FINANCIAL
ANALYSIS &
MANAGEMENT
Complete Guide
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Table of Contents
Preface .................................................................................. 5
1. Introduction ..................................................................... 6
1.1 Definition and Purpose of Financial Analysis ........................................................................ 6
1.2 Key Concepts in Financial Analysis.......................................................................................... 9
1.3 The Role(s) of Financial Analysis in a Business................................................................... 12
2. Financial Statements and Reporting ........................... 16
2.1 Introduction to Financial Statements .................................................................................... 16
2.2 Income Statement: Revenues, Costs, and Profits .............................................................. 22
2.3 Balance Sheet: Structure and Components ........................................................................ 69
2.4 Cash Flow Statement: Tracking Liquidity and Cash Movements ................................110
3. Financial Statement Analysis ..................................... 140
3.1 Vertical Analysis ........................................................................................................................140
3.2 Horizontal Analysis ..................................................................................................................147
3.3 Profitability Ratios ....................................................................................................................152
3.4 Liquidity Ratios ..........................................................................................................................178
3.5 Efficiency Ratios ........................................................................................................................199
3.6 Solvency Ratios .........................................................................................................................213
3.7 Leverage Ratios .........................................................................................................................223
3.8 Market Valuation Ratios .........................................................................................................227
3.9 DuPont Analysis ........................................................................................................................249
4. Break-even and Cost-Volume-Profit Analysis .......... 256
4.1 The Basics of Break-even Analysis .......................................................................................256
4.2 Understanding Fixed, Variable, and Mixed Costs ............................................................257
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4.3 Break-even Point Calculation..........................................................................................258
4.4 Cost-Volume-Profit Analysis Framework ...................................................................275
4.5 Limitations of Break-even and CVP Analysis ..............................................................277
4.6 Advanced Calculation of Contribution Margin ..........................................................282
5. Valuation Analysis ....................................................... 290
5.1 Fundamental Principles of Valuation .............................................................................292
5.2 Asset-Based Approach......................................................................................................294
5.2.1. Book Value Method ......................................................................................................294
5.2.2 Liquidation Value .............................................................................................................303
5.2.3 Replacement Cost Method ..........................................................................................309
5.2.4 Adjusted Net Asset Method ........................................................................................315
5.2.5 Strengths and Weaknesses of the Asset-Based Approach..................................319
5.3 Income-Based Approach ..................................................................................................322
5.3.1 Discounted Cash Flow ..................................................................................................325
5.3.2 Capitalized Earnings Method .......................................................................................336
5.3.3 Residual Income Model .................................................................................................344
5.3.4 Multi-Period Excess Earnings Method .......................................................................351
5.3.5 Pros and Cons of Income-Based Valuation .............................................................358
5.4 Market-Based Approach...................................................................................................362
5.4.1 Comparable Company Analysis ..................................................................................363
5.4.2 Precedent Transactions Analysis ................................................................................367
5.4.3 Market Capitalization Method .....................................................................................370
5.4.4 Revenue and EBITDA Multiples ..................................................................................372
5.4.5 Advantages and Limitations of the Market-Based Approach ..............................375
5.5 Leveraged Buyout Valuation............................................................................................377
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5.6 Adjusted Present Value...........................................................................................................382
5.7 Real Options Valuation ...........................................................................................................386
5.8 Intangible Asset Valuation ......................................................................................................390
5.9 Cost of Capital and WACC ..................................................................................................394
5.10 Terminal Value Calculation .................................................................................................402
5.11 Valuation Adjustments and Premiums..............................................................................406
5.12 Sensitivity and Scenario Analysis in Valuation ................................................................412
5.13 Valuation in Mergers and Acquisitions .............................................................................416
5.14 Valuation for Startups and High-Growth Companies ..................................................421
5.15 Common Valuation Pitfalls and Limitations ....................................................................426
6. Sensitivity and Scenario Analysis ............................... 431
6.1 Sensitivity Analysis ....................................................................................................................431
6.2 Scenario Analysis ......................................................................................................................456
7. Financial Management ................................................ 465
7.1 Financial Planning and Strategy .............................................................................................467
7.2 Budgeting ....................................................................................................................................470
7.2.1 Variance Analysis ...................................................................................................................496
7.3 Forecasting .................................................................................................................................502
7.4 Capital Budgeting and Investment Decisions ....................................................................508
7.5 Cash Flow Management ..........................................................................................................520
7.6 Working Capital Management ..............................................................................................532
7.7 Funding and Capital Structure ..............................................................................................537
7.8 Dividend Policy and Retained Earnings Management .....................................................544
Conclusions ...................................................................... 548
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Preface
Financial Analysis and Management are essential skills for
anyone involved in making business decisions. This guide serves as
a straightforward and accessible resource on the core
topics that empower effective financial oversight in a company or
organization: Covering everything from reading financial
statements to conducting thorough valuation and
processes analysis, it is built for professionals who need clear,
structured information they can apply directly to their work.
Each section is designed to stand on its own while building a
broader understanding of the financial fundamentals and
strategies businesses rely on. Topics include profit and
liquidity analysis, valuation methods, planning, budgeting,
and controlling: With these tools and frameworks, finance
professionals can make better decisions and respond more
confidently to financial challenges.
This guide is crafted to support financial students, beginners
aiming to build a strong foundation, and seasoned
professionals looking for a comprehensive reference. It
provides accessible insights and practical approaches to
strengthen essential skills relevant across various finance roles,
functions, and industries.
Start your journey into financial analysis and management here, and
remember, if you need guidance along the way, we’re here to help.
Contact us on our site.
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1. Introduction
1.1 Definition and Purpose of Financial
Analysis
This section will explain how financial analysis helps
businesses use their data to develop effective strategies and allocate
resources wisely, while also supporting long-term planning and
identifying growth opportunities.
We will start discussing how analyzing financial data is important not
only for external purposes, like comparing the business to its
competitors or talking to investors, but also for the day-to-day decisions
made inside the company.
You'll catch a glimpse of how financial analysis is used to manage cash
flow, control costs, plan for the future, and ensure that the company
stays on track with its financial goals… Before exploring these topics
further throughout the guide.
____________________
Financial analysis is a structured approach to examining
and interpreting a company’s financial information, with the
aim of uncovering key insights that inform both operational
and strategic decisions.
It involves not just reviewing financial statements but also
identifying patterns and trends that provide a deeper
understanding of profitability, liquidity, and overall financial
health.
This process allows the management of a business to assess
performance effectively and make adjustments where
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necessary, ensuring that the company/organization remains aligned
with its financial objectives.
The purpose of financial analysis extends beyond surface-level
evaluations; it serves as an important tool for identifying
strengths, weaknesses, and opportunities that may not be
immediately obvious from financial statements alone…
For example, if key financial ratios are broken down and compared
to industry benchmarks, businesses can determine how well
they are positioned relative to competitors.
Investors, too, use financial analysis as a means of evaluating
potential risks and returns, looking at a company’s
performance not just in terms of immediate profits but in the
context of long-term viability and stability.
But for the business itself, financial analysis serves as the
foundation upon which external benchmarking and investor
relations are built—it is first and foremost critical in the
day-to-day decision-making of the financial team.
In the context of daily operations, financial analysis
provides the structure for evaluating cash flow patterns,
assessing cost efficiency, and ensuring optimal resource
allocation across departments or projects.
These activities, while routine, are essential for maintaining
operational stability and preventing financial shortfalls.
When teams regularly compare actual performance against
established budgets and forecasts, they can quickly detect
variances, allowing for timely adjustments that prevent minor
issues from escalating into larger financial concerns.
Department heads rely on financial analysis to make decisions
regarding pricing, product development, and resource
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allocation for new investments—choices that directly influence
the company’s profitability and market positioning.
For example, consistent monitoring of cash flow not only ensures
liquidity but also acts as a safeguard against potential
disruptions, securing both short-term obligations and long-term
financial goals.
On the operational side, financial metrics are used to evaluate
the profitability of business units or product lines, enabling
managers to adjust strategies in response to real-time data; This
approach fosters adaptability and grounds decisions in
performance metrics rather than assumptions.
Financial analysis also plays an important role in planning and
forecasting, as it supports the development of realistic
financial strategies based on past trends and anticipated future
performance: Here, historical data is used to project future
performance, allowing businesses to anticipate challenges and
allocate resources in a more effective manner.
____________________
Now, we are going to start exploring the
essential concepts of financial analysis, along
with examples to illustrate them.
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1.2 Key Concepts in Financial Analysis
Financial analysis revolves around understanding the
financial health of a business by employing various key concepts
that reveal much about its operations, profitability, and
sustainability. At the heart of these concepts lies liquidity, which
assesses the company's ability to meet short-term obligations as
they come due. A business with strong liquidity ensures that it can
cover its immediate bills without taking on extra debt or selling
off important resources.
For example, imagine a small retail store that needs to pay its
suppliers $10,000 next month. If the store has $20,000 in cash and
money it can quickly collect from customers, it has enough to
comfortably pay its suppliers without borrowing more money or selling
off inventory at a loss.
The analysis of solvency goes deeper into long-term financial
stability, measuring a firm's capacity to endure and thrive while
meeting its obligations far into the future. This distinguishes
businesses that can manage both their debts and investments with
a careful balance. A solvent company is one that can weather
financial storms, planning for the long haul while keeping its
borrowing under control.
For example, consider a manufacturing company that owes $1
million in loans but owns factories and equipment worth $5 million. Even
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though it has debt, the value of what it owns far exceeds what it owes,
suggesting it can sustain its operations over time and pay back its loans.
Of course, in real life, it's more complicated than this, and we'll cover
more complex scenarios throughout our guide.
Profitability is another central focus of financial analysis, as it
directly examines how efficiently a company generates profit
relative to its revenue or the money invested in it. Without
consistent profitability, no business can hope to sustain growth or
remain competitive over time. Profitability ratios help investors and
managers determine whether the business model is functioning
effectively and generating acceptable returns.
For example, a bakery that earns $100,000 in sales and, after
paying all expenses, has $10,000 left as profit has a profit margin of
10%. This means for every dollar the bakery earns, it keeps ten cents
as profit, which can be considered healthy depending on industry
standards.
Efficiency ratios provide insight into how well the company uses
its resources—whether it's managing inventory, using equipment,
or handling day-to-day operations—to drive performance. These
ratios help understand whether management is making optimal use
of the resources available to them or if inefficiencies are slowing
growth and undermining profitability.
For example, if a bookstore restocks and sells out its inventory
four times a year, it indicates that it is efficiently managing its stock
levels and meeting customer demand without overstocking. On the other
hand, if another bookstore only restocks twice a year, it may have too
many unsold books sitting on shelves, tying up money that could be used
elsewhere.
The concept of leverage examines the extent to which a business
relies on borrowed funds to finance its operations and expansion.
While leverage can magnify returns during periods of growth, it
also intensifies the risks when revenues decline, especially if
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interest obligations begin to erode profits. Financial analysts often
scrutinize both the benefits and dangers of leverage, considering
how well a business balances risk and return when taking on debt.
For example, a tech startup borrows $500,000 to develop a
new app, expecting that sales will cover the loan payments. If the app
is successful and generates, let’s say, $1 million in revenue, the company
benefits from using borrowed money to grow quickly. However, if the
app fails to generate expected sales, the startup might struggle to repay
the loan, putting the entire business at risk.
Lastly, cash flow analysis—the lifeblood of any firm—focuses on
how cash moves through the business, ensuring that operational
activities, investments, and financing decisions are backed by
adequate liquidity. Even highly profitable companies can fail
without sufficient cash flow to support day-to-day operations and
growth initiatives.
For example, a construction company may have several projects
that will pay large sums upon completion, showing high potential profit.
However, if the company doesn't have enough cash on hand to pay for
materials and workers today, it can't continue its operations.
Understanding how cash flows in and out of the business helps ensure
it can meet current obligations and invest in future growth.
____________________
We have explored the importance of financial analysis for
a business and the key concepts that form its foundation. In the
next section, we will examine the specific role that financial
analysis plays within a business.
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1.3 The Role(s) of Financial Analysis in a
Business
Financial analysis shapes every financial operation within
a business, influencing the specific tasks carried out by each
individual on the finance team; it offers more than just a summary
of company performance, exploring the fine details that guide
actions at every level—whether those of accountants, financial
managers, or the CFO. By examining financial data, these
professionals adjust budgets, evaluate investments, manage costs,
and allocate resources—always with the aim of ensuring the
company's financial position remains balanced and future-focused.
Every report, from the balance sheet to the income
statement, undergoes rigorous scrutiny, revealing not just
overall health but the dynamics of the business’s financial
management. For an accountant, the process involves reviewing
transactions to ensure accuracy and consistency; for a financial
manager, it’s about dissecting these reports to identify the best
opportunities for cash management or asset allocation. Each
role, from daily transactional oversight to high-level strategic
decisions, is deeply tied to the outcomes of thorough financial
analysis.
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In the context of managing profitability and liquidity,
financial analysis extends beyond surface-level evaluation; it aids in
assessing risks and determining the financial implications of every
decision, whether it’s an operational shift or a major capital
investment. A controller might calculate financial ratios to
understand the company’s capacity to meet short-term
obligations, while the CFO weighs long-term projections to
determine the best mix of debt and equity for capital structure
decisions. These insights guide actions ranging from managing dayto-day cash flow to choosing between potential business
expansions.
Also, financial analysis is essential for cost control across the
company; it pinpoints where inefficiencies exist and where
resources can be reallocated to achieve better financial outcomes.
This isn't a static process—it evolves with every new report,
offering ongoing insights that support operational adjustments
or strategic pivots. Whether dealing with routine financial
reporting or exploring new business opportunities, each member
of the team depends on financial analysis to guide their work.
So, at its core, financial analysis provides the foundation for
every significant financial operation within the business,
ensuring that every decision—whether adjusting a budget, planning
an investment, or managing working capital—is based on a clear and
accurate understanding of the company's financial landscape. This
careful balance of precision and foresight allows businesses to
move forward confidently, with every financial choice grounded in
reality and geared towards sustainable progress.
_____________________
We have seen how each member of a financial team
relies on financial analysis to perform their specific duties, using
detailed data to inform their decisions and ensure the financial
stability and growth of the business. Let's explore the key roles
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within the team and how financial analysis directly supports their
responsibilities:
ˑˑˑ CFO ➔ Uses financial analysis to guide long-term financial
strategy, capital allocation, and risk management; ensures the
company’s financial direction aligns with its overall goals;
ˑˑˑ FINANCIAL MANAGER ➔ Analyzes financial reports to
optimize cash flow, manage investment portfolios, and develop
budgeting strategies that support the company’s growth;
ˑˑˑ CONTROLLER ➔ Employs financial analysis to ensure
accurate financial reporting, monitor internal controls, and
oversee compliance with accounting standards and regulations;
ˑˑˑ ACCOUNTANT ➔ Utilizes financial analysis to track dayto-day transactions, verify financial records, and ensure accuracy
in all accounting operations and financial statements;
ˑˑˑ TREASURER ➔ Uses financial analysis to manage the
company's liquidity, optimize cash reserves, and evaluate financing
options for ongoing and future operations;
ˑˑˑ BUDGET ANALYST ➔ Analyzes financial data to create,
review, and adjust budgets, ensuring that spending aligns with the
company’s financial objectives and identifying areas for cost
optimization;
ˑˑˑ FINANCIAL ANALYST ➔ Reviews financial data to
evaluate investment opportunities, assess market trends, and
forecast future financial performance to support informed
decision-making;
ˑˑˑ INTERNAL AUDITOR ➔ Applies financial analysis to assess
internal controls, identify discrepancies or risks in financial
reporting, and ensure compliance with financial policies and
procedures;
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ˑˑˑ RISK MANAGER ➔ Uses financial analysis to evaluate
potential financial risks, develop mitigation strategies, and assess
the impact of external market changes on the company’s financial
health;
ˑˑˑ PAYROLL MANAGER ➔ Leverages financial analysis to
ensure accurate payroll processing, manage labor costs, and
forecast future payroll needs based on financial data;
ˑˑˑ COST ACCOUNTANT ➔ Applies financial analysis to track
and control production costs, analyze cost variances, and help
improve overall cost efficiency within the organization;
ˑˑˑ TAX MANAGER ➔ Uses financial analysis to ensure tax
compliance, optimize the company’s tax liabilities, and provide
strategic advice on tax-related financial decisions;
ˑˑˑ FINANCIAL PLANNING & ANALYSIS (FP&A)
MANAGER ➔ Employs financial analysis to prepare financial
forecasts, develop financial models, and analyze performance
against budget and forecasts to inform business decisions.
____________________
➔ After gaining an overview of the main concepts, uses, and roles
of financial analysis in a business, we are now ready to start
exploring Financial Statements, which serve as the
foundation of financial analysis for every member and
stakeholder: We will begin with simple explanations and
progressively explore the technicalities and advanced features.
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2. Financial Statements and
Reporting
2.1 Introduction to Financial Statements
[ If you're already familiar with the notions of financial
statements, feel free to skip ahead to the specific sections of this
chapter or move on to the next one. ]
In this section, we'll start by explaining what
financial statements are in a simple way, as if we
were explaining it to a young student.
______________________________________
Financial statements are documents that show how a
company is “doing financially”. They help people understand how
much money the company is making, how much it is spending, and
what it owns or owes. There are three main types of financial
statements:
1. Income Statement: This report shows how much
money the company earned and spent over a certain
period, like a few months or a year. It tells if the company
made a profit (earned more than it spent) or a loss (spent
more than it earned).
2. Balance Sheet: This shows what the company owns and
what it owes at a specific moment in time. The balance
sheet has three parts:
o
Assets: What the company owns (like cash,
buildings, or equipment).
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o
Liabilities: What the company owes to others
(like loans or unpaid bills).
o
Equity: What is left for the owners after all the
debts are paid.
3. Cash Flow Statement: This report tracks the money
going in and out of the company. It’s all about cash—where
it comes from and where it goes. It shows if the company
has enough cash to pay its bills and run the business.
Together, these reports give a clear picture of a company’s
financial health, like a checkup for a business to see how it’s doing.
NOW LET’S EXPLAIN IT MORE IN DETAIL.
Financial statements are reports that tell the story of a
company’s financial health. Just like how a school report card
shows your grades, financial statements show how well a company
is doing with its money. There are three main types of financial
statements, and each one gives different information about the
company.
1. Income Statement (or “Profit and Loss Statement”)
The income statement is like a scorecard for the company’s
performance over a certain period of time, such as a month or a
year. It shows:
•
Revenue: This is the money the company earns from
selling its products or services.
•
Expenses: These are the costs of running the business,
like paying employees or buying materials.
•
Profit or Loss: If the revenue is higher than the expenses,
the company has a profit (it made money). If the expenses
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are higher than the revenue, the company has a loss (it lost
money, in profitability terms).
This statement helps us see if the company is making or losing
money from the core activity. It’s very important for investors or
owners because it tells if the core business is profitable or not.
2. Balance Sheet
The balance sheet is like a snapshot of the company’s finances at
a specific point in time. It has three key parts:
•
Assets: These are things the company owns, like cash,
equipment, or buildings. They’re valuable and help the
company run its business.
•
Liabilities: These are what the company owes, like loans
or unpaid bills. They are debts that the company has to pay
back.
•
Equity: This is what’s left after paying off all liabilities. It
shows the value that belongs to the owners of the
company.
The balance sheet gives a picture of what the company owns
versus what it owes, helping to see how stable and strong the
business is.
3. Cash Flow Statement
The cash flow statement shows how money is moving in and out
of the company. It’s not about profits, but about cash—what’s
actually the liquidity coming in and going out.
•
Cash Inflow: Money coming into the business from sales
or loans.
•
Cash Outflow: Money going out to pay expenses, bills, or
buy new equipment.
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This statement is important because even if a company is making
a profit on paper, it needs actual cash to pay bills and keep things
running smoothly!
____________________
Let’s now talk about how these financial statements
are connected; they don't stand alone but work together like
pieces of a puzzle, giving us a complete picture of a company’s
financial situation. Understanding this connection helps explain not
just what’s happening, but why.
The Income Statement, for instance, shows how much
money the company made or lost over a certain period—this
result, whether it’s a profit or a loss, directly affects both the
Balance Sheet and the Cash Flow Statement. A company
that makes a profit will see its assets (the things it owns) increase
on the balance sheet, while a loss can lead to more liabilities
(what it owes), or less equity for its owners. So, the income
statement and balance sheet are tied together: the performance
of the company changes what it owns and what it owes.
But that’s not all! The Cash Flow Statement comes into
play too: even if a company is profitable on paper, as we said
before, it still needs actual cash to pay its bills—this is where cash
flow becomes crucial. Cash generated from sales, shown in the
cash flow statement, will increase the company’s assets on the
balance sheet, but paying off debts or buying new equipment will
decrease cash, though it could also reduce liabilities. So, while the
income statement shows profits, the cash flow statement reveals
if the company can stay afloat day by day.
Think of it this way: the income statement is like tracking
your grades over the semester; it shows how well you did. The
balance sheet, though, is like checking the balance of your bank
account; it shows what you have right now, at this moment. Finally,
the cash flow statement is like looking at your cash-spending: it
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shows whether you’ve got enough money to pay for your daily
needs, even if your bank balance seems fine.
The three statements work together, creating a chain of
information: profits affect assets and cash flow, while the
company's liabilities and assets influence what it can afford to
invest in next. Each document tells part of the story, but only
together do they give you the full plot, with all the twists and turns
included.
BUT… they’re actually linked in a precise and
structured way that reflects the flow of money,
profits, and assets within a company.
First, the Income Statement is crucial because it
calculates the net income (or net loss) of the company, and this
figure flows directly into the Balance Sheet under equity.
When a company earns a profit, that profit gets added to a section
on the balance sheet called retained earnings (part of equity),
increasing the company’s overall value. If there’s a loss, the
opposite happens—equity decreases. So, the income statement is
not a standalone document; it feeds into the balance sheet’s equity
section, tying the two together.
Next, there’s the Cash Flow Statement, which directly
connects to both the income statement and the balance sheet,
explaining how money is moving in and out of the business. Here’s
how: while the income statement shows profits, not all profits are
cash-based (some may be credit sales), so the cash flow statement
adjusts this. It starts with the net income from the income
statement and then makes adjustments for non-cash items like
depreciation (an expense shown on the income statement, but
doesn’t involve actual cash outflow). This means the cash flow
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statement links the income statement to the company’s real-time
cash position.
Moreover, cash changes recorded in the Cash Flow
Statement also influence the Balance Sheet. For example,
when cash increases because of sales or loans, this gets reflected
as an increase in assets on the balance sheet. Conversely, when
the company spends money—whether to pay off a loan, purchase
inventory, or invest in new equipment—the liabilities or assets
on the balance sheet are updated accordingly. This is why the
ending cash balance in the cash flow statement matches the
cash figure on the balance sheet at the end of the period.
So, the flow works like this: Net income from the income
statement becomes part of the equity on the balance sheet; cash
flow reconciles with both assets and liabilities, adjusting for any
non-cash transactions; finally, the balance sheet’s cash position
at the end ties back to the ending cash balance from the cash
flow statement. Together, these financial statements are a
system—each feeding into the other, ensuring that every figure is
accounted for across different aspects of the business’s financial
health.
___________________
This technical interconnection is key to understanding how
accountants track and manage a company’s performance. It's like how
the gears of a clock fit together: one turns the other, and together they
keep the business reporting ticking in a reliable, synchronized way.
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2.2 Income Statement: Revenues, Costs,
and Profits
Now let's explore how the income statement shows a company's
net profit or net loss.
This statement focuses on revenues and expenses earned or
incurred during a specific period—from one date to another.
This approach is essential for understanding the company's true
performance.
At the heart of this process is “accrual” accounting:
Transactions are recorded when they happen—not necessarily
when cash is received or paid.
This method allows for a precise reflection of financial activities.
Revenues are recognized when the company delivers goods
or services.
Expenses are recognized when they are incurred to generate
those revenues.
Therefore, the income statement matches revenues with related
expenses within the same period.
➔ This matching provides a clearer picture of profitability.
For example, suppose a company completes a project in December but
gets paid in January.
The revenue is still recorded in December because that's when the work
was done.
Similarly, if the company uses electricity in December but pays the bill
in January, the expense is recorded in December's income statement.
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This aligns the expense with the revenue generated during that time.
By doing this, the income statement reveals not just how much
profit was made, but also how and when it was earned.
This information is crucial for stakeholders assessing the company's
efficiency.
It shows how effectively the company generates profit from its activities.
_______
In contrast, the balance sheet, as said before, is like a snapshot.
It captures the company's financial position at a single point in time.
It lists assets, liabilities, and equity as of that date.
It doesn't show the flow of revenues and expenses over a period.
Instead, it illustrates what the company owns and owes at that moment.
So, while the balance sheet tells you what the financial status is, the
income statement explains how that status was achieved over time.
Understanding how the income statement is formed highlights the
importance of focusing on economic activities rather than just cash
transactions.
If we consider only cash movements, significant revenues or expenses
might be overlooked.
This could lead to a distorted view of the company's performance.
Accrual accounting ensures that all relevant financial activities are
included, since they are “accrued” in the analyzed period.
It offers a more accurate and insightful portrayal of profitability.
Isn't it intriguing how this financial report provides deeper
insights into a company's operations?
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It bridges the gap between two balance sheets.
It explains the changes that occurred over the period.
→ This is how a typical income statement would look like:
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Many times, you may see a negative number written like this:
(5,000). For example, here’s the typical layout for the section
where Gross Profit is calculated:
In financial statements, in fact, negative numbers are often shown
in parentheses (e.g., ($5,000)): This is a way to indicate that the
amount represents a loss, expense, or outflow.
The structure of the income statement seen before is called a
multi-step income statement. This format separates revenues
and expenses into distinct categories, making it easier to assess
the company’s financial performance at different stages. We will
analyze each element deeply later on.
Here’s how the multi-step income statement is structured:
1. Revenue Section: Lists all sources of income, such as
sales revenue, service revenue, and other types of revenue;
2. Cost of Sales: The direct costs related to the production
or delivery of goods/services sold (also known as Cost of
Goods Sold in manufacturing);
3. Gross Profit: Calculated as total revenue minus cost of
sales. This shows the company’s profit after accounting for
the costs of production but before other operating
expenses are considered;
4. Operating Expenses Section: Includes all expenses
related to the company’s core operations, such as salaries,
25
rent, utilities, marketing, and depreciation. These are costs
that support the company’s ability to generate revenue:
5. Operating Income: Represents the profit from core
business operations, calculated as gross profit minus
operating expenses. This figure excludes non-operating
activities like interest and taxes;
6. Other Income and Expenses: This section includes
non-operating items, such as interest income, gains or
losses on the sale of assets, and interest expense. These
are not directly tied to the company’s core operations;
7. Income Before Tax: Represents the total profit before
accounting for taxes, calculated as operating income plus
or minus other income and expenses;
8. Income Tax Expense: Reflects the taxes owed based on
the company's income before tax;
9. Net Income: The bottom line of the income statement,
showing the company’s total profit after all expenses,
including taxes and interest, have been deducted. It would
be a net loss in case of negative number.
Operating income is sometimes called EBIT (Earnings
Before Interest and Taxes) because they both measure the
profitability of a company's core operations before considering
interest expenses and taxes. However, while the terms are often
used interchangeably, they have slight differences in certain
contexts.
Operating Income:
•
Definition: Operating income refers to the profit a
company makes from its core business operations,
excluding non-operating items like interest and taxes.
26
•
Formula:
Operating income focuses solely on operational efficiency
by subtracting only operating expenses such as salaries,
rent, and depreciation from gross profit.
EBIT (Earnings Before Interest and Taxes):
•
Definition: EBIT is a broader measure of profitability that
includes non-operating income or expenses, but still
excludes interest and taxes.
•
Formula:
EBIT can include non-operating items like gains or losses
from selling assets, which may not be directly tied to a
company's day-to-day operations.
Key Difference:
•
Operating Income only accounts for revenue and
expenses directly tied to the company's operations,
whereas EBIT may include additional non-operating items,
depending on the company's accounting practices. While
both exclude interest and taxes, EBIT can be slightly
broader, making Operating Income a subset of EBIT
in some cases.
EBITDA (Earnings Before Interest, Taxes, Depreciation,
and Amortization) is a financial metric that expands on EBIT
by adding back depreciation and amortization. These are noncash expenses that reduce reported earnings but do not represent
27
actual cash outflows. EBITDA is often used to assess a company's
operating performance and cash flow generation potential, as it
focuses on earnings before accounting for the impacts of capital
structure and non-cash expenses.
From EBIT to EBITDA:
To calculate EBITDA from EBIT, you simply add back
depreciation and amortization:
Formula:
Depreciation
•
Definition: Depreciation is the accounting method used
to allocate the cost of a tangible asset (such as
machinery, equipment, or buildings) over its useful life. It
"transfers" a portion of the asset’s value recorded on the
balance sheet to the income statement each year,
reflecting the gradual decline in the asset’s value due to
use, wear and tear, or obsolescence.
•
How it transfers: Each year, a calculated portion of the
asset's total value is expensed on the income statement,
reducing profits but not involving any actual cash outlay.
•
Example: If a company buys machinery for $100,000 with
a useful life of 10 years, it might record $10,000 in
depreciation expense each year on its income statement.
This reduces the asset's value in the balance sheet and
moves the corresponding expense to the income
statement.
28
•
Methods of Calculation:
1. Straight-Line Depreciation: The most common
method, where the asset's cost is spread evenly
over its useful life.
Example: If a building costs $500,000 and is expected to have a
useful life of 20 years with a salvage value of $50,000, the annual
depreciation expense is:
2. Declining
Balance
Depreciation:
An
accelerated depreciation method where a higher
depreciation expense is recorded in the earlier
years of the asset’s life.
•
Why it's excluded from EBITDA: Depreciation is a
non-cash expense, meaning it does not involve actual
money leaving the business. Adding it back in EBITDA
helps focus on the company’s cash-generating ability
without being influenced by how it accounts for the decline
in asset value.
Amortization
•
Definition: Amortization is similar to depreciation but
applies to intangible assets, such as patents, copyrights,
or trademarks. Like depreciation, amortization "transfers"
a portion of the intangible asset’s value from the balance
sheet to the income statement over its useful life.
29
•
How it transfers: Each year, a portion of the asset's value
is expensed, reducing the intangible asset's value on the
balance sheet and reporting it as an expense in the income
statement.
•
Example: A company acquires a patent for $50,000 with
a useful life of 5 years. Each year, the company records an
amortization expense of $10,000, reflecting the gradual
expiration of the patent’s value.
•
Methods of Calculation:
Straight-Line Amortization: Similar to straightline depreciation, the cost of the intangible asset is
spread evenly over its useful life.
Example: For a $100,000 trademark with a useful
life of 10 years, the annual amortization would be
$10,000 per year.
•
Why it's excluded from EBITDA: Amortization is also
a non-cash expense. By excluding it, EBITDA presents a
clearer view of the company’s core operational
performance, free from the effects of accounting for
intangible asset reduction.
How EBITDA is used:
•
Cash Flow Proxy: EBITDA is often considered a proxy
for operating cash flow, as it excludes non-cash
expenses (depreciation and amortization), making it a
useful metric for comparing companies with different
capital structures. But of course, it’s not equivalent;
30
•
Comparison Across Companies: Investors and
analysts use EBITDA to compare companies across
industries, as it removes the impact of how companies
finance their operations and the impact of tax jurisdictions;
•
Other valuation methods will be analyzed
throughout the specific sections of the guide.
➔ Let’s see other possible calculation methods
for depreciation and amortization.
Other Depreciation Methods
Units of Production Depreciation:
Depreciation is based on the actual usage or output of the asset
rather than the passage of time.
For example, if a machine is expected to produce 10,000 units over its
life and costs $100,000 with no salvage value, and it produces 2,000
units in a year, depreciation for that year would be $20,000.
Sum-of-the-Years' Digits (SYD)
An accelerated method where the expense is higher in earlier
years and decreases over time. The asset’s useful life is summed,
and each year’s fraction decreases over the asset's life.
For example, for a 5-year asset, the sum of years would be 5+4+3+2+1
= 15. The first year’s depreciation would be a fraction of the total asset
value.
31
Other Amortization Methods
Percentage of Revenue Amortization:
The amortization expense is calculated based on the percentage
of revenue generated by the intangible asset relative to the total
expected revenue during its useful life.
For example, if an intangible asset is expected to generate $2,500,000
in total revenue over 5 years and it generates $400,000 in the first
year, the amortization for that year would be 16% (400,000 /
2,500,000) of the asset’s value.
Sum-of-the-Years' Digits (SYD) Amortization:
Similar to SYD depreciation, this method allocates a larger
expense in the earlier years and gradually reduces it.
For example, for a patent with a 5-year useful life, the total sum of
years is 15. The first year’s amortization would be a fraction of the total
cost of the patent.
We’ve seen how a multi-step income statement is
structured.
In addition to the single-step format (which consists of
summarizing revenues and expenses in one simple
calculation), there are also other ways a company can
prepare its income statement, especially for internal
reporting purposes.
These alternative formats may provide more detailed
insights or focus on specific areas of performance → Let’s
explore some examples.
32
1. Contribution Margin Income Statement (Variable
Costing)
Typically used for Internal Management, Manufacturing, and
Decision-Making purposes. This format is relevant in industries
where variable and fixed costs play significant roles, such as
Manufacturing and Technology sectors.
•
Purpose: It separates variable costs from fixed costs and
focuses on the contribution margin, which helps with
cost-volume-profit (CVP) analysis and decision-making
around pricing and profitability;
•
Example Users: Manufacturers, businesses with
significant variable costs (e.g., retail chains with sales
commissions).
Example of Calculation:
•
Sales Revenue: $400,000
•
Variable Costs: $200,000
•
Contribution Margin: $200,000 (Sales Revenue Variable Costs)
•
Fixed Costs: $150,000
•
Operating Income: $50,000 (Contribution Margin Fixed Costs)
Variable costs are expenses that fluctuate in direct proportion
to a company’s level of production or sales. As production
increases, variable costs rise; when production decreases, variable
costs fall. These costs are closely tied to business activity.
Examples of variable costs include:
•
Raw materials: The more products a company makes,
the more raw materials it needs;
33
•
Direct labor: Wages for workers paid based on hours
worked or units produced;
•
Sales commissions: Payments to salespeople that
increase with the number of products sold.
Fixed costs, on the other hand, are expenses that remain
constant regardless of the company’s level of production or sales.
These costs don’t change with activity in the short term, so
whether the company produces a lot or very little, fixed costs
remain the same. Examples of fixed costs include:
•
Rent: The cost of leasing office or manufacturing space
stays the same each month, regardless of production
levels;
•
Salaries: Salaries paid to employees on a fixed monthly or
annual basis;
•
Insurance: Premiums for coverage, which remain the
same regardless of company activity.
2. Segmented Income Statement
Used in Multi-Division or Multi-Product Companies such as
Conglomerates and Multinationals with different product
lines or divisions.
•
Purpose: This format tracks the performance of each
segment separately, enabling the business to understand
which areas contribute most to revenue and profitability.
It helps management make informed decisions about
resource allocation or segment improvement;
•
Example Users: Large multinational corporations or
conglomerates.
34
3. Departmental Income Statement
Common in Hospitality, Retail, and Service-Based
Companies such as hotels, restaurants, and retail chains.
•
Purpose: This format is similar to the segmented income
statement but focuses on analyzing the performance of
different departments or areas of operation. It helps
businesses evaluate which departments (e.g., lodging, food
& beverage) contribute the most to profitability;
•
Example Users: Hotels, resorts, multi-department retail
stores.
Examples:
•
Lodging Revenue: $100,000
•
Food & Beverage Revenue: $50,000
•
Lodging Expenses: $60,000
•
Food & Beverage Expenses: $30,000
•
Lodging Profit: $40,000
•
Food & Beverage Profit: $20,000
4. Cash Basis Income Statement
Used by Small Businesses and Cash-Oriented Sectors such
as freelance work or businesses following cash accounting
methods.
•
Purpose: This method recognizes revenue and expenses
only when cash is received or paid (as opposed to accrual
35
accounting). It’s especially useful for cash
management in small, cash-heavy businesses;
•
Example Users: Small service-based
freelancers, self-employed individuals.
flow
businesses,
Example of Calculation:
•
Cash Received: $60,000
•
Cash Paid for Expenses: $30,000
•
Net (Cash) Income: $30,000
SUMMARY
36
PERIODICITY OF THE INCOME STATEMENT
The income statement is typically prepared for different time
periods depending on the reporting needs of a business. Most
companies generate monthly income statements for internal
reporting purposes; this allows management to closely monitor
performance on a more regular basis.
Monthly statements enable quick adjustments to operations if
trends indicate the need for changes in strategy or cost control.
For external reporting, companies usually produce quarterly
and annual income statements; these are required for
regulatory purposes, particularly for publicly traded firms.
The quarterly reports provide a snapshot of a company’s financial
health throughout the year, giving investors a chance to review
performance over short intervals. Annual reports, on the other
hand, offer a comprehensive view of the company's performance
over a full year (which investors and stakeholders rely on to assess
the company's long-term viability).
Interestingly, some companies may opt for a thirteen-period
cycle (especially in retail industries) to even out reporting across
months, as this method accounts for seasonality and differing
lengths of months. This unique approach ensures that each period
is roughly equal in duration, which can make financial comparisons
between periods more accurate. Internal and external users of
financial information depend heavily on the frequency of these
reports; the more frequently data is produced, the better it is for
decision-making.
Despite these advantages, more frequent reporting can come with
challenges: companies must maintain high accuracy in their
accounting practices, ensuring that each report provides a true
and fair view.
Moreover, the time and resources required to generate reports
can be substantial for companies with complex operations or large
37
transaction volumes. And also… the choice of reporting period
depends on the company’s structure, industry, and regulatory
environment. In summary, the periodicity of the income statement
plays a critical role in financial analysis and planning.
USE IN FINANCIAL MODELING
The income statement is a vital component of financial modeling,
serving as a foundation for projecting a company’s future
performance. Financial models typically begin with historical data
from the income statement, which is used to establish trends and
relationships between revenues, expenses, and profits.
When they analyze past performance, financial analysts can create
drivers (such as sales growth rates, margins, and cost ratios)
that forecast future values for each line item on the income
statement. These drivers form the basis for the entire model,
influencing not only future income but also cash flow and
balance sheet projections.
One of the key steps in using the income statement for financial
modeling is differentiating between fixed and variable
costs; this helps analysts understand how costs will behave as the
company grows or shrinks in size. For example, fixed costs (like
rent) remain constant regardless of production levels, while
variable costs (such as raw materials) fluctuate in line with
revenue. These assumptions must be accurate to ensure the
financial model reflects real-world conditions.
In financial modeling, future projections are built incrementally,
with the income statement being linked directly to the balance
sheet and cash flow statement. Changes in revenue or costs
on the income statement directly impact the cash position,
capital expenditures, and other balance sheet items. Once the
future income statement is built, analysts often calculate key
performance indicators that we’ve seen before, like gross
38
margin, EBITDA, and net income to assess how profitable the
company will be under various scenarios. Sensitivity analysis is also
commonly performed to test how small changes in assumptions
(like revenue growth rates) can impact the overall financial
projections.
Also, the income statement in a financial model becomes a
powerful tool for making future decisions, allowing managers
and investors to assess potential risks and opportunities under
different economic conditions. It’s a critical piece of the financial
puzzle when evaluating whether to expand operations, raise
capital, or restructure debt. Its role in forecasting future
performance makes the income statement essential in corporate
planning and strategic decision-making.
SUMMARY
39
In the following sections of this part dedicated to the Income Statement, we will
take a closer look at each key element that forms this crucial financial document.
We'll explore how these elements are reported and structured based on general
international standards followed by businesses worldwide.
These standards ensure that financial statements are clear, consistent, and
comparable, regardless of the industry or country in which a company operates.
We will also examine how these components are typically classified into operating
and non-operating sections, providing insights into the financial health of a
company. For instance, we'll explore how revenue is recognized, how costs are
categorized, and how profitability is measured across different time periods.
40
➔ Now we want to show you a comprehensive list of
possible elements that appear or may appear on an
income statement, organized in the typical (multi-step)
order they are presented. This includes various types of
revenues, expenses, and other elements, following the
standard structure used in financial reporting.
Note:
•
Presentation Order: The order below reflects a typical income statement
layout, but actual presentation may vary based on company policies,
regulatory requirements, and whether the company uses a single-step or
multi-step income statement;
•
Expense Classification: Companies may choose to present expenses by
function (e.g., cost of sales, administrative expenses, as required by
international standards) or by nature (e.g., raw materials, employee benefits),
depending on which method provides more relevant information;
•
Discontinued Operations: These are components of an entity that have
been disposed of or are classified as held for sale and represent a separate
major line of business or geographical area;
•
Earnings Per Share (EPS): Although not listed below, EPS is often
presented on the face of the income statement for companies with publicly
traded shares. In this case, there are the following data:
o
Basic EPS;
o
Diluted EPS.
1. Revenue (Net Sales):
o
Gross Sales;
o
Less: Sales Returns and Allowances;
o
Less: Sales Discounts;
= Net Sales Revenue
41
2. Cost of Goods Sold (COGS):
o
Beginning Inventory
o
Plus Purchases:
▪
Less: Purchase Returns and Allowances
▪
Less: Purchase Discounts
▪
Plus: Freight-In
= Cost of Goods Available for Sale
o
Less: Ending Inventory
= Cost of Goods Sold.
→ Instead of Cost of Goods Sold, we may find the term 'Cost of Sales':
this is particularly common in service-based businesses. In these cases, there
are no physical goods to sell, so the 'Cost of Sales' refers to the direct costs
associated with delivering the service. This can include employee wages,
subcontractor costs, materials used in the service, and other
expenses directly tied to service delivery. Essentially, it reflects
the costs incurred to generate revenue, similar to how COGS operates
in product-based businesses or when a manufacturing or retail company
wants to emphasize the sales aspect of their operations. In such cases, 'Cost
of Sales' may be used to cover both the cost of goods sold and additional
costs related to selling and distributing those goods. This terminology shift
allows companies to present a broader view of their expenses related to
generating revenue, particularly when sales-related costs, such as marketing
or distribution, are significant components of their overall cost structure.
3. Gross Profit:
o
Net Sales Revenue minus Cost of Goods Sold.
4. Operating Expenses:
o
Selling Expenses:
▪
Advertising Expense;
42
o
▪
Sales Salaries and Commissions;
▪
Travel and Entertainment Expenses;
▪
Shipping and Delivery Expenses;
▪
Depreciation of Sales Equipment;
General and Administrative Expenses:
▪
Administrative Salaries and Wages;
▪
Office Rent Expense;
▪
Utilities Expense;
▪
Insurance Expense;
▪
Depreciation of Office Equipment;
▪
Amortization Expense;
▪
Office Supplies Expense;
▪
Telephone and Communication Expenses;
▪
Professional Fees (Legal, Accounting);
▪
Bad Debt Expense;
▪
Property Taxes;
▪
Repairs and Maintenance.
o
Research and Development Expenses;
o
Other Operating Expenses.
5. Total Operating Expenses:
o
Sum of all Operating Expenses.
6. Operating Income (Operating Profit):
o
Gross Profit minus Total Operating Expenses.
7. Other Income and Expenses:
o
Other Income:
43
o
▪
Interest Income;
▪
Dividend Income;
▪
Rental Income;
▪
Gain on Sale of Assets;
▪
Unrealized Gains on Investments;
▪
Foreign Exchange Gains.
Other Expenses:
▪
Interest Expense;
▪
Loss on Sale of Assets;
▪
Unrealized Losses on Investments;
▪
Impairment Losses;
▪
Foreign Exchange Losses;
▪
Restructuring Costs;
▪
Litigation Expenses.
8. Earnings Before Interest and Taxes (EBIT):
o
Operating Income plus Other Income minus Other
Expenses.
9. Interest Expense (if not included above):
o
Interest on Short-Term Debt;
o
Interest on Long-Term Debt.
10. Earnings Before Tax (EBT):
o
EBIT minus Interest Expense.
11. Income Tax Expense:
o
Current Tax Expense;
o
Deferred Tax Expense.
44
12. Net Income from Continuing Operations:
o
Earnings Before Tax minus Income Tax Expense.
13. Discontinued Operations (net of tax):
o
Income or Loss from Discontinued Operations;
o
Gain or Loss on Disposal of Discontinued
Operations.
14. Net Income Before Non-Controlling Interest:
o
Net Income from Continuing Operations plus/minus
Discontinued Operations.
15. Non-Controlling Interest (if applicable):
o
Less: Net Income Attributable to Non-Controlling
Interest.
16. Net Income:
o
Net Income Before Non-Controlling Interest minus
Non-Controlling Interest.
17. Other Comprehensive Income (OCI):
o
o
Items That May Be Reclassified to Profit or Loss:
▪
Unrealized Gains/Losses on Available-forSale Financial Assets;
▪
Foreign Currency Translation Adjustments;
▪
Gains/Losses on Cash Flow Hedges.
Items That Will Not Be Reclassified to Profit or
Loss:
▪
Revaluation Surplus;
▪
Actuarial Gains/Losses on Defined Benefit
Pension Plans;
▪
Changes in Fair Value of Equity Instruments.
45
18. Total Comprehensive Income:
o
Net Income plus Other Comprehensive Income.
Let's go through the list of income statement elements together.
1. Revenue (Net Sales):
This is where it all begins.
We start with Gross Sales—the total amount from all sales.
Then, we subtract Sales Returns and Allowances; these are
refunds or price reductions given to customers.
Next, we subtract Sales Discounts, which encourage
customers to pay early.
After these deductions, we arrive at Net Sales Revenue.
This figure shows the actual revenue the company earned from
its sales.
2. Cost of Goods Sold/Cost of Sales:
Now, let's consider the costs directly related to producing the
goods sold.
We begin with the Beginning Inventory—what the company
had in stock at the start.
Then, we add Purchases made during the period.
But wait—we need to adjust for Purchase Returns and
Allowances (goods returned or discounts received).
We also subtract Purchase Discounts received for early
payment.
46
Don't forget to add Freight-In costs; these are shipping costs
paid to bring inventory in.
This gives us the Cost of Goods Available for Sale.
Subtract the Ending Inventory—what's left at the end.
The result is the Cost of Goods Sold.
This number tells us how much it cost to produce the goods we
sold.
In case of services business, or manufacturing/retail companies
with other accounting methods, this element is called “Cost of
Sales”, and it includes all the expenses that were necessary to
deliver the services/goods.
3. Gross Profit:
We calculate this by subtracting Cost of Goods Sold from Net
Sales Revenue.
It's a key figure—it shows how much money is left after covering
the cost of the products or services sold.
4. Operating Expenses:
These are expenses not directly tied to producing goods or
services.
Selling Expenses include things like:
•
Advertising Expense—money spent to promote
products;
•
Sales Salaries and Commissions—payments to sales
staff;
•
Travel and Entertainment Expenses—costs for
business trips and client entertainment;
47
•
Shipping and Delivery Expenses—costs to send
products to customers;
•
Depreciation of Sales Equipment—the wearing out
of sales tools over time.
General and Administrative Expenses cover:
•
Administrative Salaries and Wages—payments to
office staff;
•
Office Rent Expense—costs of office space;
•
Utilities Expense—electricity, water, and other
services;
•
Insurance Expense—payments for insurance policies;
•
Depreciation of Office Equipment—wearing out of
office tools;
•
Amortization Expense—gradual write-off of intangible
assets;
•
Office Supplies Expense—costs of everyday items like
paper and pens;
•
Telephone and Communication Expenses—phone
and internet bills;
•
Professional Fees (Legal, Accounting)—payments to
lawyers and accountants;
•
Bad Debt Expense—money lost when customers don't
pay;
•
Property Taxes—taxes on property owned;
•
Repairs and Maintenance—costs to fix and maintain
equipment.
48
We also include Research and Development Expenses—
money spent to innovate.
And Other Operating Expenses—any other costs related to
operations.
5. Total Operating Expenses:
Add up all the operating expenses.
This total shows how much the company spent to run its
business operations.
6. Operating Income (Operating Profit):
Subtract Total Operating Expenses from Gross Profit.
This figure tells us how much profit the company made from its
core business activities.
7. Other Income and Expenses:
These items are not part of the main business operations.
Other Income might include:
•
Interest Income—money earned from investments;
•
Dividend Income—earnings from shares in other
companies;
•
Rental Income—money received from renting out
property;
•
Gain on Sale of Assets—profit from selling equipment
or property;
•
Unrealized Gains on Investments—increases in
investment value not yet sold;
49
•
Foreign Exchange Gains—profits from currency value
changes.
Other Expenses might include:
•
Interest Expense—costs of borrowing money;
•
Loss on Sale of Assets—losses from selling assets
below value;
•
Unrealized Losses on Investments—decreases in
investment value;
•
Impairment Losses—write-downs of asset values;
•
Foreign Exchange Losses—losses from unfavorable
currency changes;
•
Restructuring Costs—expenses to reorganize the
company;
•
Litigation Expenses—legal costs from lawsuits.
8. Earnings Before Interest and Taxes (EBIT):
We calculate this by adding Other Income to Operating
Income, then subtracting Other Expenses.
It shows the company's profitability before interest and taxes.
9. Interest Expense (if not included above):
Includes costs like:
•
Interest on Short-Term Debt—interest on loans due
within a year;
•
Interest on Long-Term Debt—interest on loans due
after more than a year.
10. Earnings Before Tax (EBT):
50
Subtract Interest Expense from EBIT.
This figure shows the earnings before income taxes are
considered.
11. Income Tax Expense:
Consists of:
•
Current Tax Expense—taxes owed for the current
period;
•
Deferred Tax Expense—taxes that will be paid or
recovered in future periods.
12. Net Income from Continuing Operations:
Subtract Income Tax Expense from Earnings Before Tax.
This number represents profit from the company's ongoing
activities.
13. Discontinued Operations (net of tax):
Includes:
•
Income or Loss from Discontinued Operations—
results from parts of the business that are no longer in
operation;
•
Gain or Loss on Disposal of Discontinued
Operations—profit or loss from selling these parts.
14. Net Income Before Non-Controlling Interest:
Combine Net Income from Continuing Operations with
gains or losses from discontinued operations.
This gives us the total net income before considering minority
interests.
51
15. Non-Controlling Interest (if applicable):
Subtract Net Income Attributable to Non-Controlling
Interest.
This is the portion of income belonging to minority shareholders.
16. Net Income:
Subtracting non-controlling interests, we arrive at Net Income.
This is the profit available to the company's own shareholders.
17. Other Comprehensive Income (OCI):
These are gains and losses not included in net income.
Items that may be reclassified to profit or loss include:
•
Unrealized Gains/Losses on Available-for-Sale
Financial Assets—changes in value of investments not
yet sold;
•
Foreign Currency Translation Adjustments—
effects of currency exchange rates on foreign operations;
•
Gains/Losses on Cash Flow Hedges—adjustments
from hedging future cash flows.
Items that will not be reclassified include:
•
Revaluation Surplus—increases in asset values
recognized in equity;
•
Actuarial Gains/Losses on Defined Benefit Pension
Plans—changes in pension obligations;
•
Changes in Fair Value of Equity Instruments—
adjustments in the value of certain equity investments.
52
18. Total Comprehensive Income:
Add Other Comprehensive Income to Net Income.
This total shows all changes in equity from non-owner sources
during the period.
Going through each element, we see how the income
statement builds up from revenues to the final net
income and comprehensive income.
It reflects the company's financial performance over a
period, showing how various revenues and expenses
contribute to the overall profit or loss.
Isn't it interesting how each piece fits together to tell the
financial story of a business?
➔ As mentioned earlier, we will now explore how the
individual elements of the income statement should be
reported, following international guidelines. These are
based on the most widely recognized frameworks
globally, such as IFRS and GAAP;
➔ First, we will explain what these frameworks are, and
then we will dive into the specific rules and standards
they set for structuring and presenting the income
statement accurately.
53
What are IFRS and GAAP?
IFRS (International Financial Reporting Standards) is a set
of globally recognized accounting standards developed by the
International Accounting Standards Board (IASB). These
standards aim to create a common accounting language so that
financial statements are comparable across international
boundaries. IFRS is widely used in over 140 countries, particularly
in Europe, Asia, and parts of Latin America. The goal of IFRS is to
promote transparency, accountability, and efficiency in financial
markets around the world.
Key Characteristics of IFRS:
•
Principles-based: IFRS focuses on the intent behind the
transactions and the overall financial picture, providing
flexibility in how transactions are reported but requiring
more judgment by accountants;
•
Global focus: IFRS is designed to be used globally,
facilitating comparability between companies in different
countries;
•
Transparency:
IFRS
emphasizes
clear
and
understandable financial reporting for stakeholders,
including investors, regulators, and other interested
parties.
GAAP (Generally Accepted Accounting Principles) is the
accounting framework used primarily in the United States. It is
governed by the Financial Accounting Standards Board
(FASB) and consists of rules and guidelines on how companies
should prepare their financial statements. Unlike IFRS, GAAP is
mostly applied within the U.S. and is considered the standard for
companies listed on U.S. stock exchanges.
54
Key Characteristics of GAAP:
•
Rules-based: GAAP provides detailed rules and
guidelines on how to report specific transactions, which
minimizes ambiguity but can be less flexible;
•
U.S.-focused: GAAP is used primarily by companies that
operate in or are listed in the United States, but it is not
typically used for international reporting;
•
Consistency: GAAP ensures consistency in financial
reporting across industries in the U.S., making it easier for
analysts, regulators, and investors to understand financial
reports.
While both IFRS and GAAP aim to ensure accurate and reliable
financial reporting, they differ in their approaches. IFRS is more
principles-based, providing general guidelines and requiring
judgment for application, whereas GAAP is more rules-based,
offering specific instructions for various transactions.
➔ Now let’s examine how each element of the income
statement is treated under International Financial
Reporting Standards (IFRS) and Generally
Accepted Accounting Principles (GAAP). The focus
is solely on elements that are explicitly considered under
IFRS and GAAP, providing detailed treatments without
definitions.
1. Revenue Recognition
IFRS Treatment
•
Standard: IFRS 15 Revenue from Contracts with Customers
•
Approach:
55
•
o
Recognizes revenue when control of goods or services
transfers to the customer;
o
Utilizes a five-step model:
1.
Identify the contract with a customer;
2.
Identify the performance obligations;
3.
Determine the transaction price;
4.
Allocate the transaction price to performance
obligations;
5.
Recognize revenue when performance obligations
are satisfied.
Key Points:
o
Focuses on the transfer of control, not just risks and
rewards;
o
Requires extensive disclosures about contracts with
customers;
o
Addresses variable consideration, significant financing
components, non-cash consideration, and consideration
payable to a customer.
GAAP Treatment
•
Standard: ASC 606 Revenue from Contracts with Customers
•
Approach:
•
o
Mirrors IFRS 15 with the same five-step model;
o
Emphasizes the importance of the collectibility threshold;
o
Provides additional industry-specific guidance.
Key Points:
o
Requires similar disclosures as IFRS;
o
Includes detailed implementation guidance and examples;
56
o
Addresses topics like contract modifications, principal
versus agent considerations, and licensing.
2. Cost of Goods Sold (COGS)
IFRS Treatment
•
Standard: IAS 2 Inventories
•
Approach:
•
o
Permits First-In, First-Out (FIFO) and Weighted
Average Cost methods;
o
Last-In, First-Out (LIFO) is prohibited;
o
Inventories are measured at the lower of cost and net
realizable value.
Key Points:
o
Write-downs to net realizable value are recognized as an
expense;
o
Reversals of prior write-downs are permitted if net
realizable value increases;
o
Requires consistent use of inventory costing methods.
GAAP Treatment
•
Standard: ASC 330 Inventory
•
Approach:
•
o
Permits FIFO, LIFO, and Weighted Average Cost
methods;
o
Inventories are measured at the lower of cost or market;
o
Market value is defined as replacement cost, but cannot
exceed net realizable value or be less than net realizable
value minus a normal profit margin.
Key Points:
57
o
Write-downs to market value are recognized as a loss in
earnings;
o
Reversals of inventory write-downs are not allowed;
o
LIFO conformity rule requires LIFO for tax purposes if used
for financial reporting.
3. Operating Expenses
Selling, General, and Administrative Expenses (SG&A)
IFRS Treatment
•
Standard: IAS 1 Presentation of Financial Statements
•
Approach:
•
o
Allows classification of expenses either by nature (e.g., raw
materials, staff costs) or by function (e.g., cost of sales,
administrative expenses);
o
Requires entities to choose the method that provides
information that is reliable and more relevant.
Key Points:
o
Flexibility in presentation;
o
Must disclose additional information if function method is
used.
GAAP Treatment
•
Standard: Various sections within ASC
•
Approach:
•
o
Expenses are generally classified by function;
o
Detailed breakdowns by nature are disclosed in the notes if
necessary.
Key Points:
58
o
Less flexibility compared to IFRS;
o
Emphasis on consistency and comparability in classification.
Research and Development Expenses
IFRS Treatment
•
Standard: IAS 38 Intangible Assets
•
Approach:
•
o
Research costs are expensed as incurred;
o
Development costs are capitalized when specific criteria
are met:
▪
Technical feasibility;
▪
Intention to complete and use or sell the asset;
▪
Ability to use or sell the asset;
▪
Generation of probable future economic benefits;
▪
Availability of adequate resources;
▪
Reliable measurement of expenditures.
Key Points:
o
Capitalized development costs are amortized over their
useful lives;
o
Requires annual impairment testing for capitalized
development assets.
GAAP Treatment
•
Standard: ASC 730 Research and Development
•
Approach:
o
Both research and development costs are expensed as
incurred;
59
•
o
Software development costs intended to be sold are
capitalized after technological feasibility is established (ASC
985-20);
o
Software for internal use can be capitalized during the
application development stage (ASC 350-40).
Key Points:
o
No capitalization of development costs for non-software
projects;
o
Provides specific guidance on software-related R&D.
Depreciation and Amortization
IFRS Treatment
•
Standards: IAS 16 Property, Plant and Equipment; IAS 38 Intangible
Assets
•
Approach:
•
o
Depreciation and amortization are systematic allocations of
the depreciable amount over the asset's useful life;
o
Residual values and useful lives are reviewed at least
annually;
o
Changes in depreciation method or useful life are accounted
for prospectively.
Key Points:
o
Component depreciation is required when significant parts
of an asset have different useful lives;
o
Revaluation model is allowed for PPE and intangible assets.
GAAP Treatment
•
Standards: ASC 360 Property, Plant, and Equipment; ASC 350
Intangibles—Goodwill and Other
•
Approach:
60
•
o
Similar to IFRS in systematic allocation over useful life;
o
Residual values and useful lives are reviewed when
events indicate they may have changed;
o
Changes in estimates are accounted for prospectively.
Key Points:
o
Component depreciation is permitted but not required;
o
Revaluation of assets is not allowed; assets are carried at
historical cost less accumulated depreciation.
4. Other Income and Expenses
IFRS Treatment
•
Standard: IAS 1
•
Approach:
•
o
Items not part of operating activities are presented
separately;
o
Includes finance costs, investment income, gains and losses
from disposal of assets.
Key Points:
o
Requires separate disclosure of material items;
o
Unusual or infrequent items are included in profit or loss
but may be presented separately for clarity.
GAAP Treatment
•
Standard: ASC 225 Income Statement
•
Approach:
o
Similar to IFRS; non-operating items are reported separately
from operating income;
61
o
•
Includes interest income and expense, gains or losses on
sales of investments.
Key Points:
o
Extraordinary items are no longer recognized separately;
o
Unusual or infrequent items are presented as part of income
from continuing operations.
5. Interest Expense
IFRS Treatment
•
Standard: IAS 23 Borrowing Costs
•
Approach:
•
o
Capitalization of borrowing costs directly attributable to
the acquisition, construction, or production of a qualifying
asset is required;
o
Other borrowing costs are recognized as an expense in the
period incurred.
Key Points:
o
A qualifying asset is one that necessarily takes a substantial
period of time to get ready for its intended use or sale;
o
Capitalization ceases when substantially all the activities
necessary to prepare the asset are complete.
GAAP Treatment
•
Standard: ASC 835 Interest
•
Approach:
o
Similar to IFRS; interest costs are capitalized for qualifying
assets;
62
o
•
Capitalization period begins when expenditures and
borrowing costs are incurred and activities are in progress
to prepare the asset.
Key Points:
o
The definition of a qualifying asset is similar to IFRS;
o
Capitalization stops during intentional delays but continues
during ordinary delays.
6. Income Tax Expense
IFRS Treatment
•
Standard: IAS 12 Income Taxes
•
Approach:
•
o
Recognizes both current tax and deferred tax;
o
Deferred tax is based on temporary differences between
accounting and tax bases of assets and liabilities;
o
Uses the balance sheet liability method.
Key Points:
o
Deferred tax assets are recognized if recovery is probable;
o
Deferred tax liabilities are recognized for all taxable
temporary differences, with some exceptions;
o
Tax rates enacted or substantively enacted by the end of the
reporting period are used.
GAAP Treatment
•
Standard: ASC 740 Income Taxes
•
Approach:
o
Also recognizes current and deferred taxes using the
balance sheet approach;
63
o
•
Deferred tax assets are recognized in full but reduced by a
valuation allowance if it is more likely than not that
some portion will not be realized.
Key Points:
o
Emphasizes the "more likely than not" (>50%) threshold for
recognizing deferred tax assets;
o
Tax rates enacted by the reporting date are used;
substantively enacted rates are not considered;
o
Provides detailed guidance on uncertain tax positions.
7. Net Income
IFRS Treatment
•
Standard: IAS 1
•
Approach:
•
o
Net income is presented as profit or loss for the period;
o
All items of income and expense recognized in a period are
included unless a standard requires otherwise.
Key Points:
o
Certain items may be presented separately due to their size
or nature to explain performance.
GAAP Treatment
•
Standard: ASC 225
•
Approach:
•
o
Net income is the residual amount after all revenues and
expenses, including taxes;
o
Must be clearly presented in the income statement.
Key Points:
64
o
Similar to IFRS in including all recognized items unless
excluded by standards.
8. Other Comprehensive Income (OCI)
IFRS Treatment
•
Standard: IAS 1
•
Approach:
•
o
OCI includes items that are not recognized in profit or loss
but affect equity;
o
Items in OCI may or may not be reclassified to profit or loss
in future periods (recycling).
Key Points:
o
Includes revaluation surplus, actuarial gains and losses, gains
and losses on financial assets measured at fair value through
OCI;
o
Reclassification adjustments are made when amounts
previously recognized in OCI are reclassified to profit or
loss.
GAAP Treatment
•
Standard: ASC 220 Comprehensive Income
•
Approach:
•
o
OCI includes items excluded from net income under GAAP
but affect equity;
o
All OCI items are eventually reclassified to net income
when realized (except for certain pension adjustments).
Key Points:
o
Includes unrealized gains and losses on available-for-sale
securities, foreign currency items, and derivative
instruments;
65
o
Reclassification adjustments are required when
amounts are realized.
9. Total Comprehensive Income
IFRS Treatment
•
Standard: IAS 1
•
Approach:
•
o
Total comprehensive income comprises net income and
other comprehensive income;
o
Can be presented in a single statement or two consecutive
statements.
Key Points:
o
Aims to provide a complete picture of all changes in equity
arising from non-owner sources.
GAAP Treatment
•
Standard: ASC 220
•
Approach:
•
o
Similar to IFRS; total comprehensive income includes net
income and OCI;
o
Presentation options are consistent with IFRS.
Key Points:
o
Encourages clarity and transparency in reporting all income
and expenses.
10. Earnings Per Share (EPS)
IFRS Treatment
•
Standard: IAS 33 Earnings per Share
66
•
•
Approach:
o
Requires presentation of basic and diluted EPS for profit
or loss attributable to ordinary equity holders;
o
Basic EPS is calculated by dividing profit or loss by the
weighted average number of ordinary shares outstanding;
o
Diluted EPS adjusts the earnings and shares for the effects
of dilutive potential ordinary shares.
Key Points:
o
EPS figures must be presented on the face of the income
statement;
o
Requires disclosure of the amounts used in calculations.
GAAP Treatment
•
Standard: ASC 260 Earnings Per Share
•
Approach:
•
o
Similar requirements to IFRS for public entities;
o
Provides detailed guidance on computing EPS, including
complex capital structures.
Key Points:
o
Requires presentation of EPS data for income from
continuing operations and net income;
o
Disclosures include reconciliation of numerators and
denominators used.
Key Differences Summary
•
Revenue Recognition:
o
Both frameworks have converged significantly, but GAAP
includes more detailed industry-specific guidance;
67
•
•
•
•
•
•
Inventory Costing:
o
LIFO is permitted under GAAP but prohibited under IFRS;
o
Reversals of inventory write-downs are allowed under IFRS
but not under GAAP;
Development Costs:
o
IFRS allows capitalization of development costs when
criteria are met;
o
GAAP generally requires all research and development costs
to be expensed, with limited exceptions for software;
Classification of Expenses:
o
IFRS provides flexibility to classify expenses by nature or
function;
o
GAAP typically requires classification by function;
Revaluation of Assets:
o
IFRS allows revaluation of PPE and intangible assets;
o
GAAP does not permit revaluation; assets are carried at
historical cost;
Income Taxes:
o
Recognition criteria for deferred tax assets differ; IFRS uses
"probable," GAAP uses "more likely than not";
o
GAAP requires a valuation allowance for deferred tax assets
when realization is uncertain;
Other Comprehensive Income:
o
Some items in OCI under IFRS are not reclassified to profit
or loss;
o
Under GAAP, most OCI items are eventually recycled to
net income.
68
2.3 Balance Sheet: Structure and
Components
As we have seen in the introductions, the balance sheet
provides a snapshot of a company's financial position at a specific
point in time: it has three main components: assets, liabilities,
and equity, offering a clear picture of what the business owns,
owes, and the shareholder’s stake in the company.
Assets
These are what the company owns that has value: They are
classified into two main categories: current assets and noncurrent assets (also known as long-term or fixed assets).
•
Current assets are short-term in nature and can be
converted into cash within one year. These include Bank
accounts and cash equivalents (such as highly liquid
investments), accounts receivable (money owed to the
company by customers for goods or services already
delivered), inventory, and prepaid expenses (payments
made in advance for goods or services to be received in
the future).
•
Non-current assets, on the other hand, are long-term
investments that cannot be easily liquidated within a year.
These include property, plant, and equipment
(PP&E), long-term investments, intangible assets
such as patents and trademarks, and goodwill (extra value
paid when acquiring a company's reputation or
relationships).
Liabilities
These represent the obligations or debts a company owes to
external parties, such as creditors and suppliers. Similar to assets,
liabilities are divided into current and non-current liabilities:
69
•
Current liabilities are obligations the company needs to
settle within one year, such as accounts payable (money
owed to suppliers), short-term loans, accrued
expenses, and tax liabilities.
•
Non-current liabilities are long-term obligations,
typically due in more than one year. These include longterm debt, deferred tax liabilities, and pension
liabilities.
Equity
This section represents the ownership interest held by
shareholders and is calculated by subtracting total liabilities from
total assets. It reflects the net value of the company that belongs
to its owners. Equity is made up of share capital (the funds raised
by issuing shares) and retained earnings (profits that have been
reinvested in the business rather than distributed to
shareholders).
Additionally, equity may include other components, such as
additional paid-in capital, treasury stock (repurchased
shares), and accumulated other comprehensive income,
which records unrealized gains and losses from certain
investments.
The relationship between assets, liabilities, and equity is expressed
in the accounting equation:
This equation must always be in balance: every transaction a business
makes affects at least two of these components, ensuring that the
overall financial position is accurately reflected.
How is a Balance Sheet typically presented graphically?
A balance sheet is usually presented in a tabular format, divided
into two main sections. In academic contexts, you will find assets
on the left side; and on the right side, you'll see liabilities and
70
equity. As said before, these two sides must always balance,
reflecting the accounting equation.
Here's the typical layout used in academic contexts:
➔ So, for example, you may see these amounts:
But the vertical balance sheet is more widely used in
modern financial reporting due to its simplicity and clarity. It
organizes financial data in a top-to-bottom structure, making it
easy to read and interpret for a variety of stakeholders.
71
1. Corporate Reporting → In publicly traded companies, the vertical
balance sheet is used in annual and quarterly reports: It presents
a clear picture of the company’s assets, liabilities, and equity, which
helps investors and regulators quickly assess the company’s
financial health. This structure aligns well with global accounting
standards, such as IFRS and GAAP, making it ideal for companies
operating internationally. As we did with the income statement,
we will analyze how these international standards require the
reporting of each element of the balance sheet.
2. Auditing and Tax Reporting → Auditors prefer the vertical format
because it follows a logical flow from the most liquid assets to less
liquid ones, then from short-term liabilities to long-term. This
structure simplifies the auditing process, allowing for easier
verification and compliance with regulatory standards. Tax
authorities also find this format useful for assessing a company’s
taxable income and financial stability.
3. Investor and Stakeholder Communication → Investors rely on the
vertical balance sheet to quickly evaluate a company’s financial
performance, particularly its liquidity and solvency. The format
provides a straightforward comparison between assets and
liabilities, making it easier for stakeholders to make informed
decisions.
4. Internal Management → Companies use vertical balance sheets
for internal financial planning and decision-making. It helps
management teams monitor the company's financial progress over
time, track performance, and plan future investments or debt
reduction strategies.
The two-sided balance sheet, though less common
today, is primarily used in educational settings or legacy
systems for easier visual comparison of financial elements.
72
The vertical balance sheet can be found in a variety of
online documents, especially in annual reports of public
companies, like this one from Apple:
Now it is time to dive into the specifics of each
individual element of the Balance Sheet… We will
look closely at what each one is and how it is required
to be reported according to IFRS and GAAP.
73
➔ As we explore each element of the Balance Sheet, we will
see how both IFRS and GAAP require these items to be
recognized and presented, ensuring compliance with
their respective frameworks.
CURRENT ASSETS
1. Cash, Cash Equivalents, and Bank Balances
•
Definition → This includes physical cash, balances held in
bank accounts, and highly liquid short-term investments
like Treasury bills or certificates of deposit (CDs) that are
readily convertible into cash with minimal risk;
•
GAAP Treatment → Reported at face value for cash
and bank balances; Cash equivalents are reported at fair
market value (FMV); Any restricted cash is disclosed
separately; The statement of cash flows distinguishes
between cash and cash equivalents used in operations,
financing, or investing activities;
•
IFRS Treatment → Similar to GAAP, cash, bank
balances, and cash equivalents are reported at fair value;
Disclosure is required for restricted cash, and such
amounts are separated from unrestricted cash in financial
statements;
74
2. Marketable Securities
•
Definition → Short-term investments in debt or equity
securities (e.g., stocks, bonds, commercial paper) that can
be easily sold or converted into cash within a year;
•
GAAP Treatment → Classified as trading, available-forsale, or held-to-maturity; Trading securities are reported
at fair market value (FMV), with unrealized gains/losses
recorded in the income statement; Available-for-sale
securities' unrealized gains/losses are reported in other
comprehensive income (OCI);
•
IFRS Treatment → Marketable securities are classified
under financial assets based on the business model and
cash flow characteristics; They are valued at fair value
through profit and loss (FVTPL) or fair value through other
comprehensive income (FVOCI);
3. Accounts Receivable
•
Definition → Amounts owed to the company by
customers who have purchased goods or services on
credit; These are generally expected to be collected within
one year;
75
•
GAAP Treatment → Reported at net realizable value
(NRV), which is the total receivables minus an allowance
for doubtful accounts, which is based on historical
experience and current market conditions;
•
IFRS Treatment → Measured at amortized cost using
the effective interest rate, with adjustments for expected
credit losses under the expected credit loss (ECL) model;
4. Inventory
•
Definition → Goods held for sale, including raw
materials, work-in-progress, and finished goods; Inventory
is a significant current asset for manufacturing and retail
businesses;
•
GAAP Treatment → Reported at the lower of cost or
market value; Companies can choose to use FIFO (FirstIn, First-Out), LIFO (Last-In, First-Out), or weighted
average to value inventory; LIFO is allowed under GAAP;
•
IFRS Treatment → Inventory is valued at the lower of
cost or net realizable value (NRV); FIFO or weighted
average methods are used, but LIFO is not permitted
under IFRS;
76
5. Prepaid Expenses
•
Definition → Expenses paid in advance for goods or
services to be received in the future (e.g., prepaid
insurance, rent, or utilities);
•
GAAP Treatment → Reported as current assets as long
as the benefits are expected to be realized within one year;
The expense is recognized when the service or benefit is
actually received;
•
IFRS Treatment → Similar to GAAP, prepaid expenses
are recognized as assets and expensed over the period
when the related benefits are consumed;
6. Short-term Investments
•
Definition → Investments in debt or equity securities that
are expected to be sold or converted into cash within a
77
year; These include Treasury bills, mutual funds, and other
short-term financial instruments;
•
GAAP Treatment → Valued at fair value with gains or
losses recognized in either the income statement (for
trading securities) or in other comprehensive income (for
available-for-sale securities); Held-to-maturity investments
are recorded at amortized cost;
•
IFRS Treatment → Short-term investments are
classified based on the company’s business model and the
cash flow characteristics of the asset; They are reported
either at fair value through profit or loss (FVTPL) or at
amortized cost;
7. Notes Receivable (due within a year)
•
Definition → Written promises to receive a specific sum
of money at a future date, typically with interest; Notes
due within one year are classified as current assets;
•
GAAP Treatment → Reported at face value if the note
matures within one year; Notes are adjusted for any
estimated uncollectibility using an allowance for doubtful
accounts;
78
•
IFRS Treatment → Measured at amortized cost using
the effective interest rate method, adjusted for impairment
based on expected credit losses;
8. Accrued Revenue
•
Definition → Revenue that has been earned but not yet
invoiced or received; This includes services provided or
goods delivered but not yet paid for by the customer;
•
GAAP Treatment → Revenue is recognized when
earned, even if payment has not yet been received;
Accrued revenue is reported at its estimated realizable
value and recognized as a current asset;
•
IFRS Treatment → Similar to GAAP, accrued revenue
is recognized when the company satisfies its performance
obligations, and the amount can be measured reliably;
Accrued revenue is recognized as an asset until the
customer makes payment;
9. Other Receivables
•
Definition → Miscellaneous amounts to be received, such
as interest receivable, dividends receivable, and tax refunds
due within a year;
79
•
GAAP Treatment → Reported at fair value or net
realizable value, depending on the expected recoverability
of the amounts; Allowances for uncollectible amounts are
created when necessary;
•
IFRS Treatment → Other receivables are measured at
amortized cost or fair value, depending on their nature and
the expected timing of cash flows; Impairment is measured
using the expected credit loss model;
10. Deferred Tax Assets (Current Portion)
•
Definition → Amounts recognized for tax benefits
related to deductible temporary differences or tax losses
carried forward, which are expected to be realized within
a year;
•
GAAP Treatment → Reported as current if expected
to be realized within one year; A valuation allowance is
recorded if it is more likely than not that some portion of
the deferred tax asset will not be realized;
•
IFRS Treatment → Recognized only if it is probable that
future taxable profit will be available to use the deferred
tax asset; Like GAAP, it is presented as a current asset if
realizable within one year;
80
11. Restricted Cash (If Current)
•
Definition → Cash that is restricted for specific purposes
(e.g., for loan repayment, collateral, or specific projects),
which is expected to be released or used within the next
12 months;
•
GAAP Treatment → Restricted cash is reported
separately from unrestricted cash on the balance sheet; If
the restriction is expected to last for more than one year,
it is classified as a non-current asset;
•
IFRS Treatment → Similar to GAAP, restricted cash is
classified separately from unrestricted cash and disclosed
as current or non-current based on the expected timing of
its use.
_________
NON-CURRENT ASSETS
1. Property, Plant, and Equipment (PP&E)
•
Definition → Tangible fixed assets used in business
operations, such as land, buildings, machinery, vehicles, and
81
equipment, that provide economic benefits over multiple
periods;
•
GAAP Treatment → Reported at historical cost
(purchase price plus costs to get the asset ready for use),
minus accumulated depreciation and any impairment
losses; Depreciation is generally calculated using methods
like straight-line, declining balance, or units-of-production;
•
IFRS Treatment → Initially measured at cost; After
recognition, PP&E can be measured using either the cost
model (historical cost less depreciation and impairment)
or the revaluation model (fair value, less depreciation and
impairment); Depreciation methods are similar to GAAP,
but IFRS requires reassessment of residual values and
depreciation methods at each reporting date;
2. Intangible Assets (with a finite useful life)
•
Definition → Non-physical assets with a finite useful life,
such as patents, trademarks, copyrights, customer lists, and
software;
•
GAAP Treatment → Reported at historical cost and
amortized over their useful life, typically using straight-line
82
amortization; If the asset becomes impaired, it is written
down to its fair value;
•
IFRS Treatment → Intangible assets are initially
measured at cost and then amortized over their useful
lives; They are subject to impairment testing, and IFRS
allows revaluation to fair value only if an active market
exists (which is rare for most intangibles);
3. Intangible Assets (with an indefinite useful life)
•
Definition → Non-physical assets without a foreseeable
end to their useful life, such as goodwill, certain
trademarks, and perpetual franchises;
•
GAAP Treatment → Not amortized, but tested
annually for impairment; Goodwill is written down if its
carrying amount exceeds its fair value;
•
IFRS Treatment → Similar to GAAP, these assets are
not amortized but are subject to annual impairment tests
or more frequent testing if there are indicators of
impairment;
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4. Goodwill
•
Definition → An intangible asset that arises when a
company acquires another business for more than the fair
value of its identifiable net assets; It represents future
economic benefits that cannot be individually identified or
recognized;
•
GAAP Treatment → Goodwill is not amortized but is
tested annually for impairment; Impairment is recognized
if the fair value of the reporting unit where the goodwill
resides is less than its carrying amount;
•
IFRS Treatment → Goodwill is not amortized and is
tested annually for impairment at the cash-generating unit
level; Impairment losses are recognized if the carrying
amount exceeds the recoverable amount;
5. Long-term Investments
•
Definition → Investments held for more than one year,
such as stocks, bonds, and other securities, intended for
long-term purposes and not for immediate sale;
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•
GAAP Treatment → Classified as available-for-sale,
held-to-maturity,
or
equity-method
investments;
Available-for-sale investments are reported at fair value
with unrealized gains/losses in other comprehensive
income (OCI), while held-to-maturity investments are
carried at amortized cost;
•
IFRS Treatment → Financial assets are classified as
measured at amortized cost, fair value through profit or
loss (FVTPL), or fair value through other comprehensive
income (FVOCI), depending on the nature of the
investment and the business model;
6. Deferred Tax Assets (Non-current Portion)
•
Definition → Taxes paid or carried forward to future
periods due to temporary differences between the book
value of assets/liabilities and their tax base, expected to be
realized beyond one year;
•
GAAP Treatment → Reported as non-current if the
realization of the tax benefits is expected to occur beyond
one year; A valuation allowance is applied if it is more likely
than not that some portion of the deferred tax asset will
not be realized;
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•
IFRS Treatment → Similar to GAAP, deferred tax
assets are recognized if it is probable that taxable profits
will be available to utilize the temporary differences, and
they are classified as non-current;
7. Investment Property
•
Definition → Property held to earn rental income or for
capital appreciation rather than for use in the company’s
operations, such as land and buildings;
•
GAAP Treatment → Investment property is generally
included under PP&E and treated similarly (historical cost
less depreciation and impairment); There is no separate
category for investment property under GAAP;
•
IFRS Treatment → Investment property is a separate
category and can be measured using either the cost model
(cost less depreciation and impairment) or the fair value
model (changes in fair value are recognized in profit or
loss); Fair value is reassessed at each reporting date;
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8. Biological Assets
•
Definition → Living plants and animals used in agricultural
activities, such as livestock, crops, and timber, that are part
of an agricultural production process;
•
GAAP Treatment → GAAP does not have specific
guidance for biological assets; They are generally treated
as inventory or PP&E, depending on their use and lifecycle;
•
IFRS Treatment → Biological assets are measured at
fair value less costs to sell, with changes in fair value
recognized in profit or loss, reflecting the fair value-based
valuation of agricultural products;
9. Mineral Rights and Natural Resources
•
Definition → Rights to extract natural resources, such as
oil, gas, and minerals, which are depleted over time as they
are extracted;
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•
GAAP Treatment → Reported at historical cost, which
includes acquisition cost, exploration, and development
costs; Depletion is calculated using the units-of-production
method based on the actual extraction of resources;
•
IFRS Treatment → Similar to GAAP, mineral rights and
natural resources are measured at cost, and depletion is
recognized based on actual production relative to the
estimated reserves;
10. Long-term Prepaid Expenses
•
Definition → Payments made for expenses that will be
incurred over a period longer than one year, such as longterm insurance or multi-year lease payments;
•
GAAP Treatment → Reported as non-current assets
and expensed over the period in which the benefit is
received; Prepaid expenses are carried at historical cost
and expensed in the appropriate periods;
•
IFRS Treatment → Similar to GAAP, these are treated
as non-current assets and are amortized over the periods
to which they relate;
11. Non-current Receivables
•
Definition → Amounts due to be collected beyond one
year, such as long-term loans provided to customers or
employees, or installment sales receivables;
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•
GAAP Treatment → Reported at amortized cost
(present value of future cash flows), with interest income
recognized over the life of the receivable; Impairment is
recorded if the receivable is deemed uncollectible;
•
IFRS Treatment → Non-current receivables are
measured at amortized cost, with impairments assessed
using the expected credit loss (ECL) model; Interest
income is recognized based on the effective interest rate;
12. Lease Assets (Right-of-use Assets)
•
Definition → Lease assets that represent the company's
right to use an underlying asset (such as property or
equipment) for a lease term longer than 12 months;
•
GAAP Treatment → Under ASC 842, companies
recognize a right-of-use asset and a corresponding lease
liability on the balance sheet; The right-of-use asset is
amortized over the lease term, and the lease liability is
reduced as payments are made;
•
IFRS Treatment → IFRS 16 is similar to GAAP; Rightof-use assets are recognized for leases longer than 12
months, initially measured at cost and subsequently
depreciated over the lease term.
____________
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CURRENT LIABILITIES
1. Accounts Payable
•
Definition → Amounts a company owes to suppliers for
goods or services purchased on credit; These are typically
short-term obligations due within one year;
•
GAAP Treatment → Reported at the invoiced amount
or the amount owed on the balance sheet, with no need
for adjustments unless the amount is disputed or unlikely
to be paid; Accounts payable is a key component of
working capital management;
•
IFRS Treatment → Similar to GAAP, accounts payable
is recognized at the invoiced amount and is not adjusted
unless there is a dispute or uncertainty over payment; It is
considered a current liability unless payment is deferred
for more than a year;
2. Accrued Liabilities (Accrued Expenses)
•
Definition → Expenses that have been incurred but not
yet paid or invoiced, such as wages, utilities, and taxes;
Accrued liabilities are obligations that are typically settled
in the next financial period;
•
GAAP Treatment → Recognized as liabilities when the
expense is incurred, even if payment has not yet been
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made; Accrued liabilities are reported at their estimated
amount and adjusted for actual amounts when invoiced;
•
IFRS Treatment → Similar to GAAP, accrued liabilities
are recognized when an expense is incurred but payment
has not been made; They are measured at the best
estimate of the amount required to settle the obligation at
the reporting date;
3. Short-term Debt (Current Portion of Long-term Debt)
•
Definition → The portion of long-term debt that is due
within the next 12 months, such as scheduled loan
repayments or bonds maturing within the year;
•
GAAP Treatment → Classified as a current liability on
the balance sheet; Reported at face value or the current
portion of the long-term debt; The repayment schedule
must be disclosed;
•
IFRS Treatment → Similar to GAAP, the current
portion of long-term debt is classified as a current liability
and is reported at amortized cost; If any changes to the
repayment terms occur, they are disclosed;
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4. Notes Payable (due within a year)
•
Definition → Written promises to pay a certain amount
of money, typically with interest, within a short-term
period (usually within a year); These can include shortterm loans or trade-related notes;
•
GAAP Treatment → Recognized at the face value of
the note, with any accrued interest recognized separately
as a liability; Notes payable are classified as current if they
mature within a year;
•
IFRS Treatment → Measured at amortized cost using
the effective interest rate method; Notes payable are
classified as current liabilities if due within one year and are
subject to reclassification if the terms change;
5. Dividends Payable
•
Definition → Amounts owed to shareholders for
dividends that have been declared but not yet paid;
Dividends payable represent a current obligation of the
company to its shareholders;
•
GAAP Treatment → Recognized as a liability when
dividends are declared by the board of directors and are
classified as current liabilities until paid; They are reported
at the amount declared;
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•
IFRS Treatment → Similar to GAAP, dividends payable
are recognized as a liability when declared and are classified
as current liabilities until settlement; The amount declared
is recognized in the balance sheet;
6. Income Taxes Payable
•
Definition → Taxes owed to the government based on
the company's taxable income for the period, which have
not yet been paid;
•
GAAP Treatment → Reported as a current liability for
taxes owed in the current period; The liability is adjusted
for payments made throughout the year and any estimated
tax under/overpayments;
•
IFRS Treatment → Similar to GAAP, income taxes
payable are recognized as liabilities for current period
taxes and are adjusted based on actual and estimated
payments; Deferred tax liabilities are reported separately;
7. Unearned Revenue (Deferred Revenue)
•
Definition → Payments received by a company for goods
or services that have not yet been delivered or performed;
This creates a liability until the revenue is earned;
•
GAAP Treatment → Reported as a current liability on
the balance sheet until the company delivers the goods or
services and recognizes the revenue; The amount is
reduced as performance obligations are satisfied;
•
IFRS Treatment → Similar to GAAP, unearned revenue
is recognized as a liability and is reduced as the company
satisfies its performance obligations under the contract;
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IFRS requires more detailed disclosures regarding the
nature of the performance obligations;
8. Current Portion of Lease Liabilities
•
Definition → The portion of lease obligations under
operating or finance leases that is due within the next 12
months;
•
GAAP Treatment → Under ASC 842, lease liabilities
are recorded on the balance sheet for finance and
operating leases; The current portion of the lease
obligation is reported as a current liability, and the rightof-use asset is amortized;
•
IFRS Treatment → Under IFRS 16, the current portion
of lease liabilities is recognized similarly to GAAP, with
lease liabilities and right-of-use assets recorded on the
balance sheet; The current portion is disclosed separately
as a current liability;
9. Wages and Salaries Payable
•
Definition → Employee compensation that has been
earned but not yet paid, such as wages, salaries, bonuses,
or other benefits payable within the next financial period;
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•
GAAP Treatment → Recognized as a current liability
when the wages and salaries are earned by employees,
even if payment has not yet been made; This includes
unpaid overtime and bonuses;
•
IFRS Treatment → Similar to GAAP, wages and salaries
payable are recognized when the employees earn the
compensation, and the liability is reported at the amount
owed to the employees at the balance sheet date;
10. Interest Payable
•
Definition → Interest that has accrued on debt but has
not yet been paid, such as interest on loans or bonds
payable;
•
GAAP Treatment → Recognized as a current liability
when the interest expense has accrued; Interest payable is
classified as current if it is due within the next 12 months;
•
IFRS Treatment → Similar to GAAP, interest payable is
recognized as a liability once the interest has accrued; It is
reported as a current liability if it is due within the
operating cycle or the next 12 months;
11. Customer Deposits
•
Definition → Amounts received from customers as
advance payments or security deposits for services or
goods to be delivered in the future; These are considered
liabilities until the obligation is fulfilled;
•
GAAP Treatment → Reported as a current liability until
the obligation to deliver goods or services is fulfilled; The
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deposit is then recognized as revenue or returned to the
customer;
•
IFRS Treatment → Similar to GAAP, customer deposits
are recognized as a liability until the performance
obligations are satisfied; They are reported at the amount
of the deposit and classified as current if expected to be
settled within one year.
____________
NON-CURRENT LIABILITIES
1. Long-term Debt
•
Definition → Debt that is due in more than one year,
including long-term loans, bonds payable, or other financial
obligations that are not expected to be settled within the
next 12 months;
•
GAAP Treatment → Long-term debt is reported at its
face value or amortized cost on the balance sheet, with
disclosures required for repayment schedules and interest
rates; Interest is recognized as an expense as it accrues
over time;
•
IFRS Treatment → Similar to GAAP, long-term debt is
measured at amortized cost using the effective interest
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rate method, with interest expense recognized over the
life of the debt; IFRS also requires detailed disclosures
regarding the terms of the debt and repayment schedules;
2. Bonds Payable
•
Definition → Long-term debt securities issued by a
company to investors with a promise to pay periodic
interest and repay the principal at a future date, typically in
more than one year;
•
GAAP Treatment → Bonds payable are recorded at
face value, net of any discounts or premiums; Amortization
of the discount or premium is recognized over the bond’s
life, and interest is expensed as it accrues;
•
IFRS Treatment → Similar to GAAP, bonds payable are
measured at amortized cost using the effective interest
rate method; Discounts and premiums are amortized over
the bond's life, and detailed disclosures are required for
bond terms and amortization schedules;
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3. Lease Liabilities (Non-current Portion)
•
Definition → The portion of lease obligations under
finance or operating leases that is due beyond the next 12
months;
•
GAAP Treatment → Under ASC 842, companies
record lease liabilities for both finance and operating leases
on the balance sheet; The non-current portion is
recognized separately from the current portion, with
amortization of the right-of-use asset over the lease term;
•
IFRS Treatment → Under IFRS 16, similar to GAAP,
lease liabilities are recognized for leases longer than 12
months; The non-current portion is classified separately,
and the right-of-use asset is amortized over the lease term;
4. Deferred Tax Liabilities
•
Definition → Future tax obligations resulting from
temporary differences between the book value of assets
and liabilities and their tax base, which are expected to
reverse in future periods;
•
GAAP Treatment → Deferred tax liabilities are
reported as non-current on the balance sheet and are
recognized when temporary differences result in taxable
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amounts in future periods; The liability is measured based
on enacted tax rates;
•
IFRS Treatment → Similar to GAAP, deferred tax
liabilities are recognized for taxable temporary differences
and measured using the tax rates that are expected to
apply when the liability is settled; Deferred tax liabilities
are classified as non-current liabilities under IFRS;
5. Pension Liabilities (Defined Benefit Plans)
•
Definition → The present value of the future obligations
to employees under defined benefit pension plans, where
the employer guarantees a certain payout at retirement;
•
GAAP Treatment → Pension liabilities are measured
based on actuarial valuations and reported as non-current
liabilities; Any underfunded portion of the plan is
recognized as a liability, and actuarial gains or losses are
recorded in other comprehensive income (OCI);
•
IFRS Treatment → Similar to GAAP, pension liabilities
are measured based on actuarial valuations; IFRS requires
the recognition of remeasurements (actuarial gains and
losses) in other comprehensive income and classifies the
net defined benefit liability as non-current;
6. Long-term Provisions
•
Definition → Obligations that may arise from uncertain
future events, such as warranties, legal claims, or
environmental cleanup, where the timing and amount of
the obligation are uncertain but expected to settle beyond
one year;
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•
GAAP Treatment → Provisions are recognized when
there is a probable obligation, and the amount can be
reasonably estimated; Provisions are measured based on
the best estimate of the amount required to settle the
obligation and are reported as non-current if they will be
settled after 12 months;
•
IFRS Treatment → Similar to GAAP, provisions are
recognized when a present obligation exists and can be
reliably estimated; They are measured at the best estimate
of the expenditure required to settle the obligation and are
discounted to present value if the time value of money is
material;
7. Contingent Liabilities (Long-term)
•
Definition → Potential liabilities that may arise depending
on the outcome of uncertain future events, such as legal
disputes or guarantees, which are not recognized unless
certain criteria are met;
•
GAAP Treatment → Contingent liabilities are disclosed
in the notes to the financial statements if the obligation is
reasonably possible but not probable; They are only
recognized as a liability if the event is probable and the
amount can be reasonably estimated;
•
IFRS Treatment → Similar to GAAP, contingent
liabilities are disclosed in the financial statement notes if
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they are possible but not probable; IFRS requires
recognition if it is more likely than not that an outflow of
resources will be required to settle the obligation;
8. Long-term Notes Payable
•
Definition → Written promises to pay a certain amount
of money, typically with interest, over a period longer than
one year; These notes are often used to finance long-term
projects or acquisitions;
•
GAAP Treatment → Long-term notes payable are
measured at the present value of future cash flows, with
interest recognized as an expense over time using the
effective interest rate method;
•
IFRS Treatment → Similar to GAAP, long-term notes
payable are measured at amortized cost using the effective
interest rate method, with interest expense recognized
over the life of the note;
9. Asset Retirement Obligations (ARO)
•
Definition → The future costs associated with the legal
obligation to dismantle or remove an asset, such as
environmental cleanup costs or decommissioning nuclear
facilities, recognized as a liability when the obligation is
incurred;
•
GAAP Treatment → AROs are measured at the
present value of the estimated future cash flows required
to settle the obligation and recognized as non-current
liabilities; Changes in the obligation due to the passage of
time are recognized as an expense;
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•
IFRS Treatment → Similar to GAAP, AROs are
measured at the present value of the future cash flows
required to settle the obligation; The liability is discounted,
and subsequent changes are recognized as an expense over
time;
10. Deferred Revenue (Long-term)
•
Definition → Payments received for goods or services
that will be delivered or performed after one year, creating
a liability for the company until the revenue is earned;
•
GAAP Treatment → Reported as a non-current liability
if the delivery of goods or services is expected beyond the
next 12 months; Deferred revenue is recognized as income
over time as the company satisfies its performance
obligations;
•
IFRS Treatment → Similar to GAAP, long-term
deferred revenue is recognized as a liability until the
performance obligations are fulfilled; IFRS requires more
detailed disclosures on the nature and timing of the
revenue recognition;
11. Customer Deposits (Non-current)
•
Definition → Amounts received from customers as
advance payments or security deposits for goods or
services that will be delivered after more than one year;
•
GAAP Treatment → Classified as non-current liabilities
if the delivery of goods or services will occur after 12
months; The deposit is recognized as revenue when the
obligations are met, or the deposit is returned to the
customer;
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•
IFRS Treatment → Similar to GAAP, non-current
customer deposits are recognized as liabilities until the
performance obligations are satisfied; They are classified as
non-current if expected to be settled after more than 12
months.
__________
EQUITY
1. Common Stock (Ordinary Shares)
•
Definition → Represents ownership in the company,
providing shareholders with voting rights and a residual
claim on the company's assets after liabilities are settled;
Common shareholders are typically entitled to dividends if
declared by the board of directors;
•
GAAP Treatment → Reported at par value (if any) or
stated value, with any additional amount paid by investors
above par classified as additional paid-in capital (APIC);
Shares issued are recorded at the issuance price, and the
total value is classified under shareholders' equity;
•
IFRS Treatment → Similar to GAAP, common stock is
recognized at par value or nominal value with any excess
paid over par recorded as share premium (additional paidin capital); IFRS requires the disclosure of the number of
shares authorized, issued, and outstanding;
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2. Preferred Stock (Preference Shares)
•
Definition → A class of ownership in a company that
provides shareholders with preferential treatment in terms
of dividend payments and claims on assets in the event of
liquidation, but usually without voting rights;
•
GAAP Treatment → Preferred stock is classified as
equity if it has no obligation to be redeemed; It is reported
at par value, with any excess over par value recorded in
additional paid-in capital; If it is mandatorily redeemable, it
is classified as a liability;
•
IFRS Treatment → Similar to GAAP, preferred stock is
classified as equity unless it includes a contractual
obligation to pay cash or other financial assets, in which
case it is treated as a liability; The treatment depends on
the specific terms of the preferred shares;
3. Additional Paid-in Capital (APIC) / Share Premium
•
Definition → The excess amount paid by investors over
the par or stated value of the company's stock during a
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share issuance; This represents contributions
shareholders above the nominal value of the shares;
by
•
GAAP Treatment → Reported as a separate
component of shareholders' equity on the balance sheet;
APIC is recognized when shares are issued above their par
or stated value and is not affected by subsequent trading
of shares in the secondary market;
•
IFRS Treatment → Referred to as "share premium,"
similar to GAAP; The share premium account is reported
in equity and represents the excess amount paid over the
nominal value of the shares issued;
4. Retained Earnings
•
Definition → The accumulated profits or losses of the
company that have not been distributed to shareholders as
dividends; Retained earnings represent the portion of net
income kept in the company for reinvestment or debt
repayment;
•
GAAP Treatment → Retained earnings are reported as
part of shareholders’ equity and are adjusted annually for
net income or loss and dividends paid; The balance reflects
the company’s cumulative profitability over time;
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•
IFRS Treatment → Similar to GAAP, retained earnings
are reported as part of equity and reflect accumulated
profits or losses after dividends; IFRS requires similar
reporting and adjustments for income, losses, and dividend
distributions;
5. Treasury Stock (Repurchased Shares)
•
Definition → Shares that were previously issued and
outstanding but have been repurchased by the company;
These shares are typically held in the company's treasury
and are not entitled to dividends or voting rights while in
treasury;
•
GAAP Treatment → Reported as a contra-equity
account, meaning it reduces total shareholders' equity;
Treasury stock is recorded at the cost of repurchase, and
the par value of the shares is not affected; When the shares
are reissued, the difference between the cost and the
reissue price is adjusted in APIC;
•
IFRS Treatment → Similar to GAAP, treasury shares
are recognized as a reduction in equity, recorded at the
repurchase cost, and do not affect the par value; IFRS does
not allow gains or losses to be recognized in profit or loss
from treasury share transactions;
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6. Accumulated Other Comprehensive Income (AOCI)
•
Definition → A component of equity that includes
unrealized gains and losses on items such as foreign
currency translation adjustments, unrealized gains or
losses on available-for-sale securities, and pension plan
adjustments; These items bypass the income statement and
are recognized directly in equity;
•
GAAP Treatment → Reported as a separate
component of shareholders’ equity; AOCI includes items
that are recognized in comprehensive income but not in
net income, such as foreign currency translation, pension
adjustments, and unrealized gains/losses on certain
investments;
•
IFRS Treatment → Similar to GAAP, AOCI includes
items recognized in other comprehensive income that
bypass the income statement; These items are transferred
to the income statement upon realization or settlement
and are disclosed as part of equity in the statement of
financial position;
7. Non-controlling Interests (Minority Interests)
•
Definition → The portion of equity in a subsidiary that is
not owned by the parent company; Non-controlling
interests represent the minority shareholders' stake in the
subsidiary's net assets;
•
GAAP Treatment → Reported as part of equity but
separately from the parent company's equity; Noncontrolling interests are measured at fair value or
proportionate share of the subsidiary’s net assets, and
changes in ownership that do not result in a loss of control
are recognized in equity;
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•
IFRS Treatment → Similar to GAAP, non-controlling
interests are reported as part of equity but distinct from
the equity attributable to the parent company; IFRS allows
for two options to measure non-controlling interests: at
fair value or at the proportionate share of the subsidiary’s
net assets;
8. Share-based Payment Reserves
•
Definition → The equity reserve associated with the
issuance of stock options or share-based compensation to
employees or other stakeholders; These reserves
represent the company’s obligation to issue shares or pay
cash based on changes in the company’s stock price;
•
GAAP Treatment → Share-based payment expenses
are measured at fair value at the grant date and recognized
as an expense over the vesting period; The related equity
reserve increases with the recognition of the expense and
is transferred to APIC when options are exercised or
expire;
•
IFRS Treatment → Similar to GAAP, share-based
payments are measured at fair value at the grant date and
recognized as an expense over the vesting period; IFRS
requires equity-settled share-based payment transactions
to be recognized in equity, while cash-settled awards are
recorded as liabilities;
9. Revaluation Surplus
•
Definition → The increase in the value of fixed assets
(such as property, plant, and equipment) resulting from a
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revaluation to fair value, which is recognized directly in
equity rather than in the income statement;
•
GAAP Treatment → Revaluation of assets is generally
not permitted under GAAP, meaning that fixed assets are
carried at historical cost less accumulated depreciation,
and revaluation surpluses are not typically recognized;
•
IFRS Treatment → IFRS allows for the revaluation of
fixed assets to fair value, with any resulting surplus
recognized in other comprehensive income and
accumulated in a revaluation surplus account within equity;
The surplus is transferred to retained earnings when the
asset is sold or derecognized;
10. Capital Reserves
•
Definition → Reserves created out of non-operating
activities, such as profits on the sale of fixed assets,
revaluation of assets, or capital contributions not related
to earnings; These are typically not available for
distribution to shareholders as dividends;
•
GAAP Treatment → Capital reserves are generally not
distinguished separately in U.S. GAAP; Gains or surpluses
from non-operating activities are typically included in
retained earnings unless specific rules apply to differentiate
the nature of the reserve;
•
IFRS Treatment → IFRS may require the separate
reporting of capital reserves based on specific transactions,
such as revaluation surpluses, asset sales, or contributions
not related to profits; These are reported within equity
but are restricted from being distributed as dividends.
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2.4 Cash Flow Statement: Tracking
Liquidity and Cash Movements
Let's explore the Cash Flow Statement and understand how it shows a
company's cash movements.
The Cash Flow Statement focuses on cash inflows and outflows
during a specific period—from one date to another.
It records actual cash transactions, unlike the income
statement which uses accrual accounting.
The Cash Flow Statement is divided into three main sections:
1. Operating Activities
2. Investing Activities
3. Financing Activities
Operating Activities show cash generated or used by the
company's core business operations.
This includes cash received from customers and cash paid to
suppliers and employees.
For example, when the company sells products and receives cash, it's
recorded here. Similarly, cash paid for inventory, wages, and utilities is
included.
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Investing Activities reflect cash used for or generated from
investments in long-term assets.
This includes purchasing or selling equipment, property, or investments.
If the company buys new machinery, the cash paid is recorded here.
Selling an old asset for cash also appears in this section.
Financing Activities show cash flows related to funding the
business.
This includes cash received from issuing shares or borrowing
money, and cash paid to repay loans or pay dividends.
For instance, if the company takes out a loan, the cash received is
recorded here. Paying dividends to shareholders is also included.
By analyzing these three sections, we can see how the company
generates and uses cash.
The Cash Flow Statement helps us understand the company's
ability to generate cash to fund operations, pay debts, and
invest in growth.
Unlike the balance sheet, which is a snapshot at a specific date, the
Cash Flow Statement shows the flow of cash over a period.
This report is crucial because a company can be profitable on the
income statement but still face cash shortages.
Cash is the lifeblood of a business; without enough cash, a
company might struggle to meet its obligations.
Therefore, the Cash Flow Statement provides valuable insights
into the company's financial health.
It complements the income statement and balance sheet, offering
a complete picture of the company's financial performance.
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➔ Let’s recap what we have seen so far:
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➔ Now we're going to see an example of a Cash Flow
Statement for the period ending December 31, 2024.
KEY TAKEAWAYS
•
Operating Activities generated a positive cash flow of
$1,358, indicating efficient core operations.
•
Investing Activities resulted in a net cash outflow of
$(4,999), reflecting significant investment in long-term
assets.
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•
Financing Activities provided additional cash inflow of
$5,025, suggesting that external financing was obtained
during the period.
•
The Net Increase in Cash and Cash Equivalents was
$1,384, leading to a higher cash balance at the end of the
period compared to the beginning.
•
Cash and Cash Equivalents increased from $2,469 at
the beginning of the period to $3,853 at the end.
________________________
So far, we have seen the direct method for structuring the Cash
Flow Statement, where cash inflows and outflows are listed
directly under each section (Operating, Investing, and Financing
Activities). This method reports the actual cash receipts and
payments made by the company during the reporting period,
making it easy to see where cash is coming from and how it’s being
spent.
Another commonly used way to prepare the cash flow statement
is the indirect method, especially for the operating activities
section. In this method, you start with net income and adjust it
for non-cash items like depreciation. Then, you account for
changes in working capital, such as increases or decreases in
accounts receivable, inventory, and accounts payable. These
adjustments help you arrive at the net cash provided by
operating activities. While the investing and financing
sections stay similar to those in the direct method, the operating
activities section is presented differently.
While both the direct and indirect methods arrive at the same
total for net cash provided by operating activities, the indirect
method is widely adopted because:
114
•
Ease of Preparation: It uses readily available financial
data without the need to track individual cash receipts and
payments.
•
Accounting Standards: Some accounting frameworks
and regulatory bodies allow both methods but require
additional disclosures if the direct method is used.
•
Common Practice: Since most companies use the
indirect method, it provides consistency and comparability
across financial statements.
So, in practice, you're more likely to see the indirect method used
in published financial reports.
➔ This is how the first section of the statement in
question would look like:
Here’s what happens there:
•
•
•
Non-cash adjustments like depreciation are added
back to net income since they reduce profit but do not
involve actual cash outflows;
Working capital adjustments are presented as
(increase)/decrease, indicating that changes in these
accounts affect cash flow;
If accounts receivable increase, it's subtracted from cash
flow because more money is tied up in receivables;
115
•
•
If inventory decreases, it's added to cash flow because
the company is reducing stock levels, implying fewer
purchases;
Payables and accrued expenses follow a similar logic,
with increases representing deferred payments, thus
conserving cash.
To measure the increase or decrease in an account for the
Cash Flow Statement, follow these steps:
1. Pick the account you want to check (like Accounts
Receivable or Inventory);
2. Get the beginning and ending balances from the
balance sheets for the start and end of the period;
3. Calculate the change by subtracting the beginning
balance from the ending balance:
( Change = Ending Balance − Beginning Balance )
o
If the result is positive, the account has
increased.
o
If the result is negative, the account has
decreased.
4. Interpret the result
o
Assets (like receivables or inventory):
▪
Increase means cash was used (subtract
in cash flow);
▪
Decrease means cash was freed up (add
in cash flow).
o
Liabilities (like payables)
116
▪
Increase means cash was saved (add in
cash flow);
▪
Decrease means cash was used to pay off
debt (subtract in cash flow).
____________________
Sometimes, other assets and liabilities are included in
the operating activities section of the Cash Flow Statement
because they can impact the company's cash flow even though
they are not part of typical working capital accounts like
receivables or payables. These additional assets and liabilities
might involve items that affect the company's cash flow in ways
that are not immediately tied to core operational activities but
still require adjustment when using the indirect method.
Examples of Other Assets and Liabilities:
1. Prepaid Expenses
o
Why it's included: Prepaid expenses, such as
insurance or rent, represent cash payments made
in advance of the recognition of the expense. If
prepaid expenses increase, it means more cash
was used up front, which reduces operating cash
flow. If they decrease, it means previously paid
amounts are now being expensed, improving cash
flow.
2. Deferred Revenue
o
Why it's included: Deferred revenue occurs
when the company receives cash in advance for
goods or services it has not yet delivered. As the
company earns this revenue, the liability
decreases. A decrease in deferred revenue means
the company is recognizing the income, and no
117
new cash inflows are occurring, which negatively
affects cash flow.
3. Accrued Liabilities
o
Why it's included: These liabilities refer to
expenses that have been incurred but not yet
paid, like wages or interest. If accrued liabilities
increase, it means the company has incurred an
expense but hasn't yet paid the cash, which
conserves cash flow. A decrease means the
company is paying down these liabilities, reducing
cash.
4. Deferred Taxes
o
Why it's included: Deferred tax assets or
liabilities arise when there are differences
between taxable income and accounting income.
Changes in deferred taxes may result in
adjustments to operating cash flow, as cash taxes
paid differ from the tax expense recognized on
the income statement.
5. Other Long-term Liabilities
o
Why it's included: Items like pension obligations
or long-term employee benefits may be included
when their cash payments are recognized in the
operating section. If a company contributes to
pension funds, it directly impacts cash outflow,
even though it's not part of everyday operations.
Why Include Them?
These other assets and liabilities are included to ensure that
the operating cash flow properly reflects the economic reality
of the business's cash transactions during the period. While they
118
may not be part of the regular working capital cycle, they still
influence the company's liquidity. The indirect method adjusts for
these changes to provide a comprehensive picture of the actual
cash impact of operational activities, aligning the cash flow
statement with the accrual-based net income reported on the
income statement.
LINKING CASH FLOW STATEMENT TO OTHER
FINANCIAL STATEMENTS
As we have seen, before, starting with the net income from the
Income Statement, the Cash Flow Statement adjusts for noncash expenses and changes in working capital. Depreciation
reduces net income but doesn't decrease cash; thus, we add it
back to calculate actual cash flow.
Changes in Balance Sheet accounts—such as inventory,
accounts receivable, and accounts payable—directly affect cash
flow. For example, an increase in accounts receivable indicates
that not all sales have resulted in cash inflow; this adjustment
appears on the Cash Flow Statement under operating activities.
Investing activities on the Cash Flow Statement reflect
changes in long-term assets from the Balance Sheet.
Purchasing new equipment shows up as a cash outflow in investing
activities and increases fixed assets on the Balance Sheet.
Financing activities link to changes in liabilities and equity.
Issuing new debt provides cash inflow and increases long-term
liabilities; repaying loans does the opposite. These movements are
captured on both the Cash Flow Statement and the Balance Sheet.
The ending cash balance from the Cash Flow Statement updates
the cash position on the Balance Sheet. This closing loop
ensures all financial statements are synchronized.
119
___________________
OTHER DETAILS TO WATCH OUT FOR
Beyond the basics, there are deeper details to consider when
linking the Cash Flow Statement with the other financial
statements.
These nuances help us ensure that the Cash Flow Statement
accurately reflects the company's financial activities.
Let's explore them.
First, examine the quality of earnings.
If net income is rising but cash flow from operating
activities isn't, it might be a red flag.
Why?
Because it suggests that profits aren't being converted into cash.
This could indicate issues like aggressive revenue recognition
or poor receivables collection.
Next, pay attention to non-cash investing and financing
activities.
Some transactions don't involve cash but significantly
impact the financial statements.
For example, issuing stock to purchase assets.
This won't appear on the Cash Flow Statement but will affect the
Balance Sheet and possibly the Income Statement.
We need to disclose these in the notes to the financial statements
to provide a complete picture.
Also, consider foreign currency translation effects.
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For companies operating internationally, exchange rate
fluctuations can impact cash balances.
These effects are reflected in the Cash Flow Statement under a
separate section for translation adjustments.
They also affect the equity section of the Balance Sheet.
Understanding this link helps us assess the true cash position.
Another detail is deferred taxes.
Changes in deferred tax assets or liabilities, found on the
Balance Sheet, can affect the Cash Flow Statement.
These changes are added back or deducted in the operating
activities section because they impact net income but not cash.
It's important to align these adjustments properly.
Moreover, look at impairments and write-downs.
When a company writes down the value of an asset, it
reduces net income on the Income Statement.
However, since it's a non-cash expense, we add it back in the
Cash Flow Statement.
This ensures we don't understate the operating cash flow.
Additionally, analyze changes in provisions and reserves.
Increases in provisions (like for warranties or legal settlements)
reduce net income but don't use cash immediately.
We add back these increases in the Cash Flow Statement.
Conversely, when the company pays out these obligations, it
reduces cash but doesn't affect net income at that time.
Understanding this timing difference is crucial.
121
Finally, watch for off-balance-sheet financing.
Some obligations, like operating leases, might not appear on the
Balance Sheet but require cash payments.
While recent accounting standards aim to bring more of these
onto the Balance Sheet, being aware of them helps us understand
future cash obligations.
GAAP VS IFRS: COMPARISON RELATED TO CASH
FLOW STATEMENT
Both Generally Accepted Accounting Principles (GAAP)
and International Financial Reporting Standards (IFRS)
provide detailed guidance on the preparation and presentation of
the cash flow statement.
However, there are differences between GAAP and IFRS in how
certain elements are classified within these sections.
1. Cash Flows from Operating Activities
•
GAAP and IFRS Similarities: Both standards allow the
use of either the direct or indirect method for
presenting operating cash flows;
•
DIFFERENCES
o
Interest Received and Paid
▪
GAAP: Interest received and paid are
classified as operating activities;
▪
IFRS: Interest received can be classified as
either operating or investing activities;
interest paid can be operating or financing
activities.
122
o
o
o
Dividends Received
▪
GAAP: Classified as operating activities;
▪
IFRS: Can be classified as operating or
investing activities.
Dividends Paid
▪
GAAP: Classified as financing activities;
▪
IFRS: Can be classified as operating or
financing activities.
Income Taxes Paid
▪
GAAP: Classified as operating activities;
▪
IFRS: Generally operating, but portions
can be allocated to investing or financing if
they can be specifically identified.
2. Cash Flows from Investing Activities
•
GAAP and IFRS Similarities: Both classify cash flows
from the purchase and sale of property, plant, equipment,
and other long-term investments as investing activities;
•
DIFFERENCES
o
Interest and Dividends Received
▪
GAAP: Interest and dividends received are
not classified here;
▪
IFRS: Interest and dividends received can
be classified as investing activities;
3. Cash Flows from Financing Activities
123
•
GAAP and IFRS Similarities: Both include cash flows
from issuing and repurchasing shares, and issuing and
repaying debt;
•
DIFFERENCES
o
Interest Paid and Dividends Paid
▪
GAAP: Interest paid is operating; dividends
paid are financing;
▪
IFRS: Both interest and dividends paid can
be classified as financing activities.
Additional Elements Discussed
•
Bank Overdrafts
o
GAAP: Generally reported as liabilities; not
included in cash and cash equivalents;
o
IFRS: Bank overdrafts that are repayable on
demand and form an integral part of an entity's cash
management are included in cash and cash
equivalents.
•
Presentation of the Statement
o
Direct vs. Indirect Method:
▪
GAAP: Encourages the direct method but
requires a reconciliation of net income to
net cash provided by operating activities if
the direct method is used;
▪
IFRS: Encourages the direct method but
does not require a reconciliation if the
direct method is used.
124
So, Both GAAP and IFRS discuss the following elements of the
cash flow statement:
•
Classification of cash flows into operating, investing,
and financing activities;
•
Presentation methods: Direct and indirect methods for
reporting cash flows from operating activities;
•
Specific items: Guidance on how to classify interest
received and paid, dividends received and paid, income
taxes, and bank overdrafts.
_______________________
Standards Discussing Elements of the Cash Flow
Statement in GAAP and IFRS
International Financial Reporting Standards (IFRS)
1. IAS 7 – Statement of Cash Flows
What's Inside:
•
Objective: IAS 7 requires entities to provide information
about the historical changes in cash and cash equivalents
through a statement of cash flows, which classifies cash
flows during the period into operating, investing, and
financing activities.
•
Definitions:
o
Cash and Cash Equivalents: Cash on hand and
demand deposits, along with short-term, highly
liquid investments readily convertible to known
amounts of cash.
o
Operating Activities: Principal revenueproducing activities and other activities that are not
investing or financing.
125
o
Investing Activities: Acquisition and disposal of
long-term assets and other investments not
included in cash equivalents.
o
Financing Activities: Activities that result in
changes in the size and composition of the
contributed equity and borrowings.
•
Classification of Cash Flows:
o
Operating Activities: Cash receipts from sales
of goods and services, cash payments to suppliers
and employees, cash payments or refunds of
income taxes.
o
Investing Activities: Cash payments to acquire
property, plant, and equipment (PPE), cash receipts
from disposal of PPE, cash advances and loans made
to other parties.
o
Financing Activities: Cash proceeds from issuing
shares or other equity instruments, cash payments
to owners to acquire or redeem the entity’s shares,
cash proceeds from issuing debentures, loans,
notes, bonds, mortgages, and other short- or longterm borrowings.
•
Presentation Methods:
o
Direct Method: Presents major classes of gross
cash receipts and gross cash payments.
o
Indirect Method: Adjusts profit or loss for the
effects of non-cash transactions, deferrals, accruals,
and items of income or expense associated with
investing or financing cash flows.
•
Interest and Dividends:
126
•
o
Interest Paid and Received, Dividends
Received: May be classified as operating or
investing activities.
o
Dividends Paid: May be classified as operating or
financing activities.
Income Taxes:
o
•
Foreign Currency Cash Flows:
o
•
Cash flows arising from transactions in a foreign
currency are recorded in an entity’s functional
currency using the exchange rate at the date of the
cash flow.
Non-Cash Transactions:
o
•
Cash flows arising from taxes on income are
generally classified as operating activities unless
they can be specifically identified with financing or
investing activities.
Investing and financing transactions that do not
require the use of cash or cash equivalents are
excluded from the statement of cash flows but
must be disclosed elsewhere in the financial
statements.
Disclosures:
o
Components of cash and cash equivalents.
o
A reconciliation of the amounts in the statement of
cash flows with the equivalent items reported in
the statement of financial position.
o
Disclosure of significant cash and cash equivalent
balances held that are not available for use.
127
2. IAS 1 – Presentation of Financial Statements
What's Inside:
•
Objective: Establishes overall requirements for the
presentation of financial statements, guidelines for their
structure, and minimum requirements for their content.
•
Relevance to Cash Flow Statement:
o
Outlines the general features of financial
statements, including fair presentation, going
concern, accrual basis, consistency, and materiality.
o
Requires entities to present a complete set of
financial statements, including a statement of cash
flows, at least annually.
3. IAS 21 – The Effects of Changes in Foreign Exchange
Rates
What's Inside:
•
Objective: Prescribes how to include foreign currency
transactions and foreign operations in the financial
statements and how to translate financial statements into
a presentation currency.
•
Relevance to Cash Flow Statement:
o
Provides guidance on translating cash flows
denominated in foreign currencies.
o
Specifies that cash flows should be translated at the
exchange rates at the dates of the cash flows.
128
Generally Accepted Accounting Principles (GAAP)
1. ASC Topic 230 – Statement of Cash Flows (FASB
Accounting Standards Codification)
What's Inside:
•
Objective: Requires a statement of cash flows as part of
a full set of financial statements, explaining the change in
cash and cash equivalents during the period.
•
Definitions:
•
o
Cash and Cash Equivalents: Cash on hand,
demand deposits, and short-term, highly liquid
investments with original maturities of three
months or less.
o
Operating Activities: Cash effects of
transactions that enter into the determination of
net income.
o
Investing Activities: Cash flows related to the
acquisition and disposal of long-term assets and
other investments.
o
Financing Activities: Cash flows related to
obtaining resources from owners and providing
them with a return, and obtaining and repaying
resources from creditors.
Classification of Cash Flows:
o
Operating Activities: Cash receipts from sales
of goods and services, cash payments to suppliers
and employees, interest paid and received,
dividends received.
129
o
Investing Activities: Cash payments to acquire
PPE, cash receipts from sales of PPE, cash advances
and collections on loans to others.
o
Financing Activities: Cash proceeds from issuing
equity instruments, cash payments to repurchase
equity instruments, cash proceeds from issuing
debt instruments, cash repayments of amounts
borrowed, dividends paid.
•
Presentation Methods:
o
Direct Method: Reports major classes of gross
cash receipts and payments.
o
Indirect Method: Adjusts net income for the
effects of non-cash revenues and expenses and
changes in operating assets and liabilities.
•
Interest and Dividends:
o
Interest Paid and Received: Classified as
operating activities.
o
Dividends Received: Classified as operating
activities.
o
Dividends Paid: Classified as financing activities.
•
Income Taxes:
o
Cash payments for income taxes are classified as
operating activities.
•
Non-Cash Investing and Financing Activities:
o
Significant non-cash transactions are not reported
in the statement of cash flows but must be
disclosed in the footnotes or in a supplementary
schedule.
130
•
Restricted Cash:
o
•
Provides guidance on including restricted cash and
cash equivalents in the cash flow statement and
requires a reconciliation of total cash, including
restricted amounts.
Disclosures:
o
Reconciliation of beginning and ending balances of
cash, cash equivalents, and restricted cash.
o
Information about significant non-cash investing
and financing activities.
2. ASC Topic 205 – Presentation of Financial Statements
What's Inside:
•
Objective: Provides guidance on the overall presentation
of financial statements.
•
Relevance to Cash Flow Statement:
o
Requires the presentation of a statement of cash
flows as part of a full set of financial statements.
o
Describes the components that should be included
in a complete set of financial statements.
3. ASC Topic 830 – Foreign Currency Matters
What's Inside:
•
Objective: Provides guidance on accounting for foreign
currency transactions and translating financial statements
of foreign operations.
131
•
Relevance to Cash Flow Statement:
o
Details how to report cash flows denominated in
foreign currencies.
o
Specifies that cash flows should be translated using
the exchange rates in effect at the time of the cash
flows.
Summary of Key Elements in Each Standard
IFRS – Key Elements
IAS 7 – Statement of Cash Flows
•
Flexibility in Classification:
o
Entities can classify interest and dividends received
and paid as operating, investing, or financing
activities, as long as the classification is applied
consistently.
•
Direct vs. Indirect Method:
o
Encourages the use of the direct method for
reporting cash flows from operating activities but
permits the indirect method.
•
Bank Overdrafts:
o
Bank overdrafts that are repayable on demand and
form an integral part of an entity's cash
management are included as a component of cash
and cash equivalents.
•
Non-Cash Transactions:
132
o
•
Requires disclosure of significant non-cash investing
and financing activities.
Foreign Currency Cash Flows:
o
Cash flows are translated at the exchange rates at
the dates of the cash flows.
GAAP – Key Elements
ASC Topic 230 – Statement of Cash Flows
•
•
Classification Specificity:
o
Interest paid and received, and dividends received
are classified as operating activities.
o
Dividends paid are classified as financing activities.
Direct vs. Indirect Method:
o
•
Restricted Cash:
o
•
Encourages the use of the direct method but
requires a reconciliation of net income to net cash
provided by operating activities if the direct
method is used.
Provides detailed guidance on the presentation of
changes in restricted cash and requires inclusion in
the reconciliation of beginning and ending cash
balances.
Non-Cash Transactions:
o
Significant non-cash investing and financing
activities are excluded from the statement of cash
flows but must be disclosed elsewhere.
133
•
Foreign Currency Cash Flows:
o
Cash flows are translated using the exchange rates
at the time of the cash flows.
Detailed Explanation of What's Inside Each Standard
IAS 7 – Statement of Cash Flows
Sections and Key Provisions:
1. Objective and Scope:
o
Establishes requirements for the presentation of
information about changes in cash and cash
equivalents.
2. Definitions:
o
Provides clear definitions of key terms to ensure
consistency in application.
3. Presentation of a Statement of Cash Flows:
o
Mandates that all entities must present a statement
of cash flows as an integral part of their financial
statements.
4. Classification of Cash Flows:
o
Details criteria for classifying cash flows into
operating, investing, and financing activities.
o
Emphasizes the importance of consistency in
classification.
5. Reporting Cash Flows from Operating Activities:
134
o
Encourages the direct method and provides
guidance on reporting cash flows using both the
direct and indirect methods.
6. Reporting Cash Flows
Financing Activities:
o
from
Investing
and
Provides examples of cash flows arising from
investing and financing activities.
7. Interest and Dividends:
o
Allows flexibility in classification to better reflect
the nature of transactions.
8. Taxes on Income:
o
Generally classified as operating activities unless
they can be specifically identified with financing or
investing activities.
9. Investments in Subsidiaries, Associates, and Joint
Ventures:
o
Provides guidance on reporting cash flows related
to these investments.
10. Non-Cash Transactions:
o
Requires disclosure of investing and financing
transactions that do not require the use of cash or
cash equivalents.
11. Components of Cash and Cash Equivalents:
o
Requires entities to disclose the components of
cash and cash equivalents and present a
reconciliation if necessary.
12. Other Disclosures:
135
o
Encourages additional disclosures that may be
relevant to users in understanding the financial
position and liquidity of the entity.
ASC Topic 230 – Statement of Cash Flows
Sections and Key Provisions:
1. Objective and Scope
o
Establishes the requirements for the information to
be provided in a statement of cash flows.
2. Definitions
o
Clarifies key terms to ensure consistency in
reporting.
3. Presentation of a Statement of Cash Flows
o
Requires a statement of cash flows as part of a full
set of financial statements.
4. Classification of Cash Flows
o
Provides specific guidance on classifying cash
receipts and payments as operating, investing, or
financing activities.
5. Reporting Cash Flows from Operating Activities
o
Details the requirements for using either the direct
or indirect method, with a preference for the direct
method.
6. Reporting Cash Flows
Financing Activities
from
Investing
and
136
o
Provides examples and guidance on the types of
transactions included in each category.
7. Interest and Dividends
o
Specifies the classification of interest and dividends
to promote consistency and comparability.
8. Income Taxes Paid
o
Classified as operating activities, with guidance on
presentation in certain circumstances.
9. Non-Cash Investing and Financing Activities
o
Requires disclosure of significant non-cash
transactions in the notes to the financial statements
or in a supplementary schedule.
10. Restricted Cash
o
Provides guidance on the inclusion of restricted
cash in the statement of cash flows and requires
disclosure of the nature of restrictions.
11. Foreign Currency Cash Flows:
o
Specifies the method for translating cash flows
denominated in foreign currencies.
12. Disclosures:
o
Requires detailed disclosures to enhance the user's
understanding of the cash flows and any
restrictions on cash balances.
Key Differences Between IFRS and GAAP Standards
•
Classification Flexibility
137
o
IFRS (IAS 7): Allows entities to classify interest
and dividends received and paid in operating,
investing, or financing activities based on the nature
of the transaction.
o
GAAP
(ASC
230):
Requires
specific
classifications—interest paid and received, and
dividends received as operating activities; dividends
paid as financing activities.
•
Bank Overdrafts
o
IFRS: May include bank overdrafts as a component
of cash and cash equivalents if they are repayable
on demand and form an integral part of an entity's
cash management.
o
GAAP: Generally reports bank overdrafts as
liabilities and excludes them from cash and cash
equivalents.
•
Direct Method Reconciliation
o
IFRS: Encourages the direct method and does not
require a reconciliation to the indirect method.
o
GAAP: Encourages the direct method but
requires a reconciliation of net income to net cash
provided by operating activities if the direct
method is used.
•
Restricted Cash
o
IFRS: Does not provide specific guidance on
restricted cash but requires disclosure of any
significant restrictions on cash and cash equivalents.
o
GAAP: Provides detailed guidance on the
presentation and disclosure of restricted cash,
138
including its inclusion in the statement of cash
flows.
Now we’re going to explore Financial Statement Analysis – a
chapter dedicated to techniques and tools that give a detailed view of
a company’s financial health and performance across periods. We’ll
start by examining Vertical Analysis and Horizontal Analysis:
two core approaches that reveal internal changes within financial
statements over time.
From there, we’ll delve into specific ratio analyses. Profitability
Ratios measure how effectively a company turns revenue into profit;
Liquidity Ratios assess its ability to meet short-term obligations;
Efficiency Ratios evaluate resource management and operational
performance. Moving on, Solvency Ratios indicate long-term
financial soundness, while Leverage Ratios give insight into the
company’s debt profile and financing strategy.
Our journey continues with Market Valuation Ratios – essential
tools for gauging how the market values the company’s financial
standing. Finally, we’ll conclude with DuPont Analysis: a structured
method that breaks down return on equity into detailed components,
illuminating the underlying performance drivers.
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