Reading Financial Statements for Directors

A vital and important part of a director’s duty is to guide, monitor and understand the financials of an organisation. A director is considered responsible, even liable, for the viability and financial well being of the company on which board he or she sits. This means they are legally accountable and there can be serious consequences for a board of directors who do not take such responsibility seriously.

This being said it must be that the financial reports and records presented to the board should be understood well by the board and the board able to use the reports as part of their governance in running the organisation and ensuring that management is managing the company effectively. The three principle financial records or statements the board need to consider are:

Income Statement
Balance Sheet and
Cash Flow Statement

Income Statement

This is a summary of the income and expenses from the first day to the last day of the reporting period. It shows in list form, the gross income less the expenses to arrive at the profit (or loss) before tax. It also shows this figure less tax to leave a balance of Net profit (profit after expenses and tax).

The simple formula for the Income Statement is: I – E = P
I = income and sometimes called revenue and even earnings for an individual.
E = Expenses and
P= Profit.

So it is simply income less expenses resulting in profit.

For most organisations sales of products and or services are the most common source of income or revenue. This is usually when the goods are shipped or the service delivered. Other income can include royalties, commissions etc. Expenses are those items incurred as part of the activity to generate income. This can include salaries, annual leave, rent, utilities etc.

These expenses may not bare any immediate relationship to the income earned but are nevertheless valid expenses required in order to participate in the activities needed to earn the income. For example, rent. One requires a location from which to operate, a shop, factory place of business from which products and or services are sold and income is earned.

A proper breakdown of income and expenses is necessary for management and directors to understand and monitor the performance of the organisation.

 Commonly a typical format for this would be:

Less: cost of goods sold
Gives: gross profit
Less: selling expenses
Less: administrative expenses
Add: other revenue
Gives: profit before tax.

The complexity of this will increase in relation to the size of the organisation. Where an organisation is a large retail chain it will then, have two major functions, warehousing and distribution and these would need to be included either before or after gross profit. Each outlet would have their own profit and loss and the total would result in the overall gross profit for the organisation. The larger the organisation the more reporting and breakdown of income and expenses would need to be included to show the profit and loss of each area.

Service organisations are a little different in that they do not usually have inventory but in those exceptions where you do, there would again be a cost of goods sold and a gross profit.

This then would be:

Less: cost of goods sold consisting of:
opening inventory.
Add: purchases, direct labor, manufacturing overheads for a manufacturer.
Less: closing inventory.
Gives: cost of good s sold.
Gives: gross profit.

So there is a link between the income statement and the balance sheet. The closing inventory is taken from the goods sold as it is still there at the end of the financial year and so is an asset. This can affect the year’s profit. The more the closing inventory is considered to be worth, the lower the cost of goods sold and the higher the gross profit and profit before tax. So it is important to get the value of the inventory at years end accurate.

The Australian Accounting Standards Board (AASB) defines income and expenses as:

Income is increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of
liabilities that result in increases in equity, other than those relating to contributions from equity participants. (paragraph 70(a))

Expenses are decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrence’s of
liabilities that result in decreases in equity, other than those relating to distribution to equity participants. (paragraph 70(b))

Sometimes there are unusual or one off types of items that can distort the final figures and which, without being recorded, would not allow a proper prospective to apply to the figures for management purposes,. However all items, unusual or not, must be included in any reports.

AASB, 101, paragraph 86 advises that ‘when items of income and expenses are material, their nature and amount shall be disclosed separately.’ The term ‘material’ is defined in paragraph 11 as:

Omissions or mis-statements of items are material if they could individually or collectively, influence the economic decisions of users taken on the basis of the financial report. Materiality depends on the size and nature of the omission or mis-statement judged in the surrounding circumstances. The size or nature of the item, or a combination of both could be a determining factor.

Note also that what were once called ‘extraordinary items’ are now called material items.

Taxable income is different from profit. Taxable income is defined in section 4-15 of the Australian Income Tax Assessment Act 1997 as:

Assessable income less allowable deductions

The profit before income tax is different to the taxable income in that there are disparities between the two. Such differences can be the result of:

Capital expenditures
Provisions for long service and annual leave.
Qualifying expenditure

Depreciation rates can vary between companies. Whereas a small company may use the standard tax schedule rates a larger company may have different rates.

Capital expenditures may or may not be allowed as a deduction depending upon what it is and the circumstances.

Provisions for annual leave and long service leave are expenses occurred but would, not be tax deductible until the leave is taken or paid out.

Qualifying expenditure can change the tax rates and what is paid also. Expenditure on research and development can attract a larger deduction than the cost of the expenditure itself.

The other factor that can influence the tax paid is deferred taxes. Deferred taxes are those taxes one expects to pay when a profit is realised from say, the sale of an asset. Deferred tax assets (DTA) are the amounts of income taxes which are recoverable in future periods of deductible temporary differences, such as carrying forward unused tax loses and carrying forward unused tax credits.

But a deferred tax asset is only recognised if it is considered probable that tax benefit will be realise in the future.

A director needs to make himself familiar with the basic tax principles and rules when reading any income statement and balance sheet. Particularly when it comes to assets and the tax considerations thereof.

Levels of profit are usually expressed as:

EBITDA = earnings before interest, tax, depreciation and amortisation
Less: Depreciation and amortisation
Gives: EBIT = earnings before interest and tax
Less: Interest
Gives: EBT = earnings before tax (called ‘profit before tax’ in some accounting systems)
Less: Tax
Gives: E = earnings (called ‘net profit’ and often referred to a NPAT, ‘net profit after tax – a term not generally used these days in accounting)

Balance Sheet

This shows also in list form, what the organisation owns less what it owes. The balance is the equity of the organisation at the last date of the reporting period. This would be total assets, both current and non current, less any liabilities both current and non current. The balance is the net assets or equity of the organisation.

The balance sheet, or statement of financial position as it is called now, shows the assets, liabilities and equity at a particular time. Usually the 30th of June in Australia being the end of the fiscal year.

The Balance sheet can be expressed in a formula where

A = assets, L = liabilities and E = Equity.

The formula, then, used is L + E = A

The owner’s interest in the organisation can also be expressed as:

E = A – L

A good example is where one purchases a property. Lets say the property was purchased for one million dollars. The deposit was 250,000 and the borrowing was 750,000. At the start of the term the asset is worth one million dollars and the liability 750,000 leaving an equity of 250,000. A year later, as payments are made, the situation changes. Lets say an addition 200,000 was paid. Also the value of the property increased by 10 percent.

One would have a liability of 550,000, an asset of 1,100,000 and an equity now of 550,000.

You have increase equity in the property of 100,000 as well as the contribution you made. This is called a revaluation gain. The equity therefore consists, in this simple example, of contributions made over the time period and any change in the value of the asset.

Equity does not include cash. Cash is only realised if an asset is sold, whereas then it would come of the balance sheet as equity and be considered as cash at bank, or cash holdings for example.

Equity is simply the assets held less any liabilities or in other words what is left when you deduct the liabilities from the assets. A good definition of an asset is, “Something owned” either by an individual or a company or an entity. One purchases or buys assets and one can sell assets. Another definition for asset is, “something owned which can produce a value in the future.”

Liabilities are the other side of the coin however. A definition of a liability is, “Something owed as a result of something that has occurred”. A mortgage is a liability. It is something owed as a result of a purchase of property.

Liability is defined by the AASB as:

A liability is a present obligation of the entity arising from past events, the settlement of which is expected
to result in an outflow from the entity of resources embodying economic benefits. (paragraph 49(b)).

Liabilities can be divided in current and non current.

Current liabilities include:

Accounts payable. These are also called creditors. These are those entities that the company owes money to for value received. This can be suppliers as well as accruals. An accrual is something accrued. i.e. a benefit is expected to be received, either goods or services which have not yet been paid for and so the debt is accrued. e.g. Electricity or gas. The benefit is expected and the cost is accrued but not paid for. Borrowings. Using other funds or money than owned by the entity and for which payments, in the form of interest and loan fees are due. Loans, overdrafts, commercial bills are examples.

Provisions are similar to accruals.

The AASB has defined an asset as follows:

An asset is a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity. (paragraph 49(a)).

Directors are the stewards of the organisations assets and have a duty to ensure they are treated in such a way that asset value is added to and maintained by the organisation. A director, therefore, needs to be satisfied that an asset actually exists and is valued appropriately and not over or under valued. It should be born in mind that while some assets may increase in value over a period others may decrease or be amortised. Some assets, such as intangibles like good will etc, can only be reported at cost. Assets are show on the balance sheet as either current or non current assets. Current means that that asset will be converted into cash or another asset or will be used up within the 12 months from the balance sheet date. Any other assets are classified as non current.

The most common current assets you might find on a balance sheet are:

Cash. Cash holdings such as you might find in a bank and cash on hand such as petty cash for example.
Receivables. Funds owed by debtors to the organisation from other parties. Trade debtors are the most common. These are funds owned by customers who have been sold a product or service on credit.
Inventories. This is the stock of products purchased for resale but not yet sold.
Prepayments. This is where a client or customer pays in advance for a product or service to be received. Insurance is a good example.

Non Current Assets found on a balance sheet are:

Investments. These are sometimes also labelled as ‘other financial assets’ and could be called savings for a rainy day. These include investments in shares, interest bearing securities, or investment properties for example.
Property, Plant and Equipment. These are also called fixed assets. They can include, land, buildings, plant, equipment, cars computers, furniture etc. Materials required for the organisation to produce its services or goods for resale.
Intangibles. Good will, trade or brand names, trademarks, patents and the like.
Deferred tax assessment which arises from the way income tax is accounted for as compared to how it is assessed under the tax laws.

Some non current assets would be depreciated or amortised. Cars, computers and furniture for example. Others may increase in value, such as goodwill.

Assets need to be valued on a regular basis to ensure fair value. It is easy to over value assets just as it is easy to under value them. The fair value should be assessed annually.

Cash Flow Statement

This shows the flow of cash or money through the organisations from the first to the last day of the period being counted or reported on. Again in list form this would be the total receipts less any payments to equal the net operating activities. Also receipts less any payments to show a balance of net investing activities. And receipts less any net financing activities to equal a net cash increase (or decrease). Then add cash at the beginning to give a total of the cash at the end of the reporting period.

The simple formula for the Cash Flow Statement is:

Cash at the beginning of the period Add: cash receipts
Less: cash payments
Gives: cash at the end of the period

Of course it invariably ends up more complex than this as other factors enter into it. For example:

Net cash from operating activities
Add: net cash from investing activities
Add: net cash from financing activities
Gives: net change in cash for the period
Add: cash at the beginning of the period
Gives: cash at the end of the period

Some other examples of cash flows from operating activities.

Cash receipts/ inflows Cash payments/ outflows receipts from customers payments to suppliers and employees
dividends received interest paid
interest received Income tax paid/

of course the cash received from customers should be larger than the payments to suppliers and employees otherwise the company is heading for trouble.

Cash Flows from investing activities
Cash receipts / inflows Cash payments / outflows
Proceeds from disposal of property, Payments for purchase of property
Plant and equipment plant and equipment
Proceeds from sale of investments payment for investments
Proceeds from sale of companies payments for purchases of companies
And businesses and businesses

Sometimes, these days, a company will find it more economical and tax advantageous to lease rather than buy and tie up funds in capital

Cash Flows from financing activities
Cash receipts / inflows Cash payments / outflows
Proceeds from issue of shares Return of capital/share buyback
Dividends received Dividends paid
Proceeds from new borrowings repayment of principal on borrowings

Note there are some cash flow warning signals to look for. Three of them are:

Net profit cash outflows (negative operating cash flows)
Payments to suppliers and employees are higher than receipts from customers, and
Net operating cash flows are lower than profit after tax.

If any two are found to be present then directors should be alerted as this can be a warning that insolvency is potentially looming.

A difference between the income Statement and cash Flow statement is that income and expenses are recognized when they incurred while cash and payments are recognized when they are received and paid.

Cash can be received for a sale either before, during or after the sale is made. In a supermarket, the cash is paid at the same time the goods are delivered to the customer. In a credit situation the cash is paid after the goods are delivered and in some situations (mail order or insurance for example) the cash is paid before the goods are delivered.

A separate report these days is required for a change in equity and comprehensive income.

The statement should include:

The total comprehensive income
All transactions between the entity and its owners, typically being such things as dividends, share issues, buy backs and a returns of capital.
The statement should show the opening balance of each, any transactions, such as gains, losses, transfers etc and then the closing balance for each.

Notes to the Accounts

These go further in providing additional detailed information to the data presented in a report and should be read, not skipped over, by the directors. These are usually numbered one (1) through to the total number of notes presented and each will oten give very extensive information, regarding that element or figure in the accounts. They can show a very enlightened view not immediately apparent in the three basic reports.

The first note is usually a statement of the financial or accounting policies used by the company. Subsequent notes might cover such matters as:

Significant other party transactions
Market value of assets and liabilities
Interest rates
Currency rates and significant changes
One off extraordinary items
Reporting of various areas, such as geographical or business segments, subsidiaries and associated companies.
Analysing Financial Reports

Each report shows a difference aspect of the company’s financial activities. The income statement shows how much income is being made less the expenses incurred in making that income, the balance sheet shows how much equity the company owns and the cash flow statement shows the flow of money through the organisation.

Most important for a director is to ensure that compliance with the various regulatory accounting standards are being in effect. This is where committees for larger companies assist. Committees to monitor and ensure compliance with the various laws and guidelines imposed on companies and on board members. The board has a duty to ensure the company is complying with the various regulations and there can be stiff penalties where a board has been remiss in this. If a director cannot show they have done all they can to ensure legal compliance then they can face fines and even imprisonment.

Setting the financial risk for the company is an important factor also for the board to consider. should want to be able to monitor risk as it applies to the purposes and objectives of the company.

Lastly, the board is accountable to the shareholders and should be reporting progress and matters of interest to the shareholders. This might include the direction the board is taking with regard to the company, any change of direction, any acquisition or divestment of a significant asset and full disclosure of matters which the board consider are significant to report to the shareholders.