2.2: The Finance in the Financial Statements

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Why do we care about Financial Statements in a Finance course? Finance begins where the Certified Public Accountant’s job ends. The accountant’s job is to carefully examine the company’s financial records (its “books”) in order first to determine their accuracy and veracity. The accountant will then simplify the data and summarize them into three Financial Statements: The Balance Sheet, The Income Statement, and the Cash Flow Statement. In this text we will deal only with the first two statements.

The accountant does not have completely free rein regarding the manner in which the financial data are summarized. S/he must abide by “Generally Accepted Accounting Principles”, also known simply as GAAP. This is the rulebook for the accounting profession. GAAP rules are set by the accounting profession’s central organization, the American Institute of CPAs, or AICPA. The AICPA, in turn, derives its legal status from a federal government organization called the Security and Exchange Commission or “SEC.”By law, the SEC empowers the accounting profession to make its own rules and to police the rules – with the SEC’s oversight. As many of you may already know, the SEC also oversees the United States’ financial markets.

All Financial Statements, including the Balance Sheet, will be provided to lenders who will examine the statements prior to making any lending determinations. “Public Companies,” i.e., corporations whose stock is “traded” (bought and sold) on a public stock exchange where stock is bought and sold, are required to release their statements to anyone who requests them. Again, this is an SEC requirement.

The skilled financial analyst will then read the statements because s/he is an “interested party” and wants to know whether an investment in the company is well and fine or whether a potential investment may be advised. S/he may represent lenders or equity shareholders; either party may be considered “investors.” Reading the statements requires advanced education concerning how the accountant compiled the statements. GAAP rules are quite complex.

In summary, the accountant is a trained historian of sorts. The financial analyst will read the accountant’s end-product but is more future oriented. The latter is only concerned about how a potential investment will perform in the future.