COMM1140 - Understanding Financial Statements Notes

Accrual vs. Cash Accounting

• Accrual Accounting:
  • Records revenues and expenses when they occur, regardless of when cash is exchanged.
  • Provides a more accurate picture of a company's financial performance over a period.
• Cash Accounting:
  • Records revenues when cash is received and expenses when cash is paid.
• Revenue:
  • An increase in company wealth (e.g., sales, interest income, dividends).
• Expenses:
  • A decrease in company wealth incurred to earn revenue (e.g., wages, electricity).
  • Important: Dividends to shareholders are NOT expenses.

Course Overview: COMM1140 Financial Management

• Draws on expertise from Accounting, Finance, and Tax.
• Aims to provide skills for leaders, advisors, and entrepreneurs to make sound business decisions.
• Key areas include:
  • Understanding and analyzing financial statements.
  • Company valuation and investment decisions.
  • Optimizing business decision-making and reducing risk.
• Assessment components:
  • Tutorial Participation (15%)
  • Group Presentation (25%)
  • Final Exam (60%)

Learning Objectives: Understanding Financial Statements

1. Understand how accounting information is presented in financial statements.
2. Describe the relationship between the balance sheet and the income statement (retained profits).
3. Identify the components of the income statement, balance sheet, and cash flow statement.
4. Prepare an income statement and balance sheet.

Financial Accounting Information: Annual Reports

• Presented in an annual report, a comprehensive document produced at the end of a company's financial year.
• Provides a detailed account of financial performance, operational activities, and overall position.
• Serves as a crucial communication tool for stakeholders (investors, employees, customers, regulators).
• Annual reports can be found on company websites and stock exchanges.

Key Financial Statements

• Balance Sheet:
  • Financial position at a specific point in time (also known as the Statement of Financial Position).
  • Shows a company's resources (assets) and how they are financed (liabilities + equity).
• Income Statement:
  • Financial performance over a period of time (also known as the Statement of Financial Performance or Profit & Loss Statement).
  • Shows revenues earned and expenses incurred over a period.
  • Prepared using accrual accounting.
• Cash Flow Statement:
  • Measures cash inflows (sources) and outflows (uses) over a period.
  • Prepared using cash accounting.

The Balance Sheet: Core Elements

• Reports an entity's financial position at a specific point in time.
• Three main components: Assets, Liabilities, and Equity.

Balance Sheet Elements Explained

• Assets:
  • Resources used by the company, either this year or in future years.
  • Examples: Cash, accounts receivable, property, equipment, inventory.
• Liabilities:
  • Debt and other financial obligations (what the company owes).
  • Examples: Accounts payable, loan payable, income taxes payable.
• Shareholders’ Equity (Owners’ Equity):
  • What belongs to the owners (shareholders); also referred to as "net assets".
  • $SE = A – L$
  • Components:
    • Share Capital: Amount invested by owners (contributed capital or equity).
    • Retained Profits: Cumulative profit retained in the business rather than paid as dividends.

Balance Sheet: Resources and Claims

• Shows resources (assets) and claims on those resources (liabilities and equity) at a point in time.
• Accounting Equation:
  • $Assets = Liabilities + Equity$
• Key Rules:
  • Assets are used during business operations to generate revenue.
  • Liabilities and equity are sources of financing for assets.
  • The accounting equation MUST always balance.

Examples

• Example 1:
  • A company purchases an apartment for $500,000$ fully financed by a loan.
  • $Assets = Liabilities + Equity$ --> $500,000 = 500,000$
• Example 2:
  • A company purchases an apartment for $500,000$ using $100,000$ cash and a $400,000$ bank loan.
  • $Assets = Liabilities + Equity$ --> $500,000 - 100,000 = 400,000$ --> $400,000 = 400,000$

Income Statement: Overview

• Displays financial performance over a specific period.
• Reports revenues earned and expenses incurred.
• Revenue:
  • Inflows of economic benefits that increase shareholders' equity (e.g., sales revenue, service revenue, fees earned).
• Expenses:
  • Use or loss of economic benefits that decrease shareholders’ equity.
  • Incurred when using resources to generate revenue.
• Net Profit: Revenues > Expenses
• Net Loss: Revenues < Expenses

Income Statement: Accrual Accounting

• Prepared using accrual accounting.
• Recognizes the impact of transactions when revenues and expenses occur, not when cash changes hands.
• Example: Vodafone telephone bill dated June 20, 2022, for $120$, paid on July 15, 2022. Vodafone records the sale in the year ended June 30, 2022 because that's when the service was used.

Cash Flow Statement: Details

• Provides details of movements in a company’s cash balance over a specific time period.
• Cash flows are categorized into:
  1. Operating Activities: Main revenue-producing activities (e.g., receipts from customers, payments to suppliers/employees).
  2. Investing Activities: Acquisition and disposal of long-term assets (e.g., sale of property, dividends received).
  3. Financing Activities: Equity capital and borrowings (e.g., proceeds from borrowings, repayment of borrowings, dividends paid).
• Importance:
  • Informs users of the company’s cash position.
  • Essential for covering expenses, loan repayments, taxes, and new asset purchases.

The Cash Flow Statement: Cash Accounting

• Prepared using cash accounting.
• Records the impact of transactions when cash is received or paid.
• Example: Vodafone receives $120$ on July 15, 2022, records it in the cash flow statement for the year ended June 30, 2023 as that is when the cash was received.

Financial Statement Preparation: Rules Summary

• Balance Sheet:
  • Reports financial position at a point in time.
  • Uses the accounting equation ($A = L + SE$).
  • Shows resources (assets) and claims (liabilities and equity).
• Income Statement:
  • Reports on a company’s ability to generate profit.
  • Prepared using accrual accounting.
  • Shows profit or loss over a period.
• Cash Flow Statement:
  • Reports on a company’s ability to generate cash.
  • Prepared using cash accounting.
  • Shows the overall increase or decrease in cash over a period.

Connecting Income Statement and Balance Sheet: Retained Profits

• Retained Profits represent:
  • Sum of all previous profits (since the company began).
  • Less all dividends paid to shareholders.
• Shareholders’ Equity:
  • Residual interest in assets after deducting liabilities ($A – L = SE$).
• Common components:
  • Retained profits (cumulative profits not distributed to shareholders).
  • Share capital (money invested in return for shares).

Retained Profits: The Link

• Profit can be distributed as dividends or kept as retained profits for business growth.
• Retained Profits account is the link between the Balance Sheet and Income Statement.
• Statement of Retained Profits Formula:
  • $Opening Retained Profits + Net Profit - Dividends = Closing Retained Profits$
• Dividends are NOT an expense; they are a distribution of profits.

Profit and Shareholders’ Equity

• Revenue increases Shareholders’ Equity.
• Expenses decrease Shareholders’ Equity.
• Net profit increases Shareholders’ Equity.
• Net loss decreases Shareholders’ Equity.
• $A = L + SE$

Expanded Accounting Equation

• Retained Profits (RP):
  • $Retained Profits = Opening Balance + Profit - Dividends$
  • $Profit = Revenue - Expenses$
• Comprehensive Equation:
  • $Assets = Liabilities + {Share Capital + Op. RP + R – E – D}$
• Where:
  • SC = Share Capital
  • Op. RP = Opening Retained Profits
  • R = Revenue
  • E = Expenses
  • D = Dividends

The Balance Sheet: More Information

• Summarizes financial position at a point in time.
• Resources (Assets) and Sources (Debt or Equity).
• Provides information about:
  • Financial structure (debt/equity mix).
  • Liquidity (ease of converting assets to cash).
  • Solvency (ability to pay debts when due).

Assets: Current vs. Non-Current

• Current Assets:
  • Expected to realize benefits within 12 months.
  • Converted to cash or used up within a year (e.g., cash, accounts receivable, inventory).
• Non-Current Assets:
  • Realize benefits over a longer period (more than 12 months).
  • Used to generate revenue for longer than a year (e.g., property, plant, equipment).

Liabilities: Current vs. Non-Current

• Current Liabilities:
  • Paid off within one year (e.g., accounts payable, wages payable).
• Non-Current Liabilities:
  • Remain liabilities for at least the next year (e.g., loan payable).
• Distinction helps assess short-term financial position.

Income Statement: Key Points

• Shows results of business operations over a specific period.
• Reports revenues less expenses.
• Measures organizational efficiency.
• Calculates profit available to shareholders.
• Profit: Revenues > Expenses
• Loss: Revenues < Expenses
• Accrual profit is not the same as cash profit!

Income Statement Example: Swift Ltd

• For the year ended June 30, 2023:
  • Revenue: $1,500,000$
  • Cost of Goods Sold: ($700,000$)
  • Gross Profit: $800,000$
  • Operating Expenses: ($315,000$)
  • Operating Profit: $485,000$
  • Other Income: $80,000$
  • Profit Before Tax: $565,000$
  • Income Tax Expense: ($100,000$)
  • Profit After Tax: $465,000$

Example: Preparing Financial Statements (Gomez Ltd)

• Gomez Ltd started on November 1, 2023. Transactions:
  1. Issued share capital: $200,000$
  2. Paid rent: $4,000$
  3. Provided services on credit: $60,000$ (received $22,000$)
  4. Paid wages: $14,000$ (owed $2,000$)
  5. Received maintenance bill: $3,000$
• Prepare Income Statement and Balance Sheet.

Example: Income Statement (Gomez Ltd)

• Using Accrual Accounting
• Gomez Ltd Income Statement For the Month of November 2023:
  • Sales Revenue: $60,000$
  • Wages Expense: ($16,000$)
  • Maintenance Expense: ($3,000$)
  • Rent Expense: ($4,000$)
  • Net Profit: $37,000$

Example: Preparing the Balance Sheet (Gomez Ltd)

• Gomez Ltd Balance Sheet preparation considerations:
  • Cash increase: $200,000$ from share capital.
  • Cash decrease: $4,000$ (rent).
  • Cash Increase: $22,000$ (revenue).
  • Cash Decrease: $14,000$ (wages).
  • Wages payable: $2,000$
  • Maintenance payable: $3,000$
  • Cash reported: $200,000 - 4,000 + 22,000 - 14,000 = 204,000$

Example: Balance Sheet (Gomez Ltd)

• Gomez Ltd Balance Sheet As at 30 November 2023
  • Assets:
    • Cash: $204,000$
    • Accounts Receivable: $38,000$
    • Total Assets: $242,000$
  • Liabilities:
    • Maintenance Payable: $3,000$
    • Wages Payable: $2,000$
    • Total Liabilities: $5,000$
  • Shareholders’ Equity:
    • Share Capital: $200,000$
    • Retained Profits: $37,000$
    • Total Shareholders’ Equity: $237,000$
  • Total Liabilities & Shareholders’ Equity: $242,000$

Test Your Understanding: Prepare Financial Statements

• A company purchased a one-bedroom apartment for $500,000$ on 1/7/2020 and rented it to tenants.
• Finance source: cash of $100,000$, borrowing from bank $400,000$ (maturity 20 years).
• Revenue (cash) $400$/week, interest expense (cash) $200$/week, tax expense (cash) $1,000$/year.
• Assume 52 weeks per year and no depreciation.
  1. Prepare a balance sheet on 01/07/2020 and 30/06/2021.
  2. Prepare an income statement on 30/06/2021.

COMM1140 – What’s Next?

• Part One: Foundations of Financial Management
  • Topic 1 – Introduction to Financial Management
  • Topic 2 – Understanding Financial Statements
  • Topic 3 – Analysing Business Transactions
  • Topic 4 – Financial Statement Analysis
• Part Two: Integrating Financial Management in Organisations
  • Topic 5 – Company Valuation
  • Topic 6 – Free Cash Flow Estimation
  • Topic 7 – Business Taxation
  • Topic 8 – Audit and Internal Control – Corporate Scandals
  • Topic 9 – Responsible Financial Management