102 Footnotes to ﬁ nancial statements
Exhibit 15.1 at the start of the chapter shows the principal com-
ponents of the three ﬁ nancial statements of a business and shows
that footnotes are included with the three statements. Footnotes
are the fourth essential part of every ﬁ nancial report — the three
ﬁ nancial statements plus their footnotes. This chapter explains
the reasons for and problems with footnotes.
Before discussing footnotes, it ’ s a good idea at this point to
review the three ﬁ nancial statements of a business that I explain
in previous chapters.
1. Balance Sheet: Also called the statement of ﬁ nancial con-
dition, the balance sheet is a summary of the company ’ s
assets, liabilities, and owners ’ (stockholders ’ ) equity at
the close of business on the last day of the income state-
ment period. To understand a balance sheet, you need to
understand the differences between the basic types of
assets (inventory versus property, plant, and equipment,
for instance), and the differences between operating liabili-
ties (mainly accounts payable and accrued expenses pay-
able) versus debt on which the business pays interest. Also,
you should know the difference between the two different
sources of owners ’ equity — capital invested by the owners
in the business versus proﬁ t earned but not distributed to
owners, which is called retained earnings .
2. Income Statement: This is the summary of a company ’ s
sales revenue and expenses for the period (the proﬁ t - making
activities of the business) and, of course, it reports the
company ’ s bottom - line proﬁ t or net income for the period.
A publicly owned business corporation must report earn-
ings per share (EPS) with its income statement. A nonpub-
lic company doesn ’ t have to report earnings per share.
3. Statement of Cash Flows: Making a proﬁ t has cash ﬂ ow
effects, that ’ s for sure! But the amount of cash ﬂ ow from
making proﬁ t during the year does not equal net income
for the year. This ﬁ nancial statement divides cash ﬂ ows
into three groups. The ﬁ rst section provides a trail from
net income to cash ﬂ ow from operating (proﬁ t - making)
activities . The second section summarizes the cash ﬂ ow
of the company ’ s investing activities during the year. The
third section summarizes the cash ﬂ ow from the company ’ s
ﬁ nancing activities during the year. The cash ﬂ ows state-
ment exposes the ﬁ nancial strategy of the business. You
have to interpret this statement very carefully to get a good
sense of its ﬁ nancial strategy.
In short, the three ﬁ nancial statements report on the three
ﬁ nancial imperatives facing every business — to make a proﬁ t, to
remain in healthy ﬁ nancial condition, and to make good use of
cash ﬂ ow.
Although authoritative ﬁ nancial reporting standards in the
United States, called generally accepted accounting principles (GAAP)
do not strictly require it, most businesses — large and small,
Financial Statements — Brief Review
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