Corporate Structure and Financial Statement Fundamentals

Posted on Oct 30, 2025 in Accounting and Finance

The Corporation: Definition and Objectives

A corporation is an ingenious device for creating individual profit without individual responsibility.

Defining a Corporation

A corporation is:

  • A virtual or fictitious entity.
  • Created by the state through the process of incorporation.
  • An entity with its own rights and liabilities: it can enter into contracts, buy, sell, or own property, bring lawsuits, and pay taxes.

Corporate Power and Control

Corporations:

  • Are no longer merely instruments of the state.
  • Are state-created but have managed to operate outside strict state control.
  • Are more powerful than ever.

Objectives of the Corporation

The primary objective is the conduct of business activities with a view to enhancing corporate profit and shareholder gain.

  • Be profitable.
  • Create value for shareholders.

Conduct of the Corporation

Corporate conduct:

  • Must act in accordance with the law.
  • May take ethical considerations into account.
  • May devote a reasonable amount of resources to public welfare, educational, and humanitarian purposes.

Primary Purpose: Maximizing shareholder value.

Chameleon-Like Tendencies

A corporation can be in the automobile industry one day and in the pharmaceutical business the next, demonstrating flexibility in its operations.

Fundamentals of Financial Analysis

Financial analysis is the process of selecting, evaluating, and interpreting financial data, along with other pertinent information, to formulate an assessment of a company’s present and future financial condition and performance.

Note: Financial statements are important sources of data, but since they are provided by the company itself, analysts should look at other data sources, not only the financial analysis provided internally.

Basic Accounting Principles

Accountants respect four basic principles when preparing public financial statements:

  • Objective: Data must be verifiable and unbiased.
  • Unambiguous: Statements must be concrete. They must provide one clear value for a given asset being evaluated.
  • Conservative: Never overly optimistic about the future financial outlook.
  • Cost-Effective: Avoid costs that are not necessary (e.g., excessive marketing campaigns).

The Cash Flow-Production Cycle

This cycle illustrates how the company is using its money.

Most Important Financial Statements

  • The Balance Sheet
  • The Income Statement
  • The Cash Flow Statement

The Balance Sheet

The Balance Sheet is a financial snapshot, taken at a specific point in time, detailing all the assets the company owns and all the claims against those assets.

The basic relationship is: Assets = Liabilities + Shareholders’ Equity

Assets, Liabilities, and Equity Definitions

Assets: Requirements

Assets need to meet four requirements:

  1. A probable future benefit must exist.
  2. The business must have the right to control the resource.
  3. The benefit must arise from some past transaction or event.
  4. The asset must be measurable in monetary terms.

Current Assets

Current assets:

  • Are held for sale or consumption during the business’s normal operating cycle.
  • Are expected to be sold within the next year.
  • Are held principally for trading.
  • Are cash, or near equivalents to cash, such as easily marketable, short-term investments.

Liabilities

Liabilities:

  • Represent the claims of all individuals and organizations other than the owners.
  • Will be settled through an outflow of assets (usually cash).

Current Liabilities

Current liabilities:

  • Are expected to be settled within the business’s normal operating cycle.
  • Are held principally for trading purposes.
  • Are due to be settled within a year.
  • There is no right to defer settlement beyond a year after the date of the relevant statement of the financial position.

Equity

Equity represents the claim of the owners against the business.

Revenue and Expense Recognition

Different Forms of Revenue

  • Sales of goods (e.g., by a manufacturer)
  • Fees for services (e.g., of a solicitor)
  • Subscriptions (e.g., a gym membership)
  • Interest received (e.g., on an investment fund)

Different Forms of Expenses

  • Cost of sales or cost of goods sold (buying or making inventory)
  • Salaries and wages
  • Motor vehicle running expenses
  • Insurance
  • Printing and stationery

Recognition of Revenue Criteria

Revenue is recognized when:

  • The amount can be measured reliably.
  • There is a sufficient probability that the money will be received.
  • Ownership and control of the item should pass to the buyer.
  • The moment of placing an order, collection of the item, or payment for the good determines recognition.
  • Specific rules apply to long-term contracts.
  • Expenses associated with a particular revenue must be taken into account in the same reporting period as that in which the item of revenue is included (Matching Principle).

Depreciation and Amortization

Depreciation (Tangible Assets)

Depreciation is the loss of value of tangible assets over time.

  • It represents how much of an asset’s value has been used up.
  • The method used should reflect the pattern of benefits provided by the asset.

Calculating Depreciation

To calculate depreciation, you need to know the following:

  • The original value of the asset.
  • The useful life of the asset (economic vs. physical).
  • The residual value of the asset.
  • The depreciation technique chosen.

Depreciation Techniques

Straight-Line Depreciation Method

Allocates the amount to be depreciated evenly over the useful life of the asset.

Reducing Balance Depreciation

Applies a fixed percentage rate of depreciation to the carrying amount (book value) of the asset each year.

Amortization (Intangible Assets)

Amortization is the loss of value of intangible assets over time.

  • It often involves a valuation problem due to the nature of the asset.
  • Assets with an infinite useful life are typically not amortized.
  • Impairment Value: The total profit, cash flow, or other benefit expected to be generated by that specific asset is periodically compared with its current book value.
  • An assumed residual value of zero is common.

The Cash Flow Statement

The Cash Flow Statement identifies a company’s principal sources and uses of cash, placing each of them into one of three categories:

Cash Flow from Operating Activities

Cash flow arising from day-to-day trading activities.

Cash Flow from Investing Activities

Cash flow arising from acquiring additional non-current assets and cash receipts from the disposal of non-current assets.

Cash Flow from Financing Activities

Cash flow arising from the repayment or redemption of long-term financing, as well as the raising of new financing.

Financial Analysis Tools

Common tools used in financial analysis include:

  • Graphics
  • Regression analysis

Common-Size Analysis

Common-size analysis expresses financial data, including entire financial statements, in relation to a single financial statement item or aggregate value.

Horizontal Common-Size Analysis

Uses the amounts in accounts in a specified year as the base, and subsequent years’ amounts are stated as a percentage of that base value.

Vertical Common-Size Analysis

Uses the aggregate value in a financial statement for a given year (e.g., total assets or total revenue) as the base, and each account’s amount is restated as a percentage of that aggregate.