Chapter 3
Financial statements
Note: Before starting to learn the items of chapter, study technical words of
accounting that presented at the end of book.
Introduction
The end result of an accounting system is the financial statements .the two most
commonly used statements by businesses are income statement and balance sheet.
Corporations prepare two other statements to users, which are statement of cash
flows and statement of retained earnings (or statement of comprehensive income).
The objective of this lesson is to provide you with a brief explanation about these
statements in a service enterprise. In next lessons you will be familiar with the
statements of merchandising and manufacturing enterprises.
Purpose of Financial Statements
The objective of financial statements is to provide information about the financial
position, performance and changes in financial position of an enterprise that is useful
to a wide range of users in making economic decisions (IASB Framework). Financial
Statements provide useful information to a wide range of users as follows:
Managers require Financial Statements to manage the affairs of the company by
assessing its financial performance and position and taking important business
decisions.
Shareholders use Financial Statements to assess the risk and return of their investment
in the company and take investment decisions based on their analysis.
Prospective Investors need Financial Statements to assess the viability of investing in
a company. Investors may predict future dividends based on the profits disclosed in
the Financial Statements. Furthermore, risks associated with the investment may be
gauged from the Financial Statements. For instance, fluctuating profits indicate higher
risk. Therefore, Financial Statements provide a basis for the investment decisions of
potential investors.
Financial Institutions (e.g. banks) use Financial Statements to decide whether to
grant a loan or credit to a business. Financial institutions assess the financial health of
a business to determine the probability of a bad loan. Any decision to lend must be
supported by a sufficient asset base and liquidity.
Suppliers need Financial Statements to assess the credit worthiness of a business and
ascertain whether to supply goods on credit. Suppliers need to know if they will be
repaid. Terms of credit are set according to the assessment of their customers'
financial health.
Customers use Financial Statements to assess whether a supplier has the resources to
ensure the steady supply of goods in the future. This is especially vital where a
customer is dependent on a supplier for a specialized component.
Employees use Financial Statements for assessing the company's profitability and its
consequence on their future remuneration and job security.
Competitors compare their performance with rival companies to learn and develop
strategies to improve their competitiveness.
General Public may be interested in the effects of a company on the economy,
environment and the local community.
Governments require Financial Statements to determine the correctness of tax
declared in the tax returns. Government also keeps track of economic progress
through analysis of Financial Statements of businesses from different sectors of the
economy.
Statement of Financial Position [Balance Sheet]
Statement of Financial Position, also known as the Balance Sheet, presents the
financial position of an entity at a given date. It is comprised of three main
components: Assets, liabilities and equity.
Example 1: The following balance sheet portrays the financial position of Well-days
services at august31, 2012.
Well-days services
Balance sheet august31, 2012
Liabilities & owner’s equity:
Assets:
Cash
Notes payable
$ 17000
Accounts receivable $ 25000
Accounts payable
$ 20000
Equipment
$ 30000
Capital
$ 128000
Total assets
$ 165000
Total
$ 165000
Example 2
Example 3
$ 110000
Key elements of a balance sheet
Assets: An asset is something that an entity owns or controls in order to derive
economic benefits from its use. According FASB (Financial Accounting Standards
Board), assets are probable future economic benefits obtained or controlled by a
particular entity as a result of past transactions or events. Indeed, assets are economic
resources owned by a firm.
Assets are classified in the balance sheet as current or non-current depending on the
duration over which the reporting entity expects to derive economic benefit from its
use. An asset which will deliver economic benefits to the entity over the long term is
classified as non-current whereas those assets that are expected to be realized within
one year from the reporting date or used during the normal operating cycle of the
business, are classified as current assets. Examples of current assets include cash,
notes and accounts receivable, inventories, prepayments and some instance for
noncurrent assets are long-term investments in stocks and bonds, Property, plant, and
equipment, office building, machine, land, intangibles, etc.
There are a lot of examples of current and non-current assets and liabilities. We will
review several so you can obtain understanding of how to categorize them, and then,
you can apply the concept to your own situation. Refer to the below table:
Current Assets:
Normally, cash is considered a current asset
because it can be used within one year after the
balance sheet date. However, in certain situations,
cash may be classified as a non-current asset. For
example, if a company has restricted cash in a
bank account (i.e. cash that can't be used), and
restriction is for more than one year after the
balance sheet date, then, this cash is considered
non-current.
Accounts receivable are amounts expected to be
collected from customers in a credit transaction
Accounts
and without receiving any document. Usually,
Receivable
collection is within one year, and thus, accounts
receivable are considered a current asset.
Notes
are amounts expected to be collected from
receivable
customers in a credit transaction. In this kind of
transaction, company always receives a document.
is a current asset which kept by a merchandising
An inventory or a manufacturing company to sell to the
customers within one year in the future.
are daily needs of a company, things such
Supplies
common chairs, calculator sets, pens and etc.
Prepaid expenses (e.g. prepaid insurance
premiums) are usually used within a year after the
Prepaid
balance sheet date and thus, are considered a
Expenses
current asset. However, if a company paid a
(prepayments) premium for two years as of the balance sheet
date, then, one half (one year) of the prepaid
expenses balance will be current and the other half
(another year) will be non-current. Prepaid
expense isn’t an expense at the time of contract;
because the company has not yet received any
service.
Non-current Assets:
Fixed
Fixed assets are used (depreciated) by a company for
Assets:
more than a year, and thus, they are considered noncurrent.
vehicles
are cars and automobiles which a company need for
transportation and convey products and materials.
Vehicles They have more than one year life. Thus can be
classified as non-current assets.
Cash
Furniture
is also a non-current asset because it has more than
one year life and benefit future operations of a firm.
Buildings
are also a durable asset which last more than one year
and a firm can expect of them to benefit future
operations.
Land
is also a non-current asset and has indefinite life. But
other fixed assets have definite life and will
deteriorate after passing some years. The main intent
of a company isn’t sale of land.
Intangible
Assets
Similar to fixed assets, intangibles are used
(amortized) by a company for more than a year, and
thus, they are considered non-current. Examples are,
goodwill, copyrights, franchise etc.
Long-term
Notes
Receivable
Notes receivable that are not expected to be collected
until after one year after the balance sheet date are
considered long-term. Note, however, that there are
some notes that have a maturity date within a year
after the balance sheet date: such notes are classified
as current (short-term).
Characteristics of Assets: An asset has three essential characteristics: (a) item
bodies a probable future benefit that involves a capacity, singly or in combination with
other assets, to contribute directly or indirectly to future net cash inflows, (b) a
particular entity can obtain the benefit and control others' access to it, and (c) the
transaction or other event giving rise to the Entity's right to or control of the benefit
has already occurred.
Assets are also classified in the statement of financial position on the basis of their
nature:

Tangible & intangible: Non-current assets with physical substance are
classified as property, plant and equipment whereas assets without any
physical substance are classified as intangible assets. Goodwill is a type of an
intangible asset.

Inventories balance includes goods that are held for sale in the ordinary course
of the business. Inventories may include raw materials, finished goods and
works in progress.

Trade receivables include the amounts that are recoverable from customers
upon credit sales. Trade receivables are presented in the statement of financial
position after the deduction of allowance for bad debts.

Cash and cash equivalents include cash in hand along with any short term
investments that are readily convertible into known amounts of cash.
Liabilities: A liability is an obligation that a business owes to someone and its
settlement involves the transfer of cash or other resources. According FASB,
Liabilities are probable future sacrifices of economic benefits arising from present
obligations of a particular entity to transfer assets or provide services to other entities
in the future as a result of past transactions or events.
Liabilities classify in the statement of financial position as current or non-current
depending on the duration over which the entity intends to settle the liability. A
liability which will be settled over the long term is classified as non-current whereas
those liabilities that are expected to be settled within one year from the reporting date
are classified as current liabilities. Examples of current liabilities include income taxes
payable, notes and accounts payable, cash dividends payable, and some instance for
noncurrent liabilities are long-term service contracts, long-term notes payable, bonds
payable, mortgage payable, etc. Refer to the below table:
Current Liabilities:
Accounts payables are obligations of a company to
Accounts vendors, suppliers, etc. Such obligations are normally
Payable
settled with current assets (e.g. cash), and thus, they
are considered current liabilities.
Accrued
Expenses
Accrued expenses may include accrued (i.e. incurred
but not paid) utility charges, insurance payments, and
others. Such accrued expenses are usually paid
within a year after the balance sheet date, and
therefore, they are considered current liabilities.
Examples of Non-current Liabilities:
A bank loan that has a maturity date after one year
from the balance sheet date is not going to be paid
with current assets, and therefore, it is considered a
Bank Loan non-current liability. However, if a portion of the
loan is due within one year after the balance sheet
date, that portion is classified as current liability on
the balance sheet and is excluded from the noncurrent portion of the loan.
Tax
is tax that not yet paid and should be reflected on the
payable
liabilities section of a balance sheet.
Wages/sala is payroll that a company owes to its employees or
ries
workers. It occurs because the company hadn’t be
payable
able to pay it in time within last year.
Characteristics of Liabilities: A liability has three essential characteristics: (a) item
bodies a present duty or responsibility to one or more other entities that entails
settlement by probable future transfer or use of assets at a specified or determinable
date, on occurrence of a specified event, or on demand, (b) the duty or responsibility
obligates a particular entity, leaving it little or no discretion to avoid the future
sacrifice, and (c) the transaction or other event obligating the entity has already
happened .
Liabilities are also classified in the statement of financial position on the basis of their
nature:

Trade and other payables primarily include liabilities due to suppliers and
contractors for credit purchases. Sundry payables which are too insignificant to
be presented separately on the face of the balance sheet are also classified in
this category.

Short term borrowings (loans), typically include bank overdrafts and short term
bank loans with a repayment schedule of less than 12 months.

Long-term borrowings comprise of loans which are to be repaid over a period
that exceeds one year. Current portion of long-term borrowings include the
installments of long term borrowings that are due within one year of the
reporting date.

Current Tax Payable is usually presented as a separate line item in the
statement of financial position due to the materiality of the amount.
Owner's Equity or capital: Equity is what the business owes to its owners. The
owner’s equity in a business is equal to the total assets minus liabilities, and represents
the resources invested by the owner. The owner of a business is entitled to receive
whatever remains after the liabilities are fully paid. According FASB, Equity or net
assets is the residual interest in the assets of an entity that remains after deducting its
liabilities. Equity is derived by deducting total liabilities from the total assets. It
therefore represents the residual interest in the business that belongs to the owners.
Increases in owner’s equity of a business come from two sources: 1) Investment by
the owner, 2) Earnings from profitable operation of the business. Withdrawals by the
owner and losses from unprofitable operation cause owner’s equity to decrease.
The equity or net asset of both a business enterprise and a not-for-profit organization
is the difference between the entity's assets and its liabilities. It is a residual, affected
by all events that increase or decrease total asset s by different amounts than they
increase or decrease total liabilities. Thus, equity or net assets of bot h a business
enterprise and a not-f or-profit organization is increased or decreased by the entity' s
operations and other events and circumstances affecting the entity.
Characteristics of Equity of Business Enterprises: In a business enterprise, the
equity is the ownership interest. It stem s from ownership rights (or the equivalent)
and involves a relation between an enterprise and its owners as owners rather than as
employees, suppliers, customers, lenders, or in some other non-owner role. Since
equity ranks after liabilities as a claim to or interest in the assets of the enterprise, it is
a residual interest: (a) equity is the same as net assets, the difference between the
enterprise's assets and its liabilities, and (b) equity is enhanced or burdened by
increases and decreases in net assets from non-owner sources as well as investments
by owners and distributions to owners.
The three general class of items appear on the balance sheet are assets, liabilities, and
equity. These items are then divided into several sub classifications as below:
Rationale - Why the balance sheet always balances?
assets
Current assets
Liabilities
Long-term
investments
Tangible fixed
assets
Intangible assets
Owner’s
equity
Other assets
Current
liabilities
Long-term
liabilities
Capital stock
Additional
paid-in capital
Retained
earnings
The balance sheet
is structured in a
manner that the
total assets of an
entity equal to the
sum of liabilities
and equity. This
may lead you to
wonder as to why
the balance sheet
must always be in
equilibrium.
Assets of an entity may be financed from internal sources (i.e. share capital and
profits) or from external credit (e.g. bank loan, trade creditors, etc.). Since the total
assets of a business must be equal to the amount of capital invested by the owners (i.e.
in the form of share capital and profits not withdrawn) and any borrowings, the total
assets of a business must equal to the sum of equity and liabilities.
This leads us to the Accounting Equation: Assets = Liabilities + Equity as below.
Accounting equation
In every balance sheet, the total figure for assets always equals the total for liabilities
and owner’s equality. This equality between the total assets and the total of liabilities
plus owner’s equity is one reason for calling this statement of financial position, a
balance sheet. The equality of the two sides of the balance sheet comes from the fact
that these two sides are merely two views of the same business property.
The listing of assets represents what the business owned and the listing of liabilities
and owner’s equity shows who supplied these resources to the business and how much
each group supplied. All the assets owned by a business have been supplied to it by
the creditors or by the owner itself. Therefore, the total claims of the creditors plus the
claims of the owner equal the total assets of the business.
A balance sheet is simply a detailed statement of this equation. Because creditors
have preferential rights to the assets, it is customary to place liabilities before
owner’s equity in the accounting equation and on the balance sheet.
Transactions and the accounting equation: All business transactions can affect the
accounting equation and they can be stated in terms of the resulting change in the
three basic elements of the equation, no matter how complex those transactions are.
The effect of these changes on the accounting equation can be described by examining
the transactions of HP Service Company.
Transactions are for the month of December as you see below:
1.
2.
3.
4.
5.
6.
7.
Invested $ 10000 in cash.
Paid $ 800 for cash.
Purchased equipment on account, $ 3000.
Rendered services to customers for cash $ 1500.
Borrowed $700 from a bank on a note payable.
Rendered cleaning services to customers on account, $ 2000.
Paid monthly expenses : salaries $ 500; utilities $ 300; and telephone $ 100.
Purpose & Importance: Statement of financial position helps users of financial
statements to assess the financial health of an entity. When analyzed over several
accounting periods, balance sheets may assist in identifying underlying trends in the
financial position of the entity. It is particularly helpful in determining the state of the
entity's liquidity risk, financial risk, credit risk and business risk. When used in
conjunction with other financial statements of the entity and the financial statements
of its competitors, balance sheet may help to identify relationships and trends which
are indicative of potential problems or areas for further improvement. Analysis of the
statement of financial position could therefore assist the users of financial statements
to predict the amount, timing and volatility of entity's future earnings.
The income Statement or Profit & Loss Account
Income Statement, also known as Profit & Loss Account, is a report of income,
expenses and the resulting profit or loss earned during an accounting period. An
income statement shows the results of operations of a business for a given period of
time. To determine net income for the period, a business must measure revenues
earned and expenses incurred during that period. Thus, it may be stated that net
income equals revenues.
Example 1:
ABC dry cleaning services
Income statement
For the month ended july31, 2004
Revenues:
Fees earned
$ 4600
Expenses:
Insurance
$ 800
Salaries
$ 900
Utilities
$ 600
Rent
$ 200
Total expenses
$ 2500
Net income
$ 2100
Example 2: Following is an illustrative example of an Income Statement prepared in
accordance with the format prescribed by IAS 1 Presentation of Financial Statements.
2013
USD
2012
USD
Basis
of
Revenue
Cost of Sales
120,000
(65,000)
100,000
(55,000)
Gross Profit
55,000
45,000
Other Income
Distribution Cost
Administrative Expenses
Other Expenses
Finance Charges
17,000
(10,000)
(18,000)
(3,000)
(1,000)
12,000
(8,000)
(16,000)
(2,000)
(1,000)
Profit before tax
(15,000)
40,000
(15,000)
30,000
Income tax
(12,000)
(9,000)
Net Profit
28,000
21,000
preparation: Income statement is prepared on the accruals basis of accounting. This
means that income (including revenue) is recognized when it is earned rather than
when receipts are realized (although in many instances income may be earned and
received in the same accounting period).Conversely, expenses are recognized in the
income statement when they are incurred even if they are paid for in the previous or
subsequent accounting periods. Income statement does not report transactions with the
owners of an entity. Hence, dividends paid to ordinary shareholders are not presented
as an expense in the income statement and proceeds from the issuance of shares is not
recognized as an income. Transactions between the entity and its owners are
accounted for separately in the statement of changes in equity.
Key elements of an Income statement
Revenue: The prices of goods sold and services rendered to the customers and clients,
during a given accounting period is called revenue. A business usually receives cash
or acquires an account receivable at the time it renders services or sells merchandise to
its customers. Therefore, the total assets of the company will increasers by the amount
of cash received or accounts receivable acquitted. On the other hand, the owner’s
equity will increase because part of the assets belongs to the owner of the company.
Thus, earning revenue causes owner’s equity to increase. In fact, revenues are the
gross increase in owner’s equity resulting from operations of the business. According
to FASB, Revenues are inflows or other enhancements of assets of an entity or
settlements of its liabilities (or a combination of both) from delivering or producing
goods, rendering services, or other activities that constitute the entity's ongoing major
or central operations. So for example, in case of a manufacturer of electronic
appliances, revenue will comprise of the sales from electronic appliance business.
Conversely, if the same manufacturer earns interest on its bank account, it shall not be
classified as revenue but as other income.
Expense: The cost of goods and services used up in the process of generating
revenues is called expenses. Unlike revenue, an expense always causes the owner’s
equity to decrease. An expense reduces cash if the payment is made at the time of
transaction, or it will finally reduce cash if the payment is made at a later date.
According to FASB, expenses are outflows or other using up of assets or incurrences
of liabilities (or a combination of both) from delivering or producing goods, 42
rendering services, or carrying out other activities that constitute the entity's ongoing
major or central operations.
Gains: increases in equity from incidental transactions of an entity except those that
result from revenues or investments by owners.
Losses: decreases in equity from incidental transactions of an entity except those that
result from expenses or distributions to owners.
Cost of Sales: Cost of sales represents the cost of goods sold or services rendered
during an accounting period. Hence, for a retailer, cost of sales will be the sum of
inventory at the start of the period and purchases during the period minus any closing
inventory. In case of a manufacturer however, cost of sales will also include
production costs incurred in the manufacture of goods during a period such as the cost
of direct labor, direct material consumption, depreciation of plant and machinery and
factory overheads, etc. You may refer to the article on cost of sales for an explanation
of its calculation.
Other Income: Other income consists of income earned from activities that are not
related to the entity's main business. For example, other income of an entity that
manufactures electronic appliances may include:

Gain on disposal of fixed assets

Interest income on bank deposits

Exchange gain on translation of a foreign currency bank account
Distribution Cost: Distribution cost includes expenses incurred in delivering goods
from the business premises to customers.
Administrative Expenses: Administrative expenses generally comprise of costs
relating to the management and support functions within an organization that are not
directly involved in the production and supply of goods and services offered by the
entity.
Examples of administrative expenses include:

Salary cost of executive management

Legal and professional charges

Depreciation of head office building

Rent expense of offices used for administration and management purposes

Cost of functions / departments not directly involved in production such as
finance department, HR department and administration department
Other Expenses: This is essentially a residual category in which any expenses that
are not suitably classifiable elsewhere are included.
Finance Charges: Finance charges usually comprise of interest expense on loans and
debentures. The effect of present value adjustments of discounted provisions are also
included in finance charges (e.g. unwinding of discount on provision for
decommissioning cost).
Income tax: Income tax expense recognized during a period is generally comprised of
the following three elements:

Current period's estimated tax charge

Prior period tax adjustments

Deferred tax expense
Purpose & Use: Income Statement provides the basis for measuring performance of
an entity over the course of an accounting period.
Performance can be assessed from the income statement in terms of the following:

Change in sales revenue over the period and in comparison to industry growth

Change in gross profit margin, operating profit margin and net profit margin
over the period

Increase or decrease in net profit, operating profit and gross profit over the
period

Comparison of the entity's profitability with other organizations operating in
similar industries or sectors
The statement of Cash Flows
Statement of Cash Flows, also known as Cash Flow Statement, presents the
movement in cash flows over the period as classified under operating, investing and
financing activities. According FASB, the primary purpose of a statement of cash
flows is to provide relevant information about the cash receipts and cash payments of
an enterprise during a period.