Financial Statement Information

Other pieces of information contained in the financial statements

Management Discussion and Analysis
In Korea, there is no independent report corresponding to management discussion and analysis
But, in annual reports provided by firms, there are similar contents

Statement of change in equity (Statement of stockholders’ equity in US)

It provides a reconciliation of the opening and closing equity position
It also provides details of the movements in share capital and reserves

Notes to the Financial Statements

It contains additional details on the information provided in the statements
 The notes document important accounting assumptions that were used in preparing the
statements
 They often provide information specific to a firm’s subsidiaries, its separate product lines, or
the firm’s share-based compensation plans for employees

Financial Management 23 Lecture Note 2. Financial Statements

6. Financial Reporting in Practice

Even with safeguards such as GAAP and auditors, though, financial

reporting abuses unfortunately do take place
One of the most infamous examples for a fraudulent accounting is Enron in U.S. and
SK global and Daewoo Shipbuilding & Marine Engineering in Korea

The Sarbanes-Oxley Act

In 2002, Congress passed the Sarbanes-Oxley Act (SOX) to prevent a fraudulent
accounting and penalize it more strictly
While SOX contains many provisions, the overall intent of the legislation was to improve the
accuracy of information given to both boards and to shareholders
SOX attempted to achieve this goal in three ways:
 Overhauling incentives and independence in the auditing process
 Stiffening penalties for providing false information
 Forcing companies to validate their internal financial control processes

Financial Management 24 Lecture Note 2. Financial Statements