READING FINANCIAL STATEMENTS

Suppose a firm presents the following balance sheet information for the year ended 31 December 20X5.

Balance Sheet of Burns Ltd. (in TEUR) 31 Dec 20X5 31 Dec 20X4
Non-current assets
Property, plant & equipment (PPE) 220 178
Intangibles 237 1,147
Other 0 3
Total 457 1,328
Current assets
Cash and cash equivalents 8,765 23,777
Financial assets 6,000 0
Trade receivables 0 3
Inventories 33 21
Other 675 612
Tax receivables 7 44
Total 15,480 24,457
Total assets 15,937 25,785
Non-current liabilities
Deferred income 10 9
Total 10 9
Current liabilities
Trade payables 554 483
Other 370 398
Financial liabilities 19 1
Total 943 882
Equity
Subscribed capital 15,420 15,412
Capital reserves 66,721 65,811
Accumulated losses -67,157 -56,329
Total 14,984 24,894
Total equity and liabilities 15,937 25,785

What we can see is that the firm provides not only data for the fiscal year 20X5 but also for a comparison period
(20X4). This makes it a bit easier for the analyst to see what changed in the fiscal year. Note that data for the
comparison period is not necessarily identical to the original data pronounced in 20X4. For instance, if there is
a significant change of accounting standards or methods which become applicable in 20X5, also the respective
numbers for the comparison period need to be adjusted “as if” the new methods would have applied already
in the year before. Still there are many changes which do not require the firm to adjust numbers in the
comparison period. An example is the change of estimates regarding depreciation: Changing assumptions
about the useful life (length of depreciation period), the consumption of resources (depreciation method) or
residual value (depreciable amount) are required at the end of each fiscal year to provide meaningful data and
any change is prospectively applied.

IFRS do not prescribe a specific format for a balance sheet or any other item of financial statements. However,
IAS 1 provides a list of positions that – if existent – need to be disclosed separately (see IAS 1.54). There is a
general distinction into current and non-current assets (see IAS 1.66) and liabilities (see IAS 1.69). For equity,
such a distinction does not make any since equity has no maturity. The idea behind a balance sheet is it depicts
a firm’s assets, that is, the firm’s investments into current and non-current assets. What is treated as a current
asset depends on the firm’s business, but a simple rule is to assume an asset is non-current when still in place
at the next fiscal year-end. The firm’s investments might be classified into categories such as operating or non-
operating assets (depending on whether they are used to generate operating or financial income) or working
capital accruals. Obviously, all assets held by a firm need to be financed. The “other side” of the balance sheet
thus shows the financing perspective. There are two sources of funds: First, they could come from debtholders.
Such funds are again classified into current liabilities when they need to be paid back within the operating

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cycle, usually the next 12 months. Second, they could also come from equity holders. An important accounting
equation says that the sum of all assets need to equal the sum of equity plus all liabilities.

The following is the statement of comprehensive income. Note that in the case at hand the firm does not
have any other comprehensive income (OCI, the full list of items recognized in OCI can be found in IAS 1.10),
hence, the statement is simply a statement of profit or loss. For the calculation of profit or loss – also referred
to as net income – there are two options: the cost of sales format (revenues – cost of goods sold = gross
margin; gross margin – administrative expenses – distribution expenses +/- other operating income = operating
income) (see IAS 1.103) and the nature of expense method (see IAS 1.102) which is used below. Again, there
is no comprehensive list of line items that need to be disclosed separately (see IAS 1.99).

Statement of Comprehensive Income 31 Dec 20X5 31 Dec 20X4

Burns Ltd. (in TEUR)
Revenues 227 60
Other operating income 10 271
Materials expenses -2,904 -1,763
Personnel expenses -4,364 -3,561
Depreciation -1,014 -311
Other operating expenses -2,813 -2,735
Income before interest and tax -10,858 -8,039
Interest and other financial expenses -1 -2
Interest and other financial income 31 55
Income before taxes -10,828 -7,986
Tax 0 0
Net Income -10,828 -7,986

We proceed with the statement of cash flows. Most companies – like in our case – use the indirect method
which adjusts net income for all effects on net income that did not go in hand with cash inflows or outflows.
For example, depreciation needs to be added back to net income because net income is reduced by depreciation
but depreciation is not a cash outflow. To calculate operating cash flows, we also need to adjust net income
for everything not related to operations such as the sale of PPE above book value. Here, PPE with a book value
of € 0 has been sold for € 1,000 as reflected in the profit recognized in net income that needs to be deducted
because it is not an operating activity. The receipts from sale of PPE are then recorded as an investing activity.
Note that the net cash flow (after currency translation) of -15,012 can also be obtained from the balance sheet
as the total change in cash and cash equivalents. The informational value of the cash flow statement thus is not
the calculation of the net cash flow but rather the explanation of the change in cash by operating, investing
and financing activities.

Cash flow statement Burns Ltd. (TEUR) 31 Dec 20X5 31 Dec 20X4
Net income -10,828 -7,986
Depreciation 1,014 311
Income from sale of PPE -1 -2
Other non-cash transactions 914 805
Change in inventories, receivables etc. -32 153
Change in operating liabilities and similar items 64 -227
Cash flow from operations -8,869 -6,946
Receipts from sale of PPE 1 2
Investment into PPE -121 -98
Investment into Intangibles -25 -19
Investment into financial assets -6,000 2,000
Cash flow from investing activities -6,145 1,885
Net receipts from issuance of equity 8 23,362
Cash flow from financing 8 23,362
Currency translation effects -6 0
Net cash flow -15,012 18,301

Finally, let us take a look at the statement of changes in equity. The period’s net income figure of -10,828
TEUR from the statement of comprehensive income (above) can be found in the column entitled “Accumulated
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Losses”. The firm at hand seems to have a long track record of losses, because accumulated losses equal to -
67,157 TEUR. The position would be called “Retained Earnings” instead of “Accumulated Losses” in case of
positive accumulated past net income figures. The column “Common Stock” informs about the firm’s nominal
capital. As of 31 Dec. 20X5, the firm has 15,419,512 shares outstanding which have a nominal value of € 1 per
share. Hence, the amount recognized as common stock is 15,420 TEUR (rounding). Capital reserves arise
when shares are issued above their nominal value (which has happened in the past). Accumulated capital
reserves equal to 66,721 TEUR end of 20X5. Note that our firm also grants equity-settled employee stock
options. Under such schemes, an employee receives a stock option at the grant date that can be exerted in the
vesting period if vesting conditions are met (and will, of course, only be exerted if the option is “in the money”,
i.e. allows to buy shares below their market price). Vesting conditions can be service conditions (e.g., a specified
number of years of service) or performance conditions (e.g., market price needs to exceed a certain threshold
value). IFRS 2 requires a firm to estimate the value of the stock option at the grant date (according to option
pricing models) and to allocate the total expense to the periods in which the employees render their services.
The journal entry for a period in which services have been rendered is “Dr Personnel Expense / Cr. Capital
Reserves”. Note that the firm simultaneously increases equity (capital reserves) and decreases equity (via
personnel expense). The purpose of the journal entry is mainly to show personnel expense in the statement of
profit or loss. Suppose stock options are granted to an employee who leaves the firm before during the vesting
period and will not fulfill the vesting conditions. In this case, the capital reserves need to be reduced. This is the
explanation there is a decrease in capital of -35 TEUR in 20X5.

Statement of Changes in
Equity Burns Ltd. Common Stock Capital Accumulated Total
(in TEUR, # shares nominal) # shares Amount Reserves Losses Equity
As of 31 Dec 20X3 12,459,275 12,459 44,595 -48,343 8,711
Increase in capital (in cash) 2,889,819 2,890 20,019 22,909
Exertion employee stock options 63,355 63 390 453
Granting employee stock options
(= expense) 807 807
Profit (+) or Loss (-) of the period -7,986 -7,986
As of 31 Dec 20X4 15,412,449 15,412 65,811 -56,329 24,894
Increase (+) or decrease (-) in capital -35 -35
Exertion of employee stock options 7,063 7 36 43
Granting employee stock options
(= expense) 909 909
Profit (+) or Loss (-) of the period -10,828 -10,828
Rounding 1 1
As of 31 Dec 20X5 15,419,512 15,420 66,721 -67,157 14,984

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Questions

1) The financial statements provided above are obtained from a real company. Reviewing the financial
statements provided above, which of the following seems plausible?
(a) Sector: Financial statements are somewhat sector-specific because sectors differ regarding the necessity
to invest into property, plant and equipment, intangibles or working capital accruals such as inventories.
( ) The company is from the energy sector running coal-fired power stations and selling energy.
( ) This is a company running a social network where people can post their pictures and thoughts.
( ) This is a biotech company in the field of immunotherapy.

(b) Age: According to Agrarwal & Gort (2002), on average, roughly 5-10 per cent of the firms in a given
market leave the market over the span of a single year. Their analysis suggests that hazard rates are
particularly high in the startup phase and also depend on the lifecycle of the firm’s products, where
market maturity and increased competitiveness might increase hazard rates for more mature firms.
( ) The firm likely is a startup that has been founded in 2013.
( ) The firm was founded in 1998.

2) An entity prepares financial statements on a going concern basis when, under the going concern
assumption, the entity is viewed as continuing in business for the foreseeable future (usually a period of 12
months from the entity’s reporting date). Going concern implies the entity has neither the intention, nor
the need, to liquidate or curtail materially the scale of its operations. If management conclude that the
entity has no alternative but to liquidate or curtail materially the scale of its operations, the going concern
basis cannot be used and the financial statements must be prepared on a different basis (such as the ‘break-
up’ basis). Also auditors have to address going concern risks.
(http://www.accaglobal.com/an/en/student/exam-support-resources/fundamentals-exams-study-
resources/f8/technical-articles/going-concern.html). Do you think the company has a going concern risk?
Why (not)?

3) Accruals
(a) One basic accounting equation suggests the following relationship: Incomet = Cash flowst ± Δ
Accrualst,t-1 . Does the equation hold for the financial statements provided above?

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(b) What is the definition of accruals – and why do accountants believe “accrual accounting” is more apt
to provide decision useful information compared to a cash basis of accounting?

(c) Identify working capital accruals and net working capital accruals in the financial statements provided
above and explain why it might be useful to have a particular focus on working capital when analyzing
financial statements. Also discuss whether cash should be included when calculating working capital.

(d) What is the logic behind classifying “deferred income” as a non-current liability?

(e) Why is there no distinction between current and non-current equity?

(f) A firm can also finance assets from funds that have been generated internally. Why isn`t this a category
shown at the financing-side of the balance sheet?