Session 1: Preparation of Income Statement, Balance Sheet and Cash Flow Statements

This session provides details on how to prepare financial statements. Most commonly used financial statements are income statement, balance sheet and cash flow statements.

Session Learning Outcome
Learners will be able to understand and appreciate the process in the preparation of the Income Statement or the Trading and Profit and Loss Account, Balance sheet and Cash Flow statements and their importance.

Important Learning Terms

• Financial Statements
• Income statement
• Balance sheet statement
• Cash flow statement
• Revenue/sales determination
• Cost of goods sold
• Manufacturing overheads
• Sources of funds
• Uses of funds

Basic Definitions

Financial statement
A report of basic accounting data that helps investors understand a firm's financial history and activities.
Income statement (statement of operations)
A statement showing the revenues, expenses, and income (the difference between revenues and expenses) of a corporation over some period of time.
Balance sheet
Also called the statement of financial condition, it is a summary of a company's assets, liabilities, and owners' equity.
The document distributed at the annual meeting to shareholders of record who wish to vote their shares in person.
Cash flow statement
Statement showing earnings before depreciation, amortization, and non-cash charges. Sometimes called cash earnings. Cash flow from operations indicates the ability to pay dividends.

Preparation of Income Statement
The Income Statement normally shows whether the business is earning profits or sustaining losses. It communicates the financial performance of the business. The structure of the income statement differs with the nature of the business. The business can either be a manufacturing, merchandising/trading or service entity. Regardless of the structure, they however, communicate the same information.
Factors to be considered in the preparation of income statements are:

Revenues/Sales
This item carries the revenues/sales generations of the company. Sales consist of Cash Sales (cash is paid at the time of sale) or Credit Sales (Cash paid later). The sales/revenue is made up with the following items:

Note: Other Incomes/Revenues results from the revenues which are not core business of the company. Such revenues are for example, if a company earns interest from banking services, dividends received from investment of other companies or subsidiaries, money awards, etc.
For a trading and service entity the same consideration is made for the revenues/income as sown above. The only difference for the service company is the return inwards since in most cases services are consumed when manufactured/prepared with nothing to be left as a return.

Cost of Goods Sold
This represents the total cost of buying raw materials, and paying for all the factors that go into producing finished goods. The cost of goods should be deducted from the sales revenues.

Note: For manufacturing firm, the process of manufacturing goods is a continuous process. Hence there might be materials which are in stock or some of the goods may be half processed (work in progress) both at the opening of the financial year or at the closure of the financial year. Hence, calculation of the cost of goods sold should include consideration of all the items shown in the table above.

Trading Firms

Service Firms
In service companies such as telecommunications, cost of service provided may be expressed as percentage of sales say 60% of the revenues generated regarded as cost of services to pay for bandwidth access in a satellite company.

Gross Profit
This is the difference between Net Sales and the Cost of Goods Sold. Gross profit is the profit obtained from the normal operation of a business firm before incurring operating expenses, tax and other deductions.

Expenses
These are the expenses the company incurs in the process of generating revenues. The expenses depend on the nature of the business firm.

Profit Before Interest and Tax: This is equal to the Cost of goods sold less expenses

Note: Dividend is a portion of a company's profit paid to common and preferred shareholders. It is paid to common stock holders only when the company makes profit.

In arriving at the income statement as shown above, there should be supporting documents which when totalled brings the figures for the above items.

Preparation of the Balance Sheet Statement
The Balance Sheet shows the value of assets owned by the business, the amount of its debts and the equity of the owner. In other words, it communicates the financial position of the business.

Discussion 3
Post your response in the discussions area. (See the procedure for discussions in Course Info.)

1. Review financial statements of communication of the regulatory body of your country.
   a) Identify the common items in the financial statements.
   b) Relate the financial statements to three other regulatory bodies in the SADC region.
2. Review financial statements of at least two telecommunication companies in your country. Where possible, one company should be a producer of ICT products and the other should be a service firm.
   a) Identify the common items in the financial statements.
   b) Relate the financial statements of these firms to each other.

Preparation of Cash flow Statement
This statement shows the changes that have taken place in actual cash and the working capital of the firm as well as the sources and use of the working capital during the accounting period.
It is a summary of a firm’s changes in financial position from one period to another; it is also called the sources and uses of funds statement or a statement of changes in financial position. The flow of cash/funds in a firm may be visualized as a continuous process. For every use of cash/funds, there must be an offsetting source. In a broad sense, the assets of a firm represent the net uses of cash/funds; its liabilities and net worth represent net sources.

The fund flow statement is useful to know whether the uses of the funds can be met by the available sources funds or there is a need for external financing sources such as bank overdrafts, etc.

Sources and Uses of Funds Statement

Tracing Cash and Net Working Capital

Sources of Funds
Consist of all events that increase cash:

• A net decrease in any asset other than cash or fixed assets
• A gross decrease in fixed assets
• A net increase in any liability
• Proceeds from the sale of preferred or common stock
• Funds provided by operations
  Note: Funds provided by operations usually are not expressed directly on the income statement. To determine them, one must add back depreciation and any other non-cash item that was deducted and also deduct any non-cash item that was added to the net income.

Uses of Funds
Consist of all events that decrease cash and include:

• A net increase in any asset other than cash or fixed assets
• A gross increase in fixed assets
• A net decrease in any liability
• A retirement or purchase of stock
• Cash dividends

Statement of Cash Flows
It emphasizes the critical nature of cash flow to the operation of the firm. The primary sections of the statement of cash flows are:

• Cash flows from operating activities
• Cash flows from investing activities
• Cash flow from financing activities

The results from each section are added together to compute the net increase or decrease in cash flow for the firm. The format of the cash flows statement is given below:

Preparation of Other Financial Related Statements

(ii) Explanatory Notes
The explanatory notes communicate additional information regarding items included and excluded from the body of the statement. These normally include:

• Accounting policies
• Detailed disclosure regarding individual elements
• Commitments and contingencies
• Business combinations
• Transactions with related parties
• Legal proceedings etc.

These are prepared to justify each accounting figure in the prepared financial statements.