What are Financial Statements?
According to Wikipedia, financial statements “are formal records of a business' financial
activities.” Let’s break this definition down a bit.
First the word formal: This refers to the fact that business’ cannot simply create
records that capture information they deem relevant, in a format they find useful, but
must use records and formats that are prescribed by regulatory and quasi-regulatory
agencies. By formalizing the format of financial statements they become comparable
for individuals who use them to make decisions (more on these decisions later), making
them more relevant. Formalizing the statements also helps to ensure that each
company records business transactions in the same (or at least similar) way. This helps
to prevent misleading or fraudulent reports from being presented to users of the
financial statements. By formalizing the format they become easier to vouch for,
making them more reliable.
While there is a formal structure that must be followed when preparing the records and
financial statements it is important to note that there is more than one agency which
promulgates the rules. In the United States there is the S.E.C. and the FASB which
together create G.A.A.P (Generally Accepted Accounting Principles, that’s what will be
learning in this course). In other countries the records and financial statements are
promulgated by the International Accounting Standards Board (IASB), which create the
International Financial Reporting Standards. There are many differences between
G.A.A.P. and I.F.R.S., and if you are an accounting major you will be studying these
differences quite a lot over the next few years as the two standards are set to merge.
Next the word records: This refers to the data that is captured and stored by
organizations that serve as the inputs to the financial statements (the output). Today of
course those records are kept in digital form by many different types of computer based
1|Page
accounting systems – from small checkbook like programs (Quicken) to Mom and Pop
type systems (Quicken), to medium range systems (Microsoft Accounting) to full-scale
international conglomerates using integrated enterprise systems such as SAP, which
can cost $millions. But in the end recording business transactions comes down to
following a set program of steps (designed by the accounting system hundreds of years
ago) for storing financial information for easy retrieval and easy summarization. In
much the same way that the financial statements follow a specific structure to meet its
formal requirements, so do the accounting records. What is captured and stored by an
accounting system does so by following the rules of an accounting system, which at its
fundamental level is based on a simple equation: Assets = Liabilities + Equity
(Stockholders Equity, Partnership Equity, Sole-Proprietor’s Equity). The data captured
in these records are the results of a business’ financial activities – the last part of our
definition.
Financial activities are those things that an organization does to generate both
revenue and cash (they are two different things), as well as the things that end up
costing organizations cash and non-cash costs. Organizations all have similar activities
that need to be captured. For example, most companies sell things and eventually
receive cash for the things they sell, whether those things are tangible goods or
intangible services. Most companies also acquire things and eventually have to pay for
them. Most companies hire individuals and have to pay their salaries. Each
organization has similar activities that occur when they are fist established, and all
organizations usually need ways to finance themselves over time. These and other
activities are recorded by the accounting system. The type of activity determines how
the records are updated. The records are really only a way to keep a summary of these
business activities so that an owner can answer questions such as, “How much cash
do we have on hand?”, “How much money do we owe for next months, rent, insurance,
payroll?”, “Do we have enough or will we have to borrow some?”.
It is important to
understand that the accounting records are used internally and external users only have
access to a summary of these records in the form of the financial statements.
2|Page
Since most companies have the same or similar business activities and since most
organizations need to make the same basic decisions and since outside users of
financial statements are making similar decisions – e.g. should I invest in this company,
should I loan this company money, should I work for this company, etc. – the financial
statements are composed of four main documents each of which tells a different story
about the company. These documents are called the Balance Sheet (aka Statement of
Financial Position), the Income Statement (aka Profit and Loss statement), The
Statement of Stockholders Equity, and the Cash Flow statement. The main statement
is the Balance Sheet and as you will learn the other three statements either reconcile an
account or section from the Balance Sheet. The Cash Flow statement shows the
changes that effected cash from the beginning of the period to the end of the period.
Similarly the statement of stockholders equity shows changes for all the accounts that
appear on that section of the Balance Sheet. And the amounts that appear on the
Income Statement eventually (at the end of a period) are incorporated into the Balance
Sheet. Each tells a different part of an organizations story so to learn about the
organization you would need to read them all.
Interestingly the formal rules for preparing these statements allow for certain estimates
and in some cases choices with regard to how business activities are recorded, thus
reducing the comparability that was mentioned earlier. However, one statement is not
subject to these choices (or can we call these manipulations) and that is the Cash Flow
statement, thus many investors view the Cash Flow statement as the most important.
So now we understand a bit more what financial statements are, let’s take a look at one.
For our example I chose the J.M. Smuckers’ Company financial annual report (another
name given to the financial statements as a whole) for 2011. Why? Because I love a
good PB&J. The report itself is 69 pages long, probably right around the average for
annual reports. Of the total of 69 pages only 5 are used for the financial statements,
many of the rest contain detailed notes providing additional information about the
amounts that are reported on the financial statements. In addition there are various
3|Page
attestations that are included to help ensure to anyone reading the report that it is
accurate. These include statements by auditors who have reviewed the financial
statement, attesting to the fact that the statements are prepared according to the formal
structures discussed earlier; by management of the company indicating their
responsibility in preparing the statements among others. Let’s take a look at each of the
statements briefly.
Smuckers’ Income Statement shows 3 years of information with the heading Year
Ended April 30. This means that the amounts that are in this report are an
accumulation of amounts from May 1st through April 30th. On May 1st of 2011 all the
records for these accounts are reset to zero and the counting or err the accounting
starts anew.
So this statement reports the “bottom line”, the amount of profit that Smuckers’ was able
to generate between May 1st and April 30th for 2011, 2010 and 2009, $479, $494 and
$265 million respectively. It also reports how Smuckers’ was able to do this by
separating Income and Expenses into Operating and non-operating sections. Operating
means what a company does, so in the case of Smuckers’ were talking mostly about
selling Jelly (well not really, but will see the components of their revenue a bit later on).
Well how much Jelly did Smuckers’ actually sell? $4.8 Billion dollars worth – now that’s
a lot of Jelly sold. Of course making Jelly isn’t free and it cost Smuckers’ $2.9 billion to
do so. If you want to know how well (and from where) a company is generating profits
you would look at the Income statement.
The next statement we see is the Balance Sheet and the heading for this is a bit
different than the others, it’s just the date April 30th. That’s because the balance sheet
reports the ending summary of the amounts that represent those records we talked
about earlier – and this summary is a running total from the very first day of the
companies existence – in the case of Smuckers’ that’s 91 years, they were incorporated
in 1921. Like the Income Statement the Balance Sheet is also categorized. The
categories are Assets, Liabilities and Equity – sound familiar? It should that’s what
makes up the accounting equation I spoke about earlier that is the basis for keeping the
4|Page
records of a business. Assets are reported first and represent things that a company
owns. These things (or resources) can also be thought of as those that help to
generate cash for the organization (and thus its owners, employees, etc.) and of course
the Cash and other investments the organization makes once they receive cash from
their operations and other activities. Next are Liabilities, which represents the amount
of money, goods, or services that an organization owes to outside entities (e.g. other
organizations, the government) or internal entities (e.g. employees). These two parts of
the balance sheet are further categorized into a current and non-current (or long-term)
part. What appears in the current section are those things that will become cash
(Assets) or which will be paid (Liabilities) within one accounting period. Everything else
is non-current. Finally the Stockholders Equity section contains accounts related to
the Ownership of the company and there are two parts to this section. The first part
summarizes the types and amount of stock that are held by the outside owners, and the
second summarizes the amount of earnings that the company has generated and kept
or re-invested into the business (this is called Retained Earnings).
All right, so what does Smuckers’ Balance Sheet tell us: On April 30th, 2011 and 2010,
they have $1,637 and $1,224 million of current assets respectively. Of that amount,
$320 and $284 million was in the form of Cash, we see that Cash has increased from
2010 to 2011 by $36 million. We also see that the amount that is owed to Smuckers has
increased from 2010 to 2011 (that is what Receivable means) by $105 million. And
finally we see that Inventory (the things Smuckers’ sells) has also increased by almost
$209 million. Are these changes something we should be concerned about? The
Assets used to produce products that Smuckers’ sells (PP&E) hasn’t increased much.
Well what about what Smuckers’ owes to outsiders? Between May 1 st 2011 and April
30th 2012, Smuckers’ owes $483 million, not much more than they did a year ago. Can
they afford to pay this? Additionally we see that Smuckers owes a lot in the long-term
compared – almost $2,550 million. When we look at the last section we see that
Smuckers’ hasn’t had any major changes related to stockholders equity, but there is
important information there nonetheless. We can see the type of stock that the
company issues – only common. And we can see how many shares have been issued
5|Page
and how many remain to be issued – the amount remaining to be issued is important
because that represents a potential dilution of your ownership in the company. We also
see that Smuckers’ has bought back some of its own stock – sometimes this is a sign
that a company feels its stock is trading below what it should be selling for. Please also
note that this statement “balances”, that is total Assets = the total of Liabilities +
Stockholders Equity. It has to because of the accounting equation and the system that
keeps everything in balance, which is what, is really cool about accounting.
Next let’s look at the two statements that show (reconcile) some of the changes on the
balance sheet. The first is the Cash Flow Statement. This statement tells us how
Smuckers’ was able to generate cash and what they spent that cash on. It’s up to the
reader to assess whether the money was spent wisely. We see from this statement that
Smuckers’ was able to generate $36 million in 2011, they “spent” $173 million in 2010
and generated $285 million in 2009, why so much fluctuation? Well in 2010 we can see
that Smuckers’ paid off $625 million in debt, so that accounts for the “negative” cash
flow in 2010. What about why 2011 cash generation was so small? Well we see that in
2011 Smucker’s purchased their own shares of stock (Treasury stock) in fact $389
million of their own stock. Not always but usually this is an indication of a company that
thinks their stock is selling at a cheap price.
The last statement of stockholders equity shows the changes for each of the accounts
that appear in that section of the balance sheet from May 1st to April 30th. I’m not going
to go over most of the details but I want to draw your attention to one part of the
statement – the Retained Earnings (or Income as Smuckers’ calls it) account. Notice
that the changes to this account are an increase for Net Income (note that amount is the
“bottom line” Net Income figure from the Income Statement (which in turn represented
the Revenues – Expenses for the year ended April 30th 2011) and decreases for
dividends that were paid, and treasury stock that was purchased. Remember that earlier
I said that the Income Statement accounts are reset to zero at the beginning of the
period, well those amounts don’t vanish, they simply get added to the Retained
6|Page
Earnings account and thus that account reflects all the Net Income, Dividends, and
changes to accounting that have occurred to Smuckers’ over the last 91 years.
OK, so we’ve learned a lot and might be able to make some decisions about this
company like should I invest in it, lend it money, work for it, etc. But you wouldn’t be too
smart if you made any of those decisions by just reading the 5 pages of financial
statements. To learn more about Smuckers’ we have to read the Notes to the Financial
Statements. Now I neither have the time nor do I want to put the few of you that are still
awake to sleep, so I won’t read the notes to you, but let’s take a look at some of them:
Now we’ve learned a lot about Smuckers’ in a very short time, and there is certainly
much more to understand, but hopefully you now have a better understanding of what
the financial statements are, and why they might be used. I’ve described the records
that are used in the creation of these statements, and we will spend most of the
semester learning how to make these records, the choices that can be found for
recording certain business transactions and the estimates that have to be made as part
of the record keeping process. With this information you will be able to read a financial
statement for yourself and make important decisions.
I want to end by having you think about where financial statements can be found. They
are not just created and prepared for publicly traded companies for investors to use.
They are created by every single business – for-profit, and not-for-profit, legal and
illegal. They are created for governments – every government from the United States
government to the smallest local community to Home Owners Associations within
Communities. They determine how much taxes you will pay, how much your tuition will
be, how much your car, health, life insurance will cost. They determine when you can
retire, or if you can retire. Understand these things and you can avoid serious errors
and problems both individually and globally as is evidenced by the world wide recession
we are in now. Not understanding these statements has led to billions, more likely
trillions of dollars of losses when considering the collapse of companies like Enron,
7|Page
WorldCom, and all the financial firms who made greed driven investments. Understand
them and you can find results similar to Warren Buffet and many other investors who’ve
made money in good times and bad times. But you need to know what you are doing
and that means you need to be able to read financial statements, and that means you
need to understand the accounting system that created them. I hope that after the end
of the semester you are closer to that point then you are now.
8|Page