Understanding financial statements: A user guide for Family Lawyers

While all family law proceedings are unique, one common element is the requirement for financial disclosure. The disclosure can become much more complex if one or both parties are business owners or otherwise self-employed.

As a family lawyer, you will likely be accustomed to seeing these financial statements as part of a spouse’s standard disclosure. Financial statements have their own accounting language, and it is critical that family lawyers understand the story these tell. In some cases, an accountant may be retained to interpret the financial statements and other information in the context of family property division or support issues; however, this is not always the case. Knowing some of the fundamentals will therefore benefit you as the lawyer advising your clients and working with financial experts on your files.

The purpose of financial statements

Regardless of how they are presented, financial statements are effectively a scorecard. Their purpose, according to the CPA Canada Handbook Section 1000.15, is to provide information to investors, creditors, and others about:

• the entity’s resources (assets), obligations (liabilities), and equity/net assets;
• any changes to the resources, obligations, and net assets; and,
• the economic performance of the entity.

Depending on the legal question at issue, you may need to refer to different components of the financial statements, as set out below.

Five components in financial statements

The financial statements for a profit-oriented company will typically include the five following components:

1. Balance Sheet;
2. Income Statement;
3. Statement of Retained Earnings (or Accumulated Deficit);
4. Cash Flow Statement; and,
5. Notes to the Financial Statements.

You may encounter documents that have different names from the five listed above but which convey the same information. For example, a balance sheet may be called a “statement of financial position” and an income statement may be called a “statement of operations” or “profit and loss” (P&L) statement, but these are fundamentally the same.

This introductory article focuses on for-profit corporations. Keep in mind that the financial statements will look different if the spouse(s) have interests in other types of entities like sole proprietorships, partnerships, or joint ventures.

Each of the financial statements is inter-connected — together they tell the story of the corporation’s financial condition at a point in time, its profitability or operating performance, and its sources and uses of funds.

The Balance Sheet

The Balance Sheet is a useful starting point for family lawyers to understand what assets and debts a spouse holds within a corporation, which forms part of the family property to be divided. It is also helpful context for a spouse’s ability to pay support on pre-tax earnings retained in the company.

The Balance Sheet is a snapshot of the financial position of the company at a point in time, often its fiscal year-end. The date of the Balance Sheet will coincide with the last day of the period covered by the income statement.

The Balance Sheet is divided into three main categories:

• Assets (what the company owns to generate future earnings);
• Liabilities (the debt and obligations the company owes to others); and,
• Shareholders’ equity (the amount that the shareholder paid for the shares or otherwise contributed and the undistributed earnings retained in the company).

The amounts reported on the Balance Sheet represent the net book value. This refers to an asset’s original purchase price (the historical cost), less adjustments made to reflect the decline in value over time, such as depreciation or amortization. It is important to remember that amounts reported on the Balance Sheet may be significantly different from the market value of those assets and liabilities.

The Income Statement

The Income Statement or “Profit and Loss” statement is the starting point for determining whether there are additional pre-tax earnings retained in a company that may be available to a spouse for support purposes. An examination of the company’s expenses may result in additional income to be imputed to a spouse as well.

The Income Statement covers a period of time, most commonly the company’s fiscal year, and summarizes the company’s economic performance over that period. Its purpose is to tell the story behind the company’s net earnings or loss during the period, including the sources of revenue earned and the nature of expenses incurred. This may include non-cash amounts such as amortization or depreciation and unrealized gains or losses.

The Statement of Retained Earnings

The Statement of Retained Earnings connects the Income Statement to the Balance Sheet by explaining the change in the company’s retained earnings from the prior year to the current year. A major contributing factor to the change in retained earnings is the addition of the net income, or deduction of the net loss, reported on the Income Statement.

Dividends are deducted from the company’s retained earnings (rather than expensed on the Income Statement) and may need to be considered in terms of the company’s pre-tax earnings already paid to a spouse and included in their income available for support. The ending retained earnings is what is left over from the company’s net earnings, less dividends paid to shareholders and other adjustments at the end of the period, as reported on the Balance Sheet.

The Cash Flow Statement

The Cash Flow Statement is not included in every set of financial statements; however, it can be a useful tool to understand how the company’s cash resources are being used. It reconciles the company’s cash resources at the beginning of the period to those at the end of the period. In contrast to the Income Statement which looks at the company’s performance including the impact of non-cash items, the Cash Flow Statement includes only the actual cash inflows and outflows.

It is broken down into three components to show cash flows received from or used in:

• operating activities (cashflows for the primary business such as collecting revenues and paying expenses);
• investing activities (including cashflows for purchasing and selling assets); and,
• financing activities (including cashflows for debt advances and repayments and shareholder and other related party amounts)

The Notes to the Financial Statements

Not all financial statements include notes; however, where these are provided they often include helpful information to better understand the amounts reported on the Balance Sheet and Income Statement.

For example, the notes may describe:

• a company’s accounting policies and basis for presentation
• share capital including the types and the number of shares issued
• categories of capital assets
• related party transactions or balances
• long-term debt obligations and covenants
• other commitments or contingencies that impact the company in the future

This information may help a family lawyer more fully understand the company in terms of the property division, income available for support, and the ability of the company to contribute to the settlement of the parties' claims.

Additional sources of information

While the financial statements aim to tell a story about a company’s financial position and performance, in some cases the information is summarized at a high level and more information is required to assess legal claims in a family law matter. Often times more detailed disclosure is required to determine a company’s value for property division or income available for support purposes. The financial statements are useful as a guide to request more detailed information in the form of trial balances (accounts that make up the balances on the financial statements), general ledger (transaction) details, or other supporting documentation.