Part 1 Section A Section A.

1 – Financial Statements

Section A. External Financial Reporting Decisions

Section A.1 – Financial Statements
Prelude
Financial reporting is the way companies show their performance to outside world. The objective behind
financial statement analysis is to use the company’s financial statements & other relevant information to make
economic decisions. Such an analysis is used to evaluate a company’s past performance & current financial
position and project company’s ability to earn profits and future cash flows so that economic decisions like
whether to invest in the company's securities or whether to extend bank credit to the company can be taken.
Financial statements are the different formats which Structure of Financial Statement Analysis
have been prescribed by the law (accountancy) to be
used for the purpose of financial reporting. Each
format communicates a separate aspect of the
business. Different Financial Statements are:
1. Statement of Financial Position (Balance Sheet)
2. Statement of Earnings (Income Statement)
3. Statement of Cash Flows
4. Statement of change in Shareholders’ Equity
a. identify the users of these financial statements and their needs
There are two types of users of these financial statements: internal (working inside the company) and external
(outside of company). Please refer to the table below:
Sl. No. Stakeholder Objectives / Needs
A. INTERNAL USERS
• Financial Performance assessment
1. Management • Preparation of budgets, forecasts etc.
• Take Business Decisions
• Financial performance assessment to evaluate the impact on
2. Employees wages/salaries (variable compensation)
• Negotiate for wages and salaries
B. EXTERNAL USERS
• Investment Decisions – ROI
1. Shareholders / Prospective Investors
• Risk vs Return
2. Financial Institutions / Lenders • Credit worthiness
3. Suppliers • Liquidity Position - Credit Terms
4. Customers • Sustainability of operations
• Corporate Governance
5. Capital markets / Regulators
• Check conformance to regulations
• Cross Sectional Analysis
6. Competitors
• Strategies to improve competitiveness
• Correctness of tax declaration
7. Government • Economic development
• Employment generation
• Impact on economy, environment & local community,
8. General Public
• Employment generation
9. Financial advisors and analysts • To analyse and assist investors with recommendations

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Part 1 Section A Section A.1 – Financial Statements
b. demonstrate an understanding of the purposes and uses of each statement
Please refer to the table below:
Sl. No. Statement Purpose Use
Income Statement (or Provide information about the
P&L statement or financial performance of the  To assess the profitability and growth of the
1. Statement of earnings or company in a specified period. It company
Statement of contains all the revenues and  To identify the sources of revenue and costs
Operations) expenses of the organization.
It is the statement of financial  To assess sources and uses of funds
position of business as on a  To assess growth rates in them
2. Balance Sheet
particular date; shows balances of  To assess what company owns and who has claims
assets, liabilities and equity on a date on them
 To assess the sources and uses of cash (further
split across three heads of operations, investing &
Summarizes the cash flowing into / financing)
3. Cash Flow out of the organization over a period  To assess the liquidity position
of time  Helps to understand company’s requirement of
financing, ability to pay interest, dividends or incur
capital expenditure
Statement of changes in Displays the changes in equity of the  To analyse all the transactions between the
4.
shareholders’ equity company over a period of time company and its owners / shareholders / investors

c. identify the major components and classification of each statements

INCOME STATEMENT
A typical Income Statement has been shown below:

Major components and classifications are:

Sl. No. Component / Classification Explanation
Primary source of Income; total income / revenue / sales from ordinary course of business.
Sales / Gross Sales / Net
1. Sales is same as Income OR Turnover. Net sales = Gross sales – returns – allowances – duties
Sales
and taxes.
Direct costs (recall your learnings from Part 1) related to the products and / or services
Cost of Goods Sold / Cost of
2. offered by the company. This will include direct material, direct labour and (fixed and
Sales / Cost of Services
variable) factory overheads.
3. Gross Margin Net Sales - Cost of Goods Sold / Cost of Sales / Cost of Services.
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Part 1 Section A Section A.1 – Financial Statements
All other costs and expenses incurred to earn the revenue but that are not included on cost
4. Operating Expenses
of goods sold.
Other non-operating income (gain on sale of assets / investments) or expenses (loss due to
5. Other income / expenses
currency fluctuations, interest expenses).
6. Taxes / provision for taxes Tax liabilities arising in relation to the income reported.
Excess of revenues over expenses. Represents an economic benefit to the firm by way of
inflows or increase in assets or decrease in liabilities except contribution by equity
7. Profit / PAT / Net Income
participants. Other gains and losses are included in Net income. These may or may not result
from ordinary business activity.
BALANCE SHEET
A typical Balance Sheet is shown below:

Balance Sheet is governed by the equation: Assets = Liabilities + Equity

Major components / classification of a balance sheet are:
Sl. No. Component / Classification Explanation
Assets which are likely to be converted into cash or consumed or sold within 1 year OR
1 operating cycle whichever is longer. Elements of current assets are: Inventory (Raw
1. Current Assets
Material, WIP, Finished Products), Account receivable, Prepaid expenses, short term
investments, cash etc.
Assets which are not likely to be converted into cash or consumed or sold within 1 year
2. Long Term Assets OR 1 operating cycle whichever is longer. Elements of long term assets are property,
plant & equipment, long term investments, goodwill, intangible assets etc.
Liabilities which are likely to be paid within 1 year OR 1 operating cycle whichever is
3. Current Liabilities longer. Elements of current liabilities are accounts payable, interest payable, taxes
payable, salaries payable, rent payable, short term loans etc.
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Liabilities which are likely to be paid after 1 year OR 1 operating cycle whichever is
4. Long Term Liabilities longer. Elements of long term liabilities are non-current portion of debt, non-current
portion of deferred revenue etc.
Measures the total investments by the owners / investors / shareholders of the
5. Shareholders’ Equity company. Typical elements in shareholders’ equity are paid up capital (common stock)
and retained earnings
CASH FLOW STATEMENT
A typical cash flow statement is shown below:

Sl. No. Component / Classification Explanation

Cash flows arising out of transactions that involve the firm’s primary activities. This includes
the main route by which any company intends to make profits. It includes the day to day
business functions of a company. Example of inflows: Collection from Debtors / Cash Sales,
Proceeds from sale of trading securities, Tax refund; Example of outflows: Payment to
Cash flow from operating
1. suppliers, Payment for other expenses, Purchase of trading securities, Taxes paid (in relation
activities
to any transaction). This includes any cash flow from incidental transactions also (scrap sales
for a manufacturing company). Interest expense is considered to be part of operating
activities. Excludes non-cash items such as depreciation, amortization, impairment,
deferred payments etc.
Cash flows arising out of activities associated with the acquisition and disposal of long term
Cash flow from investing assets. Examples of inflows: Sale of PPE, Sale of investments other than trading securities;
2.
activities Example of outflows: Purchase of PPE, Acquisition of investment other than trading
securities etc.

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Part 1 Section A Section A.1 – Financial Statements
Cash flows arising out of activities related to obtaining or repaying capital to be used in the
Cash flow from financing business. Examples of Inflows: Issuance of shares, Receipt of loan from financer, Issue of
3.
activities debentures; Example of outflows: Payment for debentures, Buy back of stocks, Loan
repayment, Dividend paid to shareholders etc.
STATEMENT OF CHANGES IN SHAREHOLDERS’ EQUITY
A typical statement is shown below:

 Primary equation governing this is: Opening equity balance [+] Fresh issuance of equity [+] Net income for
the year [-] Dividends = Closing balance of the equity.
 It’s also calculated in terms of different components as: Capital stock (initial capital issued) [+] Additional
paid-up capital [-] Treasury stocks [+] Retained earnings (previous year’s profits) [+] Accumulated other
comprehensive incomes (special transactions) [+] Minority Interest (reflect only in case of consolidated
financial statement) = Closing Balance of equity (T/F to closing Balance Sheet)
A typical statement of other comprehensive income is shown below:

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Part 1 Section A Section A.1 – Financial Statements
d. identify the limitations of each financial statements
Sl. No. Statement Limitations
 Items that may be relevant but cannot be reliably measured are not reported (e.g. brand recognition and
loyalty)
P&L  Some figures depend on accounting methods used (e.g. using FIFO or LIFO accounting to measure
1.
Statement inventory level)
 Some numbers depend on judgments and estimates (e.g. depreciation expense depends on estimated
useful life and salvage value).
 Do not show true value of assets as they are stated mostly at historical cost which may not be the right
reflection of the prevailing market valuation
Balance  Some of the current assets are valued on an estimated basis, so the Balance Sheet is not in a position to
2.
Sheet reflect the true financial position of the business
 The Balance Sheet cannot reflect those assets which cannot be expressed in monetary terms, such as
skill, intelligence, honesty, and loyalty of workers
 Since it prepared using past information, It does not provide complete information to assess the future
Cash Flow cash flows of an entity
3.
Statement  Ignores the basic accounting concept of accrual and hence is not suitable for judging the profitability of
a firm, as non-cash charges are ignored while calculating cash flows from operating activities

e. Identify how various financial transactions affect the elements of each of the financial statements
and determine the proper classification of the transaction
It’s better explained by an example. Solution:
Example: Impact on P & L Statement:

Sundaram Corporation holds an inventory of  Sales for the accounting period go up by Rs. 25,000
 Expenses move up by Rs. 18,000
an item valued at its cost of Rs. 18,000. Sonali
 Profit goes up by Rs. 7,000
Sundaram, the Chief Sales officer sells the item Impact on changes in shareholders’ equity
@ Rs. 25,000 to its customer. As per terms of  Goes up by Rs. 7,000
purchase order, the customer has made a Impact on Balance Sheet
down payment of Rs. 15,000 and the balance  Cash goes up by Rs. 15,000 (proceeds from sale of item)
payment will be made within 15 days of receipt  Account receivables goes up by Rs. 25,000 – 15,000 = Rs. 10,000
of good. Show the impact of this financial  Inventory goes down by Rs. 18,000
 Retained earnings and hence shareholders’ equity goes up by Rs. 7,000
transaction on all the financial statements
Impact on cash flow statement
(ignore the impact of taxes as of now)
 Cash flow from operating activities goes up by Rs. 15,000
f. Identify the basic disclosures related to each of the statements (footnotes, supplementary
schedules, etc.)
A company should provide the necessary and adequate information so that users of financial statements can
make informed decisions regarding the company. The required disclosures can be found in a number of places
including the following:
 The company's financial statements including any supplementary schedules and notes (or footnotes)
 Management's Discussion and Analysis that is included in a publicly-traded corporation's annual report to
the U.S. Securities and Exchange Commission
 Quarterly earnings reports, press releases and other communications
Footnotes:
 Provides information about significant accounting policies & methods, assumptions & estimates used in
preparing financial statements. For example: notes about how and when revenues are recognized, how
property is depreciated, how inventory and income taxes are accounted for.
 Provide additional information on business segment, related party transactions, acquisitions / disposals,
contingencies (contingent liabilities), significant customers

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Part 1 Section A Section A.1 – Financial Statements
 Allows users to improve their assessment of amount, timing & uncertainty of estimates reported in financial
statements
 All footnotes are required to be audited
Supplementary Schedules:
 These schedules detail out different consolidated figures given in financial statements
 These are more or less voluntary disclosures by the company and contain additional information like:
o Operating income or sales by region or business segment
o Reserves for an oil and gas company
o Information about hedging activities and financial instruments
 Supplementary schedules are not required to be audited
Management's Discussion and Analysis (MD&A)
 Provides assessment of the financial performance of a firm from management’s perspective
 In the US, public companies are required to disclose following information in MD&A
o Result from operations with trends in sales and expense ( Qualitative and quantitative business
performance)
o General business overview and outlook based on known trends (Significant effects of currently
known trends, events)
o Capital resources and liquidity along with trends in cash flows
o Discussion on significant events & uncertainties (Risk facing the organization
 Additional information, not compulsorily required to be disclosed, under MD&A:
o Effects of known trends on business
o Accounting policies requiring significant judgment
o Issues related to capital structure and liquidity
o Information on unusual or infrequent items and extraordinary items etc.
g. demonstrate an understanding of the relationship among the financial statements
The income statement, balance sheet and cash flow statement are all interrelated. The income statement
describes how the assets and liabilities were used in the stated accounting period. All the revenues and expenses
are recorded on the accrual basis on the Income Statement. Retained Earnings (PAT less dividends) along with
accrued portion of the revenue and expenses are reported on the balance sheet. The cash flow statement
explains actual cash inflows and outflows, and it will ultimately reveal the amount of cash the company has on
hand, which is also reported in the balance sheet. Cash flow statement also reveals cash surplus and shortfall
that may necessitate changes in the capital of the company. This will ultimately play a role on the balance sheet.
Thus, financial statements feed into each other and are interrelated. Each of the financial statements provide a
part of the story about the company. In order to get a complete and consolidated picture, one needs to look at
all of them.
h. prepare a balance sheet, an income statement, a statement of changes in equity, and a statement
of cash flows (indirect method)
We believe this LOS has come little premature in the course. At this stage, our understanding is not deep enough
to prepare financial statements. However, we fully believe that once you go through the subsequent topics in
this course, you will gain enough understanding to prepare the financial statements of a company.

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