What are Audited Financial Statements?

Do you dread financial statements? Do they seem so dry and serious? Do you find it very difficult to make sense of the rows of numbers and accounting terms that fill the pages? You are not alone. Accountants, bankers and those with a particular flair or familiarity with financial statements may have no such problems, but for the rest of us, a financial statement may be the last thing that we would want to entertain ourselves with.

But then not all of us are lucky enough to avoid financial statements completely. They suddenly spring up. It could be because you have to compile your own personal financial statements, or maybe because you want to analyze your favorite company’s statements to decide whether to stay invested. There can be many other similar situations.

Therefore much as we may be not like it, a basic overview of financial statements could do a world of good. Fortunately it is not all that difficult. Without getting into the complicated and confusing details, we can get a hang of what it is all about and then go about building on that knowledge.

If you start searching for a definition, you will come across many different definitions. But basically we are talking here about reports that tell us about the financial status and results of an individual or organization.

There are of course certain conventions and accounting principles that govern the manner in which these reports are prepared. In the United States, financial statements have to be prepared according to generally accepted accounting principles (GAAP) as laid out by the Financial Accounting Standards Board (FASB). Other countries will have their own similar rules and conventions and mandating and regulatory authorities.

Since we have different kinds of firms and companies which prepare their financial statements it becomes a little complicated. Therefore to simplify matters we will confine ourselves to an understanding of financial statements prepared by public companies.

Since financial statements have to follow certain accounting standards / conventions and rules and have to provide a faithful report of the transactions and financial position of the company, these statements are often verified independently by an audit firm. After the audit is completed and the auditors satisfy themselves and sign off, we refer to the statements as audited financial statements.

A set of financial statements will generally include:

1. Balance sheet

2. Income statement

3. Cash Flow statement

4. Supplementary notes

Generally annual financial statements are audited whereas quarterly statements may be unaudited.

Balance Sheet

The balance sheet gives us a snapshot of the financial condition on a particular date. What are the assets that are owned? What are the amounts owed by the firm? What is the extent of owner’s funds invested in the business?

Just as a photograph tells us how we looked at the point in time when the photograph was taken, so also the balance sheet only tells us the financial condition on a particular day. And just as a photograph can be manipulated, so also balance sheets can be dressed up or misrepresent facts. Therefore they need to be audited so that we can be sure that they faithfully represent the factual position of the state of affairs.

There is a lot that can be gleaned from a balance sheet but to begin with we can take a look at the different types of assets and liabilities and ask some common sense questions. Why are the liabilities increasing disproportionately while the owner’s funds remain constant? Why has this company suddenly invested so heavily in fixed assets? Is it required for their operations? And so on.

Income statement

Sometimes called profit and loss statement, the income statement shows the income earned and expenses incurred by a business during a particular period (usually year or quarter). It would tell us whether the business activities resulted in a profit (if the income exceeds the expenses) or loss (expenses exceed the income). Unlike the balance sheet, which is a snapshot at a point in time, the income statement provides us a summary of income and expenses for a given period of time.

The income statement will help us understand the various income sources and types of expenses incurred by the business. By comparing with past periods we can determine the trend and then look for explanations for the trend. We can also study the breakup of income and expenses and get a good insight into the way the business is run and how it compares with other firms in the industry.

Cash flow statement

The cash flow statement shows whether the firm will be in a position to pay its bills. It shows the cash inflows and outgoes and the increase or decrease in cash balance. We can also analyze whether the cash inflows are on account of the operations or arising from its investing or financing activities.

Supplementary notes

The footnotes or supplementary notes provide a lot of information regarding the significant accounting policies and other matters having a bearing on the other financial statements. Quite often these notes will completely change your understanding of the business and therefore it is a good practice to go through all the notes.

Once we have a basic understanding it is a good practice to go through quarterly or annual results whenever the opportunity presents itself. Over a period of time, you will find yourself developing a degree of comfort and a fairly good understanding.