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Reading financial statements – Understanding the ABC’s

July 16, 2013

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Don’t take anything for granted.  Life is full of lessons that seem intended to reinforce that basic commandment of parents everywhere.  Yet somehow it fails to ingrain itself permanently into my consciousness.

I was reminded of that the other day during a conversation with a client.  The client, an owner of a specialized engineering firm, and I were discussing a recent meeting he had with his bankers.  They were reviewing the annual compiled financial statements, and concluded that if the company would just repay a loan owed to him, the operating results and net income of the company would improve accordingly.  Yikes.

With the company’s financial statements in hand, I was able to demonstrate to the client the difference between a balance sheet and an income statement.  I was able to differentiate the nature of a liability (loan owed to him) and the nature of income generating transactions (revenue and expenses).  His takeaway was a much better understanding of the financial statements themselves, the significance of the information communicated in the compilation report and footnotes, and the understanding that, interest aside, paying the loan owed to him would have no effect on the operating results and net income of the company.

I’ll give the bankers the benefit of the doubt.  I suspect the message they intended to deliver was misunderstood by the client.  As accountants, we often take for granted that our clients and other users of the financial statements are as well versed in accounting terminology and financial statement literacy as we are.  Recognizing that that may not always be the case, the following is a quick refresher on some of the basics.

Levels of Assurance

Accountants issue one of three types of reports on financial statements, based on the level of service rendered: audit, review or compilation.

An audit represents the highest level of service an accountant can provide from an assurance perspective.  That is, a clean audit opinion assures the user of a set of financial statements that the auditor has conducted a testing protocol designed to identify material misstatements, and that no such misstatements were found and not corrected.  The audit report includes an affirmative statement to that effect.

A review represents a lesser level of assurance.  That is, a review report assures the user of a set of financial statements that the accountant has conducted a testing protocol based only on inquiry of the client and analytical analysis, and that based on that inquiry and analysis, the accountant is not aware of any material changes that need to be made to the statements.  The review report does not contain the affirmative language found in the audit report.

A compilation represents the lowest level of assurance.  In fact, a compilation report provides no assurance.  A compilation is a tool used to assemble and present client data in the form of a financial statement, nothing more.

Financial Statement Basics

A basic set of financial statements includes a balance sheet, an income statement, a cash flow statement, and a statement of changes in owners’ equity.

The balance sheet presents the company’s assets and liabilities as of a specific date (usually the year-end).  It lists the company’s assets (e.g. its cash, the cash its customers owe it, its inventory, its plant and equipment) and its liabilities (e.g. the cash it owes to its vendors and employees, its obligations to its lenders).  Generally speaking, the balance sheet of a healthy company will show more assets than liabilities.  This is referred to as equity.  Understanding the relationship between assets, liabilities and equity as presented in the balance sheet is important in understanding the overall financial health of the company.

Unlike the balance sheet, which is as of a point in time, the income statement presents the company’s revenue and expenses over a period of time (generally the fiscal or calendar year).  The ability of the company to build sales and control its costs is presented in the income statement, and that information is normally most useful in comparison with previous years.

As popular as the income statement is with financial statement users (it seems to be the first and last item of interest to most people), the cash flow statement really tells the financial story of the company.  Starting with net income or loss, the company’s non-cash expense items are added back, and changes in operating assets and liabilities are calculated and included to determine whether or not the central operation of the company produced or consumed cash for the year.  Further, the statement identifies cash investments made and other sources of cash funding used by the company.

The statement of changes in owners’ equity is relatively straightforward and self-descriptive.  It details changes made to equity resulting from additional investment in the company, payment of dividends out of the company, and the posting of the results of the income statement for the year.

The footnotes included with a set of financial statements are valuable in terms of helping to understand the manner in which the numbers were derived.  The notes can also point out potential problems and commitments made by the company that may not be included in the financial statements themselves.

Matt Gutzwiller is a Shareholder at Clark Schaefer Hackett, and a member of the firm’s Professional Services Provider Industry Group. He can be reached at 513.241.3111 or [email protected]

All content provided in this article is for informational purposes only. Matters discussed in this article are subject to change. For up-to-date information on this subject please contact a Clark Schaefer Hackett professional. Clark Schaefer Hackett will not be held responsible for any claim, loss, damage or inconvenience caused as a result of any information within these pages or any information accessed through this site.

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