CHAPTER 3

UNDERSTANDING
FINANCIAL STATEMENTS
 Identify the users of financial statements
 Describe the International Finanacial
Reporting Standards (IFRS)
 Explain how the types of accounts may be
classified
 Record changes in the financial position
 Summarize financial information in the
financial statements
 Financial statements must provide a fair
presentation of a firm’s financial
performance and financial position.

 Financial statements answer these questions:

 What is the company’s current financial status?
 What was the company’s operating results for
the period?
 How did the company obtain and use cash during
the period?
 Performance statement – measures the
financial performance of a firm during a
certain period i.e. profits or losses
 Position statement – indicates the
financial position of the firm at a
specific point in time (e.g. 28 February
2015)
- what the assets of the firm are worth (b.v)
- how the firm was financed (equity or debt)
- equity is the capital provided by the owner
- debt refers to liabilities that needs to
be paid back at a certain date (loans
etc)
 Statement of retained earning – indicates
the increase or decrease in the firm’s
retained earnings.
 Cash flow statement – indicates which cash
flows were generated from operating
activities, from financing and from
investment activities.
 Financial statements normally contain
comparative income statement figures for
the past three years and the balance sheet
of the previous year.
 Shareholders – to assess the worth to them of
their firm.
 Management – to help them plan and control the
activities of the firm to accomplish the set
objectives.
 Lenders or creditors – to assess the likelihood
that the firm will repay their funds or whether it
will default.
 Investment analyst – who investigate the firm for
investment purposes.
 Labour unions – as a basis for wage negotiations
 The government – to assess the paid tax
 Credit bureaus – to issue credit ratings
 The International Financial Reporting
Standards (IFRS) are determined by
accounting profession and is aimed
at:
- ensuring standardization
- uniformity
- and quality in financial reporting
 All financial statements have to be
drawn up in accordance with IFRS
accounting concept explained:
 The process of recording of business
transactions is called accounting.

Three main categories of IFRS are:

 Assets: An asset is an item of value owned
by a company.
 Liabilities: are obligations of the
company, to transfer something of value
to another party.
 Equity: Equity is the owner's value in
an asset or group of assets.
The IFRS principles:
The IFRS principles are divided into two
categories:

1. Accounting Concepts: Accounting Concepts

are basic assumptions or conditions upon
which science of accounting is based.

2. Accounting Conventions: Accounting

Conventions include those customs and
traditions which are followed up by an
accountant while preparing a financial
statement.
Accounting Concept Includes:

Separate Entity Concept

 It is helpful in keeping the business affairs

strictly free from the effect of the private affairs
of the proprietor(s).

 Amount invested by the proprietor is shown as “

Liability”.

 Amount paid for the personal expenses of the

proprietor are shown as drawings from the
capital of the proprietor.
 Money Measurement Concept

 Only the transactions which can be

recorded in terms of money are recorded.

 This is being used so as to provide a common

yardstick (i.e. money) for measurement.
 Double-entry system

 Every business transaction has a dual affect i.e.

it affects two accounts.
 For every credit entry there must be a debit
entry

 This is based on accounting equation:

Liabilities = Assets.

 Owner’s equity + Outsider’s equity = Assets.

 This equation can be explained as “for

every debit there is an equivalent credit”.
 Matching Concept

 It is the basis for recording expenses and

includes two steps:

 Identify all the expenses incurred during the

accounting period.

 Measure the expenses and the match the

expenses against the revenues (income) earned.

Income – Costs = Net income or Profit.

 Going Concern Concept

 Business would continue to operate

indefinitely in the future.
 Business will not cease doing business,
neither; it will sell its assets to pay off
its liabilities.
 Historic Cost Concept

 Assets and liabilities should be recorded at

the historical cost i.e. costs as on
acquisition.
 Assets are initially brought into account in
the accounting process at the cost that
the entity incurred in acquiring those
assets.
 Accounting Period Concept

 Accounting period is the span of time, at the

end of which financial statements are
prepared to throw light on the results of the
operations at the end of a relevant period
and the financial position at the end of a
relevant period.
 Realization Concept

 The Revenue principle governs two things:

1. When to record revenue
2. Amount of revenue to record

 To be recognized, revenue must be:

Earned: Goods are delivered or a service is
performed.
Realized: Cash or claim to cast (credit) is
received in exchange for goods and services
rendered.
 Full Disclosure

 Financial statements should be honestly

prepared and sufficiently, disclose
information which is of material interest to
proprietors, present and potential creditors
and investors.

Materiality

 Only material or significant details are to be

recorded leaving the insignificant or minute
details. This is done to prevent overburdening of
accounts.
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 AAsssseettss aaccccoouunnttss
 Liabilities

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 Expense accounts
 Assets = Liabilities + Owners' Equity

Resources
I Sources of Funding
I
Q
Resources Creditors' Owners'
used to
generate
- claims
against + claims
against
revenues
resources resources
 Occurrence of a business transaction

Preparation of a business document

Information recorded

Debits and credits posted to ledger account

Financial statements prepared at the end of accounting

period
Type of Account Rule
Assets Increases are recorded by debits
Decreases are recorded by credits
Liabilities Increases are recorded by credits
Decreases are recorded by debits
Owner’s equity Increases are recorded by credits
Decreases are recorded by debits
Revenue (Income) Since revenue increases the owners’ equity, it is
recorded by credits
Expenses (cost) Since an expenses decreases owners’ equity, it is
recorded by a debit.
I NCOME STATEMENT FOR THE YEAR ENDED 28 February 2020
 ·

Position Statement as at 28 February 2011

Fix.ed Shareholders' inte1r,est

assets

Land and buildings 8 490 200 Ordinary shares 12 000 000

Plant and 7.252 200 Preference shares 1000000
equi1p,ment
1 ,238 Retained earnings 7 870 500
V,ehicles Long-term liabilities
000
Cunent assets
Montage Ioan 2 400 000
Cash , Current liabilities
1
690 080
Accounts receivable 4 000 Accounts payable·
020
Inventoryy 24 070 500
1 600 000
1

24 070 500
2

 The cash flow statement shows the sources (cash

inflows) and the uses (cash outflows) of all the
financial resources of the firm
 The 3 objectives of the CFS are to provide
information about the cash utilized or
generated by:
- operating activities
- investing activities
- financing activities
 NB: Balance Sheet – shows financial position of a
firm at a particular date
 Income statement – explain the details of the
balance sheet
 CFS – focus on the cash receipts and payments

P
The auditor’s report states
that statements fairly
represent:
 The financial position of the firm at
the financial year-end date
 The results of the firms’ operations
for the year under review
 The cash flow information
The director’s report deals with all matters
that are relevant to understanding the nature
of firms activities;
 Additional financing raised
 Any major changes in the nature of the
firm’s fixed assets
 Dividends paid or declared.
 Generally accepted Accounting Practice (GAAP)
 Assets
 Liabilities
 Owner’s equity
 Revenue
 Expense accounts
 Income statement
 Balance sheet
 Cash flow statement
 Auditor’s report
 Directors report