Introduction to external financial reporting

Prerequisite knowledge

Candidates are assumed to have prior knowledge in five areas: preparation of financial statements, business economics, time value of money, statistics, and probability. These topics are not covered here in detail.

There will also be references to the FASB Accounting Standards Codification (ASC) and the FASB Conceptual Framework for Financial Reporting chapters throughout the review material. References to the FASB ASC and Conceptual Framework are for further reading only; you do not need to memorize them.

Users of the financial statements

The users of the financial statements can be generally divided into:

1. the primary users
2. other users

The primary users of general purpose financial reporting

The objective of general purpose financial reporting is to provide information about the reporting entity to the following users in making decisions about providing resources to the entity:

• Existing and potential investors
• Existing and potential lenders and other creditors

The users above are considered as the primary users of the financial information.

Below is a summary of the primary need of each user:

Primary user	Primary need
Existing and potential investors	Expected returns from equity/debt instruments (dividends, interest, fair value changes), informed by the entity’s projected net cash inflows
Existing and potential lenders and other creditors	Expected principal and interest payments, informed by the timing and uncertainty of the entity’s future net cash inflows

In order to assess the future net cash inflows of the reporting entity, the primary users need information about the following:

• Resources of the entity (i.e., assets)
• Claims against the entity (i.e., liabilities)
• How efficiently and effectively the entity’s management and governing board have discharged their responsibilities to use the entity’s resources (i.e., other financial information such as the income statement, cash flows, and relevant notes)

Despite the identified uses, the general purpose financial reports have the following limitations:

• The reports cannot provide all information that existing primary users need. Normally, these users need to consider other pertinent information such as the general economic conditions and expectations, the political climate and events surrounding the reporting entity and also outlooks on the industry as a whole.
• The reports are not designed to provide the value of the reporting entity but they may be used to help the users compute an estimate of the reporting entity’s value.

Other users of general purpose financial reporting

Other than the primary users identified above, the general purpose financial reports also are useful to the following set of other users:

• The management of a reporting entity - since this group of users are internal to the reporting entity, internal information is also available to the management that is not normally available to investors and creditors.
• Other parties - such as regulators and members of the public other than investors, lenders, and other creditors, financial analysts and rating agencies. Although the general purpose reports are not prepared with these users in mind, these other users may also find the reports useful for various specific purposes.

Types of financial statements

The following is an overview of the core set of financial statements:

Definitions

Balance sheet

Shows a snapshot of an entity’s assets, liabilities, and equity as at a specific date. Also known as the statement of financial position (the IFRS caption; “balance sheet” is the conventional U.S. GAAP term tested on the CMA exam).

Income statement

Shows an entity’s revenues, expenses, gains, and losses for a given reporting period. Also known as the statement of profit or loss (the IFRS caption; “income statement” is the conventional U.S. GAAP term).

Statement of comprehensive income

A statement that combines the income statement and other comprehensive income items.

Statement of cash flows

Shows the movement in the entity’s cash and cash equivalents classified into operating, investing, and financing activities.

Statement of changes in equity

Shows the details of the movements of each equity item in the balance sheet from the ending of the previous period. These movements generally include net income, other comprehensive income, and transactions with owners during the period.

Notes to the financial statements

Provides additional information necessary for understanding the financial statements. These include accounting policies, significant estimates used, and other information.

Each of these financial statements is discussed in the succeeding sections.

Elements of financial statements

The FASB Conceptual Framework (Concepts Statement No. 8, Chapter 4) identifies ten (10) elements of financial statements, which are considered the building blocks from which financial statements are constructed. (The IFRS Conceptual Framework defines a different, five-element set - assets, liabilities, equity, income, and expenses - so don’t mix the two frameworks.) Presented below are the elements with the corresponding financial statement where they can be found:

Element	Balance sheet	Statement of comprehensive income		Statement of changes in equity	Statement of cash flows
		Income statement	Other comprehensive income
Assets	X	-	-	-	-
Liabilities	X	-	-	-	-
Equity	X	-	-	-	-
Investments by owners	X	-	-	X	-
Distributions to owners	X	-	-	X	-
Comprehensive income	X	X	X	X	-
Revenues	-	X	-	-	-
Expenses	-	X	-	-	-
Gains	-	X	-	-	-
Losses	-	X	-	-	-

Note on other comprehensive income (OCI): OCI appears in two places. Current-period OCI flows through the other comprehensive income section of the statement of comprehensive income. The cumulative balance of OCI is carried on the balance sheet as accumulated other comprehensive income (AOCI), an equity component. OCI is a component of the comprehensive income element (net income + OCI), not a separate element.

The statement of cash flows is not constructed from the elements because cash flows are classified by their nature: operating, investing, and financing. More discussion about this topic is found in the succeeding section about the statement of cash flows.

In the statement of changes in equity, only the total amount of comprehensive income during the period is included and a breakdown is normally not presented per element (revenue, expense, gains, and losses).

Each element is further discussed in the subsequent chapters on the financial statements.

Lastly, the notes to financial statements are not elements, though they serve important functions that are distinct from elements, including amplifying or complementing information about items in financial statements.

The relationship of the financial statements

Before going into the details of each financial statement, it is important to understand how they are all interrelated. The figure below shows the relationships of each financial statement:

In the above illustration, two balance sheets are presented, as of December 31, Year 1 and as of December 31, Year 2. This shows the nature of the balance sheet being a snapshot of the assets, liabilities, and equity of the entity as at a specific date (i.e., December 31).

The other financial statements serve as “bridges” between two balance sheets that explain the movements of certain elements (i.e., equity) and balances (i.e., cash and cash equivalents) between the balance sheets as of December 31, Year 1 and December 31, Year 2.

The statement of cash flows explains the movement in cash from Year 1 to Year 2.

The statement of changes in equity explains the movement of the equity element between two balance sheets from Year 1 to Year 2. It normally has two components:

1. The total comprehensive income during the period which is composed of: (a) net income (revenue, expenses, gains, losses); and (b) other comprehensive income (OCI)

2. The transactions with owners which are composed of: (a) investments by owners; and (b) distributions to owners during the period.

To make the bridge concept concrete: suppose equity on the Year 1 balance sheet is $500. During the year the entity earns net income of $80, records OCI of $10, and pays dividends of $20. The statement of changes in equity captures all three movements, and the Year 2 balance sheet reports equity of $570 ($500 + $80 + $10 − $20).

Key concept: point in time vs. period of time

It is important to notice that the balance sheet is captioned “as of December 31” while all other financial statements are captioned “for the period from January 1 to December 31”.

This is consistent with the nature of the amounts you will see in the financial statements being:

• A snapshot as of a single point in time for the balance sheet (e.g., the cash balance in Year 2 balance sheet means it is the exact cash existing as at the day December 31, Year 2); versus
• An amount pertaining to a period for all other financial statements (e.g., the revenue amount in the income statement means it is the total amount earned for the period January 1 to December 31 in Year 2).