Drafting and Interpreting Financial Statements
The regulatory framework and financial statements
You must be able to draft and interpret statements of financial position, statements of profit or loss and other comprehensive income, and statements of cash flows for single entities, applying relevant accounting standards in outline. Understand the qualitative characteristics (relevance, faithful representation, comparability, verifiability, timeliness, understandability) and the elements: assets, liabilities, equity, income and expenses. Know the accruals basis, going concern and consistency.
Preparing the statements
For the statement of financial position, adjust for accruals and prepayments, depreciation, irrecoverable debts and allowances, inventory valuation at the lower of cost and net realisable value, and tax. For the statement of cash flows, classify cash flows as operating, investing or financing; operating cash flow can be derived from profit before tax adjusted for non-cash items and working capital movements. Interest and tax paid are usually shown within operating or separately, consistently with the standard used.
Interpretation and ratios
Interpret using profitability (gross margin, operating margin, ROCE), liquidity (current and quick ratios), efficiency (inventory days, receivables days, payables days, asset turnover) and gearing (debt ÷ equity or debt ÷ (debt + equity)). Always state the formula you use. Compare across years or against a benchmark, and explain causes and consequences rather than listing ratios.
Traps and a worked rule
Traps: confusing profit with cash, treating a revaluation surplus as profit, misclassifying interest paid, and forgetting that a rights issue changes share capital and share premium separately. Rule of thumb: reconcile profit to operating cash flow by adding back depreciation and losses, deducting gains, then adjusting for working capital.
Worked example: Profit before tax £80,000, depreciation £15,000, inventory increased £5,000, receivables increased £8,000, payables increased £3,000. Operating cash flow before interest and tax = 80,000 + 15,000 − 5,000 − 8,000 + 3,000 = £85,000.