2.3 Financial Statement Preparation and Presentation

Financial statements are the backbone of a company's financial reporting. They provide a snapshot of a business's financial health, showing its income, assets, liabilities, and cash flows. Understanding these statements is crucial for investors, managers, and stakeholders to make informed decisions.

Preparing financial statements involves a systematic process, from recording transactions to creating the final reports. Following GAAP or IFRS ensures consistency and comparability across companies. These frameworks dictate how information should be presented, classified, and disclosed in financial statements.

Financial Statement Fundamentals

Purpose and Components of Financial Statements

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• The four main financial statements provide a comprehensive view of a company's financial position and performance (income statement, balance sheet, statement of cash flows, statement of shareholders' equity)
• The income statement reports revenues, expenses, and net income over a period of time to show a company's profitability
  • Key components include sales/revenue, cost of goods sold, operating expenses, and net income
• The balance sheet reports a company's assets, liabilities and shareholders' equity at a specific point in time
  • Follows the accounting equation: Assets = Liabilities + Shareholders' Equity
• The statement of cash flows reports the inflows and outflows of cash over a period of time
  • Broken into operating activities, investing activities, and financing activities
  • Reconciles the income statement to the balance sheet
• The statement of shareholders' equity reports changes in equity accounts over a period of time
  • Includes share issuances, dividends, net income, and other comprehensive income

Interrelationships Between Financial Statements

• Net income from the income statement flows into the retained earnings account on the balance sheet and statement of shareholders' equity
  • Illustrates how income increases owners' claims on assets
• The ending cash balance on the statement of cash flows equals the cash account balance reported on the balance sheet
  • Shows how cash flow activities impact the company's cash position
• Depreciation expense on the income statement is added back on the statement of cash flows as a non-cash expense
  • Demonstrates how some income statement items do not affect cash
• Increases in assets on the balance sheet that did not result from profit are investments
  • Will appear as outflows on the statement of cash flows
  • Shows growth in assets requires either increasing liabilities or investments by owners
• Dividends declared on the statement of shareholders' equity will appear as a financing cash outflow on the statement of cash flows
  • Also results in a reduction in retained earnings on the balance sheet
  • Shows how distributions to owners reduce assets
• Significant differences between net income and cash flows from operations can indicate poor earnings quality
  • High income without actual cash inflows is not sustainable
  • Comparing the income statement and statement of cash flows can uncover such discrepancies

Preparing Financial Statements

Income Statement Preparation

• Starts with sales/revenue, subtracts cost of goods sold to calculate gross profit
• Subtracts operating expenses to calculate operating income
• Factors in non-operating items and taxes to arrive at net income
• Prepared using either the single-step or multi-step format

Balance Sheet Preparation

• Lists assets (current and long-term), liabilities (current and long-term), and shareholders' equity (common stock, retained earnings, accumulated other comprehensive income)
• Assets are listed in order of liquidity, liabilities in order of maturity
• Must balance following the accounting equation: Assets = Liabilities + Shareholders' Equity

Statement of Cash Flows Preparation

• Prepared using either the direct or indirect method
  • Direct method lists cash receipts and payments
  • Indirect method starts with net income and adjusts for non-cash items
• Divided into cash flows from operating, investing, and financing activities

Statement of Shareholders' Equity Preparation

• Starts with beginning balances of each equity account
• Adds share issuances and net income
• Subtracts dividends and other deductions
• Arrives at ending balances
• Explains the changes in equity over the period

Accounting Cycle for Financial Statement Preparation

• Involves analyzing and recording transactions, posting to the general ledger
• Preparing an unadjusted trial balance
• Recording adjusting entries
• Preparing an adjusted trial balance
• Preparing the financial statements
• Closing the books

GAAP and IFRS Presentation

Accounting Frameworks

• GAAP (Generally Accepted Accounting Principles) is the accounting framework used in the US
• IFRS (International Financial Reporting Standards) is used in most other countries
• Companies must specify which framework they follow

General Presentation Requirements

• Financial statements must include a header identifying the company, the statement title, and the period ending date
• Each statement must have proper columnar presentation of account names and amounts
• Must include any required accompanying footnote disclosures
  • Explain accounting policies, estimates, and additional details not apparent from the statements themselves
  • Significant accounting policies and changes must be disclosed

Balance Sheet Presentation

• Must properly classify and subtotal assets, liabilities and equity as current/non-current or short-term/long-term
• Assets and liabilities are presented in order of relative liquidity under GAAP
  • Presented in order of ascending/descending liquidity under IFRS

Income Statement Presentation

• Must separately present operating vs. non-operating activities
• Must disclose earnings per share (EPS)
• Expenses may be presented by natural category or by function
• IFRS prohibits extraordinary items

Statement of Cash Flows Presentation

• Must be divided into cash flows from operating, investing, and financing activities
• Direct or indirect method may be used, but direct method is encouraged
• IFRS requires a reconciliation between the indirect and direct method cash flows from operations

Statement of Shareholders' Equity Presentation

• Must display the changes in each equity account
• GAAP requires disclosure of changes in accumulated other comprehensive income components
• IFRS has looser presentation requirements