Chapter Three: Financial Statements

Lecture one: Balance sheet (Assets)

shareholders, lenders, potential investors, and

many other stakeholders need information to make

investing or crediting decisions, annual reports are

considered the top source of this information.

Annual reports provide readers with

information on a company, ranging from company

visions, goals, and strategies, to its financial

statements and other required or compulsory

disclosures. But the audited financial statements are treated as the substance

of annual reports. If you read a series of the same company’s annual reports,

you can often construct a story about how a particular business venture is

doing, how the company has grown or declined, or how its management

team and strategy have changed throughout the years.

1.Financial Statements

The Conceptual Framework states that the objective of financial reporting is

to provide financial information, in the form of general-purpose financial

statements, which comprises:

➢ a statement of financial position at the end of the period

➢ a statement of comprehensive income for the period

➢ a statement of changes in equity for the period

➢ a statement of cash flows for the period

➢ notes, comprising a summary of significant accounting policies and

other explanatory information

1. To provide useful information to the management of an organisation for

the purpose of planning, controlling, analysing, and decision making.

2. To provide information to prospective investors to attract them, so

that they can take rational decisions regarding their investment based on

the reports.

3. To demonstrate a company’s creditworthiness to lenders and creditors,

as financial reports help them in evaluating the ability of a company in

repaying their money.

4. To provide information to the shareholders and public at large about

the various aspects of the entity.

5. To disclose how an organisation is procuring and using various resources.

6. To facilitate the statutory audit.

7. To abide by different legal and governmental regulations.

8. To disclose information about the economic resources of an entity

claims to these resources (liability and owner’s equity), and to show how

these resources and claims have undergone changes over a period of time.
9. To supply details on the cash flows that a business is exposed to,

including their timeliness and volatility.

10. To determine the liquidity position of an organisation, which in turn can

be used to evaluate whether an organisation can continue as a going

concern.

3-Balance sheet (Financial position)

The balance sheet reports on a company’s financial condition, and is divided

into three components: assets, liabilities and stockholders’ equities at a point

in time. It provides information about the resources available to

management and the claims against those resources by creditors and

shareholders. IAS1 requires an entity to classify assets and liabilities as

current or non-current in the entity’s balance sheet according to their

liquidity. An entity shall classify an asset as current when:

➢ It expects to realize the asset or intends to sell or consume in its

normal operating cycle

➢ It holds the asset primarily for the purpose of trading

➢ The asset is cash or cash equivalent

The entity should classify a liability as current when:

➢ It expects to settle the liability in its normal operating cycle

➢ The entity does not have an unconditional right to defer settlement of

the liability for at least 12 months after the reporting period

from which future economic benefits are expected to flow to the entity. This

definition identifies three essential characteristics of an asset:

➢ The resource must contain future benefits (it can be exchanged for

another assets, it can be used to settle a liability or to produce goods or

services to be sold)

➢ It must possess probable future benefits that can be measured in

monetary units.
3.1.1.Current assets: the assets section of the balance sheet is presented in
order of liquidity, which refers to the ease of converting noncash assets into

cash. The most liquid assets are called current assets. some typical examples

of current assets include the following accounts, which are listed in order of

their liquidity:

➢ Cash and cash equivalents—currency, bank deposits, certificates of

deposits and other cash equivalents;

➢ Marketable securities—short term investments that can be quickly sold to

raise cash;

➢ Accounts receivable—amount due to the company from customers arising

from the past sale of products and services on credit. The company cannot

collect from some customers. Accountants label this cost uncollectible-

account expense, doubtful-account expense, or bad-debt expense. To

measure uncollectible-account expense, accountants use the allowance

method that depends on the observable data that comes to the attention of

the holder of the loans.

Beginning Allowance-Receivables Write-offs + Bad Debt Expense = Ending

Allowance

➢ Inventory—goods purchased or produced for sale to customers, and

supplies used in operating activities. There are three types of inventories:

raw materials, goods in process, and finished goods. the cost of the

inventory sold shifts from asset to expense when the seller delivers the

goods to the buyer. The Balance Sheet reports the inventory that the

company still holds in warehouses and the Income Statement reports the

cost of the units sold, inventory costing methods include first-in, first-out

(FIFO); last-in, first-out (LIFO); and weighted average cost method.

Beginning Inventory + Purchases = Cost of Goods Available for Sale = Ending

Inventory + Cost of Goods Sold

➢ Prepaid expenses—cost paid in advance for insurance or other services.

include the following asset accounts:

➢ Long-term financial investment—investment in debt securities or

shares of the other firms that management does not intend to sell it in

the near future;

➢ Property, plant and equipment PPE—include land, factory buildings,

warehouses, office buildings, machinery, office equipment, and other

items used in the operations of the company;

➢ Operating lease right-of-use asset—representation of the lessee’s right to

use a leased asset over the course of the lease term;

➢ Intangible and other assets—include patents, trademarks, franchise

rights, goodwill, and other items that provide future benefits but do

not possess physical substance.

Measuring assets: physical (tangible assets) that are intended to be used, such

as inventory and property, plant and equipment, are reported on the

balance sheet at their historical cost (with adjustments for depreciation in

some cases). Historical cost refers to the original acquisition cost. The use of

historical cost to report assets values rather than market, or fair value, in

this case is because fair value is not often verifiable. The disadvantage of

historical cost is that some assets can be undervalued on the balance sheet.

For example, the land in Algiers on which a company factory was built more

than 60 years ago, was purchased for a mere fraction of its current fair

value. But some assets, such as marketable securities, are reported at current

value or fair value, because it can be easily obtained from online price

quotes.