FINANCIAL MANAGEMENT

Business A first step in understanding financial reporting mechanics is to understand how

business activities are classified for financial reporting purposes. Business activities
Activities are classified into three main activities for financial reporting purposes: operating,
financing, and investing.

Operating activities (also called core business activities) include inflows and
outflows or revenue and expenses associated with the core and on-going business
activities of the business. Operating activities generally include the sales,
marketing, production and distribution of products and/or services. For example, if
a firm’s core business activity is to manufacture granola bars, then the operating
activities are those associated producing and selling the granola bars and could
include items such as sales of granola bars, paying employee wages, paying rent for
the manufacturing plant or purchasing supplies to make the granola bars. In
contrast, the buying and selling of the manufacturing equipment used to produce
the granola bars are not considered an operating activity but instead considered an
investment activity because the firm’s core business activity is the production and
sale of granola bars and not equipment sales.

Financing activities involve the transactions that increase and decrease liabilities
and/or owner’s equity. These activities include borrowing money, issuing shares,
obtaining lines of credit, repaying loans or bonds, owner contributions, withdrawals
by owners, dividends payments, and retained earnings. Specific examples include
obtaining a new loan, principal payment on a loan, issue of dividends to
shareholders, sale of company shares or cash contribution to firm by owners.

Investing activities include transactions that increase and decrease long-term

capital assets such as land, building or equipment and investment of the firm’s profit
or extra cash in financial markets. Examples include purchase of land, sale of
manufacturing equipment or purchase of shares of another business as an
investment.

Transactions resulting from these business activities are reflected in the

firm’s financial records within the broad groupings of five elements including:
assets, liabilities, owner equity, revenue, and expenses. The financial
statements are constructed using these elements and a firm’s liquidity,
profitability, efficiency and solvency is assessed using these statements.
 Financial Statements  
Net Income Statement  Cash Flow 
Balance Sheet Net Worth 

Elements of Financial Reporting

Assets Liabilities Owner Equity
Net Worth Revenue Expenses

Operating Financing Investing

Business Activities

Elements of Assets: Assets are resources that are owned and controlled by a business,
government or individual for producing future economic benefits. Specifically, the
Financial economic benefit is obtained via the use of the assets t produce products and/or
Reporting services that will be sold to provide revenue to the firm. Assets can be classified as
either current or long-term assets based upon how long they will be owned and
used by the firm. Assets such as input supplies, finished goods inventory and cash
are classified as current assets as they will generally be used up by the firm within a
year. Assets such as equipment, buildings and land are classified as long-term assets
as they are owned and will be used for more than a year to produce products and/or
services. Assets are valued at one point in time using either the fair market or book
valuation method as dictated by legal and accounting rules. These rules and the
valuation methods will be discussed in the net worth and balance sheet factsheets.

Liabilities: Liabilities are future financial obligations. Liabilities are used to finance
asset purchases and are generally obtained from creditors including banks, suppliers
or credit unions but can also be provided via individual. The firm obtains the money
from creditors and promises to pay the original amount back plus interest and thus
this obligation represents a creditors’ claims against assets. Liabilities are often
referred to by a range of names such as debt, loans or credit. Like assets, liabilities
can be classified as current and long term. Current liabilities are debts that must be
within one year. Examples of current liabilities include overdraft, line of credit,
wages payable, principal payments due within a year, interest payable or amounts
owing to suppliers or employees. Long term liabilities are amounts that must be
paid over a term greater than one year. Examples of long term liabilities include 10-
year mortgage or equipment loans. Liabilities are valued at one point in time as the
amount owing to the creditor.

Owner Equity: Owner Equity represents the owner's investment in the business
minus the owner's withdrawals from the business plus the net income (or minus the
net loss) since the business began. Mathematically, the amount of owner's equity is
the amount of assets (valued at book value (net)) minus the amount of liabilities at
one point in time. Depending upon the legal structure of the firm, owners' equity
may represent net assets owned by the sole proprietorship, partnership or
corporation’s stockholders and thus the name is changes from owner equity to
partner equity for partnership and shareholder equity for corporations. The owner's
equity does not represent current or today’s value of the business because assets are
valued at book value and not fair market value.

Net Worth: Net Worth is calculated at one point in time as the total assets valued
at fair market value less total liabilities. The net worth represents how much the
business is worth if it was sold today and all liabilities paid because the asset
valuation is based upon today’s value.

Revenue: Revenues are the money received during a specific period of time from
core business activities such as the sale of products produced or service provided.
Revenue is calculated as the price (P) at which the products or services sold
multiplied by the quantity (Q) of units sold. It is important to be clear that revenue
is the money earned from the business activities and not the investment activities of
a firm. Thus, if a firm is manufacturing granola bars then the firm’s revenue is from
the sale of the granola bars. If the firm decides to sell their old manufacturing
equipment, the selling of the equipment is not considered a revenue because the
firm’s core business activity is producing and selling granola bars and not selling
manufacturing equipment. The recognition of revenue during a time period follows
specific accounting rules. These rules will be discussed later in the net income
section.

Expenses: Expenses are costs incurred during a specific period of time in an effort
to produce products or services and earn revenue associated with a firm’s core
business activities. Examples include payment of employee wages, rental payment,
depreciation expense, interest paid on loans and supplies used to produce a good.
The recognition of expenses during a time period follows specific accounting rules.
The rules will be discussed later in the net income section. Again, be clear that
expenses are costs incurred with operating activities. Thus, if a firm is
manufacturing granola bars then the firm’s expenses are associated with the
production of the granola bars. If the firm decides to buy new manufacturing
equipment, the purchase of the equipment is not considered an expense because the
firm’s core business activity is producing and selling granola bars and not selling
manufacturing equipment.
Net Income: Net income is calculated during a period of time as the firm’s revenue
less expense. If the net income value is positive, the firm has earned a profit and a
benefit has been gained through the core business activity. If instead, the net
income is negative then the business has suffered a loss. Profit can be withdrawn by
the business owners or retained by the firm and used to decrease liabilities (e.g.,
make loan payments) or increase assets (e.g., purchase new assets or put money into
cash accounts). This decision to withdraw profit or retain profit in the firm is made
by the business owners.

Solvency: Solvency refers to the firm’s ability to meet all their financial obligations.
A firm is considered solvent at one point in time if their net worth (e.g., total assets
valued at fair market value less total liabilities) is positive. Firms are insolvent or
bankrupt if the net worth value is negative. Net worth is just one of the methods
that can be used to assess solvency but all methods assess the same concept –
whether total assets are equal or greater than total liabilities. Additional methods to
measure this concept will be discussed in the financial analysis section.

Liquidity: Liquidity refers to the firm’s ability to meet their current financial
obligations as they come due. A firm is considered liquid at one point in time if their
current assets less current liabilities is a positive value. Additional methods to
measure this concept will be discussed in the financial analysis section.

Profitability: Profitability is a fundamental goal of a business as profit supports

growth of the firm (and an increase of the owners’ equity) via reinvestment of the
profit into the business and/or provides funds to the owners if they choose to
withdraw the profit for their own personal use. A firm is considered profitability
when their revenue less expenses during a specific period of time is positive and
non-profitable when the value is negative. Additional methods to measure this
concept will be discussed in the financial analysis section.

Efficiency: Efficiency is a measure of a firm’s performance in managing their

resources to make profit. Efficiency refers to the firm’s ability to manage inventory
while minimizing storage costs, pay creditor accounts in a timely manner, collect
money owed and utilize resources and labour to maximize production. Methods to
measure this concept will be discussed in the financial analysis section.

Financial Progression: Financial progress is an important goal for business

owners and is defined as an increase of owners’ equity through the profits of the
business. This increase in owner equity occurs when the business profit is retained
by the firm and used to decrease liabilities or increase assets. As noted earlier, this
decision to withdraw profit or retain profit and allow financial progress in the firm
is made is made by the business owners.
 There are four main financial statements that are used in the financial management
Four Main of a business. Each statement provides a different and yet coordinated perspective of
Financial the business’s financial status. The four statements are developed using the financial
Statements elements and thus therefore it is important to be able to categorize business
transactions as either operating, financial or investment activities as this provides
the basis for the financial statement development.

1. Net Worth Statement: This statement provides a snapshot of the firm’s assets
and liabilities at one point in time. Assets and liabilities are valued at fair
market value. This statement measures solvency.

2. Balance Sheet Statement: This statement provides a snapshot of the firm’s

assets and liabilities at one point in time. Assets and liabilities are valued at
book value (net). This statement measures financial progress.

3. Net Income Statement This statement presents the revenues, expenses and net
income associated with the operating activities (e.g., core business activities) of
the business during a period of time. This statement measures profitability.

4. Cash Flow Statement This statement details the timing and amount of cash
inflow and outflow of the business associated with the operating, financial and
investment activities during a period of time. This statement measures
liquidity.

GAAP are a common set of accounting principles, standards and procedures that
Generally companies use to compile their financial statements. These principles are a
Accepted combination of authoritative standards (set by national and international policy
boards) that provide the commonly accepted ways of recording and reporting
Accounting accounting information. The idea behind the principles are to provide objective
Principles standards for development and comparing financial data and its presentation, and
(GAAP) limit the manager’s ability in showing an unrealistic picture of the business.

1. Economic This assumption relates to the business structure of the

Entity business. Corporations, sole proprietors and partners have
Assumption different legal ability to own assets and pay taxes. This
principle requires business transactions of a sole
proprietorship to be kept separate from the business
owner's personal transactions.
2. Monetary Economic activity is measured in dollars. Because of this
Unit assumption the dollar's purchasing power is assumed to
Assumption remain unchanged over time. As a result, financial
statements do not consider the effect of inflation on
recorded amounts.
3. Time This assumption requires that the time period must be
Period specific, consistent and presented clearly. For example: Do
Assumption not use 2011 but instead use the 4 months ending Dec 31,
2011
4. Cost This principle requires that values on the financial
Principle statement are provided at historical cost amounts (e.g.,
amount spent in cash or the cash equivalent when an item
was originally purchased even if that was thirty years
ago).
5. Full This principles states that information relevant and
Disclosure important to an investor or lender is required to be
Principle disclosed within the statement or in the notes to the
statement. Example: lawsuit, patent pending or exit of
CEO.
6. Going This principle requires statements be created for
Concern companies that will operate long enough to carry out its
Principle objectives and commitments.

7. Matching This principle requires that expenses are matched to

Principle revenues regardless when those expenses are paid. Thus,
(one of the this principle requires businesses to use an accrual method
most of accounting.
important)
Example: A firm purchases $10,000 of supplies on credit and
uses those supplies to produce and sell $20,000 of goods for cash.
At year end the supply bill has not yet been paid. However,
because of this matching principle the records will show revenue
of $20,000 and expenses at $10,000 because those supplies were
used to make the goods and needs to be accounted for in order to
avoid expenses and net income distortion.

Be clear that adjustment entries are sometimes required

on financial statements due to this principle.
8. Revenue Revenues are recognized when the product is sold or a
Recognition service has been performed, regardless of when the cash is
Principle (one received. In other words, the revenue needs to be
of the most recognized when a sale is made to a customer. In addition,
important) revenues can also be recognized when sales are realizable
under condition that there is a ready market for these
products with reasonably assured prices.

Thus, this principle requires that a value for all goods

produced during the year be included in revenue
regardless if the products were sold for cash (cash sales),
sold for account receivable (account receivable) or waiting
to sell (inventory). For example, if a product is made this
year and sold using account receivable, then that amount
needs to be recognized in the current year revenue even
though that money will not be received by the firm during
the year. This principle is used in the development of the
accrued net income statement and distinguishes between a
cash vs accrued net income. See factsheet Net Income
Statement – Cash and Accrued for details.
 Example: A business produces $15,000 in products and sells
$10,000 for cash and $5,000 on credit to be paid in 3 months.
Revenue for the year will be $15,000.

Be clear that adjustment entries are sometimes required

on financial statements due to this GAAP requirement.

9. Materiality This assumption allows the firm to violate another

accounting principle if an amount is insignificant.
10. This principle directs the accountant to choose the
Conservatism alternative that will result in less net income and/or less
asset amount. Conservatism helps the accountant to
"break a tie" not be conservative.
Source: Accounting Coach GAAP review:
http://www.accountingcoach.com/accounting-principles/explanation

Managers, owners, stakeholders, suppliers, creditors, employees, government and

Objective of the public are interested in reviewing the solvency, financial progress, profitability
the Financial and liquidity of the business. Four financial statements are used to assess the firm
Statements on each of these aspects.

Questions for  What is the big picture of the financial statements? Consider the
statements, GAAP, activities and objectives.
Review  What is the purpose of each financial statement?
 What are the similarities and differences between the statements?
 Why is it important to distinguish between the three financial management
activities?
 What could occur if GAAP was not in place in the financial sector?
 Identify the difference between the three types of business activities
  How can the activities be used to guide categorization of items into various
statement types?
 What perspective does the term investment involve? Investment in what
and by whom? Owner? Firm? Investor?
 What items are included in each statement and why?
 What is the time frame of each of the statements? Who defines these?
 Could the four statements show contrasting versions of the business? For
example, profitable but not solvent? Financial progress but not profitable?
 What is the difference and similarity between an asset, liability, revenue and
expense?
 Can a revenue turn into an asset? Can an expense turn into a liability? Vice
Versa?
 What aspect of the business is each of the following interested? managers,
owners, stakeholders, suppliers, creditors, employees, government and the
public? Profitability? Liquidity? Solvency? Financial Progress? What
statements?
 What is the difference between the following? Profit and Net Worth? Net
Worth and Owner Equity?
 What are the examples of investing activities? Operation? Financing?
 What is the role and need for GAAP?
 Are there GAAP items that seem more important or difficult to
understand?
 Is revenue recognition and matching principle a realistic set of principles to
follow when setting up financial statements? Why or Why not?

Web  Investopedia
 http://www.investopedia.com/dictionary
Resources  Accounting Coach
 https://www.accountingcoach.com/terms
 Provides an online glossary of the basic terms of accounting.
 Pearson Financial Accounting terminology
 http://wps.pearsoned.co.uk/wps/media/objects/3507/3591169/gl
ossary/glossary_fa.html

Updated September 2017