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November, 2008

What are Financial Statements?


The principle convention of accounting is financial reporting.  Financial statements are the desired end product of financial reporting.  The central feature of financial reporting is a set of four financial statements and related footnotes and discussions.  These statements, though often referred to by different names, include:

  • Balance Sheet or Statement of Position
  • Income Statement or Statement of Profit & Loss (P&L)
  • Statement of Equity or Retained Earnings
  • Statement of Cash Flows

Because people prepare financial statements, they have limitations that are both inherent and planned.  Inherent limitations result from the fallibility of human thinking and processing of information, as well as the state of financial reporting itself.  Planned limitations result from insidious designs of managers and owners.  Professor Jan R. Williams, Ph.D. (a preeminent accounting scholar) of the University of Tennessee describes the limitations of financial statements in the following way:  


Financial statements are essentially historical representations of business activity. They are frequently used to anticipate the future and their historical orientation imposes a limitation on their value in this regard. Despite the historical orientation of the statements, accountants must consider the future to make many of the judgments that are required in reporting about past activities. For example, in determining an appropriate amount of depreciation on a plant asset for an accounting period, the accountant must make an assumption concerning how long the reporting entity will use that asset…Within limits, management has the ability to influence the content of financial statements. Certain end-of-period activities can have an important effect on the relationships that investors and creditors consider particularly important in assessing the financial activities of the enterprise.


Moreover, American financial statements do not attempt to capture all aspects of business activity that may be important factors in the success of an enterprise. One example of an item that may be very important to the future well-being of an enterprise is its human capital.  Arguably, for many companies, its management personnel and labor force may be its most valuable "asset."  Yet, this asset is widely neglected in conventional financial reporting and statements.  That said, a discussion of the chief elements of financial statements is nonetheless in order.


The Balance Sheet.  The Balance Sheet is a snap shot of the financial condition of an enterprise at any point in time (though usually at its year end).  It represents the quantifiable resources of the enterprise and a description of the three primary sources from which those resources have been garnered. The first source is creditors--those who have loaned or otherwise provided resources to the company for its use, expecting a return on those loaned amounts as well as eventual repayment of them. The second source is the owners, called stockholders in a corporation, who have committed resources to the company, expecting some combination of return and enhanced value of the investment through the effective employment of resources by the enterprise. The third source also is considered an owner source but results from the assets earned by the enterprise having been retained for its future use rather than having been distributed back to the owners on a periodic basis.


            It is a basic algebraic equation:




Said verbally, the equation sets forth the proposition that what is believed to be of value in the company (i.e. its Assets) belong to its creditors (i.e. its Liabilities) and what then remains is the residual interests of its owners (i.e. its equity).  Obviously, the economic concepts of what are assets and liabilities are at the crux of the Balance Sheet.  For example, when does research and development become intellectual property and thus assets?  How much is a patent, copyright, trademark or trade secret worth to an enterprise?  Similarly, how are liabilities ascertained and what are their values?  How are future liabilities, e.g. warranties valued?  How do we value contingent liabilities, e.g. lawsuit exposure or adjustments resulting from vendor audits as is the case with government contracting or Medi-care reimbursement in the healthcare industry?


Income Statement.  It is common for many small businesses to think that the profit and loss is the focal point of accounting.  In fact, many lenders often request an income statement (P&L) first.  With the advent of easy to use accounting software like Quickbooks, many small businesses began keeping rudimentary sets of books in-house.  Many of those same small businesses soon realized that they were only keeping an electronic checkbook and that they had failed to account for arguably the most valuable part of their businesses, i.e. the assets (and the corresponding claims on them as depicted in a balance sheet).


If the Balance Sheet is a snap shot of an enterprise, then the income statement is more a motion picture of enterprise operations over a period of time.  Income (asset inflows or liability settlements result from the business of the entity) and expenses (asset outflows or claims on assets resulting from the business of the entity) are set forth in a periodic fashion to show the operations of an entity operating cycle.  Income statements, because they are periodic, attempt to measure inflows and outflows during the operating cycle.  They also attempt to match these economic phenomena.  Revenues ordinarily can be readily associated with specific business activity that relates to specific periods of time. Once the revenues for a period of time have been identified, the accountant then attempts to associate with those revenues all expenses that relate to (1) that same period of time and/or (2) the generation of those specific revenues. These amounts are then matched, meaning that the expenses are subtracted from the revenues, to determine the results of operations for the period. The result is called net income if revenues exceed expenses; it is called net loss if expenses exceed revenues.


Statement of Changes in Owners Equity.  As noted, owners equity itself is a residual claim on the assets of an entity.  Owners equity is generally shown in the form of a statement of changes.  It is a required disclosure in a complete set of financial statements. It can be disclosed in different forms, such as a note or supplemental schedule to the other financial statements, in addition to a separate financial statement. Unlike the balance sheet as a whole, and like the income statement, the statement of owner’s equity covers a period of time rather than a specific point in time. The statement begins with the balance at the end of the period prior to that covered in the statement.


Statement of Cash Flows.  The statement of cash flows presents information about company cash receipts and payments during a period of time. This statement is similar in concept to the income statement and statement of owners equity in that it covers a period of time rather than a point in time as the Balance Sheet does. In its simplest form, the statement of cash flows simply indicates the entity's primary sources of cash and the primary ways the entity used that cash. These changes are presented in a manner that reconciles the change in cash from the beginning to the end of the accounting period.


The cash flows of an entity are presented in three major categories called activities:


  • Operating activities
  • Investing activities
  • Financing activities

Important uses of information about an entity's current cash receipts and payments include helping to assess factors such as the entity's liquidity, financial flexibility, profitability, and risk.


Footnote Disclosures.  The last integral part of a financial statement is footnote disclosures. Classification within the financial statements is an important form of disclosure, but some transactions more or less defy simple line item presentation and the only meaningful way to fully disclose what is actually happening financially is to supplement the information in the footnotes.  The notes to the financial statements, which are required by accounting standards, and sometimes dictated by reason, attempt to provide additional information on specific financial line items within the 4 statements to the financials.  They may disclose litigation or future claims against a company as well as more rudimentary matters, e.g. the accounting policies of the enterprise or its methods of depreciation.  They may be numerical, but are often explanation of a textual nature.


In determining whether a specific item of information should be disclosed, the accountant must judge whether that information would make a difference in the decision of a reasonably prudent reader of the financial statements. If the information would be important to such a person, it should be disclosed.  This need to disclose is tempered by the notion of cost-benefit balancing in order to avoid what some call disclosure overload.  Overload occurs when disclosure becomes so inundating, ultimately causing users to get lost in the details and miss the primary message being communicated.  Thus, the devil may be in the detail. Moreover, some transactions are the by-product of years of financial dealings and contracts that are nothing short of voluminous.  These phenomena must be summarized in as succinct a fashion as can be done given the cost-benefit constraints placed upon the financial statement preparer(s).


Notes to the financial statements are required by accounting standards and should not be relegated as secondary or unimportant. Their importance should not be under estimated, for the body of the financial statements are as one university professor once quipped, like bikinis inasmuch as what they show you is not as important as what they do not show you.


Typical note disclosures of a general nature include:


  • Accounting policies
  • Related party transactions
  • Subsequent events
  • Doubt concerning continued existence
  • Contingent liabilities
  • Significant risks and uncertainties
  • Innovative financial instruments
  • Uncertainty of measurements of certain assets and liabilities


Other, more detailed disclosures are often required for the following items:


  • Debt and equity investments
  • Inventories
  • Plant assets and depreciation
  • Long-term debt
  • Segment disclosures
  • Earnings per share
  • Off balance sheet financing and activities

Management Discussion and Analysis (MD&A).  Security & Exchange Commission (SEC) Form 10_K filings require a section entitled Management Discussion and Analysis of Financial Condition and the Results of Operations. The governing regulation is Section 229.303 of Regulation S-K and is referred to as Item 303. As stated in Item 303, the objective of the MD&A is to provide to investors and other users information relevant to an assessment of the financial condition and results of operations of the registrant as determined by evaluating the amounts and certainty of cash flows from operations and from outside sources. The MD&A should permit shareholders and users to see and understand the specific decisions made through the eyes of management. The SEC has stated:


(There is) the need for a narrative explanation of the financial statements, because a numerical presentation and brief accompanying footnotes alone may be insufficient for an investor to judge the quality of earnings and the likelihood that past performance is indicative of future performance. MD&A is intended to give the investor an opportunity to look at the company through the eyes of management by providing both a short- and long-term analysis of the business of the company. The Item asks management to discuss the dynamics of the business and to analyze the financials…The MD&A requirements are intended to provide…(information) with particular emphasis on the registrant's prospects for the future…


The Financial Accounting Standards Board similarly states:


Management knows more about the enterprise and its affairs than investors, creditors, or other outsiders and can often increase the usefulness of financial information by identifying certain transactions, other events, and circumstances that affect the enterprise and explaining their financial impact on it.


Conclusion.  There is more than meets the eye in properly prepared financial statements.  As many business owners and entrepreneurs do not have accounting backgrounds, it then becomes imperative for them to rely more heavily on CPAs and other accounting professionals for sound accounting oversight in the preparation of financial statements.  In the wake of the recent trillion dollar bailout on Wall Street, it should be clear that the big losers when financial statements are improperly prepared are those of us on Main Street. In a similar fashion, those of us on Main Street also suffer when the small and medium sized enterprises (SMEs) on Main Street fail to properly prepare their financial statements.


DISCLAIMER: This Newsletter is designed to give the reader an overview of a topic and is not intended to constitute legal advice as to any particular fact situation. In addition, laws and their interpretations change over time and the contents of this Newsletter may not reflect these changes. The reader is advised to consult competent legal counsel as to his or her particular situation.