8/12/24, 1:08 PM Module 2

Module 2

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Introduction to Financial Statements

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Contact Information

Taylor C. Weaver
Lecturer
[email protected]

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Overview

The purpose of financial statements is to communicate the position and performance of a company to outsiders.
This is not the information that companies use to run their business or to make decisions; it is strictly intended
for use by outsiders. In a sense, it provides a scorecard for the business. Theoretically, everybody uses the
same set of rules to build that scorecard, to put the financial information together. In the United States, this set
of rules is called “GAAP”—Generally Accepted Accounting Principles. Since everyone uses the same set of
rules to prepare the information, the reader can look at, for example, Hewlett Packard, Microsoft, and Oracle
and compare the companies. Theoretically, all the line items will have been put together the same way; revenue
means revenue, earnings means earnings. This allows the reader to perform analysis across different
companies or of the same company over a period of time.

In the United States, the Securities and Exchange Commission (SEC) is the regulatory body that serves to
protect investors by insuring they have information adequate to make informed decisions. The SEC is the
ultimate authority for setting the rules under GAAP. It has delegated that authority to the Financial Accounting
Standards Board, known as "FASB." There are actually two sets of standards in use in the world today: U.S.
GAAP and IFRS, International Financial Reporting Standards.

The Rules Are Different Around the World

U.S. GAAP is about 85% same as IFRS

For our purposes, they are about 85% the same. However, there are some interesting differences that are
explored in later modules. One of the things the reader does with the financials when they first pick them up is to
see if they're prepared under U.S. GAAP or under IFRS.

The company prepares financial reports on its own performance. To help ensure the integrity of the reporting,
the company often hires outside accounting firms to audit the financial statements and certify that the

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statements “fairly present the financial position of the company.” In the United States, audits are performed by
certified public accountants, or “CPAs”. Public companies are required to submit audited financial statements
annually to the SEC. The company pays several million dollars annually to the accounting firms to have this
work done. There are some obvious ethical implications here.

Enron Case
Many of you have probably never heard of a company called Enron. Enron was one of
the largest energy-trading and utilities companies in the world until the end of the early
2000s. For those of you who have heard of Enron, you probably remember the
company as the centerpiece of one of the largest financial scandals in history. But the
story behind Enron is much deeper and very interesting. It has a lot to tell us about
financial reporting, the relationship of companies to their auditors, and the judgment
and subjectivity that goes into financial statements.

In the mid and late 90s, Enron was an important company. Up until 1999, it was very
well respected. You might be horrified to know there's such a thing as CFO Magazine.
And in 1999, a guy named Andy Fastow, the CFO of Enron, was on the cover of CFO
Magazine as the Finance Person of the Year. These were financial gods, the smartest
people in the room. They had a very sophisticated financial structuring and very
sophisticated corporate structures. They were generating profits that a lot of people
didn't quite understand, but the numbers kept going up.

Nine months after the CFO Magazine article, Andy Fastow and Enron were falling
apart. At that time, Enron's auditor was Arthur Andersen, formerly one of the Big Five
accounting firms and, at the time, the highest-rated, most respected auditing firm in the
world. They had 43,000 associates around the globe doing auditing and consulting.

In 2000, Enron was a $50 million client for Arthur Andersen. Enron paid Arthur
Andersen $50 million to provide services—half of which was for consulting. Arthur
Andersen helped Enron with business processes and growing their business. And half
of that money—half of the $50 million—was auditing fees. Enron paid $25 million for
Arthur Andersen to come in, check the numbers, and certify that those numbers fairly
presented the financial position of Enron.

Well, as the story goes—and there's been books written about this, I'm not making this
up—Enron prepared their financials for 1999. They presented them to Arthur Andersen
in early 2000. Arthur Andersen started their review of the financials, and at one point
said, “Gee, this is interesting, Enron. You have about $2.4 billion worth of debt—money
that you owe to other people. And we don't see it listed under your liabilities. You're
supposed to list that stuff.”

And the people at Enron said, “Yeah, you know, it’s really cool. We found out if you
structure a company and its affiliates in a very certain way, the rules say you don’t have
to show that debt on your balance sheet.”

Arthur Andersen said “No, that can’t be true.” And Enron said, “Yes, it is true.” And they
showed them the rules. They went through the specific accounting regulations that did

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say, in fact, if you follow the structure that was established by Enron, it turns out you
don't have to show that debt.

Arthur Andersen turned to Enron and said, “OK, we know that’s what the rules say, but
they were never intended to be that way. The rules say you’re supposed to fairly
present the financial position of the company. And you owe this money, and it’s fair that
you would put it on your balance sheet.”

Enron said, “No, no, look at the rules. The rules say we don’t have to do that.” And
Arthur Andersen said, “Yeah, but that’s not fair. It doesn’t present the real position of
the company.” And Enron said, “Well, we’re not going to put it on the balance sheet.
The rules say we don’t have to.” And Arthur Andersen said, “Gee, you really should.”
And Enron said, “No, we’re not. The rules say we don’t have to.” And two partners in
the Houston office of Arthur Andersen said, “You know what, you’re a $50 million client.
We don’t want to lose that business. We’re covered by the rules. We’re going to let it
pass. We’re going to let you not put that debt on your financial statements, even though
it's not fair.”

Now, in fact, Enron did a lot of other things. And it turns out they had some other issues
in their financials. But the truth is, they didn’t show that debt because the rules didn’t
say they had to. Nine months later that was one of the big things that brought Enron
down. When people said, “You know what? Despite the rules, you haven’t fairly
presented the financial position of the company,” how did this all work out? Well,
Enron's gone, and Arthur Andersen's gone. All the Arthur Andersen associates are
scattered to the wind, working somewhere else.

We need to keep this in mind as we look through the financial statements. Understand
that this dynamic is going on behind the scenes as companies prepare their financial
statements and pay auditors to check those financial statements.

Financial Statements

There are three important financial statements: the balance sheet, the income statement, and the statement
of cash flows. These three reports answer two fundamental questions about the company:

How has the company performed over a certain period of time?

The concept used to organize this information is to group all the transactions and activities of the company into
three distinct categories: operating, investing, and financing. Operating activities are the day-to-day activities
that the firm engages in to produce and sell goods or services to its customers.

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Using FedEx as an example, operating activities include delivering the packages, paying the drivers, fuel costs
for the trucks and planes, and advertising.

FedEx Operating Resources

Investing activities are the acquisition and sale of assets to grow the company. For FedEx, this includes
purchasing new vehicles, buying other companies, and selling used aircraft.

Financing activities are directed at raising money for the firm from outsiders, referred to as “capital.” For
FedEx, this would include such activities as borrowing money from a bank, paying dividends to existing
shareholders to maintain the value of the stock, and repaying loans. All the activities and transactions of the
company are classified into one of these three categories. We use this categorization to report on the financial
condition and performance of the company.

Balance Sheet

The first important financial statement is the bBalance sheet, also known as the statement of financial position.
The balance sheet is a “snapshot” of the company's position at a particular point in time. The report takes a very
simple approach; at any given point in time, what you own minus what you owe is what you are “worth.” What
you own is called assets, what you owe is called liabilities, and your financial reporting worth is called equity.
It’s important to note that “worth” for financial reporting purposes is very different from the market value of the
firm. We simply mean worth from a reporting perspective.

Expressed as an equation, Assets (own) – Liabilities (owe) = Equity (“worth”). More simply, A - L = E. This
equation can also be expressed as A = L + E; this is the construct of the balance sheet. Assets are economic
resources available for use in the future. Liabilities are obligations to outsiders, and equity is the claims of the
owners after the obligations. The balance sheet presents assets on one side, and the liabilities and equity it is
equal to on the other. This equation A = L + E is the “balance” in the balance sheet.

You have a personal balance sheet that might look something like this:

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A business balance sheet focuses on the results of all the investing and financing activities up to the date of the
balance sheet. Investing activities result in assets; financing activities result in liabilities and equity. Here’s a
snapshot of Berkshire Hathaway’s (BH), Warren Buffett’s company and its subsidiaries, consolidated balance
sheet (we will go into more detail on the difference between consolidated and standard financial statements in
Module 3):

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Note the time stamps: “September 30, 2020,” “December 31, 2019,” and the qualifier “Unaudited.” Now, “stop
the music” and count exactly where the company is as of midnight on September 30, 2020. By looking at the
column for December 31, 2019, you can see a comparative snapshot of where the company was nine months
before September 30, 2020. More simplistic balance sheets (without a comparative period) will have a time
stamp, “as of [a certain date],” which means you would only be looking at that company as of that specific date
and you would only see one column. Although this is less important for the purposes of this course, the
accounting for December 31, 2019 was audited, whereas the September 30, 2020 accounting was not. Also
note that these numbers are presented in millions of dollars; the cash balance of $23,078 means $23.1 billion of
cash.

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Assets are the results of all their investing activities. BH has some cash, other current assets, and long-term
assets; there was just under $636 billion worth of resources in the company at that point in time. On the bottom
half of the balance sheet are the results of the financing activities up to that point in time. Liabilities are the
money the company owes to outsiders; equity represents the claims of the owners on the company. Equity
comes in two forms: money invested by the owners (contributed capital) and company generated profits,
which are left in the company to purchase additional assets (retained earnings).

As of September 30, 2020, BH owed $411 billion; the balance of the financing was provided by the owners. Note
that, of course, Assets = Liabilities + Equity. The next day, the numbers will be different, as BH runs the
company, pays its bills, borrows more money, etc. Also note that the balance sheet amounts have been
accumulated since the inception of the company and represent the amounts as of the date of the balance sheet.

Balance Sheet Equation

Another way to think about this is that assets are what the company owns—the resources they have available to
use in the future to run the company; liabilities and equity are where the money comes from to buy those
resources. It’s important to note that there are only three sources of capital available for any company for the
purchase of assets. Liabilities represent the money the company has borrowed; equity is either the money the
owners have invested in the company, or the money the company has earned on its own from running its
business. Every company combines these three sources to fund the purchase of its resources and decides how
much will come from each of the three sources. This mix of liabilities and equity is called the “capital structure”
of the company.

Income Statement

The next financial statement is the income statement, also known as the statement of earnings. The income
statement has the opposite time perspective from the balance sheet. While the balance sheet is at a moment in
time, the income statement is over a period of time. It tells investors and other reviewers the story of the
company’s profitability for some specific period, either a month, a quarter (3 months), or annually. Like all
stories, it has a beginning and an end—a beginning date and an end date.

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The income statement tells the story of the company by reporting on revenue (what the company sold to its
customers over that period of time) minus expenses (what it cost to run the company over that period of time).
Subtracting expenses from revenue gives net income, the amount left over for the business to either reinvest in
more assets, or distribute out to the owners in the form of dividends.

You have an income statement that might look like this:

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A business income statement focuses primarily on the operating activities of a company over the reporting
period. This is Berkshire Hathaway's income statement or s,tatement of earnings, as it is sometimes referred to:

Note that the time stamp is similar to the consolidated balance sheet time stamp. Here, you can also see that
BH has the ability to break down time periods within a year for comparative purposes (third quarter of 2020). If
this were an income statement for a small business, the standard way we would express the fact that financial
statements are from one date to another would be stamping the title as “for the [period] ending [___].” For
example, if we were looking at January 1, 2019, to December 31, 2020, you would see “for the period ending
December 31, 2020.” They tell the story of what happened to BH over that period of time. Revenues were over

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$181 billion for the first nine months of 2020 (meaning January 1 to September 30); this is the value BH
received from customers as a result of the exchange of the goods and services BH provided. Like almost every
company, BH spent most of this running the company. Expenses represent the value of the resources used to
create the goods and services provided to customers. BH expenses for this period were over $172 billion. The
difference between revenue (plus investment and derivative contract gains/losses) and expenses is earnings (or
net income), in BH's case over $9 billion. This $9 billion is available to either distribute as dividends or to leave
in the company to increase retained earnings, which is reported on the balance sheet as a source of capital. Net
income is also referred to as both net profit and earnings. In practice, these words are used interchangeably.

Statement of Cash Flow

The third financial statement is the statement of cash flow or cash flow statement. Think of this report as a
“cousin” to the Income Statement. It does the same thing as the income statement, telling the story of the
company from one date to another. But it tells that story from a different perspective. It focuses specifically on
what happened to cash over that period of time.

The different perspectives are best illustrated by example. Suppose a company shipped $1,000 worth of goods
to a customer on December 15, 2020. The contractual terms of the transaction call for the customer to pay for
the goods on January 15, 2021. Most transactions between businesses are done on credit terms similar to this.
On the income statement, this transaction would be reflected in revenue for 2020. On the statement of cash
flow, which is based strictly on when the cash changes hands, the transaction would be part of the operating
cash flow for 2021. There are many transactions where these events, the exchange of the product and the
exchange of cash, take place in different periods. This will be discussed in more detail in Module 4.

The statement of cash flow focuses on all three business areas: operating, investing, and financing. It looks at
all the cash inflows and outflows and organizes them into the three categories. In effect, it explains how the cash
balance changed from one balance sheet date to another. Here is Berkshire Hathaway’s consolidated statement
of cash flow:

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The time stamp is the same as the income statement, “First Nine Months.” Cash flow, the sum of cash inflows
minus cash outflows, is reported for each category for the period. In BH's case, the company generated a
positive cash flow from operations of $29.2 billion. Note that the net income for this period as reported on the
income statement (the other method to report on the net results of the company) was $9.9 billion. Two different
perspectives yield two different results. BH used $54.4 billion on investing activities, the buying and selling of
assets. In their case, most of this was spent purchasing other companies to grow through acquisition. Finally,
they had a negative cash flow of over $11 billion from financing activities.

This was the result of loan principal payments exceeding borrowings over the period. The overall result of these
three types of cash flows was a decrease to cash of $37.1 billion. At the bottom of the report, BH notes that cash
on December 31, 2020 was just under $65 billion; adding the decrease in cash of $37.1 billion left them on
September 30, 2020, with $27.4 billion of cash. Note that before accounting for other items not listed such as
railroad, utility, and energy, the amount at the end of the third quarter, $23.078 billion, is the same as the first line
item on the balance sheet of the same date. The cash flow statement thus explains the change in cash between
the two balance sheet dates.

Summary

The balance sheet explains where the company was at a certain period in time, the
assets the company had, and the liabilities and equity they had (i.e., how the company
paid for those assets). Over a period of time, we have the income statement and
statement of cash flow. They tell the story of what happened from one date to another.
And that brings us finally to a new balance sheet with a new set of assets, new money
that's owed, and new money that belongs to the owners. This is how the financial

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statements work. This is how they present the financial condition and performance of
the company over some period of time.

Judgment

The next two modules will discuss the three financial statements in detail. Before moving to this, there is a
critically important, fundamental point to understand. While the financial statements may look very precise, very
“real,” they are not. With very few exceptions, the numbers in the financial statements are made up. There is a
significant amount of judgment that goes into the numbers. In fact, accounting rules require many judgments
and estimations by management. In many cases, management is required to give its best guess on a particular
value. Further, the rules allow for significant variation on how the numbers are prepared and presented. In many
cases, the actual numbers include some estimate of the effect of future events, and is thus unknowable. To be a
real user of the financial statements is to understand these judgment areas, how the judgments are made, and
how they affect the financial results.

Warren Buffett, the CEO of Berkshire Hathaway, is widely considered to be one of the
most honest, direct, and reputable CEO's in the world. He is certainly one of the most
famous investors of the last 50 years. Here's his take on accounting judgment, from his
annual letter to BH shareholders back in February 2012:

“Regardless of how our businesses might be doing, [we] could—quite legally—cause

Buffett's quote demonstrates just how much judgment goes into the financial statements. To be a real user of the
financial information, to bring value to and to protect clients, a lawyer needs to understand these judgment
areas. For a litigator preparing for a deposition in a matter where numbers from the financial statements are
involved, the interesting questions are around the judgment areas: how was that number put together, could it
have been put together another way, what other ways are there to represent that information? Transactional
lawyers working with a client who is borrowing money will negotiate and document the transaction; the
document often requires that the client reach certain financial metrics. Understanding the variability of how those
metrics get reported is very important in documenting the transaction and protecting the client.

GAAP and IFRS require the reporting company to use the judgment and variability of the rules to “fairly present
the financial position of the company.” This is the standard applied by the CPA who audits the financial
statements. Note that nowhere does it say the reports are “correct” or “accurate” or “right”. Only that they are
“fair.” Modules 3 and 4 explore how the judgment is used to prepare the financial statements.

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