Review of Basic Financial Statements

Financial statements convey information about the vital signs of the business. Properly constructed and interpreted, they can provide the information needed to monitor and assess business stability and profitability. In Part 2, we will describe and discuss three chief financial statements. These are:

1. The Income Statement

2. The Balance Sheet

3. The Statement of Cash Flows

(A formal treatment of the Statement of Retained Earnings is excluded here since most of the information in this statement is contained in the income statement and the balance sheet. We informally compute this statement after our discussion of the balance sheet.)

 

Yearly Vs Quarterly Statements

As mentioned in Part 1, accounting financials present summaries of the various transactions the firm has engaged in over the accounting cycle. They are computed quarterly or annually and can follow a calendar year or fiscal year format.    

Funds Recognition in Accounting and Finance

The income statement and balance sheet recognize funds using the accrual method. This means fund flows are recognized for a given period when the revenues or expenses are incurred. The accrual method is based upon the matching principle—the desire to match revenues with expenses in the period in which they are recorded.  Conversely, decision making in finance relies heavily on the cash basis method of funds flow recognition - where a given revenue or expense activity is recorded when that activity actually produces a cash inflow or outflow for the period irrespective of when the revenues and expenses are incurred. 

Neither method is superior, but each can provide different measuring rods of corporate performance. The accrual method is concerned with the longer-run process of wealth creation under the assumption that the firm is a going concern.  For example, sales not collected today will be collected within a normal period of time; expenses not paid today will be paid under the normal terms of trade with vendors. Simply put, the firm is not facing a financial distress. In such a situation, the firm could not afford to give credit sales and vendors would want immediate cash payment for purchased supplies. As a going concern, the firm is operating normally cash flow problems like these two situations would not arise.  As a result, management and investors can afford to take a more relaxed appraisal of actual cash flows.

The cash basis method takes a more focused view of cash flow. The cash basis method is more concerned with the firm's liquidity, solvency, and general cash flow health. Studies show that fund flows measured under either the accrual or cash basis method and that qualify as going concerns will be highly correlated. However, in implementing accounting procedures that are keyed to tracking money flows and determining the firm's current solvency position, the cash basis method would probably take on more importance for management. This is where the Statement of Cash Flows comes in since it only tracks revenue and expense activities that produce or use cash for a given period. We will discuss this important statement subsequently as well as give a numerical example of how accrual and cash basis accounting can give substantially different fund flow results. 

 

Book Value Versus Market Value Numbers

Conventional financial statements are recorded using book value dollar amounts. This means the numbers are historical in nature and are recorded at their cost values. Given the account values are recorded at historical cost they usually differ from their market value counterparts.This distinction is probably more important for the balance sheet than for the income statement or the statement of cash flows since the latter two statements are updated annually (if not more often). 

While the items on the firm's balance sheet can be amended to reflect changes in market value, this is typically not done since many balance sheet account entries are difficult to quantify in terms of going market price and given the fact that their values can change daily. Two exceptions to this general practice, however, should be mentioned:

1. A writing down reduces the book value of a given asset when there is a large and obvious reduction the asset's book value;

2. Liquidation revaluation occurs when a firm is in bankruptcy and the court has ordered its assets be sold and its debts paid off. In this case the assets and debts (including preferred stock if any) must be revalued according to their estimated market values. The remaining amount (if any) when the assets have been sold and debts paid is then distributed to the stockholders and the firm ceases to exist. For convenience in what follows we will assume book value and market values are approximately equal.

 

Transparency and financial statements: Formal financial statements are considered transparent when they present an accurate and unbiased numerical summary of the firm's income, expenses, net profit or loss, assets, liabilities, and net worth for the year. Lack of financial transparency means investors and managers are reading invalid numbers about the firm. Improper or bad decision making can result. 

 Lack of transparency can be due to accounting methodology or to dishonesty and fraud. Transparency based upon honesty is an assumption, one that has not been met in the last few years. The fraud motive is a big issue today and has resulted in major financial reporting legislation (e.g., the Sarbanes-Oxley Act of 2004). More will be said about financial transparency when we get to a discussion of ethics in financial reporting. The point that we make here is that we will assume the hypothetical financial statements that follow have been accurately and honestly prepared according to established GAAP standards and other reporting guidelines.

 

Efficient capital markets in corporate finance: The above specific comments describing the need for transparency in financial statement presentation are closely related to the more general idea of efficient capital markets. Both transparency and efficiency share a common trait—quick and accurate information flow.  

A capital market is considered efficient if information that is relevant to the true value of the corporation and/or its securities is quickly transmitted to the market and to investors that trade the firm's securities. You can see that quick and accurate information flow is a necessary condition for the existence of an efficient market.

An outcome of market efficiency is price equilibrium. This means that assets (be they the whole corporation or its secutries) will be "fairly-priced" if they trade in an efficient market setting. A fairly- priced asset is one whose going market price equals the asset's intrinsic value (i.e., what the asset is really worth). Rapid information flow means the asset's price quickly reflects all available information and any mis-allignment between the going market price and its intrinsic value won't last long. As investors (quickly) learn of a dis-equilibrium state (i.e., a mis-priced security) they will buy or sell the asset thereby bringing its market price into allignment with its intrinsic value. For example, it is no coincidence that an earnings surprise (an earnings announcement that is greater than what was anticipated by investors) is quickly followed by an increase in a company's stock price.  

What drives market efficiency and why is it important in corporate finance? Market efficiency is driven by knowledgeable and greedy investors who will act quickly on any new information about the firm or its securities. Information that is "old" will not cause investors to act since this knowledge has already been incorporated into the market value of the company and its securities.

Another driver of market efficiency in U.S. financial markets is our legal system. A chief manadate of the Securities and Exchange Commission (SEC) is the requirement of full disclosure—the requirement that corporations and traders of corporate securities make available to all any material information about the corporation and its securities. Violations of this mandate are illegal for good reason. Suspicion about the true worth of a corporation's stocks and bonds due to a lack of accuracy and timely information can easily lead to a state of paralysis in the trading of these securities. Without the active trading of a corporation's securities funds flow and liquidity will quickly dry up and the company's access to capital markets will fade.  The result is that the ability to attract external financial capital necessary for growth will stall.

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