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Chapter 2: Main Financial Statements

An overview

The objective of general purpose financial reporting is to


provide information about the reporting entity that is useful to
existing and potential investors, lenders and other creditors in
making decisions about providing resources to the entity.
Those decisions involve buying, selling or holding equity and
debt instruments, and providing or settling loans and other
forms of credit.

International Accounting Standards Board (2010), The Conceptual


Framework for Financial Reporting

Three main statements:


i. Balance Sheet (Statement of Financial Position )
ii. Income Statement
iii. Statement of Cash Flows
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Balance Sheet

Fundamental Structure:
Resources

Sources of Capital

Assets

Liabilities
Qwners Equity

Asset: Resource
owned or controlled by the
accounting entity
expected to provide future
economic benefits to the
accounting entity
ownership or control acquired
in a past transaction

Liability:= obligation to settle a


past transaction by transferring
resources to an outside party
Owners equity =
Residual claims
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The basic accounting equation

Note that the following equation always holds:


Assets = Liabilities + Owners Equity

The effect of a transaction on the left hand side of the balance sheet
always equals the one on the right hand side
Examples:

An increase in one asset and a decrease in another asset


An increase in an asset and an increase in a liability
An increase in an asset and an increase in owners equity
An increase in a liability and a decrease in owners equity

Each transaction affects at least two accounts

Line items on the balance sheet

Assets
... economic resources owned (or controlled) by a business as
a result of past transactions that are expected to yield future
economic benefits and eventually result in cash inflows to the
business enterprise.
Examples: property, plant, cash, copyrights, patents, investments

Liabilities
... claims of those to whom money is owed, i.e. liabilities are
existing debts and obligations
Examples: loans payable to a bank, salaries payable to employees

Owners Equity
... residual interest in the assets of a business
enterprise after deducting its liabilities; also referred to as residual
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equity or net assets

Classification of assets

Assets
current
cash and marketable securities
Receivables
Inventories
Prepayments and accrue income
fixed
property, plant and equipment
long-term financial investments
intangible assets

Classification of liabilities and shareholders equity

Liabilities
current
short-term debt and current portion of long-term debt
payables
accrued expenses and deferred income
long-term
long-term debt
provisions for contingencies and charges
other long-term liabilities

Equity
Common Stocks at par value
additional paid-in capital (= capital surplus, share premium)
Reserves
accumulated other comprehensive income / loss
retained earnings
net income for the year
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Understanding the basic accounting equation

The story : Angie has a degree in political science and economics,


and decides to start her own business Vote-Consult. Some time
ago she received 8.000 from a very good friend, money that she
now uses to invest in her enterprise. During the first days of her new
enterprises life the following transactions occurred (in chronological
order):

1. Angie deposits 8.000 in a bank account in the name of VoteConsult.


2. She purchases computers and other office equipment for 4.000.
3. Angie buys office supply for 500 on credit.
4. She pays 300 of the total amount she spent on supplies.
5. She pays the remaining 200 out of her personal pocket.
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What happens to the balance sheet?

1. Angie deposits 8.000 in a bank account in the name of Vote-Consult.

[Extension of both assets and liabilities side]


2.

She purchases computers and other office equipment for 4.000.

[Exchange of assets]
3.

Angie buys computer paper and office supply for 500 on credit.

[Extension of both assets and liabilities side]


4.

She pays 300 of the total amount she spent on supplies.

[Contraction of both sides]


5.

She pays the remaining 200 out of her personal pocket.

[Exchange on the liabilities side]


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The Income Statement


Income:
Increase in an entitys net assets
Resulting from an entitys operations
Over a period of time

Fundamental balance sheet equation:


Assets = Liabilities + Equity
Net Assets = Assets Liabilities
=> Net Assets = Equity
Assets

Liabilities

Owner's Equity
(profits)

(losses)
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Income

Income results only from entity operations


Capital transactions with owners
Gains or losses from changes in exchange rates when group accounts
are concerned
are not operations
Such transactions do not affect income but equity

Income is generated over a period of time


The period between two balance sheet dates

The income statement provides detailed information about how


income was generated
It adds up revenues and deducts expenses
Income is the bottom line of the income statement
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Income Statement Format

(funcional basis)

Net Revenue
Cost of goods sold (by product category)
Gross margin
Operating expense
Operating Income (EBIT)
+ Financial, Investment & other revenue
Financial expenses
expenses from investments and other
Income before Taxes
Income taxes
Income after Tax
+ Extraordinary Items
Net income

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Income statement

Balance sheet and income statement are interrelated

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Clean vs. dirty surplus accounting

+
+
=

Net assets (End of period)


net assets (Beginning of period)
contributions to equity (receipts from share issues)
dividends
amount used to redeem shares
Comprehensive income

usually not equal to income according to income statement


difference: change in value of assets and liabilities due to exchange rate
changes and other, depending on countrys accounting regulations

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Revenues and Expenses

Revenues
gross increase in owners equity resulting from operating the business with the
objective of generating profits
usually results in an increase in an asset
Examples: sales; fees, commissions; interest; dividends; rents

Expenses
cost of assets consumed or services used resulting from business activities
and are, in general, actual or expected cash outflows
Examples: salaries, wages; interest on loans; insurance premiums; cost of
providing fringe benefits to employees; decrease in inventory

Revenues

>

Expenses

Net profit

Revenues

<

Expenses

Net loss
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Angies business story continued


transactions (in chronological order):
6. Invited speech at a regional conference, 1000, remitted to the
bank account

This is a revenue:
Accounts affected: Bank; Revenues; Amount: 1.000

7. First rent and utility payment due, charged to bank account, 500.

This is an expense:
Accounts affected: Cost of office space; Bank

8. Prepayment received for a series of invited speeches, 4.500.

This is not yet a revenue, this is unearned revenue


Accounts affected: Bank; Unearned revenue.

9. Personal expenses (haircut, groceries, etc.), 400, paid using the


EC card.

This is a withdrawal
Accounts affected: Owners equity; Bank.

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Explanations of income statement items

Net revenue = gross revenue


discounts
returns
Cost of goods sold = cost of goods available for sale
ending product inventory
Cost of goods available for sale = beginning product inventory
+ cost of goods manufactured
Cost of goods manufactured = direct materials
+ direct labour
+ allocated production
overhead cost
ending product inventory (finished and work in process)
value to be determined according to an inventory valuation method, e.g.
LIFO, weighted average cost
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Cash Flow Statement

Cash flow statements records cash inflows and cash outflows


Cash inflows e.g., from sales
Cash outflows e.g., expenses paid
Easier to manipulate profit than cash flow
Opening Cash +

Inflows

Outflows

Closing Cash

All large companies required to prepare a Statement of Cash Flows


using either:

(a)

Direct method

(b)

Indirect method
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Relationship Between Cash and Profit

Cash and profit fundamentally different:


=

Cash Flow

Profit

Cash Paid

Income Earned

Cash Received

Expenses
Incurred

A business may make a profit, but run out of cash. This is


overtrading
Depreciation is an important non-cash item
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