Financial statements Essay

Financial statements
Part I. Introduction to Financial Statements and some concepts:

Financial statements are important management tool that are used to convey a company’s financial viability, credibility, and success. They can be used to understand a company’s current financial condition, problems and even possibilities for future. Moreover, they help uncover problems and identify corrective action.

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The most important financial statements are the balance sheet, the profit and loss statement, and the cash-flow statement. The balance sheet “shows the financial position of a business at a specific point in time”. It shows a list of the accumulated assets and liabilities incurred by the business. The difference between the two represents the net worth of the business.

The income statement answers the question, “How did we do?” by showing the revenues, cost of goods sold, operating expenses and the net income/loss before taxes. The cashflow statement answers the question, “Where was the cash used?” by listing down all the cash inflows and outflows under three headings: cashflows from operating, financing and investing activities.

Following terms discussed below are important concepts that help in understanding and using the financial statements.

Generally Accepted Accounting Principles
Generally Accepted Accounting Principles are “widely accepted set of rules, conventions, standards, and procedures for reporting financial information, as established by the Financial Accounting Standards Board.”

            These accounting rules are used to “prepare, present, and report financial statements for publicly traded as well as privately held companies.”

“GAAP has considerable institutional legitimacy, and it identifies the professional standards of accounting. If it is not adopted for ratemaking, utilities will incur some additional record-keeping costs. GAAP is the accepted medium for the communication of financial information to the public.” (Wirick, Gibbsons 1994)

Compliance with these principles helps maintain creditability with creditors and stockholders because it reassures them that the company’s financial reports accurately portray its financial position just because they comply with the standards. It assures the stakeholders and the third parties that the data is free from bias and inconsistency. This is why it is important for the financial statements to comply with the standards.

Moreover, it helps the auditors properly conduct the auditing process. Auditing is done by certified public accountants of the audit companies at regular intervals to determine if the financial statements are prepared according to GAAP and if the numbers given present the accurate picture of the company. It also helps in comparing financial statements of different companies in the same industry to determine progress.

Historical Cost
Historical cost basically means recording the items at original cost at which the item was purchased, and not the current market value. It is an “accounting principle requiring all financial statement items to be based on original cost. It is usually based upon the dollar amount originally exchanged in an arm’s-length transaction; an amount assumed to reflect the fair market value of an item at the transaction date.” (www.ventureline.com/glossary_H.asp)

            It is one of the principles of GAAP, also called the cost principle. It does not account for any changes in the inflation. Historical cost principle is used because it is reliable and free of bias when compared to fair market value principle. However, historical cost does not always provide relevant information and does not account for inflation, consumer demand and preference which make up the current market price. Thus there is an increasing pressure to use fair market value.

Even though it does not indicate the fair value, it is important for the financial statements because it is GAAP compliant. Moreover, it removes the subjectivity of the market value and is an objective way of valuing assets. Historical cost is used by those businesses that will not dispose off their assets but will use them for business operations.

Accrual Basis vs. Cash Basis Accounting
Accrual basis and cash basis are two accounting methods. Accrual basis accounting is GAAP compliant whereas cash basis is not GAAP compliant. These methods are used for keeping track of a business’s income and expenses. The main difference is that of timing of recording the transactions.

Accrual Basis Accounting
Under the accrual basis accounting method, revenues and expenses are recorded when they are recognized or incurred. The revenues are recorded in the period in which they incur and then matched with related expenses that generate the revenue, to conform to the Matching Principle as given by the GAAP. Even though cash is not received or paid in a credit transaction, they are recorded because the cash will be received or paid in the future, i.e. cash flow will happen in the future.

Accrual basis accounting records the financial effects of a business activity in the period the effect occurs. Revenue is recognized when it is earned i.e. the ownership of the goods is legally transferred or the service is performed regardless of when the cash flow is made or when the revenue is realized or realizable i.e. when the cash is received or is expected to be received in the future.

The accrual basis accounting is important for the financial statements because it is compliant with the Generally Accepted Accounting Principles. Moreover, it measures current income more accurately than the cash basis accounting method. Therefore, it enables the balance sheet to present a more accurate estimate of financial position or value of the business entity. In addition to this, it gives accurate, current information which makes it easier to predict future income and financial position.

However, the accrual accounting method is difficult to understand which results in confusion. This is because the net income does not equal the period’s change in cash. A company may face shortage of cash even if it is earning a lot of profits. The liquidity of the company may suffer.

Even though the accrual basis accounting is a little complicated, it is a relatively straightforward method by which most individuals and many small businesses handle their finances.

Cash Basis Accounting
Under the cash basis accounting method, the expenses are recognized when cash is paid and the revenues are recognized when the cash is received. Hence, a transaction is recorded only when cash is received or disbursed. It’s a relatively straightforward method and mostly used by individuals and many small businesses for handling their finances. It does not recognize promises to pay or expectations to receive money or service in the future, such as payables, receivables, and prepaid expenses. Hence, it is simpler for individuals and organizations that do not have significant amounts of these transactions, or when the time lag between the initiation of the transaction and the cash flow is very short. Therefore, it is easier to use on a day-to-day basis since there are fewer transactions to track.

Cash basis accounting fails to meet GAAP requirements because it does not adhere to two GAAP principles namely revenue recognition principle which states that  revenue should be recognized when it is realized and the matching principle which states that revenue should be matched to the expense if possible. Hence, it does not give a clear picture of a company’s financial situation. Moever, cash-basis accounting is not viable for cost accounting in manufacturing concerns because expenses cannot always be correctly matched with product costs.

Current Assets and Liabilities vs. Non-Current Items.

Assets and liabilities are characterized as either “current” or “non-current” in nature.

Current assets include cash and assets expected to become cash or used up soon or can be readily converted into cash, usually within one year. Current assets include cash, securities, marketable securities, inventory (goods being held for sale), accounts receivables (amount owed to the business due to normal extension of credit), notes receivables (based on a customer’s promissory note to pay what is owed) and prepaid items.

Non current assets are expected to be useful for more than a year. Non current assets include tangible (fixed) assets and intangible assets such as goodwill or brand equity. Tangible assets are those assets with a physical presence such as property, plant, and equipment. Also included is accumulated depreciation which is that portion of the tangible assets that has been “used up” and subtracted from cost to yield a “net” value of the asset. Intangible assets are those non current assets that do not have a physical presence. These include patents, trade marks, investments or securities that are held over a year and goodwill which is the amount paid for the company in excess of the value of its assets.

Current Liabilities are those debts the company owes that come due within one year and have to be paid off within a short time. These obligations include existing (or accrued) obligations to suppliers, employees, the tax office and providers of short-term finance. Companies try to manage cash flow to ensure that funds are available to meet these short-term liabilities as they come due. Types of current liabilities are employee benefits, short term debts, bank overdrafts, unearned revenue, accounts payables, accrued liabilities, tax liabilities and current portion of the long term debt.

Non-current liabilities include long tem debts that are due after one year. Usually interest has to be paid on the long-term loans. Hence, it is essential to keep it separately from the current liabilities.

All these current and non current assets and liabilities are an essential part of the balance sheet. The difference between the two gives the net worth of the company. The balance sheet is an important financial statement which shows the financial position of the company at one point in time.

Part II. Case Study: Financial Statements of three companies

Ford Motor Company
The financial statement of year 2005 is very well organized and gives detailed information of the internal (employees and management) and well as the external environment (suppliers and dealerships). It gives the consolidated as well as the sector wise income statements, balance sheet and cash flow statements. It gives a detailed discussion of the risks involved and the management’s notes in detail.

            Both the net income and the cash flows from operating activities are important for analyzing the financial performance of the company. The net income shows how profitable the company is and the cash flows show how liquid the company is. The liquidity is especially important while taking loans because it indicates the company’s ability to regularly pay off debt.

            The cash flows from operating debt represents the net cash flow the company generates from it core business activities. It includes the net results of revenues and expenses from the income statement and shows the amount of cash reinvested in the business in the form of working capital. The discrepancy between the net income and the cash flow arises because of the revenues that have not been earned or expenses that have incurred but have not been paid for.

            Since, Ford Motor is a manufacturing concern, cash flow would be more important because it is better to have working capital and liquidity for developments required in the manufacturing.

Prediction about the company
Even though the sales have increased, the net income has decreased from previous years. This is because of the losses incurred in certain sectors. This trend is likely to continue unless the cash inflows are increased and the ability to pay to the creditors is improved.

Conclusion
The company is doing fine but needs to be more liquid so that it can make investments to that the business cycle is shortened and the collection system is managed properly.

Microsoft
The financial statements of the company for the year 2005 have been very well organized. The notes given are very detailed and explain all the trends and happenings in the organisation. The income statement shows that the net income over the years has increased. Even though the total cash inflow has decreased, the cash inflow from the operating activities has increased considerably. The decrease in the cash flow is because of the increase in the financing activities.

For Microsoft, both the net income and the cash flow from the operating activities are important because the net income shows how profitable the company is and the cash flow shows the liquidity and the working capital available.

Prediction about the company
I think that the company is likely to follow the trend and the net income will continue to rise unless any unforeseen mishap affects the company. Since the IT industry is rather unpredictable industry, care needs to be taken to account for any contingencies so that that the company’s strong financial position is not affected.

Conclusion
Microsoft currently has a very strong financial position with increasing stock prices. However, the company needs to improve its cash flows and continuously spend more on R&D and innovation to keep from falling if anything like the dot com burst happens.

ExxonMobil
The financial statements for the year 2003 are very comprehensive and yet very precise. Most of the figures have been explained with graphs. The income statement shows an increase in the net income. The shareholder’s equity has also increased. The total cash inflows have increased because of the cash inflows from operating activities. However, the outflows for financing as well as the investing activities have also increased.

            For an oil exploration company that has a long business cycle, it is hard to keep up the cash flows. However, both the net income and the cash flow from the operating activities are important for the company. Also, there should be minimal discrepancy between the two.

Prediction about the company
I think the company will continue to do well. However, the company needs to keep its eyes and ears open to the political situation in the world and the affect on the oil prices which are skyrocketing.

Conclusion
The company at present is financially strong. However, the company needs to build a strong network around itself so that the affect of the fluctuation the economies, political situation and the oil prices are minimal on the company.

References
“Generally Accepted Accounting Principles” Definition, 3 June 2007 <http://www.investorwords.com/2141/GAAP.html>

Wirick, David; Gibbons, John J. “GENERALLY ACCEPTED ACCOUNTING PRINCIPLES FOR REGULATED UTILITIES: EVOLUTION AND IMPACTS”; THE NATIONAL REGULATORY RESEARCH INSTITUTE (April 1994)

“What are Generally Accepted Accounting Principles?” 3 June 2007 <http://www.allbusiness.com/accounting/methods-standards-generally-accepted-accounting/1261-1.html#>

Accrual and Cash basis accounting methods, 3 June 2007  <http://www.labyrinthinc.com/SharedContent/SingleFaq.asp?faqid=35>

“UNIT 4 – Constructing Cash Flow”, Analyzing Business Cash Flow ; Edge Development Group, LLC, (1999)

Klein, Kim, “Accrual and Cash basis accounting methods”01-17-2006, 3 June 2007  <http://www.compasspoint.org/askgenie/details.php?id=83>

Annual Report of Ford Motor Company for Year 2005, taken from <http://www.ford.com/NR/rdonlyres/eufz5jp55ox6v4aqqfjsy2sp4s2ixqwsnfweb6opfsd3lmhue4zpbxx5sd4aics3w27zzayzvl54lwuouzhmqeb5cdh/2005_AR_Financials.pdf>

“Assets, Liabilities and Equity”, June 07 <http://www.lemoineandjames.com/gaap/22ale.html>

Annual Report of Microsoft for Year 2005, 3 June 2007  <http://www.microsoft.com/msft/reports/ar05/staticversion/10k_fr_dis.html>

http://www.investopedia.com

http://www.accountingstudy.com