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

Owner‘s 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 + Owner‘s 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

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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

• Owner‘s Equity
... residual interest in the assets of a business
enterprise after deducting its liabilities; also referred to as residual
equity or net assets 4
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

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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
enterprise‘s life the following transactions occurred (in chronological
order):

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

Consult.
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 entity’s net assets
– Resulting from an entity’s 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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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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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 country‘s accounting regulations

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 Revenues and Expenses

• Revenues
– gross increase in owner‘s 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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Angie‘s 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: Owner’s equity; Bank. 16
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 = Cash Paid Cash Received

Income Earned Expenses

Profit =
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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