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MUKESH PATEL SCHOOL OF TECHNOLOGY MANAGEMENT & ENGINEERING

FAA Assignment
Financial Statements: Overview

Abbas Sheik Dawood (101), MBA Tech (IT) - Shirpur


Bhavuk Chandak (103), MBA Tech (IT) - Shirpur
Dharmendra Choudhary (104), MBA Tech (IT) – Shirpur
Shruti Bihani (201), MBA Tech (Chemical) – Mumbai
Vaibhav Chaudhary (301), MBA Tech (Manufacturing) - Mumbai
Siddharth Devnani (302), MBA Tech (Manufacturing) – Mumbai
Table of Contents
What are Financial Statements? ................................................................................................. 2
Types of financial statements..................................................................................................... 2
Case Study relevance ................................................................................................................. 3
Importance of Financial Statements........................................................................................... 4
Importance of Each Part......................................................................................................... 4
Importance to Managers ........................................................................................................ 4
Uses of Financial statements ...................................................................................................... 5
Principles for Preparing Financial Statements ........................................................................... 6
Limitations of Financial Statements .......................................................................................... 9
Loss of Major Customers ....................................................................................................... 9
Change in Management ......................................................................................................... 9
Competitive Environment .................................................................................................... 10
Forged Company Image from P&L ..................................................................................... 10
Different Accounting Standards .......................................................................................... 10
Works Cited ............................................................................................................................. 11

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What are Financial Statements?

To perform any operation involving a purpose tools and performance analysers are required.
Financial managers of any organisation require tools for financial analysis and planning to
make rational decisions to meet the objectives of the firm.

The financial statement can be considered as reports in a language understandable to the firm
and outside providers of capital, both creditors and investors. The parties that require
understanding the financial credibility of the firm may require a report which is in line with
their specific interests. The financial statements may be varied and as many as possible, but
they are primarily classified as statements prepared internally and statements prepared
externally. The main users of the financial statements are listed below:

1. Trade creditors: They are interested in the liquidity of the firm, which will help the
organisation to pay for the goods and services offered by the creditors
2. Bondholders: They are interested in the cash-flow of the firm, so as to analyse how
the firm can pay the debts or services provided for their operation. They are also
interested in the firm’s profitability over time and profitability in the future
3. Investors in stocks of the firm: They are concerned with the present and expected
future earnings of the firm
4. Management of the firm does a detailed financial analysis to know the current state of
performance in order that they decide on the future business strategy. Also, the
financial information is used to develop the internal controls and the firm’s efficiency
in its operations. The financial manager of the firm is concerned with the Return on
Investment (ROI) of the firm. Also, bargaining for external funds for additional
capital requires a company to be able to show its financial stronghold.

Types of financial statements

1. Balance Sheet: This summarizes the assets, liabilities and owner’s equity of a
business of at a moment of time, usually the end of a year or a quarter.
2. Income statement: This statement summarizes the revenues and expenses of the firm
over a particular period of time, again usually a year or quarter. This analyses the
financial position of a firm over a time period.
3. Cash Flow statement: It is prepared to know the cash flows in order to know the
liquidity position of the company. In other words, a firm’s ability to meet its liabilities
as and when they arise, known as liquidity can be easily assessed through cash flow
statements. It’s quite possible that a very profitable company may face liquidity crisis
if there is no proper cash flow to meet its liabilities as and when they arise.

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Case Study relevance

In the case given, Margarita Torres purchased shares in Costco Wholesale Corporation in
1997 as part of her personal investment portfolio. Having seen Costco increase its number of
stores and studying the valuation of assets and stocks, she wanted to determine whether those
factors would hold consistent going forward.

She then researched the company and found out the profitability and other such factors that
will help her decide whether to invest or not in the company’s stocks. The factors that helped
her decide include the following:

1. Tremendous growth potential


2. Strong operational efficiency
3. Dedicated management team
4. Reasonable stock prices

However, with the growth of the company, Torres wanted to study if and whether the
operational efficiency had declined substantially. To research about the mentioned points,
Torres evaluated her investments using two methods: ratio analysis and cash flow analysis.

Common size income statements expressed the line items of a company’s income statement
as a percent of revenues. Costco being a wholesale club, it involved membership fees. Torres
noticed that there were two revenue lines: the membership fees and the net sale of goods.

Common size balance sheets expressed the line items of a company’s balance sheet as a
percent of total assets, and she was able to analyse the asset structure and understand how its
assets are funded.

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Importance of Financial Statements

Financial statements are important reports. They show how a business is doing and are very
useful within the organization for a company's stockholders and to its board of directors, its
managers and some employees, including labour unions.

Externally, they are important to prospective investors, to government agencies responsible


for taxing and regulating, to lenders such as banks and credit rating agencies, and to
investment analysts and stockbrokers.

There are basically three parts of financial statement: a balance sheet, a profit and loss
statement, cash flow statement.

Importance of Each Part

Analysis of balance sheets shows whether the company owes too much or whether they are
lending too much or they have too much in the inventory. Attached detailed statements shows
to whom the money is lent or from whom money is taken.

Analysis of profit and loss statements shows whether the prices or goods sold are high
enough to make sufficient profit.

Analysis of cash flows shows whether internally generated money is fulfilling most of the
needs or money is borrowed from outside for some needs.

Importance to Managers

Among the many users Managers are the most beneficial and frequent users of financial
statements particularly those good in analyzing and understanding the financial statements.

Business Managers discover problems in the statements and find the action needed to be
taken and executes the actions planned.

They are also able to make projections of the financial statements for future usage; it helps in
setting goals and standards for upcoming period. They assess the performance compared to
the projections made earlier.

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Uses of Financial statements

Financial statements are used by users for various purposes some of them are:

 To make business decisions owners and managers require financial statements. To


understand in more detail financial analysis is done on these statements. In
managements annual report these statements are also used for stakeholders use.

 Before investing in any business investors make use of these statements to assess the
creditability. Financial analyst does the work of financial analysis and investors use
this analysis report to make basic investment decisions.

 Employees also need these reports in making collective bargaining agreements (CBA)
with the management, in the case of labour unions or for individuals in discussing
their compensation, promotion and rankings. If the company is in profit then the
employees can make a request of promotions or bonuses.

 Vendors who extend credit to a business require financial statements to assess the
creditworthiness of the business. These financial statements help them in assessing the
true creditability of the business.

 Financial institutions (banks and other lending companies) use them to decide
whether to grant a company with fresh working capital or extend debt securities (such
as a long-term bank loan or debentures) to finance expansion and other significant
expenditure and other duties declared and paid by a company.

 Media and the general public are also interested in financial statements for a variety of
reasons. For example if any person wants to become a shareholder in the company
then the financial statements of the company’s previous years will help the person in
checking the creditability of the company

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Principles for Preparing Financial Statements

1. Economic Entity Assumption: The accountant keeps all the owner’s personal
transactions different from the transactions of his business of sole proprietorship.
For legal purposes, a sole proprietorship and its owner are considered to be one
entity, but in accounting they are two separate entities.
2. Monetary Unit Assumption: Any Economic activity taking place is measured in
U.S. dollars, and the ones which can be expressed in U.S. dollars are recorded.
Because of this principle, an assumption is made that the purchasing power of the
dollar has not changed over time. Hence, accountants do not take into account the
effect of inflation on recorded amounts.

For example, dollars from a 1952 transaction are shown with dollars from a 2008
transaction.

3. Time Period Assumption: According to this principle it is possible to report the


ongoing activities of a business in relatively short, distinct time intervals such as
the five months ended June 31, 2009, or the 5 weeks ended June 1, 2009. The
bigger the time interval, the less likely is the need for the accountant to estimate
amounts relevant to that period.

For example, the property tax bill is received on December 15 of each year. On
the income statement for the year ended December 31, 2008, the amount is
known; but for the income statement for the three months ended March 31, 2008,
the amount was not known and an estimate had to be used. It is imperative that the
time interval be shown in the heading of each income statement, statement of
stockholders' equity, and statement of cash flows. Labelling one of these financial
statements with "December 31" is not good enough—the reader needs to know if
the statement covers the one week ending December 31, 2008 the month ending
December 31, 2008 the three months ending December 31, 2008 or the year
ended December 31, 2008.

4. Cost Principle: From an accountant's view point, the term "cost" refers to the
money spent (cash equivalent or cash) when an item was originally obtained,
whether that purchase happened 2 years ago or fifty years ago. So, the amounts
shown on the financial statements are referred as historical cost amounts.

In view of this principle, assets are not adjusted in accordance with the inflation
factor. An increase in value cannot be reflected by making changes to the assets.
Thus, if an asset were to be sold at their present prices it would not tell how much
amount of money a company would finally receive. However, an exception to the
above are the investments made in the stock exchange in the trading of bonds and
stocks. To get the value of a company's long term assets one needs to look for a
third party because it is not reflected in the financial statements of the company.

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5. Full Disclosure Principle: If some important information of an investor or lender
is there using the financial statements, that information has to be disclosed in the
statement or in the notes of the statement. It is due to this accounting principle that
many "footnotes" have to be attached to the financial statements.

As an example, let's say a company X is named in a lawsuit that demands a lot of


money. When the financial statements are prepared it is not clear if the company
X would win or lose the lawsuit. Because of this principle the lawsuit will be
described in the notes to the financial statements. A company generally lists its
significant accounting policies as the first note to its financial statements.

6. Going Concern Principle: The basic assumption made by the accounting principle
is that a company will fulfil all its functions, objectives and at the same time will
not liquidate in the following course of time. However, if the accountant believes
that the company is in a financial crunch and will not be able to carry its work
forward, he is required to make this assessment public. In such a situation the
going concern principle allows the company to postpone part of its prepaid
expenses to another time or till one of the future accounting periods

7. Matching Principle: This above stated principle uses accrual basis of accounting
i.e. the expenses must be synchronized with the revenues. For example, sales
commission’s expense should be recorded in the time period when the actual sales
were carried out and not in the time period of payment of commissions. Similarly,
wages are calculated as expense in the period when the employees actually
worked excluding the period when the wages were dispersed. If a company
decides on a bonus of 3% of its 2008 revenues on January 25, 2010, the bonus
would be included in its expenses of 2008 and the amount unpaid at December 31,
2008 is considered as a liability. Since there are no means to measure the future
economic profit of things like advertisements the accountant makes sure that the
ad amount to expense is charged only in the period when the ad is shown.

8. Revenue Recognition Principle: Under the accrual basis of accounting (as opposed
to the cash basis of accounting), revenues are recognized as soon as a product is
sold, and not when the money was received. Under this basic principle, a company
could earn and report $40,000 of revenue in the first month of operation but
receive $0 in actual cash in that month.

For example, if ABC Consulting completes its service at an agreed price of


$1,000, ABC should recognize $1,000 of revenue as soon as its work is done—it
does not matter whether the client pays the $1,000 immediately or in a month. Do
not confuse revenue with a cash receipt.

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9. Materiality: Because of this principle or guideline, an accountant might be
allowed to violate another accounting principle if an amount is insignificant. An
example of an obviously immaterial item is the purchase of a $165 scanner by a
multi-million dollar company. Since the scanner will be used for four years,
the matching principle directs the accountant to expense the cost over the four-
year period. The materiality guideline allows this company to violate the matching
principle and to expense the entire cost of $165 in the year it was purchased. The
justification is that no one would consider it misleading even if $165 is expensed
in the first year instead of $40 being expensed in each of the four years that it is
used. Because of this principle, financial statements usually show amounts
rounded off.

10. Conservatism: If there is a situation which has two alternatives, then according to
this principle the accountant can choose the alternative which will result in less
asset amount and/or less net income. Accountants should not be biased. The basic
accounting principle of conservatism leads accountants to show losses, but it does
not allow them to show gains.

For example, losses from lawsuits will be shown in the financial statements or in
the notes, but potential gains won’t be shown. Also, an accountant may give the
amount of inventory less than the actual cost, but not vice versa.

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Limitations of Financial Statements

Financial statements give information about the financial position of the company. As
described in the previous pages, there are number of users to these financial statements.
Although the income statement and cash flow statement give a crux of the profitability and
the balance sheet gives the activities of the company in a specified period, there are some
imitations to the financial statements.

“Financial Statements Provide Good Quantitative Data but Do Not Address Any Qualitative
Variables”

Loss of Major Customers

The financial statement does not indicate the quality of the revenue achieved. It does not
specify reasons why the company is losing customers like;

1. Lack of Innovation
2. Poor Operation Strategies
a. As in the case of Wall-mart opening SAMs Club next to Wall-Mart stores
3. Risk factors
4. Lack of Technological Development

Change in Management

1. The entity’s human resource and knowledge are its most valuable intangible assets
which are ignored in the financial statements.
2. It does not reflect the quality and reputation of the management and employees.
3. The morale of the employees is not revealed.
4. They do not directly point out any change in management i.e. the leaving or entering
of any executive from the company.
5. Thus the future performance of the company in terms of management cannot be
judged by them.
a. SAMs change of management during the 1990s impacted its strategy
planning
b. SAM saw 4 different presidents come & go during 1994 to 1998
c. In 2001, president Thomas Grimm provided strong leadership to SAM

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Competitive Environment

1. Financial statements do not elaborate the latest industry trends which have an impact
on various strategies employed by the company
2. The do not reflect the changes in the taste of the consumer
3. It does not include the income forgone by the company because an opportunity to earn
income was not pursued.

Forged Company Image from P&L

1. The P&L incorporates the expenses accrued on R&D work.


2. This is not positively shown in the profits of the company.
3. By just looking at the P&L statement, the share holder cannot judge on what
technology the company has invested in and will the company be able to get the
projected sales in the next financial year.

Different Accounting Standards

1. One of the uses of financial statements is to compare it with the competitors


2. Comparability between firms using different accounting techniques is very difficult.
3. For e.g. If Costco accounted sales on accrual basis then its expenses will be inflated
and if SAMs used a different accounting technique wherein it did no used accrual
accounting, then it would not be fair to compare the inflated profits of SAMs with
Costco.
Also in the case study provided, by looking at the balance sheets of Costco, Sears,
wall-mart & BJs; it can just be judged that the Operating Margin of Costco was the
least compared to its competitors.
The reason behind why it could maintain these low operating expenses and give the
products at the least cost cannot be judged from the financial statements.

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Works Cited
About Financial Statements | eHow.com. (n.d.). Retrieved from eHow:
http://www.ehow.com/about_4564622_financial-statements.html

Accounting Principles | AccountingCoach.com. (n.d.). Retrieved from Accounting Coach:


http://www.accountingcoach.com/online-accounting-course/09Xpg01.html

Costco Wholesale Corporation Financial Statement Analysis (A), A-186A (June 19, 2003).

Financial Statement - Wikipedia. (n.d.). Retrieved from Wikipedia:


http://en.wikipedia.org/wiki/Financial_statement

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