Financial statements are the backbone of corporate reporting, providing a structured view of a company's financial health. They consist of the balance sheet, income statement, cash flow statement, and statement of changes in equity, each offering unique insights into different aspects of a business's finances.

These statements are interconnected, with changes in one reflected across others. While they offer valuable information, limitations like historical cost basis and reliance on estimates mean they don't always capture a company's full value. Understanding these elements is crucial for interpreting financial data accurately.

Components of financial statements

• Financial statements provide a structured representation of the financial position, financial performance, and cash flows of an entity
• The complete set of financial statements includes the balance sheet, income statement, statement of cash flows, and statement of changes in equity
• Notes to the financial statements provide additional information and explanations to help users understand the entity's financial position and performance

Balance sheet elements

Assets

• Resources controlled by the entity as a result of past events from which future economic benefits are expected to flow to the entity
• Classified as current assets (expected to be realized within one year or the entity's normal operating cycle) or non-current assets (all other assets)
• Examples include cash, accounts receivable, inventory, property, plant, and equipment, and intangible assets (patents, trademarks)

Liabilities

• Present obligations of the entity arising from past events, the settlement of which is expected to result in an outflow of resources embodying economic benefits
• Classified as current liabilities (expected to be settled within one year or the entity's normal operating cycle) or non-current liabilities (all other liabilities)
• Examples include accounts payable, short-term borrowings, long-term debt, and provisions for warranties or legal claims

Equity

• Residual interest in the assets of the entity after deducting all its liabilities
• Represents the owners' claim on the entity's assets
• Components include contributed capital (amounts invested by owners) and retained earnings (accumulated profits or losses)
• Example: common stock, additional paid-in capital, and retained earnings

Income statement elements

Revenues

• Inflows or enhancements of assets or decreases in liabilities that result in increases in equity, other than those relating to contributions from owners
• Arise from the sale of goods, rendering of services, or other activities that constitute the entity's ongoing major or central operations
• Examples: sales revenue, service revenue, interest income, and dividend income

Expenses

• Outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to owners
• Arise from the entity's ongoing major or central operations
• Examples: cost of goods sold, salaries and wages, depreciation, and interest expense

Gains vs losses

• Gains represent increases in equity from peripheral or incidental transactions, other than those related to revenues or contributions from owners
• Losses represent decreases in equity from peripheral or incidental transactions, other than those related to expenses or distributions to owners
• Examples of gains: gain on sale of non-current assets, foreign exchange gains
• Examples of losses: loss on disposal of non-current assets, impairment losses

Statement of cash flows elements

Operating activities

• Principal revenue-producing activities of the entity and other activities that are not investing or financing activities
• Cash inflows include cash receipts from the sale of goods and services and cash receipts from interest and dividends
• Cash outflows include payments to suppliers, employees, and for other operating expenses

Investing activities

• Acquisition and disposal of long-term assets and other investments not included in cash equivalents
• Cash inflows include proceeds from the sale of property, plant, and equipment, and proceeds from the sale of investments
• Cash outflows include payments to acquire property, plant, and equipment, and payments to acquire investments

Financing activities

• Activities that result in changes in the size and composition of the contributed equity and borrowings of the entity
• Cash inflows include proceeds from issuing shares or other equity instruments and proceeds from borrowings
• Cash outflows include payments to owners to acquire or redeem the entity's shares and repayments of borrowings

Statement of changes in equity

Transactions with owners

• Contributions from and distributions to owners in their capacity as owners
• Examples: issuance of shares, dividends paid, and share buybacks

Comprehensive income

• Change in equity during a period resulting from transactions and other events, other than those changes resulting from transactions with owners in their capacity as owners
• Includes all components of profit or loss (net income) and other comprehensive income
• Other comprehensive income includes items such as foreign currency translation differences, gains and losses on remeasuring available-for-sale financial assets, and the effective portion of gains and losses on hedging instruments in a cash flow hedge

Notes to financial statements

Accounting policies

• Specific principles, bases, conventions, rules, and practices applied by an entity in preparing and presenting financial statements
• Disclose the measurement basis used in preparing the financial statements and other accounting policies used that are relevant to an understanding of the financial statements

Additional disclosures

• Provide information that is not presented elsewhere in the financial statements but is relevant to an understanding of any of them
• Examples: contingent liabilities, commitments, and segment information

Interrelationships between statements

Articulation

• Financial statements are interrelated and should be viewed as an integrated whole
• Changes in assets, liabilities, and equity in the balance sheet are reflected in the income statement and statement of cash flows

Reconciliation of net income to cash flows

• Net income from the income statement is adjusted for non-cash items, changes in working capital, and investing and financing activities to arrive at the net cash flows from operating activities in the statement of cash flows
• Non-cash items include depreciation, amortization, and gains or losses on the sale of assets
• Changes in working capital include changes in accounts receivable, inventory, and accounts payable

Limitations of financial statements

Historical cost basis

• Many assets and liabilities are recorded at their historical cost, which may not reflect their current market value
• This can lead to the understatement or overstatement of assets and liabilities in the balance sheet

Estimates and judgments

• The preparation of financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues, and expenses
• Examples: estimated useful lives of assets, allowances for doubtful accounts, and provisions for warranties or legal claims

Omitted items

• Financial statements may not include certain items that are difficult to measure or value, such as internally generated intangible assets (brand value, customer loyalty) and human capital
• These omitted items can be significant drivers of an entity's value and future performance but are not captured in the financial statements