Financial Reporting

Quick Answer

Three statements tell the story. The balance sheet is a snapshot (Assets = Liabilities + Owners' Equity); the income statement shows profitability over a period; the statement of cash flows shows where cash came from and went. Public companies follow accrual accounting under generally accepted accounting principles (GAAP), and auditors issue an opinion on fairness.

The whole unit on one sheet: the three statements, the accounting basis behind them, auditor opinions, and the Securities and Exchange Commission (SEC) filings the exam loves.

The One-Liners That Win Points

  • Balance sheet = snapshot at a point in time; income statement and statement of cash flows = over a period of time.
  • "Top line" = revenue; "bottom line" = net income. A question about "bottom line" is asking about net income, not revenue.
  • Operating income and pre-tax income (earnings before taxes, EBT) are NOT the same line; you still apply non-operating items (mainly interest expense) to get from one to the other.
  • "Pre-tax income" and "EBT" are two names for the same number, not two separate calculations.
  • EBITDA = earnings before interest, taxes, depreciation, and amortization; strips out capital structure, tax, and accounting choices. Not a GAAP measure.
  • Accrual accounting (required by GAAP for public companies) recognizes revenue when earned and expenses when incurred; cash basis waits for cash to move.
  • The matching principle pairs expenses with the revenue they help generate.
  • Shareholders' equity (also net worth or book value) = Assets minus Liabilities; it is the accounting value, NOT the market value of the stock.
  • On the statement of cash flows: interest paid, interest received, and dividends received are operating; dividends paid are financing.
  • Unqualified (clean) is the BEST auditor opinion; qualified signals a problem despite the positive-sounding name.

Numbers to Lock In

  • Balance Sheet Equation: Assets = Liabilities + Owners' Equity
  • Equivalently: Assets minus Liabilities = Owners' Equity (Net Worth)
  • Working Capital = Current Assets minus Current Liabilities (positive means short-term debts are covered)
  • Shareholders' Equity = Assets minus Liabilities
  • Operating Cash Flow (indirect method) = Net Income + Depreciation + Amortization + Other Non-Cash Items, plus or minus Changes in Working Capital
  • Current assets convert to cash within 1 year; current liabilities come due within 1 year.
  • Form 8-K material events: filed within 4 business days of the triggering event.

Top Gotchas

  • Under accrual accounting a company can show high net income yet hold very little cash, which is exactly why the statement of cash flows matters.
  • Interest paid is operating (not financing) even though it relates to borrowed money; dividends paid are financing (not operating) even though they relate to profit. Dividends received and dividends paid are opposites here.
  • If an item appears on the income statement, classify it as operating on the cash flow statement; dividends paid never appear on the income statement, so they are financing.
  • Operating cash flow is NOT revenues minus expenses (that is net income), NOT assets minus liabilities (that is shareholders' equity), and NOT operating income minus interest expense (that is pre-tax income). It adds back non-cash items to net income.
  • "Unqualified" is the clean opinion; "qualified" is the warning. Qualified = material but NOT pervasive; adverse = material AND pervasive; disclaimer = auditor could not gather enough evidence.
  • The 10-K is audited annually; the 10-Q is unaudited (reviewed) quarterly. The 10-K is filed with the SEC and is not the same as the shareholder annual report.

One-Breath Recap

Three statements: the balance sheet is a point-in-time snapshot where Assets equal Liabilities plus Owners' Equity, the income statement runs top line (revenue) down to bottom line (net income) over a period, and the statement of cash flows sorts activity into operating, investing, and financing (interest paid and dividends received are operating, dividends paid are financing). Public companies keep the books on accrual under GAAP, so strong net income can hide weak cash, which is why operating cash flow adds depreciation and other non-cash items back to net income. Auditors sign off with the clean unqualified opinion at the top and qualified, adverse, or disclaimer below it, and the SEC collects the audited 10-K, the unaudited 10-Q, and the 4-business-day 8-K for material events.

Need more than the recap? This is a condensed summary. If it is not enough, read the full Financial Reporting unit for the complete lesson.