© 2000 John Petroff
C- How are financial statements prepared
The balance sheet and the income statement are the end result from the closing of the accounting books on a specific date (which is the end of an accounting period). An accounting period does not have to be the calendar year; it can be any 12 months period which ends on a date that is convenient for the closing of books, and that is usually at the lowest point of activity of the business.
Three phases can be distinguished
in the preparation of financial statements:
- recording of transactions,
- year end adjustments, and
- auditing of financial statements.
After the year end adjusting entries are completed, the accounts representing balances of assets, liabilities and equity are combined in the balance sheet; whereas balances of revenues and expenses are closed to the income statement to determine net profit. After the financial statements are completed, auditors start their tasks of auditing, verification and substantiation. The results of their work may lead to some additional adjusting entries.
See review questions Q-6C.1 through Q-6C.3.
1)- Recording transactions:
The recording of transactions, or bookkeeping, consists of writing the monetary value of every asset, claim, service received or given by the firm in a running ledger. Since all transactions are exchanges of some asset, claim or service for some other asset, claim or service, each transaction involves a double-sided entry to reflect the two sides of the exchange: one side is a debit, and the other a credit. Similar types of entries are grouped into accounts. For instance, all claims against customers (resulting from sales) are debits grouped into the account called Accounts Receivable. All accounts are two sided to allow other transactions to offset initial entries. For instance, in the above Accounts Receivable account, payments made by customers are credits. The accounts are themselves grouped into books of accounts by type: assets, liabilities and equity, revenues and expenses. At the end of the year, or accounting period, the balances of all accounts are assembled in a Trial Balance.
See review question Q-6C1.1.
2)- Year-end-adjustments necessary to prepare financial statements:
Adjustments to the year end balances
may be necessary for any one of the following reasons:
2- correction in valuation,
3- errors and omissions,
4- allocation of previously capitalized costs and revenues to the current year,
5- accruals of expenses and revenues.
Reclassification may consist of the following:
- to establish a portion of retained earnings as a reserve for a specific purpose.
- to recognize that portion of long term debt coming due within the next 12 months as a Current Liability.
- to identify inventory not needed in the coming operating cycle as non-current.
- to isolate discounts on sales (i.e. in order to make sales figures comparable in the future).
b)- Correction of value
Correction in valuation may, for instance, include:
- to value inventory at lower of cost or market.
- to recognize other than temporary decreases in market value of securities recorded on the cost basis method.
- to enter the firm's share of profits or loss associated with securities kept on the equity basis method.
c)- Errors and omissions
Correction of errors and omissions can be for example:
- to record merchandise returned by customer, for which the customer was not yet credited.
d)- Prepaid expenses
Allocation of previously capitalized cost or revenue to current year:
- to make allowance for the use of an asset in producing current year revenue:
Accruals of Expenses and Revenues may, for instance, be the following:
- to record as revenue for the year the portion of a long term contract which has been completed during the current year.
- to acknowledge interest owed on debt outstanding.
- to impute interest on loans made to employees without stated interest, and to record such interest as employee expense.
- to accrue employer's share of payroll tax expense.
Deferral (or capitalization) of expenses and revenues are, for instance:
- to reallocate the portion of the prepaid insurance premium, which applies to subsequent year(s).
- to defer recognition of revenue (e.g. magazine subscription) until the goods or services (i.e. the magazines) are actually delivered.
- to defer the portion of the current year Corporate Income Tax which does not have to be paid.
g)- Closing entries
After all year-end adjustments have been completed, the closing entries transfers all revenue and expense accounts balances to retained earnings: the net amount of this entry is the result of operations for the year. Finally, the adjusted trial balance is separated into balance sheet and income statement.
h)- Format of Income Statement:
Table T-6.1 below presents a typical format of an income statement for The Timken Company, a steel and bearings US manufacturer.
|Cost of Goods Sold||2002.4||2098.2||2005.4|
|Profit before tax||99.0||185.3||266.6|
|Profit after tax||62.6||114.5||171.4|
i)- Format of Balance Sheet:
Table T-6.1 below presents a typical format of a balance sheet for The Timken Company.
|Other current assets||39.7||42.3|
|Total Current Assets||833.5||850.3|
|Current portion of LTD||5.3||17.7|
|Other Current Liabilities||192.9||107.0|
|Total Current Liabilities||557.6||490.3|
|Long Term Debt (LTD)||327.3||325.1|
|Other non-current liabilities||504.2||578.5|
See review question Q-6C2.1.
The financial statements are substantiated (i.e. verified)
by outside accountants (called Certified Public Accountants in
the United States, Chartered Accountants in England and Canada),
who are asked
- to audit amounts shown in the Balance Sheet and Income Statement by tracing them to the source transactions;
- to verify that the method of recording entries, the rational for all bookkeeping entries and year-end adjustments comply with generally accepted accounting principles and practice (because the outside reader of financial statements will assume that such principles were followed in the financial statements preparation);
- to ascertain that the accounting methods used by the firm, any change in the methods, and any material fact affecting the financial statements, have been fully disclosed in notes to financial statements;
- to express an opinion on the financial statements.
After the auditors have rendered their opinion, the financial statements are normally considered as completed. However, some additional modification can still take place in subsequent years. Such modification would only result from a major change in accounting method that necessitates a restatement of all numbers. Less significant modification would be recorded as a adjustment of retained earnings, with, if necessary, an explanatory note to financial statements. For a discussion of the content of auditor's opinion see below.
See review question Q-6C3.1.
4)- Notes, comments and Management Discussion and Analysis of Results of Operations and Financial Condition (MDA):
Balance sheets and income statements in annual reports are usually accompanied by notes and comments. Some of the notes explain the accounting methods used, others give details on how a number is calculated, and still others offer information about contingencies or other material events that may affect the firm's financial position. In an annual report, it is also customary to find a few pages where management discusses major successes and problems it has encountered in the previous year, and offers an outline of its strategy for the future. This writing is known today as Management's Discussion and Analysis of Results of Operations and Financial Conditions" (and used to be known as "Management's Assessment of Business Conditions.")
See review question .Q-6C4.1
5)- Other accounting statements
In most annual reports of American companies several other accounting statements are present in addition to the balance sheet and income statement. They only offer numbers that are arranged in a different format for some useful purpose, but the underlying data is already contained in the balance sheet and income statement. The most common additional statements are the statement of cash flows, the statement of shareowners' equity, and five year summary of selected financial data. Less common today are statement reflecting the effect of inflation. Many large corporations also include in their annual reports some break down of the numbers shown for the entire company: for instance, unconsolidated statements for major affiliates, sales by product line and by region, statement showing the reconciliation of various amounts in the balance sheet, such as that of deferred income tax.
a)- Statement of Cash Flows:
As further describe in Chapter
8 Section J-1, the Statement of Cash Flows shows all the
elements which contributed to change the cash (or working capital)
of the firm. The elements are grouped into three category:
- cash flows from operations, which are cash revenues less cash expenses (in which, for instance, depreciation is not a cash expense),
- cash flows from investing activities, which includes purchases or sales of major fixed assets,
- cash flows from financing activities, which shows repayment of debt and new sourcing of funds.
In some older annual reports one may find the Statement of Cash Flows in its previous format when it was called Statement of Changes in Financial Position, or Sources and Uses of Funds Statement. This statement explains how changes in liquidity have occurred during a year. The liquidity is either cash or working capital and is the bottom line of the statement. The net change of every item of the balance sheet between two consecutive years is classified as either a source or a use of funds. Sources of funds include: results from operations, decrease in asset, and increase in liability or equity. Uses of funds include: increase in asset, decrease in liability or equity, and payment of dividends.
b)- Statement of retained earnings or statement of owner's equity:
This statement is simply a reconciliation of the profit for the year and the amount of profit entered into equity for the year as the increment in retained earnings. Thus, profit is decreased by any dividends and other distribution made to owners of the firm during the year, as well as reserves and provisions.
c)- Restatement of financial result for the effects of inflation:
From 1980 until 1986, these restatements were required only from large firms, i.e. those with over $1 billion in total assets or more than $125 millions in inventory, plant and equipment. The restatements was made optional in 1986, and many firms do not offer these statements any more .
There are 4 possible statements that can be present:
- statements using current cost (rather than historic cost) for the current year and for the past 5 years, and
- statements using constant dollar (i.e. with help of index) for the current year and for the past 5 years.
These statements should be helpful in correcting for the understatement of assets. But, the way the restatement were prepared revealed a great disparity in methods used (not to mention some degree of confusion). No improvement in consistency could be expected because these restatements were not audited (e.g. verifying replacement values could not part of the role of an outside auditor because such values are influenced by too many external market related conditions). Firms have used these statements to convey some additional message about their views on either the current year results, economic conditions, tax regulations or other issues. Thus, these statements are not, and were not, as useful as they ought to have been.
See review questions Q-6C5.1 through Q-6C5.4.
6)- Auditor's opinion
An auditor's opinion is supposed to give assurance that proper accounting principles where used and accounting numbers correspond to reality. It is a surprisingly brief statement carefully written in highly structured and standardized wording. The wording seems to be always the same. It is the lack of negative indications that the reader should seek to verify. Yet, even without negative comments, a positive opinion is far from removing many uncertainties and difficulties present in accounting numbers, which will be discussed later in this and other chapters.
An auditor can issue a clean opinion or a qualified opinion. An outright negative opinion is virtually never seen. But, auditors may state that they issue no opinion.
a)- Clean auditor's opinion
In a clean auditor's opinion, the opinion usually consists
in two statements or paragraphs:
1- the scope of audit: where the auditor states what he/she has done. (The work of an auditor never covers a full or 100% verification.) The actual tasks of the auditor include
- tests and recalculations,
- tracing of transactions,
- check on internal control procedures.
The statement simply states what was the overall scope of the work performed.
2- the opinion itself, which is usually worded as to imply that the financial statements represent "fairly" the result of operations and position of the firm. Note that the opinion does not say that the financial statements are accurate, but only suggests that they are not misleading. The basis for such a judgment of whether the statement would be misleading, is the use of generally accepted accounting principles. Thus, if a change in method occurred, it must be stated. The opinion also indicates that the financial statements are consistent, i.e. comparable, with prior years.
Over 90% of auditors' opinions are clean and do not present any problem. But, some have been challenged in courts, and recently even the largest accounting firms (Price Waterhouse and Arthur Anderson, for instance) have seen their hands slapped. The cause of action was that the choice of accounting principles did not permit the disclosure of some material event.
b)- Qualified auditor's opinion
Qualified opinions are of two types: they include a qualification which starts with either "except for" or "subject to".
1-"except for": this means that part of the procedures which the outside auditor intended to do, could not be completed (e.g. the inventory could not be conducted under the supervision of the auditor), or that one of the methods used in the preparation of the financial statements does not comply with generally accepted accounting principles;
2-"subject to": may result from either
- an uncertainty about some material item, such as, for instance, the existence of some given receivables (e.g. the customer who is supposed to owe the firm some money, is disputing the amount of this debt), or
- a contingency (such as the ability of the firm to refinance its operation) which may imperil the future existence of the firm.
c)- No opinion
Such auditors' statement of no opinion is only issued in connection
with unaudited statements, such as interim statements. They are
extremely rare for audited financial statements because that
would constitute a negative or adverse opinion, which are likely
to be very damaging to the firm. If such an adverse opinion were
to be issued by the C.P.A., the firm would either
- change its financial statements, or
- release the C.P.A..
When the latter happens, the new C.P.A. has an obligation to give an explanation of the issues in his opinion.
See review questions Q-6C6.1 through Q-6C6.5.
See research assignments R-6.6, R-6.7 and R-6.8.