How to Read and Understand Financial Accounting Statements

Part A: Management Judgments 

Businesses are required to make some judgments and estimates when preparing financial statements. These are done according to the requirements of International Accounting Standards. According to IAS 1.122, accounting judgments made by management should be disclosed in the financial statements. Judgments are found in the income statement and the balance sheet as off-balance sheet agreements or off-income statement agreements. “An entity must disclose, in the summary of significant accounting policies or other notes, the judgments, apart from those involving estimations, that management has made in the process of applying the entity's accounting policies that have the most significant effect on the amounts recognized in the financial statements”(International Financial Reporting Standards, 2019). 

A company’s decision regarding provision for income tax for transactions requires judgment. For instance, deferred tax is recognized as a tax loss that has not been used. It is placed on temporary differences for the probability there will be taxable revenues, which can provide an opportunity for offsetting the deferred. In impairment of goodwill, after an assessment is done as to whether the current fair value is impaired, detailed calculations are then carried out concerning the pretax cash flows, and discounted at the appropriate discount rate. This determination requires judgment. In provisioning for losses on loans, the time and amount estimation of recovery are determined through significant judgment. In addition, when provisioning for liabilities and charges, management makes a judgment on the kinds of claims that require provisioning. 

Some illiquid financial assets may require to be reflected at fair value, which is estimated (Sacer, Malis&Pavic, 2016). “Judgment and estimates are required when determining ¬deferred as well as current tax assets and liabilities. Based on estimates of the probability of releasing these tax benefits, available taxable temporary differences, periods of reversals of such differences etc., the management does not believe that the criteria to recognise deferred tax assets are met “ (Consolidated Financial Statements 2012 of the Kuehne + Nagel Group, 2012). 

“We have established liabilities for certain losses related to general liability workers’ compensation, employee group medical, and automobile claims for which we are self-insured. Our self-insured retention or deductible, as applicable, for each claim involving general liability, workers’ compensation, and automobile liability is limited to $25 million, $1 million, and $1 million, respectively. Our liabilities represent estimates of the ultimate cost for claims incurred at the balance sheet date. The estimated liabilities are not discounted and are established based upon analysis of historical data and actuarial estimates. While we believe these estimates are reasonable based on the information currently available, if actual trends, including the severity or frequency of claims, medical cost inflation or fluctuations in premiums, differ from our estimates, our results of operations could be impacted. Actual results related to these types of claims did not vary materially from estimated amounts for fiscal 2017, 2016 or 2015. On December 22, 2017, the SEC issued Staff Accounting Bulletin No. 118 ("SAB 118") to address the application of GAAP in situations when a registrant does not have the necessary information available, prepared, or analyzed (including computations) in reasonable detail to complete the accounting for certain income tax effects of the Tax Act. Following SAB 118, we were able to make reasonable estimates of certain effects and, therefore, recorded provisional amounts for the remeasurement of deferred tax assets and liabilities and the tax on the mandatory deemed repatriation of foreign earnings” (Annual Report 2017) 

Part B: Cash Flow 

Operating cash flows are determined either directly or indirectly. When using the direct method, cash received is compared with money paid in ordinary activities of business, which can be defined from cashbook or control ledger. Under the indirect way, operating profits are reconciled with the operating cash flow. Operating profit is profit before interest and tax, which is adjusted with non -cash flow items. 

Indirect and direct method of preparing the statement of cash flows have one major difference; that in using the indirect method, the section of operating income begins with net income while the direct approach does not. In the direct method, a reconciliation of net income and the cash from operating activities should be done while the indirect method, it is done automatically; therefore, no reconciliation is required. The direct method of preparing the cash flow statement is preferable by FASB, to the indirect method. The direct method is believed to achieve the objectives of preparing cash flows compared to the indirect method. However, most businesses prefer to use the indirect method to make cash flow statements. 

Using the direct method; 

Cash collected from customers = Sales + Beginning Accounts Receivable - Ending Accounts Receivable 

Cash paid for merchandise = COGS + Ending inventory - Beginning Inventory + Beginning Accounts Payable - Ending Accounts Payable 

Cash paid to employees = Wages expense + Beginning Work in Progress - Ending Work in Progress 

Cash paid for other accrued expenses = Beginning accrued expenses - Ending accrued expenses 

Cash paid for other operating costs including insurance and other prepaid expenses = Ending prepaid expenses - Beginning prepaid expenses 

Prepaid expenses, which are also prepayments, are expenses paid before an expense has been incurred. They are advance payments Normally, expenses are recognized when they are incurred in businesses. Since prepaid expenses have not yet been incurred, they are not recognized as expenses at the time but are recorded as current assets in the balance sheet At the end of the accounting period, the expenses should be adjusted depending on the journal entries that were initially made. From the concept of accounting of accruals, prepaid expenses are the opposite of unearned revenues, which recorded as liabilities in the balance sheet. 

An example of a cash flow statement is as follows; 

Abc Ltd 

Cash flow Statement For The Year Ended 31/Dec/2008 

Sh Sh 

Net cash inflow/outflow from operating 

activities XX 

Interest paid/received XX 

Divedend paid/received XX 

Net cash flow inflow/outflow from investing 

activities 

Sales of fixed assets XX 

Purchase of fixed assets (XX) XX 

Net cash flow/ outflow for financing activities 

Issues of shaves XX 

Issue of debtors XX XX 

Increase in cash/ cash equivalent XX 

The working for Net cash inflow/outflow for operating activities is as follows 

Sh 

Retained profit for the year XX 

Add non-cash expenses 

Depreciation XX 

Tax provision XX 

Proposed dividends XX 

Add Accruals 

Decrease in debtors XX 

Decrease in stock XX 

Decrease in Bill receivable XX 

Increase in creditors XX 

Less prepayment 

Increase in stock (XX) 

Increase in bill receivable (XX) 

Decrease in creditors (XX) 

Decrease in bill payable (XX) 

Net cash flow, overflow from operating activities XX 

Part C: Comprehensive Income 

Comprehensive income is income which is not reported in the income statement but appear in the reporting of stakeholders equity as other comprehensive income. Comprehensive income can be losses or gains, which are not recorded in the income statement. It is comprised of net income and other comprehensive income. 

Statement of comprehensive income should be used to report the items to investors. It gives the business the opportunity to explain the events in detailed form, showing the necessary steps the firm undertook. Comprehensive income and discontinued operations have a significant impact on the financial statements of a business. Statement of comprehensive income includes the net income of the company among other unusual items, and comprehensive income, as well as discontinued operations, are among them. Therefore, it is only reasonable that the investors and shareholders would want to get a clear explanation of the accounting procedures followed for these items. The financial analysis uses information from the financial statements to make judgments about a business. 

SFAS 130 states that comprehensive income may be presented in a single income statement with the net income and other comprehensive income presented separately, shown in two different accounts, or presented as part of a statement of changes in stockholder’s equity” (Jarnagin, 0000). Statement of Financial Accounting Standard No. 130 (SFAS 130) requires comprehensive income to be reported separately. The methods used to report comprehensive income include; reporting comprehensive income as part of shareholder’s equity, it can also be reported as part of the income statement, or be reported in a separate statement (Pandit, Rubenfield& Phillips, 2006). The best method is presenting comprehensive income as part of changes in shareholder’s equity. 

PART D: Liquidations 

Liquidation accounting takes place when a business is insolvent and cannot pay off its financial obligations. The process involves distributing the assets of the business to pay off creditors. The assets are converted into cash. Malpractices, if adopted by the company, may finally end in the liquidation of the company. The company is always faced with the danger of going out of business and faces liquidation. In short, the company should have sound financial planning, neither needing money more than its requirements nor less money to handle the successful operations of the business. Liquidation is said to be imminent when there is a liquidation plan that has been approved, and there is a likelihood of being achieved, or liquidation is being forced by a third party, and the third party is likely to make the objective. Therefore, if liquidation is imminent, the business should prepare financial statements using the liquidation basis of accounting. 

All expected future income and costs that the business will incur during liquidation must be accrued. They should pay a reasonable amount for estimation. The company should also measure its assets and liabilities based on the consideration amount they anticipate to receive or pay. However, if the consideration anticipated approximates the fair value of the asset, then the asset can be measured at fair value. Subsequent measurement should be done to record contractual liabilities at the contractual amount and should the debt be settled, relieved or forgiven, an adjustment of the amount should be made (Liquidation Basis of Accounting — Recognition and Measurement, 2012). The business is required to prepare financial statements if liquidation is imminent. The business should disclose a statement showing the change in assets ranging from the date the liquidation was determined to be imminent to the end of the period. 

References 

Annual Report 2017. (2017). Retrieved on March 3, 2019, from http://ir.homedepot.com/~/media/Files/H/HomeDepot-IR/2018_Proxy_Updates/HD_AR_Soft-Copy.pdf 

Consolidated Financial Statements 2012 of the Kuehne + Nagel Group. (2012). Retrieved on March 3, 2019, from https://www.kn-portal.com/fileadmin/user_upload/documents/about_us/Investor_Relations/documents/2012/annual_report/en/2012/consolidated-financial-statements-2012-of-the-kuehne-nagel-group/other-notes/51-accounting-estimates-and-judgments.html 

International Financial Reporting Standards. (2019). Retrieved on March 3, 2019, from https://www.iasplus.com/en/standards 

Liquidation Basis of Accounting — Recognition and Measurement. (2012). Retrieved on March 3, 2019, from https://www.iasplus.com/en/publications/us/aje/2012/liquidation 

Pandit, G. M., Rubenfield, A., & Phillips, J. J. (2006).Current NASDAQ corporation methods of reporting comprehensive income.  American Journal of Business ,  21 (1), 13-20. 

Sacer, I. M., Malis, S. S., &Pavic, I. (2016). The Impact of Accounting Estimates on Financial Position and Business Performance–Case of Non-Current Intangible and Tangible Assets.  Procedia Economics and Finance ,  39 , 399-411.