Understanding Financial Statements

Chart of Accounts

This system codifies business transactions with an account number and name. Accounts are hierarchically ordered:

• Groups (1 digit): Seven primary categories.
• Subgroups (2 digits): Subdivisions within groups.
• Accounts (3 digits): Specific items within subgroups.
• Subaccounts (4 digits): Detailed breakdown of accounts.

Group Examples:

1. Basic Financing
2. Non-Current Assets
3. Inventories
4. Trade Payables and Trade Receivables
5. Financial Accounts
6. Purchases and Expenses
7. Sales and Income

Static vs. Dynamic Financial Views

Net Worth (Static Vision)

• Economic Structure: Assets
• Financial Structure: Liabilities and Equity
• Balance Sheet: Fundamental accounting identity (end of period)

Net Income (Dynamic Vision)

• Resource Generation: Revenues
• Resource Consumption: Expenses
• Income Statement: Revenues - Expenses (during the period)

Business Activities

All businesses engage in three core activities:

1. Financing: Raising funds to invest and operate.
   • Internal: Selling shares (Equity)
   • External: Borrowing money (Liabilities)
2. Investing: Acquiring long-term resources.
   • Fixed Assets: Land, buildings, machinery, furniture, IT, vehicles, etc.
3. Operating: Day-to-day business activities.
   • Expenses: Buying goods and services
   • Revenues: Selling goods and services
   • Current Assets: Short-term resources

Understanding Financial Statements: An Analogy

Static Vision: Balance Sheet

Represents a snapshot of a business's wealth, debts, and net worth at a specific point in time.

Dynamic Vision: Income Statement

Shows the economic activity (incomes and outcomes) over a period of time.

Assets

Assets are resources controlled by a company due to past events, expected to generate future economic benefits. An item is recognized as an asset if it meets these criteria:

1. Controlled by the company.
2. Result of past events.
3. Expected to provide future economic benefits.
4. Value can be reliably measured.

Double-Entry Bookkeeping and Asset Recognition: Recognizing an asset requires a corresponding entry:

• Increase in a liability (e.g., buying assets on credit).
• Decrease in another asset (e.g., buying assets with cash).
• Recognition of income (e.g., selling an asset).

Liabilities

Liabilities are present obligations from past events that will likely result in an outflow of resources. This includes provisions for potential future expenses (lawsuits, taxes, etc.).

Double-Entry Bookkeeping and Liability Recognition: Recognizing a liability requires a corresponding entry:

• Increase in an asset (e.g., receiving a cash loan).
• Decrease in another liability (e.g., refinancing a loan).
• Recognition of an expense (e.g., purchasing on credit).