A.1. The Financial Statements - Balance Sheet

Question 1

Who are the primary users of financial statements and what do they use them for?

Answer 1

The primary users of financial information are existing and potential investors, lenders, and other creditors to make decisions that relate to buying, selling or holding debt or equity instruments and providing credit.

They use financial information to help them assess their expectations about returns - such as dividends, principal payments, interest payments, or market price increases - and the amount, timing and uncertainty of future net cash inflows to the company.

Question 2

Who are the secondary users of financial information?

Answer 2

management, employees, financial analysts, regulators

assess weaknesses and strengths of the company, evaluate management performance, determine wether the company is complying with regulatory requirements,…

Question 3

What are direct users of financial information?

Answer 3

Direct users are directly affected by the results of a company. This includes investors, potential investors, employees, management, suppliers and creditors. Direct users stand to lose money if the company has financial problems.

Question 4

What are indirect users of financial information?

Answer 4

Indirect users are people or groups who represent direct users. They include financial analysts and advisors, stock markets, and regulatory bodies.

Question 5

What are internal users of financial information?

Answer 5

Internal users such as managers make decisions from within the company regarding its operation.

Question 6

What are external users of financial information?

Answer 6

External users include investors and lenders who make decisions from outside the company about wether to begin a relationship, continue a relationship, or change their relationship with the company.

Question 7

What are the elements of financial statements?

Answer 7

assets, liabilities, equity, comprehensive income and its components, investments by owners , and distributions to owners

Question 8

What are the four financial statements under US GAAP?

Answer 8

1. Balance sheet (statement of financial position)
2. Statement of comprehensive income/income statement
3. Statement of changes in stockholders’ equity
4. Statement of cash flows

Question 9

What are the conditions for an item to be recognized in the financial statements?

Answer 9

It must:
1. Meet the definition of an element in the financial statements

2. Be measurable
3. Be able to be depicted and measured with faithful representation
4. Be representationally faithful, verifiable, and neutral

Question 10

What are the six methods for measuring and valuing an item reported in the financial statements?

Answer 10

1. Historical cost/proceeds
2. Current replacement cost
3. Current market value
4. Net realizable or settlement value
5. Present (discounted) value of future cash flows
6. Liquidation value (of assets)

Question 11

What is a balance sheet used for?

Answer 11

Provide the basis for:
- computing rates of return
- evaluating the capital structure
- predict future cash flows

Helps to assess:
- liquidity
- financial flexibility
- solvency
- net resources available,
- capability of generating future cash flows
- exposure to risk

Question 12

What is liquidity?

Answer 12

Liquidity refers to the time expected to elaps until an asset is converted into cash of until a liability needs to be paid. The greater a company’s liquidity is, the lower will be its risk of failure.

Question 13

What is financial flexibility?

Answer 13

Financial flexibility is the ability of a business to take effective actions to alter the amounts and timing of its cash flows to enable the business to respond to unexpected needs and take advantage of opportunities.

Question 14

What is solvency?

Answer 14

Solvency refers to a company’s ability to pay its long-term obligations when they are due. A company with a high level of long-term debt relative to its assets has lower solvency than a company whit a lower level of long-term debt.

Question 15

What is risk?

Answer 15

Risk refers to the unpredictability of future events, transactions and circumstances that can affect the company’s cash flows and financial results.

Question 16

What is the definition of assets?

Answer 16

Assets are rights to economic benefits that exist at the financial statement date, meaning they have arisen from past transactions or other past events or circumstances.

Question 17

What is the definition of liabilities?

Answer 17

Liabilities are obligations to provide or to be ready to provide economic benefits to others that exist at the financial statement date, meaning they have arisen from past transactions or events.

Question 18

What is the definition of equity?

Answer 18

Equity is the company’s net assets, or the difference between its assets and liabilities. For a business, equity is the ownership interest. Equity is increased or decreased by increases and decreases in net assets from nonowner sources (that is, net income or loss and other comprehensive income or loss) as well as by investments by owners and distributions to owners.

Question 19

What are the two benefits of a balance sheet?

Answer 19

Because the balance sheet provides information on assets, liabilities, and stockholder equity, it provides a basis for comuting rates of return, evaluating the capital structure of the business, and predicting a company’s future cash flows.

The balance sheet helps users to assess the company’s liquidity, financial felxibility, niet resources available, its capability of generating futur net cash flows, exposures to risk and its ability to meet its long-term financial obligations. The statement of financial position can also be used in financial statement analysis to assess a company’s ability to distrute cash to its investors to provide them an adequate rate of return.

Question 20

What are the limitations of a balance sheet?

Answer 20

A balance sheet reports a company’s financial position at one point in time, but it does not report the company’s true value, for the following reasons:
-many assets are not reported on the balance sheet
-values of certain assets are valued at historical cost
-judgements and estimates are used in determining the value of many balance sheet items
-Most liabilities are valued at the present value of cash flows discounted at the rate that was current when the liability was incurred.