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How to Read a Financial Report: Wringing Vital Signs Out of the Numbers by John A. Tracy

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15
FOOTNOTES TO
FINANCIAL STATEMENTS
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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
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
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
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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Footnotes to fi nancial statements 103
public and private present two - year or three - year fi nancial
statements. This multiyear presentation allows fi nancial state-
ment readers to make comparisons between the year just ended
and the preceding year, and the year before that. The federal
agency that regulates fi nancial reporting by public corporations,
the Securities and Exchange Commission (SEC), requires three -
year comparative fi nancial statements.
According to various estimates, there are about 10,000
public companies in the United States. The fi nancial reports
of public companies are required to be audited by an indepen-
dent certifi ed public accountant (CPA) fi rm. The largest four
international CPA fi rms (called the Big Four) audit the large
majority of public companies. There are millions of private busi-
nesses in the United States. Private companies may or may not
decide to have their fi nancial reports audited by an independent
CPA fi rm. Generally, they are not legally required to have audits.
I discuss fi nancial report audits in Chapter 21 .
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