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Financial Statements and Reports

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Financial acc → specific rules / past / external users

Management acc→ no rules / futur / mainly internal users

Accounting concepts’ refers to the axioms or basic assumptions underlying the financial accounts. Those concepts are:

  • Going concern → company will continue to trade for the foreseeable future + fixed assets and stock will be used in the normal course
  • Accruals → revenues and costs recognised as earned or incurred and matched with one another, profit measurement based on accruals and matching, not when cash is received
  • Consistency →  accounting treatment of similar items within each accounting period and from one period to the next + enables comparability
  • Prudence → revenues and profits are only recognised when realised, expenses and losses are recognised whether amount is known with certainty +ensures that revenues profits and assets (losses and liabilities) not overstated (understated)
  • Separate Valuation → value of each item on financial statements should be estimated independently + one item should not be offset against another

Four objectives to be met by acc practice:

  • Relevance → important to users in predicting future or confirming present/past
  • Reliability → transactions represented faithfully, info neutral, free from errors, complete


  • Comparability → facilitates cross section comparison (disclosure, consistency)
  • Understandability → ability to understand content of financial statements

The Balance Sheet = snapshot of what company finance look like at a certain time

Presents financial position of a company at a certain point in time + summarizes assets and liabilities of the company

ASSETS = what company owns / controlled by business activity / short term assets or long term

Following characteristics:

  • Probable future benefit
  • Benefit should be result of past event or transaction
  • Business must have right to control the resource
  • Asset should be measurable in monetary terms

Examples of short term assets (current assets) : inventories, trade receivables (debt), cash/bank deposit, investments, prepayments

Operating cycle

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Examples of non-current assets (long-term/fixed assets): tangibles fixed assets (property, plant and equipment, depreciation), intangibles assets (goodwill, patents, trademarks), investm

LIABILITIES = what company owes / obligation to owners and third parties / short-term or long

Examples of current liabilities: trade payables (creditors), accruals (service received but not paid yet), VAT and taxes payables, bank overdrafts

Examples of non-current liabilities: long-term loans, bonds and debentures, mortgages

EQUITY = owner’s interest in the business

  • Shareholders’ equity (equity, capital, net worth) / amount invested in firm / par value of shares
  • Share premium → excess paid over the par value of shares
  • Retained profits → portion of profits reinvested in the business / residual amount after paying dividends

Assets, liabilities & equity: relationship

Accounting definition: liabilities represent obligations to owners and third parties + assets represent what company owns

Finance definition: liabilities represent source of financing + assets represent uses of financing

Balance sheet equation

Uses of funds = sources of funds (amount invested should be reflected in value of assets)

→ Sources = Liabilities + Shareholders’ equity

→ Uses = Total Assets

Assets = Liabilities + Shareholders’ equity → value of assets a company owns cannot exceed amount of money invested

Assets – Liabilities = Shareholders’ equity → value of a company can be found if we deduct

liabilities from total assets

Balance sheet and profit

Profit figure can be derived from balance sheet:

  • Revenue from sales increase assets and increase equity
  • Expenses decrease assets
  • Successful businesses show increases in equity
  • Change in equity is called profit or income

Profit can also be calculated using balance sheet as follows:

  • Increase in equity (net asset year 2 - net asset year 1)
  • Minus proceeds of share issue
  • Plus any dividends paid
  • Minus any amount resulting from revaluation of assets

Balance sheet: Uses

  • Can be used to analyse company performance
  • Asset/Capital management → analysis of relationship between assets and liabilities
  • Liquidity → analysis of relationship between current assets and current liabilities
  • Profitability/Efficiency → analysis of relationship between output and resources
  • Cross section and time series comparison
  • Ratio analysis

Balance sheet: Limitations

  • Limited usefulness → it reflects the financial position of the company at certain point in time
  • Balance sheet figures are at historical prices → no adjustments for inflation
  • Off-balance sheet activities → derivative instruments
  • Real value of business depends on its ability to generate income and not on the individuals asset and liability values

The Profit and Loss Account

Income statement: Overview

  • Presents activities of a company for a given period → states revenue, expenses and profit
  • Summarises financial performance for a defined period
  • Presents amount of: revenues earned, expenses incurred, tax to be paid, distribution of profit
  • Preparation and content underpinned by accounting standards and principles
  • Reminder = profit is not the same as cash receipts
  • It follows a general form

Income statement: Structure & Terminology

  • Revenues → total amount of sales for the period / also known as turnover or sales
  • Cost of sales → also known as COGS
  • Gross profit → difference between sales figure and cost of goods that have been sold / excludes inventory
  • Distribution costs → cost related to distribution of products
  • Administration expenses → not directly tied to manufacturing or sales
  • Depreciation
  • Operating profit → difference between gross profit and sum of OPEX /  shows profit from operations / earnings before interest and tax / allows comparison of companies with /=/ capital
  • Finance income → interest received
  • Financing costs → interest paid
  • Profit bef tax → Operating profit + finance income-finance expenses / comparison in /=/ tax env
  • Tax
  • Profit after tax → profit for the period / difference between EBT and tax payable
  • Determines → earnings per share / amount of dividend / retained earnings / changes in equity

Detailed items: Revenues

  • Sales: how much is earned for goods sold → sales revenue; Turnover
  • Income for service rendered → rent revenues, fees, subscriptions
  • Underlying principles: “Realisation concept” → invoice sent / incentive to bring sales forward
  • Has the service been provided during the period → cash may be received earlier or later / sales include “credit sales”

Detailed items: Expenses

  • Amounts used in providing sale or service during period
  • Accruals concept → (wages, electricity…) not amount paid during period / incurred in earning
  • Trading businesses have significant “Cost of Sales” or “COGS” expenses
  • COGS = Opening inventory + Purchases - Closing inventory / overstating closing = good
  • Depreciation → purchase of non-current assets not immediately treated as expense / cost allocation - not asset valuation / less obvious in standardised income statements
    Depreciation method: Straight line method → takes into account initial cost, useful life and salvage price / Diminishing balance method → takes into account initial cost, percentage of yearly depreciation + leads to higher depreciation in early years and lower in later years
  • Impairment of goodwill → non-current asset / does not last indefinitely / difficult to assess its useful life / grey area in acc

Problem Areas and Items

  • Capital and revenue expenditures → cap exp = purchase of asset / rev exp = maintenance + cost of usage
  • Depreciation
  • Valuation of inventories…
  • Timing and recognition of revenue....

 all impact on the level of reported profit

Income statement: Role and Limitations

Role → summarises financial performance / reveals areas for profit improvement / facilitates financial control, comparison (monitoring and budgetary control / time series and cross sections)

Limitations → performance differs across firms (/=/ acc policies) / profit not same as cash flows / Profit not enough (consider profit in relation to investment)



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