What are Financial Statements?

Definition - What are Financial Statements?

Financial Statements represent a formal record of the financial activities of an entity. These are written reports that quantify the financial strength, performance and liquidity of a company. Financial Statements reflect the financial effects of business transactions and events on the entity.

Four Types of Financial Statements

The four main types of financial statements are:

1. Statement of Financial Position
   
   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 the following three elements:
• Assets: Something a business owns or controls (e.g. cash, inventory, plant and machinery, etc)
• Liabilities: Something a business owes to someone (e.g. creditors, bank loans, etc)
• Equity: What the business owes to its owners. This represents the amount of capital that remains in the business after its assets are used to pay off its outstanding liabilities. Equity therefore represents the difference between the assets and liabilities.

View detailed explanation and Example of Statement of Financial Position

2. Income Statement
   
   Income Statement, also known as the Profit and Loss Statement, reports the company's financial performance in terms of net profit or loss over a specified period. Income Statement is composed of the following two elements:
• Income: What the business has earned over a period (e.g. sales revenue, dividend income, etc)
• Expense: The cost incurred by the business over a period (e.g. salaries and wages, depreciation, rental charges, etc)

Net profit or loss is arrived by deducting expenses from income.

View detailed explanation and Example of Income Statement

3. Cash Flow Statement
   
   Cash Flow Statement, presents the movement in cash and bank balances over a period. The movement in cash flows is classified into the following segments:
• Operating Activities: Represents the cash flow from primary activities of a business.
• Investing Activities: Represents cash flow from the purchase and sale of assets other than inventories (e.g. purchase of a factory plant)
• Financing Activities: Represents cash flow generated or spent on raising and repaying share capital and debt together with the payments of interest and dividends.

View detailed explanation and Example of Cash Flow Statement

4. Statement of Changes in Equity
   
   Statement of Changes in Equity, also known as the Statement of Retained Earnings, details the movement in owners' equity over a period. The movement in owners' equity is derived from the following components:
• Net Profit or loss during the period as reported in the income statement
• Share capital issued or repaid during the period
• Dividend payments
• Gains or losses recognized directly in equity (e.g. revaluation surpluses)
• Effects of a change in accounting policy or correction of accounting error

Types of Accounting

Types of Accounting

Accounting is a vast and dynamic profession and is constantly adapting itself to the specific and varying needs of its users. Over the past few decades, accountancy has branched out into different types of accounting to cater for the diversity of needs of its users.

Main types of accounting
are as follows:

1. Financial
2. Management
3. Governmental
4. Tax
5. Forensic
6. Project
7. Social

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Financial Accounting, or financial reporting, is the process of producing information for external use usually in the form of financial statements. Financial Statements reflect an entity's past performance and current position based on a set of standards and guidelines known as GAAP (Generally Accepted Accounting Principles). GAAP refers to the standard framework of guideline for financial accounting used in any given jurisdiction. This generally includes accounting standards (e.g. International Financial Reporting Standards), accounting conventions, and rules and regulations that accountants must follow in the preparation of the financial statements.

Management Accounting produces information primarily for internal use by the company's management. The information produced is generally more detailed than that produced for external use to enable effective organization control and the fulfillment of the strategic aims and objectives of the entity. Information may be in the form budgets and forecasts, enabling an enterprise to plan effectively for its future or may include an assessment based on its past performance and results. The form and content of any report produced in the process is purely upon management's discretion.

Cost accounting is a branch of management accounting and involves the application of various techniques to monitor and control costs. Its application is more suited to manufacturing concerns.

Governmental Accounting, also known as public accounting or federal accounting, refers to the type of accounting information system used in the public sector. This is a slight deviation from the financial accounting system used in the private sector. The need to have a separate accounting system for the public sector arises because of the different aims and objectives of the state owned and privately owned institutions. Governmental accounting ensures the financial position and performance of the public sector institutions are set in budgetary context since financial constraints are often a major concern of many governments. Separate rules are followed in many jurisdictions to account for the transactions and events of public entities.

Tax Accounting refers to accounting for the tax related matters. It is governed by the tax rules prescribed by the tax laws of a jurisdiction. Often these rules are different from the rules that govern the preparation of financial statements for public use (i.e. GAAP). Tax accountants therefore adjust the financial statements prepared under financial accounting principles to account for the differences with rules prescribed by the tax laws. Information is then used by tax professionals to estimate tax liability of a company and for tax planning purposes.

Forensic Accounting is the use of accounting, auditing and investigative techniques in cases of litigation or disputes. Forensic accountants act as expert witnesses in courts of law in civil and criminal disputes that require an assessment of the financial effects of a loss or the detection of a financial fraud. Common litigations where forensic accountants are hired include insurance claims, personal injury claims, suspected fraud and claims of professional negligence in a financial matter (e.g. business valuation).

Project Accounting refers to the use of accounting system to track the financial progress of a project through frequent financial reports. Project accounting is a vital component of project management. It is a specialized branch of management accounting with a prime focus on ensuring the financial success of company projects such as the launch of a new product. Project accounting can be a source of competitive advantage for project-oriented businesses such as construction firms.

Social Accounting, also known as Corporate Social Responsibility Reporting and Sustainability Accounting, refers to the process of reporting implications of an organization's activities on its ecological and social environment. Social Accounting is primarily reported in the form of Environmental Reports accompanying the annual reports of companies. Social Accounting is still in the early stages of development and is considered to be a response to the growing environmental consciousness amongst the public at large

Introduction to Accounting

Introduction to Accounting

Accountancy is the process of communicating financial information about a business entity to users such as shareholders and managers (Elliot, Barry & Elliot, Jamie: Financial accounting and reporting).

Accounting has been defined as:

the art of recording, classifying, and summarizing in a significant manner and in terms of money, transactions and events which are, in part at least, of financial character, and interpreting the results thereof.(AICPA)

Users of Accounting Information - Internal & External

Accounting information helps users to make better financial decisions. Users of financial information may be both internal and external to the organization.

Internal users (Primary Users) of accounting information include the following:

• Management: for analyzing the organization's performance and position and taking appropriate measures to improve the company results.
• Employees: for assessing company's profitability and its consequence on their future remuneration and job security.
• Owners: for analyzing the viability and profitability of their investment and determining any future course of action.

Accounting information is presented to internal users usually in the form of management accounts, budgets, forecasts and financial statements.

External users (Secondary Users) of accounting information include the following:

• Creditors: for determining the credit worthiness of the organization. Terms of credit are set by creditors according to the assessment of their customers' financial health. Creditors include suppliers as well as lenders of finance such as banks.
• Tax Authourities: for determining the credibility of the tax returns filed on behalf of the company.
• Investors: for analyzing the feasibility of investing in the company. Investors want to make sure they can earn a reasonable return on their investment before they commit any financial resources to the company.
• Customers: for assessing the financial position of its suppliers which is necessary for them to maintain a stable source of supply in the long term.
• Regulatory Authorities: for ensuring that the company's disclosure of accounting information is in accordance with the rules and regulations set in order to protect the interests of the stakeholders who rely on such information in forming their decisions.

Statement of Cash Flows

Statement of Cash Flows

Definition

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.

Topic Contents:

1. Definition
2. Example
3. Basis of Preparation
4. Operating Activities
5. Investment Activities
6. Financing Activities
7. Purpose & Importance
8. Template

Example

Following is an illustrative cash flow statement presented according to the indirect method suggested in IAS 7 Statement of Cash Flows:

ABC PLC Statement of Cash Flows for the year ended 31 December 2013
	Notes	2013	2012
		USD	USD
Cash flows from operating activities
Profit before tax		40,000	35,000
Adjustments for:
Depreciation	4	10,000	8,000
Amortization	4	8,000	7,500
Impairment losses	5	12,000	3,000
Bad debts written off	14	500	-
Interest expense	16	800	1,000
Gain on revaluation of investments		(21,000)	-
Interest income	15	(11,000)	(9,500)
Dividend income		(3,000)	(2,500)
Gain on disposal of fixed assets		(1,200)	(1,850)
		35,100	40,650
Working Capital Changes:
Movement in current assets:
(Increase) / Decrease in inventory		(1,000)	550
Decrease in trade receivables		3,000	1,400
Movement in current liabilities:
Increase / (Decrease) in trade payables		2,500	(1,300)
Cash generated from operations		39,600	41,300
Dividend paid		(8,000)	(6,000)
Income tax paid		(12,000)	(10,000)
Net cash from operating activities (A)		19,600	25,300
Cash flows from investing activities
Capital expenditure	4	(100,000)	(85,000)
Purchase of investments	11	(25,000)	-
Dividend received		5,000	3,000
Interest received		3,500	1,000
Proceeds from disposal of fixed assets		18,000	5,500
Proceeds from disposal of investments		2,500	2,200
Net cash used in investing activities (B)		(96,000)	(73,300)
Cash flows from financing activities
Issuance of share capital	6	1000,000	-
Bank loan received		-	100,000
Repayment of bank loan		(100,000)	-
Interest expense		(3,600)	(7,400)
Net cash from financing activities (C)		896,400	92,600
Net increase in cash & cash equivalents (A+B+C)		820,000	44,600
Cash and cash equivalents at start of the year		77,600	33,000
Cash and cash equivalents at end of the year	24	897,600	77,600

Basis of Preparation

Statement of Cash Flows presents the movement in cash and cash equivalents over the period.

Cash and cash equivalents generally consist of the following:

• Cash in hand
• Cash at bank
• Short term investments that are highly liquid and involve very low risk of change in value (therefore usually excludes investments in equity instruments)
• Bank overdrafts in cases where they comprise an integral element of the organization's treasury management (e.g. where bank account is allowed to float between a positive and negative balance (i.e. overdraft) as opposed to a bank overdraft facility specifically negotiated for financing a shortfall in funds (in which case the related cash flows will be classified under financing activities).

As income statement and balance sheet are prepared under the accruals basis of accounting, it is necessary to adjust the amounts extracted from these financial statements (e.g. in respect of non cash expenses) in order to present only the movement in cash inflows and outflows during a period.

All cash flows are classified under operating, investing and financing activities as discussed below.

Operating Activities

Cash flow from operating activities presents the movement in cash during an accounting period from the primary revenue generating activities of the entity.

For example, operating activities of a hotel will include cash inflows and outflows from the hotel business (e.g. receipts from sales revenue, salaries paid during the year etc), but interest income on a bank deposit shall not be classified as such (i.e. the hotel's interest income shall be presented in investing activities).

Profit before tax as presented in the income statement could be used as a starting point to calculate the cash flows from operating activities.

Following adjustments are required to be made to the profit before tax to arrive at the cash flow from operations:

1. Elimination of non cash expenses (e.g. depreciation, amortization, impairment losses, bad debts written off, etc)
2. Removal of expenses to be classified elsewhere in the cash flow statement (e.g. interest expense should be classified under financing activities)
3. Elimination of non cash income (e.g. gain on revaluation of investments)
4. Removal of income to be presented elsewhere in the cash flow statement (e.g. dividend income and interest income should be classified under investing activities unless in case of for example an investment bank)
5. Working capital changes (e.g. an increase in trade receivables must be deducted to arrive at sales revenue that actually resulted in cash inflow during the period)

Investing Activities

Cash flow from investing activities includes the movement in cash flow as a result of the purchase and sale of assets other than those which the entity primarily trades in (e.g. inventory). So for example, in case of a manufacturer of cars, proceeds from the sale of factory plant shall be classified as cash flow from investing activities whereas the cash inflow from the sale of cars shall be presented under the operating activities.

Cash flow from investing activities consists primarily of the following:

• Cash outflow expended on the purchase of investments and fixed assets
• Cash inflow from income from investments
• Cash inflow from disposal of investments and fixed assets

Financing activities

Cash flow from financing activities includes the movement in cash flow resulting from the following:

• Proceeds from issuance of share capital, debentures & bank loans
• Cash outflow expended on the cost of finance (i.e. dividends and interest expense)
• Cash outflow on the repurchase of share capital and repayment of debentures & loans

Purpose & Importance

Statement of cash flows provides important insights about the liquidity and solvency of a company which are vital for survival and growth of any organization. It also enables analysts to use the information about historic cash flows to form projections of future cash flows of an entity (e.g. in NPV analysis) on which to base their economic decisions. By summarizing key changes in financial position during a period, cash flow statement serves to highlight priorities of management. For example, increase in capital expenditure and development costs may indicate a higher increase in future revenue streams whereas a trend of excessive investment in short term investments may suggest lack of viable long term investment opportunities. Furthermore, comparison of the cash flows of different entities may better reveal the relative quality of their earnings since cash flow information is more objective as opposed to the financial performance reflected in income statement which is susceptible to significant variations caused by the adoption of different accounting policies.

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