Understanding the Financial Statements

5/26/2018 Understanding the Financial Statements

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Understanding the basics of accounting

The complete set of IFRS financial statements includes:

1. Balance Sheet (Statement of Financial Position)2. Statement of Comprehensive Income (Includes the Profit or Loss and so called Other

Comprehensive Income). In some countries, the Statement of Comprehensive Income does notexist and there exists only Profit or Loss (sometimes called the Income Statement).

3. Statement of Cash Flows4. Statement of Changes in Equity5. Notes to Financial Statements

Balance Sheet

Basic structure of the Balance Sheet

Assets Equity and Liabilities

Non-current (fixed, long-term assets) Equity

Tangible fixed assets (land, buildings, factoryand office equipment, cars, etc) Share capital (Investments in the business fromthe owners)

Intangible assets (patents, brands and similarassets without physical substance)

Other parts of equity (share premium, reserves,etc.)

Financial assets (long-term receivables,investments in other entities, long-term deposits)

Retained earnings (profits or losses fromprevious years together with those from currentaccounting period)

Current assets (short-term assets) Non-current (long-term) liabilities

Inventories Long-term borrowings

Trade and other receivables Provisions

Cash and cash equivalents Other long-term payables

Current (short-term) liabilities

Short-term borrowings

Trade and other payables

Provisions

Current tax liabilities

Total Assets = Total Equity + Liabilities


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There are many possible forms of the Balance Sheet. Normally, the form of the Balance Sheet could

be this:

Assets

Non-current (fixed, long-term assets)

Tangible fixed assets (land, buildings, factory and office equipment, cars, etc)

Intangible assets (patents, brands and similar assets without physical substance)Financial assets (long-term receivables, investments in other entities, long-term deposits)

Current assets (short-term assets)

Inventories

Trade and other receivables

Cash and cash equivalents

Total Assets

Equity and Liabilities

Equity

Share capital (Investments in the business from the owners)Other parts of equity (share premium, reserves, etc.)

Retained earnings (profits or losses from previous years together with those from currentaccounting period)

Non-current (long-term) liabilities

Long-term borrowings

Provisions

Other long-term payables

Current (short-term) liabilities

Short-term borrowings

Trade and other payables

Provisions

Current tax liabilities

Total Equity and Liabilities


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Changes in Balance Sheet

Each accounting transaction influences the Balance Sheet in two different line items.

Example

You have decided to start a new business being an accounting adviser. At the start of your business

you put in your business 10,000 in cash. This money comes from your savings that you have had in

the bank and now you have decided to use it in your new business.The items that have changed in the Balance Sheet are highlighted.

(1) Your first accounting transaction will be as follows:

Balance Sheet at the start of your business

Current assets Equity

Cash 10,000 Capital 10,000

Total assets 10,000 Total equity and liabilities 10,000

(2) You have decided to buy a new computer for 1,000. You have paid for the computer in cash.

Balance Sheet after the transaction (2)

Non-current assets Equity

Computer 1,000 Capital 10,000

Current assets

Cash 9,000


The Balance Sheet has changed. You have spent 1,000 in cash, this suggests now you have 9,000, but

you have a new computer. We can say that in this transaction the structure of assetshas changed.

After every transaction we must check whether the Balance Sheet balances.

(3) You have decided to buy a printer. This time you have bought the asset (printer) on credit. You

have to pay your supplier in one month. The cost of the printer is 500.



Computer + Printer 1,500 Capital 10,000

Current assets Current liabilities

Cash 9,000 Trade payables 500


The Balance Sheet has changed again. You have a new printer, but you have not paid for it yet.

Instead, you have a liability that you have to pay in a month. The Balance Sheet balances.

(4) You have rent an office room. The month rentals are 600. You have paid the rents in cash.




Profit or loss (600)





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The rents are your expense (i.e. not an asset). If you account for an expense, you deduct your profit for

the period. Profit for the period can be calculated as:

Profit = Income (revenues) less expenses

Up to now, we have had no income but we have had an expense of 600. This means we have

recognised a loss of 600.

(5) You have given an advice to your customer and he has paid you for this service 2,000 in cash.




Profit or loss 1,400




You have earned in your business the amount of 2,000. The customer has paid immediately in cash.

This suggests that you have increased your cash by 2,000 and you have increased your profit by 2,000.

Now you do not recognise the loss (as in transaction 4) but instead you are in profit of 1,400.

(6) You have given an accounting advice to customer 2. You have agreed that the customer will pay

you in a month. The amount was 1,000.




Profit or loss 2,400Current assets Current liabilities


Trade receivables 1,000


In this transaction, a new trade receivable is recognised in the Balance Sheet. Also the profit hasincreased by 1,000. In this transaction, you have seen the main rule of so called ACCRUAL

accounting:

In Accrual accounting, the revenue (income) is recognised when earned and expenses are

recognised when incurred. Revenues and expenses are recorded even though cash has not been

received or paid.

(7) You have received the bill for telephone calls you have made in the past month (but in currentaccounting period). You have to pay the bill in 14 days. The amount is 100.







Trade receivables 1,000Total assets 12,900 Total equity and liabilities 12,900


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Changes in the Balance Sheetthe summary

We have had seven accounting transactions. In every transaction, the Balance Sheet has changed. Youcould observe that in every transaction the Balance Sheet has changed in two items (highlighted). Thisis a basis of so called double-entry accounting.

1 transaction = 2 accounting entries

You have also seen that the changes were not always the same. Some changes in the Balance Sheet

have increased the Assets and at the same time have increased the Equity or Liabilities. We can

describe such changes like this:


+ +

The examples of such a change are transactions number (1), (3), (5) and (6).

Some changes in the Balance Sheet we can describe like this:


The example of this change is transaction number (4).

Some changes in the Balance Sheet we can describe like this:


+

The example of such a change was transaction number (2).

The last possibility is this change:


+

The example of this change was transaction number (7).

The purpose of the Income Statement (Profit or Loss)

Note

According to IFRS, you have toproduce the Statement of Comprehensive Income, which is something like enlarged form

of the Income Statement. Statement of Comprehensive Income includes the Income Statement plus some other line items that

will be explained later during the semester. Now we will focus just on the Income Statement.

In some countries, the profit of an entity for the current period is recognised in the Balance Sheet

together with its profits (or losses) from the past accounting periods (in the line item called RetainedEarnings). In this situation, you can just read in the Balance Sheet what the total profits were since the

entity has been established but you cannot identify what the profit for the current period was.

In some countries, Retained Earnings are split into profits (or losses) from the past accounting periods

and profit (or loss) for the current period. In this situation you are able to see the profit (or loss)

separately in the Balance Sheet. But even if you see in the Balance Sheet the profit for the current

period separately, you (or the users of financial statements) normally need more information about the

structure of profit(or loss). The purpose of the Income Statement is to show:

1. The total profit or loss for the current accounting period, and2. The structure of the profit or loss


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The basic structure of the Income Statement is:

Revenue X

Expenses (X)

Profit or loss X

The Income Statement of real entity is more detailed than the basic format mentioned above. In some

countries, the Income Statement has three parts (in some countries just two parts):

1. Operating Operating revenues include product sales and fees earned fromservices rendered; operating expenses include cost of sales andother expenses that differ based on the nature of particular

business. The examples are: wages, insurance, rentals, utilities,equipment maintenance, depreciation of tangible fixed assets oramortisation of intangibles, etc.

2. Other (non-operating) Interest expenses and revenue, gains or losses from the sale offixed assets, etc.

3. Extraordinary This exists only in some countries. Examples are earthquake,floods, hurricanes, terrorist attacks or nationalisation of someformerly private property.

Example

During the explanation of the purpose of the Balance Sheet we have had seven accounting

transactions.

1. The contribution of the owner in the business 10,000.2. Purchase of a computer 1,000 in cash.3. Purchase of a printer 500 on credit.4. Payment of the rent of 600 in cash.5. Revenue from the service rendered 2,000 in cash.6. Revenue from the service rendered 1,000 sold on credit.7. The telephone bill for calls that have already incurred 100 (but the expense belongs to the

current accounting period).

After the transaction number (7) the Balance Sheet looked like as follows:





Current assets Current liabilitiesCash 10,400 Trade payables 600



Because all seven transactions have occurred in one accounting period, retained earnings are equal to

profit for the period. In the list of transactions, the transactions with the impact in the Income

Statement are highlighted. We can read in the Balance Sheet that our profit is 2,300.

If we now produce the Income Statement, we will also see the structure of our profit.


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The Income Statement for the period....

Operating revenues

Rendering of services 3,000

Operating expenses

Rents (600)Telephone (100)

Profit 2,300

Using T-Accounts

The Balance Sheet is normally not produced (or printed from the records in your computer) after every

single transaction as we did in our transactions. So called Accounting cycle means that you prepare the

complete set of financial statements at the end of accounting period (typically 1 year). The closing

Balance Sheet at the end of previous accounting period is simultaneously the opening Balance Sheet

of the new accounting period. The accounting cycle means:

Balance Sheet at the beginning of the period (Opening Balance Sheet) Opening the Accounts

Recording the transactions on particular accounts Closing the accounts at the end of accounting

period Preparing the Closing Balance Sheet (and the rest of Financial Statements) Publishing the

complete set of Financial Statements (including Notes).

The knowledge of Balance Sheet means the understanding accounting. The accountant must

distinguish: what is an asset, what is a liability, what belongs to the equity. The accountant must also

identify when the expense has incurred or revenue was earned. The reason is that when we need to

open the accounts, it really matters what kind of account we are speaking about. When you want to

produce accounts from the Balance Sheet, the name of the Balance Sheet item is usually

simultaneously the name of the T-account (sometimes you open accounts in higher detail and when

you prepare the Balance Sheet you put them together into one Balance Sheet item) and the amount istypically called the Opening Balance. The left side of account is called DEBIT (Dr); the right side is

called CREDIT (Cr).

Dr Cash Cr

Openingbalance (OB)

The basic rule when opening the accounts is:

The Opening balance of accounts that are produced from the Balance Sheet is ALWAYS on the same

side of the T-account as the item underlying is placed in the Balance Sheet.


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Example

We open the T-accounts from our Balance Sheet after the Transaction number (1):

Balance Sheet after transaction (1)

Current assets Equity

Cash 10,000 Capital 10,000


Cash Capital

OB 10,000 OB 10,000

How to recognise which side of T-account should be used?

It depends on what kind of account we speak about. The behaviour of all ASSETS and EXPENSES

accounts is:

Dr Assets + Expenses Cr

OBAdditions Reductions

The behaviour of all EQUITY, LIABILITIES and REVENUES accounts is:

Dr Equity, Liabilities, Revenues Cr

OBReductions Additions

Example

Now we can use T-accounts and record all seven transactions that we have had in previous text.

1. The contribution of the owner in the business 10,000.2. Purchase of a computer 1,000 in cash.3. Purchase of a printer 500 on credit.4. Payment of the rent of 600 in cash.5. Revenue from the service rendered 2,000 in cash.6. Revenue from the service rendered 1,000 sold on credit.7. The telephone bill for calls that have already incurred 100 (but belong to the current

accounting period).


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Cash Capital

Tangible fixed assets

(computer + printer)

(1) 10,000 (2) 1,000 (1) 10,000 (2) 1,000(5) 2,000 (4) 600 (3) 500

Trade payables Expenses (rent + telephone) Revenues

(3) 500 (4) 600 (5) 2,000(7) 100 (7) 100 (6) 1,000

Trade receivables

(6) 1,000

At the end of accounting period, the closing balances are calculated. The closing balance is calculated

as follows:

Opening balance + AdditionsReductions = Closing balance

After calculation of closing balances we can prepare the Balance Sheet and the rest of financial

statements. We focus on two financial statements the Balance Sheet and the Income Statement. In

the Balance Sheet, the items of expenses and revenues are not explained line-by-line (as we already

know). That means the profit (or loss) are included in the Balance Sheet in one line item (in some

countries called Retained Earnings; in some countries Retained Earnings are split into Retained

Earnings of previous accounting periods and Profit or Loss of the current period).









The Income Statement for the period....Operating revenues

Rendering of services 3,000

Operating expenses

Rents (600)

Telephone (100)

Profit 2,300

Understanding the Financial Statements

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