Financial statements

Historical financial statement

Financial statements (or financial reports) are a record of a business' financial flows (revenues/expenses) and levels (assets/liabilities). The big four statements are :

1. Balance sheet which describes a company's assets, liabilities and net equity at both a specific point of time and at the beginning of the period of time.
2. Income statement which describes a company's income, expenses and net income/loss over a period of time.
3. Cash flow statement which describes how much cash was used in corporate operating, investment, and financing activities over a period of time.
4. Statement of changes in shareholder equity which reconciles the difference between the equity at the two different points in time..

Because these statements are often complex an extensive set of Notes to the Financial Statements and management discussion and analysis is usually included. The notes will typically describe each item on the Balance Sheet, Income statement and Cash flow statement in further detail. In many cases the notes are much longer than the financial statement they are elucidating.

The reason financial statements are required by many statutes is to require management of the enterprise to report to the owners and government. Debtholders, suppliers and employees, as well as internal mangement are other users of the statements. The POV of the statements though, is for the owner's use. Accounting is the language of finance. Financial statement presentation rules are the grammar. The statements are necessary for owners to asses management and make rational economic decisions.

Analogy

Knowing is not the same as understanding, so it is helpful to present an analogy.

• Think of an investment as a water reservoir. The value of the investment is the volume of water in it. The shareholder equity on the balance sheet measures this value.
• Streams empty into the reservoir, adding more water. These inflows are measured by revenues on the income statement.
• Streams run out of the reservoir, depleting it. These outflow are measured by expenses on the income statement.
• When a neighbour joins in the investment as a partner, he digs a canal from his own reservoir so it drains into yours. This additional water is measured by an increase in the share capital.
• When employees install an underground pipe to drain the reservoir into one of their own, the value of the investment falls. This draw is for stock options. Historically this drain has not been measured, and even now is not fully measured.

While measuring the volume of water in the reservoir at a point in time (balance sheet) is relatively easy, keeping track of the streams' volumes at every second of the year is difficult. Accountants may chose to ignore some streams: they may not know some streams exist: water may be evaporating, and unmeasurable. As a result the income statement is easily wrong. Regardless, the net sum of inflows less outflows should equal the difference in the reservoir (beginning vs. ending). The statement of changes in shareholder equity attempts this reconciliation.

None of the financial statements measures your own personal share of the reservoir when you have partners. It is up to the individual investor to measure, not the business totals, but his share. The methods to use 'equity per share' is shown at shareholders' equity.

Government financial statements

The rules for measurement and presentation of a government's financials may be different from those required for business and even for non-profit organizations. They may use either accrual accounting, or cash accounting, or a combination of the two. Because most governments may not lawfully spend money previously approved in a budget, the financial results are usually presented side by side with the budget.

Audit

Although the legal statues differ, most jurisdictions require an audit of the financials, by independent accountants, of all businesses. Private ones can waive the requirement. Note that the auditors do not certify financial statements, that is done by the company's directors. All an auditor does is give an opinion on whether they are "true and fair" (or meet other particular requirements that the auditor is engaged to opine on).

There has been much legal debate over who an auditor is liable to. Since audit reports tend to be addressed to the current shareholders, it is commonly thought that they owe a legal duty of care to them. But this may not be the case as determined by common law precedent. In Canada, auditors are liable only to investors using a prospectus to buy shares in the primary market. In the UK, they have been held liable to potential investors when the auditor was aware of the potential investor and how they would use the information in the financial statements. Nowadays auditors tend to include in their report liability restricting language, discouraging anyone other than the addressees of their report from relying on it. Liability is an important issue: in the UK, for example, auditors have unlimited liability.

In the United States, especially in the post-Enron era there has been substantial concern about the accuracy of financial statements. Corporate officiers (the CEO and CFO) are personally liable for attesting that financial statements "do not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by th[e] report". Making or certifiing misleading financial statements exposes the people involved to substantial civil and criminal liability. For example Bernie Ebbers (former CEO of WorldCom) was sentenced to 25 years in federal prison for allowing WorldCom's revenues to be overstated by $11 billion over five years.

Standards and regulation

To ensure that financial statements prepared by different companies can be adequately compared, they must be prepared according to certain rules. Countries under the common law legal system usually follow guidelines set in generally accepted accounting principles ("GAAP"). National accounting bodies in each country have developed their own specific sets of accounting principles.

Different countries have developed their own accounting principles over time, making international comparisons of companies difficult. Recently there has been a push towards standardising accounting rules made by the International Accounting Standards Board ("IASB"). IASB develops International Financial Reporting Standards that have been adopted by Australia, Canada and the European Union (for publicly quoted companies only), are under consideration in South Africa and other countries. The United States Federal Accounting Standards Board has made a commitment to converge the US GAAP and IFRS over time.

Inclusion in annual report

To entice new investors, most public companies assemble their financial statements on fine paper with pleasing graphics and photos in an annual report to shareholders, attempting to capture the excitement and culture of the organization in a "marketing brochure" of sorts. Usually the company's chief executive will write a letter to shareholders, describing the financial year in the most favorable light.

In the United States, prior to the advent of the internet, the annual report was the main way that a corporation communicated with individual shareholders. Blue chip companies went to great expense to produce and mail out attractive annual reports to every shareholder. The annual report was often prepared in the style of a coffee table book

History

Financial statements and records have been produced for as far back as there has been human writing. The people in the old Mesopotamian societies operated both insurance and credit (see interest) corporations, and had the obvious need of record keeping.

See also

• Accounting
• Auditing
• Corporate finance
• Generally accepted accounting principles
• International Financial Reporting Standards

External links

• September 14, 2004 - Reading An Earnings Release - Glenn Schorr, CFA, Executive Director, Financials Group, UBS
• SEC.gov - Information matters
• SECfilings.com (access real time financial statements)

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