2.1.1 · 40–60 minutes · read, calculate, discuss, review
What you will learn
- Explain why investors use company accounts.
- Distinguish reported facts, estimates and investment conclusions.
- Use notes and assurance information to form questions.
2.1 · Financial Statements
Financial Statements
Financial Statements · the work you will do
- 1Find the source
- 2Read the profit
- 3Follow the cash
- 4Test the forecast
Before you begin
Two businesses report the same profit. One collects cash promptly; the other has unpaid customer bills and a large legal dispute. Would the profit figure alone justify giving them the same value?
Write your first response before continuing.
Video coming soon · about 4 minutes
Reading Financial Statements: Part 1
Use the narration below while the recording is being made, then try the decisions in this lesson.
Read the full narration
Welcome to On Judgement. Two businesses report the same profit. One collects cash promptly; the other has unpaid customer bills and a large legal dispute. Would the profit figure alone justify giving them the same value? Take a first view. You can change it when you have considered the evidence.
Start with the business model: who pays, for what, and why customers return. Then read the financial statements, accounting policies, notes, risks and relevant management commentary. The figures help an owner assess earning power and a lender investigate repayment. They do not supply an investment recommendation on their own. Public and private disclosure differs; report type, jurisdiction and reporting period matter.
An income statement measures performance over a period. A balance sheet records resources and claims at a date. A cash-flow statement explains movements in cash and cash equivalents. Accrual accounting can recognise an earned sale before collection and allocate a machine’s cost across its useful life. Estimates are unavoidable; the question is whether they are reasonable, consistently applied and sufficiently explained.
An audit provides reasonable assurance under its applicable framework, rather than a guarantee against every error or fraud. Read the opinion and relevant uncertainty disclosures, not just the auditor’s name. A changed estimate or long auditor relationship needs context; a surname alone is not evidence of a conflict. Materiality includes the nature of an item as well as its size.
Related-party transactions, contingent liabilities, revenue recognition, impairment and subsequent events can change the interpretation of a headline number. A non-cash impairment may reveal a past economic disappointment; it is not automatically a bargain signal. Tax losses are not cash at face value. For every concern, record the source, possible explanations, evidence needed and potential effect on future cash flows.
Let's work through A useful-life estimate changes the profit. A fictional machine costs £100,000, has zero residual value and uses straight-line depreciation. Compare a ten-year useful life with five years. Assume a full year of depreciation and no impairment. Pause here and try the calculation or reasoning before continuing.
Ten-year annual depreciation = £100,000 ÷ 10 = £10,000. Five-year annual depreciation = £100,000 ÷ 5 = £20,000. The shorter life raises annual expense by £10,000 and lowers annual pre-tax profit by that amount, all else equal.
No extra £10,000 cash payment is caused by that year’s depreciation charge. The estimate affects timing of accounting expense; the investment analysis must still examine replacement needs.
Now try the choices in this lesson. If your answer changes, identify the reason. Use notes and assurance information to form questions. Use the case activities to put the idea into your own words, and return to the evidence when more than one conclusion is defensible.
An annual report is an evidence file
Start with the business model: who pays, for what, and why customers return. Then read the financial statements, accounting policies, notes, risks and relevant management commentary. The figures help an owner assess earning power and a lender investigate repayment. They do not supply an investment recommendation on their own. Public and private disclosure differs; report type, jurisdiction and reporting period matter.
What the accounts measure
An income statement measures performance over a period. A balance sheet records resources and claims at a date. A cash-flow statement explains movements in cash and cash equivalents. Accrual accounting can recognise an earned sale before collection and allocate a machine’s cost across its useful life. Estimates are unavoidable; the question is whether they are reasonable, consistently applied and sufficiently explained.
Assurance and judgement
An audit provides reasonable assurance under its applicable framework, rather than a guarantee against every error or fraud. Read the opinion and relevant uncertainty disclosures, not just the auditor’s name. A changed estimate or long auditor relationship needs context; a surname alone is not evidence of a conflict. Materiality includes the nature of an item as well as its size.
Read behind the headline
Related-party transactions, contingent liabilities, revenue recognition, impairment and subsequent events can change the interpretation of a headline number. A non-cash impairment may reveal a past economic disappointment; it is not automatically a bargain signal. Tax losses are not cash at face value. For every concern, record the source, possible explanations, evidence needed and potential effect on future cash flows.
A useful-life estimate changes the profit
A useful-life judgement changes expense
Which cash payment changes when the useful-life estimate changes?
A fictional machine costs £100,000, has zero residual value and uses straight-line depreciation. Compare a ten-year useful life with five years. Assume a full year of depreciation and no impairment.
- Ten-year annual depreciation = £100,000 ÷ 10 = £10,000.
- Five-year annual depreciation = £100,000 ÷ 5 = £20,000.
- The shorter life raises annual expense by £10,000 and lowers annual pre-tax profit by that amount, all else equal.
No extra £10,000 cash payment is caused by that year’s depreciation charge. The estimate affects timing of accounting expense; the investment analysis must still examine replacement needs.
Put it into practice
1. Build an evidence hierarchy
Rank an audited statement, a management presentation and an anonymous social post for checking a reported revenue figure. Explain what each can and cannot establish.
Record your response in your workbook before opening feedback.
Compare with a model response
Use the original filing and its notes for the reported number; reconcile management adjustments; treat the post as a lead requiring verification. An audited number still needs correct period, units and interpretation.
2. Investigate, rather than jump
A company reports a £12m impairment and a director sells shares. Write two alternative explanations and three questions before making an investment conclusion.
Record your response in your workbook before opening feedback.
Compare with a model response
The impairment may reflect weaker cash flows or a revised assumption; a sale may reflect diversification or concern. Ask about the impairment model, trading evidence, sale context and valuation. Neither fact alone establishes buy or sell.
3. Make a balanced case
Write 120 words explaining why accounts are useful but insufficient for judging a company.
Record your response in your workbook before opening feedback.
Compare with a model response
They give a structured record and useful comparisons, but estimates, historical timing, business mix and future competition limit inference. Combine accounts, notes, industry evidence and a conditional view of price.
Jargon buster
Accrual
Recognition when earned or incurred, which may differ from cash timing.
Audit
Independent assurance work under an applicable framework.
Materiality
Importance to users’ decisions, considering size and nature.
Going concern
Preparing accounts on the basis of continuing operations when appropriate.
Impairment
A reduction in an asset’s carrying amount under the relevant rules.
Accounting policy
A basis used to recognise and measure items.
Knowledge check
Make each choice on the page. Feedback explains the reasoning. Use Try again after revisiting an idea.
AQA connection and further reading
AQA 7138: 3.1.4 financial management; Annexes 6–7 quantitative skills/formulae; AO2 application, AO3 analysis and AO4 evaluation. Detailed accounting policies, EPS and investment multiples are investing enrichment where used.
AQA 7138 specification
Primary curriculum mapping; teacher interpretation, not endorsement.
IAS 7 overview · IFRS Foundation
Accounting classification context. Presentation changes and effective/adoption dates must be checked for real reports.
Free Cash Flow Valuation · CFA Institute
Technical cross-check for consistent claims and valuation formulas; advanced optional reading.
Introduction to Valuation · Aswath Damodaran, NYU
Optional deeper reading on valuation approaches.
Take forward
Explain why investors use company accounts. Distinguish reported facts, estimates and investment conclusions. Use notes and assurance information to form questions.