Financial statements
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Financial statements (or financial reports) are formal records of a business' financial activities. These statements provide an overview of a business' profitability and financial condition in both short and long term. There are four basic financial statements:
1. Balance Sheet - also referred to as statement of financial condition, reports on a company's assets, liabilities and net equity as of a given point in time.
2. Income Statement - also referred to as Profit or loss statement, reports on a company's results of operations over a period of time.
3. Cash Flow Statement - reports on a company's cash flow activities, particularly its operating, investing and financing activities.
4. Statement of Retained Earnings - explains the changes in a company's retained earnings over the reporting period.
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 details. Notes to Financial Statements are considered an integral part of the Financial Statements.
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 (net 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 outflows are measured by Expenses on the Income statement.
- The difference between these inflows and outflows is the net income, also shown in 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 the reservoir. This additional water is measured by an increase in the share capital.
- If you ask a neighbour to add to the reservoir, it is considered as liability, thus reducing net equity but increasing assets. These are both shown on the Balance Sheet.
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 choose to ignore some streams: they may not know that 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.
Users of Financial Statements
Financial statements are used by a diverse group of parties, both inside and outside a business. Generally, these users are:
1. Internal Users: are owners, managers, employees and other parties who are directly connected with a company.
- Owners and managers require financial statements to make important business decisions that affect its continued operations. Financial analysis are then performed on these statements to provide management with a more detailed understanding of the figures. These statements are also used as part of management's report to its stockholders, as it form part of its Annual Report.
- Employees also need these reports in making collective bargaining agreements (CBA) with the management, in the case of labor unions or for individuals in discussing their compensation, promotion and rankings.
2. External Users: are potential investors, banks, government agencies and other parties who are outside the business but need financial information about the business for a diverse number of reasons.
- Prospective investors make use of financial statements to assess the viability of investing in a business. Financial analysis are often used by investors and is prepared by professionals (Financial Analysts), thus providing them with the basis in making investment decisions.
- Financial institutions (banks and other lending companies) use them to decide whether to grant a company with fresh working capital or extend debt securities (such as a long-term bank loan or debentures) to finance expansion and other significant expenditures.
- Government entities (Tax Authorities) need financial statements to ascertain the propriety and accuracy of taxes and other duties declared and paid by a company.
- Media and the general public are also interested in financial statements for a variety of reasons.
Government financial statements
The rules for the recording, measurement and presentation of government financial statements 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. A complete set of Chart of Accounts is also used that is substantially different from the Chart of a profit-oriented business.
Audit and Legal Implications
Although the legal statutes may differ from country to country, an audit of financial statements are usually, but not exclusively required for investment, financing, and tax purposes. These are usually performed by independent accountants or auditing firms. Results of the audit are summarized in an audit report that either provide an unqualified opinion on the financial statements or qualifications as to its fairness and accuracy. The audit opinion on the financial statements is usually included in the Annual Report.
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 officers (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 certifying 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 Regulations
Different countries have developed their own accounting principles over time, making international comparisons of companies difficult. To ensure uniformity and comparability between financial statements prepared by different companies, a set of guidelines and rules are used. Commonly referred to as Generally Accepted Accounting Principles (GAAP), these set of guidelines provide the basis in the preparation of financial statements.
Recently there has been a push towards standardizing 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 Reports
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 management's performance and the company's financial highlights.
In the United States, prior to the advent of the internet, the annual report is considered the most effective way for corporations to communicate 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.