Financial Statements and Schedules

.l inancial statements are crucial to those who use them by providing information necessary to make decisions regarding an organization. Users of financial statements are classified as either internal or external. Internal users of financial statements include accounting and finance groups, managers, senior executives, and board members. This group uses statements to measure the progress of the company, to evaluate its strength, and to identify areas where improvement is needed. External users of financial statements typically fall into one of three categories: investors, the government, and the general public. Investors include both creditors and debtors, who rely on information from financial statements to make funding decisions regarding equity and debt. Government agencies include local, state, and federal tax authorities, as well as various regulatory agencies. Finally, for corporations that are publicly traded, information is provided to the general public.

Financial statements represent the end product of the accounting process. For example, all of the information contained on an income statement is the end result of hundreds or even thousands of individual inputs. The information presented on the report is the end result of those individual inputs. Every time inventory is purchased and later resold, an entry must be made in the accounting system. Inventory becomes a cost of goods sold and flows through the system as an expense; when the item is sold, that sale is treated as revenue. The difference between revenue and cost of goods sold is income. When operating an income-producing property, services, not inventory, generate the revenue, and items such as administrative costs, employees, interest, and taxes are treated as expenses. The difference between the revenue and the expenses is income.

When setting up an accounting system, there are several things to consider. For example, a business must determine whether it will operate on an accrual system of accounting or on a cash system. Under the accrual method of accounting, revenue is recognized when goods and services are rendered, not when cash is received. For example, if the owner of a commercial office building operating under the accrual method purchased a one-year insurance policy in June, she would record each month the expense associated with the portion of the premium that had been used. When the policy is initially purchased, rather than recording it as an expense, it is recorded as an asset, typically under the category of prepaid insurance. With each passing month, one-twelfth of the premium is removed from the prepaid insurance and treated as an expense. The accrual method of accounting attempts to more closely match both revenues and expenses with the period in which they occur rather than when cash is exchanged. This method is said to have a smoothing effect on a company's income statement. Almost all larger businesses use the accrual method of accounting, and many smaller business do as well.

The cash method of accounting, on the other hand, recognizes both revenues and expenses at the time payment is made. If, for example, the owner of several rental houses purchased individual insurance policies at various times throughout a given period and expensed the entire amount at the time the policies were paid for, he would be using the cash method of accounting. The cash method of accounting matches both revenues and expenses with the period in which cash is exchanged rather than with the period in which they occur. Although some smaller businesses use the cash method of accounting, very few, if any, larger businesses use this method.

All standards of accounting are governed by what are called generally accepted accounting principles (GAAP). Financial accounting and reporting assumptions, standards, and practices that an individual business uses in preparing its statements are all regulated by

GAAP. The standards for GAAP are prescribed by authoritative bodies such as the Financial Accounting Standards Board (FASB). The FASB is an independent, nongovernmental body which consists of seven members. The standards applied by FASB are based on practical and theoretical considerations that have evolved over a number of years in reaction to changes in the economic environment. Rulings issued by the board are recognized as being authoritative.

The three common financial statements most useful for income-producing properties are the income statement, balance statement, and cash flow statement. (See Exhibit 9.1.) These statements are used to report the financial condition of a company on a periodic basis, such as monthly, quarterly, or annually. A prospective purchaser of an income-producing property would be classified as an external user of these financial statements. In order to properly and accurately assess the financial condition of this type of property, the broker or seller should furnish the prospective buyer with the most recent two or three years of historical operating statements. The ability to review several periods provides investors with a more complete picture of the property's capacity to perform over an extended period of time. Investors should be able to detect any trends that are present, such as the regular increase of rents. Conversely, an investor who observed flat or declining rents with corresponding increases in the vacancies would possibly conclude the market in that particular area has softened. This could also indicate management problems, which can be much more easily overcome than a deteriorating market.

Historical operating statements are not always readily available for one reason or another, and when they are, they are not always accurate, especially on smaller properties where no formal accounting system is used. Sellers or their brokers should be able to provide a minimum of the most recent 12-month period of operating data. The trailing 12-month period is the most important because it will enable prospective buyers to accurately evaluate an income-producing property's most recent performance. By examining in detail each of the past 12 months, investors can gauge the relative stability of the revenues, expenses, and net operating income of an enterprise.

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