Reading a financial statement: Cash flow statement, accountant’s report, and notes to the financial statements
|A set of financial statements is comprised of several key statements. This article explains the cash flow statement, the accountant’s report and more. Related articles contain details on the balance sheet and the income statement.|
Cash flow statement
In a set of financial statements, the cash flow statement shows the cash flows for the year as belonging to three main areas:
- Operating activities
- Investing activities
- Financing activities
On the cash flow statement, operating activities derive from the operations of the business itself. They can be presented either through the direct or indirect method. The direct method explicitly states the amounts received from customers and paid to suppliers and employees. The indirect method, which is more common, begins with net income and adjusts for any non-cash transactions and any changes in accounts receivable or other balance sheet items related to the operations. Both methods will have the same end result and both methods are acceptable.
Investing activities concern investments in property and equipment for the business, as well as financial investments. In the cash flow statement, investing activities include both outlays for purchases and cash receipts for disposals of investments.
Financing activities are the activities related to financing the business with both debt (loans, which are shown as liabilities) and equity (capital stock and other equity instruments). Common examples of items in this category include loan principal received, repayments and dividends paid.
Notes to the financial statements
The notes to the financial statements usually begin with a section on accounting policies. This is where the reader looks to see what accounting policies have been chosen for the company. For example, this section will explain whether shares that a company owns in other companies are recorded at cost or at fair market value. The type of valuation basis used can make a large difference to the values reported on the balance sheet.
The notes also include disclosures about the risks faced by the company, related party transactions (which can be transacted at a different amount than if they were with a party at arm’s length), tax values of the capital stock, or loan repayment terms. These disclosures can be critical to understanding how the business has been operating and how it will operate in the coming year. For example, the disclosures may refer to a loan that has been repaid in previous years at $5,000 per month, but will need to be repaid in full in the coming year. This kind of information can help explain why the company has significantly more cash on hand this year compared to the year before.
The accountant’s report can be an independent auditor’s report, a review engagement report (both are referred to as an assurance report because the accountant expresses a level of assurance on them), or a notice to reader. The report will state:
- What type of report it is
- Which financial statements it is reporting on (i.e., the company and fiscal period)
- Which accounting standards the statements are in accordance with (in the case of an assurance report)
The accountant’s report may also state any places where the financial statements are not in accordance with the standards cited. This would become a “qualification” in the report.
It is preferable not to have any qualifications in your accountant’s report. In fact, publicly listed companies are required to have “clean” audit reports (meaning there are no qualifications). However, in some instances, it may be acceptable to have a qualified report. If it seems likely that your accountant will qualify your report, consider if the qualification relates to something that will be relevant to those reading your financial statements.
A qualified opinion is different from a denial of opinion. A denial would result if the deviations from Generally Accepted Accounting Principles (GAAP) or the lack of pertinent information is so pervasive that the accountant cannot express how it might affect the financial statements.