rKT. A ' ■ ■ Vyiv> W* jHra ’'v v * V*\ : W? :...T • r V ft . „/rV7 : ‘ ’ / ' ^ • ... «S«ltr.nYSflUlf.3B : r jtUK ha T A • -. . ■ — <;-? l ( ; i ; ■ .\A wlV ■ The Preparation and Use mM of Financial Statements >( c - UKl\^r i Illinois Manufacturers’ Costs Association 76 West Monroe Street CHICAGO I The Preparation and Use of Financial Statements COPYRIGHT 1921 BY Illinois Manufacturers’ Costs Association Committee on Standardization of the Balance Sheet J. H. BLISS, Chairman, Swift & Co. O. N. LINDAHL, Universal Portland Cement Co. H. G. HOOK, Stewart-Warner Speedometer Corp. C. V. FARGO, Vesta Battery Corp. T. W. HOWARD. Griffenhagen and Associates THE PREPARATION AND USE of FINANCIAL STATEMENTS CONTENTS Page Foreword 3 I. Preparation of Financial Statements 3 II. Recommended Form for Financial Statement. 9 III. Accounting Procedure to Develop Financial Statements Along Standardized Lines 10 IV. Method of Analyzing Financial Statements 13 FOREWORD u * ct * To Members of Illinois Manufacturers’ Costs Association: The years from 1914 to the earlier part of 1920 are often spoken of as the most unusual ever experienced by American Manufacturing Industries. This was a period of ever-advancing prices, of increasing volume, of intense indus- trial activity and. of unearned or unrealized profits. Unearned profits because they came with increasing volume and advancing values, and unearned further, because they were borrowed from the years to follow, when the reactionary period of this business cycle should come. That reactionary period has come. And it brings declining values, decreasing volume, lessened industrial activities, and narrowed margins of profit. Unusual as were the times from 1914 to 1920, it is probable that the times ahead of us will be even more unusual, and certainly far more trying, to do business in. The great war-time boom has come and passed. The profits earned in industry in the future, far and wide, must be earned, not with the aid of favorable market and operating and financial conditions, but in spite of unfavor- able markets, high costs, high wages, abnormal overhead, and industrial and financial readjustments. The business expansion of the years back of us is most clearly reflected in the financial expansion in all kinds of business. With increasing prices, more capital was necessary to carry inventories, and it took more money to carry accounts receivable for the same volume of business. To meet increasing demand for products, great sums of capital were locked up in additions and improve- ments and in new plants and equipment. The financial structure of every business organization reflects the expansion in business that it has seen through- out these years, through these increased investments in inventories and accounts and plants and equipment. As the expansion progressed, the financial struc- ture was enlarged to meet the new requirements. That business is readjusting itself is acknowledged by everyone. That volume and values are seeking peace-time levels is evident. That the process of readjustment will be a prolonged and trying one, cannot be questioned. It is just as far from the peak of war-time activities back to normal peace-time business, as it was from peace-time business to the peak of war-time activities. Readjustment means that business must not only readjust its operations, — lower direct ^osts, — reduce overhead costs, — increase efficiency, — etc., — but 3 means as well a readjustment of the financial structure of the organization. As this financial structure was enlarged to meet the requirements of the period of expansion, so must it be contracted and readjusted to a peace-time or normal basis in the periods to come. No concern could do a war-time business with its peace-time financial structure, and, in the same manner, to meet competition every concern will have to adjust its financial structure to peace-time standards as we go through this period of readjustment. It is therefore highly appropriate at this time to consider the subject of financial accounting and the methods of making up Balance Sheets or Finan- cial Statements which will correctly portray the progress of readjustments to normal standards; and to study the classification of financial accounts with a view of producing promptly the most reliable information about the course of the business through this financial readjustment. The purpose of this present pamphlet is two-fold: First, to suggest methods and forms for the preparation of financial statements which will pic- ture correctly the financial condition of a concern and more clearly indicate the facts about the business which such a statement should develop. Secondly, through a discussion of the classification of balance sheet accounts, to promote a better understanding of the principles underlying the handling of these ac- counts, so that financial statements may be more readily prepared, and, when drawn up, will portray correctly the financial position of the concern and place in the hands of its executives the information which they will need in guiding the business throughout this readjustment period. 4 I— PREPARATION OF FINANCIAL STATEMENTS The financial statement or balance sheet of a concern is a statement setting forth its financial position at some certain date. It is a picture of the concern, stated in dollars and cents, indicating what it owns, what it owes, and what it is worth, net. It is the portrait of the financial structure of the organization. This financial statement shows on the one hand the sources from which the concern draws its capital, whether from a — Stockholders’ investment, which is represented by the initial investment and the surplus earnings left in the business, — or b — The investment of bondholders or capital drawn from other long-term borrowings, — or c — Capital drawn from short-term borrowings, such as current notes and bills payable, open accounts payable, sundry liabilities, etc., and it indicates on the other hand how the concern has invested this capital, — how much of it is tied up in, — a — Current Assets which are used in the daily transactions of the business, such as cash, accounts receivable, inventories, etc., — and b — Investments in Plants, Machinery, Equipment, etc., which represent the property with which the business is carried on, as distinguished from the current assets which represent the capital turning over in the daily transactions of the business, — and c — Investments in and advances to other companies; securities owned, such as bonds, stocks, etc., investments in sinking funds, etc., — and d — The amount of capital tied up in intangible fixed investments, such as Goodwill, Patents, Trade-marks, etc. It is obvious that different concerns will draw their capital from different sources and will have it invested in different kinds of assets, dependent upon the character of their business. Considering this fact, and also that the pur- pose of the balance sheet is to indicate the sources from which capital is drawn and how the capital is tied up in the business, it becomes apparent that it would be impossible to lay out or draft a form of financial statement which would fully meet the requirements of all kinds of industrial concerns. The balance sheet which would be most appropriate for any given concern is that one which meets the general principles upon which such a statement should be constructed, and best fits the individual business and the financial structure it purports to portray. 5 Naturally balance sheets of different concerns will conform along certain general lines, but each individual balance sheet should develop the peculiar facts concerning the business for which it is drawn up. For instance, if it is made for a business of which instalment accounts are a feature, these instalment accounts should then be set forth in the balance sheet and distinguished so that they may be readily understood by the reader. Again, if consignments are a feature of a business, the funds tied up in stocks out on consignment should be set forth in the balance sheet as such. Further, some concerns have a liability on account of packages which will be returned, and if this is a feature of the business it should be set forth and so indicated on the face of the bal- ance sheet. So with the construction of any balance sheet, the individual items to be shown should include every principal class of assets and liabilities which are a feature of that business, so that the picture which the balance sheet presents of the business, will be as comprehensive as is possible. The broad general features which should be observed in the preparation of any financial statement may be briefly summarized as follows : a — All assets and liabilities should be stated gross, the object being to show the total capital which the concern uses and to show on the other hand from what sources it draws this capital. Accounts payable should not be offset against accounts receivable, and accounts receivable should not be offset against accounts payable. Net equity in purchases under contracts should not be shown among the assets in the net amount, but rather the total asset should be shown on the one hand and the total liability for which the con- cern might be held, on the other. b — The balance sheet should indicate clearly on both the asset and liability sides, the distinction between current accounts and fixed investment. This is a very fundamental distinction, — the one represents the capital turning over in the daily transactions of the business ; the other represents the fixed investment, or the house in which the business is carried on. It is highly important to set forth the relationship between the fixed investment and the current investment. This relationship will vary widely in different in- dustries, each having a more or less characteristic proportion of capital tied up in each the current and fixed sections. c — The net working capital should be clearly and readily determinable from the face of the balance sheet. It might even be stated in dollars and cents with entire propriety. d — The various assets and liabilities should be logically arranged and grouped so as to set forth the total of each class of items correctly. A balance sheet may be mis-stated, — may actually be misleading, — because of improper 6 arrangement and grouping of accounts even though every item shown is entirely correct in amount and designation. e — The basis for the valuation of all asset accounts should be indicated. That is, the face of the balance sheet should show whether or not a reserve is provided against possible loss on accounts receivable, — whether or not inventories are valued at cost or market, and whether or not adequate re- serves against possible shrinkage in values, have been provided, if such are necessary. Investments and securities should show whether valued at cost, market or par. Land, buildings and machinery should show whether valued at cost or at appraised values at some definite date, and the amount of reserves for depreciation should be clearly indicated, etc. . / — The character and maturities of the liabilities should be clearly shown on the face of the balance sheet. Current liabilities should include all of those which would be liquidated within the near future, such as accounts pay- able, notes payable, federal taxes, dividends declared, etc. Every issue of long-term liabilities, however, should be set out and the maturity of the issue, and any peculiar features clearly shown. Reserves other than ap- propriated surplus should indicate clearly the nature of the provision and the possibility of its immediate requirement. g — The net worth of the organization should be shown. This will consist of the stockholders’ initial investment in stock, together with appropriated surplus and profit and loss or free surplus. The net worth of any business organization is a fundamental factor. It is immaterial whether that busi- ness organization is conducted as a partnership or is run by a private individual, or is incorporated. The net worth in all cases represents the difference between all of the assets which it owns and has on hand, and all of its liabilities. There is no more logic in showing the capital stock and surplus items in different sections of a corporation balance sheet than there would be in showing the initial investment of a prvate individual or a partner in a business in a section of his balance sheet separated from the accumulated earnings which he allows to remain in the business. The observance of these general principles in the preparation of a finan- cial statement is the practical limitation of the standardization of balance sheets for industrial concerns. To attempt to standardize beyond the observance of these general principles would mean limitations which would prevent a concern with assets or liabilities peculiar to itself from drawing up a statement which would convey to the reader all of the features concerning its business which such a financial statement should convey. While certain classes of businesses, or groups of industries, may readily have standard forms for preparing their financial statements, even within these 7 restricted groups there will be found concerns having peculiar accounts, which require special treatment, not only in justice to the concerns themselves, but in justice to those who may be interested in reading their balance sheets. The maximum benefit to be derived from standardization is limited to the meeting of these few fundamental requirements in the preparation of financial state- ments. Each concern should choose for itself a standardized form of balance sheet which meets the requirements of these general principles and best fits its own business, so as to develop that information which its executives will find most useful and which pictures its financial structure most accurately. The financial statement forms suggested in the following pages are those which would be most applicable to average circumstances. It is of course impossible to draw up a form which will recognize the unusual features that appear in all of the various kinds of businesses. These forms are offered as suggestions and as an aid- in explanation of the principles upon which balance sheets should be constructed. r 8 Eh W W W 02 w o <5 PQ fe O S o Q W 02 o Pi o d Pi (0 H tu (0 co < o o o o o o o o o O O o o ° © o' o o o o o o o o o o o © © o o o o o o o o ©_ © © © ©“ o o o ooo ©‘ © © o o -I < 0. < o o z < CO UJ o © © £> 1 £ I •2 M j) Ja® 3 3 m2 *1§3 to oS a © 2 ^ ® s O •* TS o a ni o o ti t, o V*/ w r? « r! 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There are but two general re- quirements : A — That each financial or balance sheet account be clean and represent but one element or class of assets, or liabilities, and nothing else. B — That these accounts be so grouped and like accounts be gathered together in the ledger in such manner, that sub-totals representing the sum of the groups may readily be prepared from the trial balance and transferred to the standardized statement form. In most organizations it will be found that the adoption of a balance sheet along more or less standard lines will mean but very few changes in their accounting procedure. If each balance sheet account is found to be clean and to contain but one character of assets or liabilities, a balance sheet may be pre- pared directly from the accounts by making appropriate groupings of like accounts into sums to be entered into the balance sheet. It is not necessary that various organizations have inflexible classifications of assets and liabilities, nor is it necessary that different units or branches within a given organization conform to a fixed classification of ledger accounts. In fact it is immaterial whether a concern carries a few financial accounts in its ledger or carries many detailed accounts, — the only requirement is that each account should represent but one element, so that by proper grouping, appropriate totals of each class of assets or liabilities may be determined for insertion in standardized balance sheet forms. The following exhibit may assist in making this point clear. The first column of these asset and liability accounts indicates the prime accounts which might be chosen by representative organizations as the accounts which would show in their financial statement. They might have any number of detailed accounts as shown opposite these items. If they had transactions which would produce accounts of this character, naturally they should carry them in their books, but it would only be necessary to arrange the accounts in their ledger in logical order, so that sub-totals would be readily available from their period- ical trial balances to supply the various items in their financial statement. This exhibit may serve also to indicate how various accounts are grouped in the preparation of a condensed balance sheet. It should be borne in mind, 10 however, that when any of the detailed accounts shown become sizeable and are important factors in the business, they should be set out separately in the financial accounts and be shown separately in the balance sheet prepared for the organization. This exhibit also indicates something of the difficulties which would be encountered in an attempt to make a standardized form for all businesses. These represent but a few of the more unusual accounts commonly found in various industries. And in every case these accounts should set forth on the face of the balance sheet at any time they become sizeable factors in the busi- ness. 12 PART IV— METHOD OF ANALYZING FINANCIAL STATEMENTS The value of financial statements in studying the development of the financial structure of an organization is too often overlooked. Too few business men fully appreciate the wealth of information which may be developed by carefully analyzing the balance sheets of a business at different periods. In fact, the executives of a concern who are provided with monthly balance sheets are in a position to give the most intelligent supervision to their business. The changes of the past five or six years in almost all concerns have been so important that careful analysis of their financial statements throughout this period would prove very interesting; and such analyses made of their financial statements from period to period in the future could not prove otherwise than helpful to the executive in administering the business throughout the periods of readjustment. The single balance sheet of an organization at one date conveys many in- teresting facts when carefully analyzed, but as usually prepared leaves study or analysis entirely to the reader with the result that often times the full value of the statement is not realized. But when these statements are made up in comparative form and are carefully analyzed, there may be developed such a wealth of information concerning the changes which have come over the or- ganization during the intervening periods, as would prove very valuable and be appreciated by every business executive. With the thought of developing an appreciation of the possibilities of such an analysis of financial statements, an exhibit has been prepared showing the analysis of a representative balance sheet, and setting forth the salient facts which such a statement should convey to the reader (p. 18). This statement has been drawn up to point out the large number of valuable and interesting statistics that may be shown in connection with a balance sheet. Some of these statistics will be found of value in connection with the analysis of the yearly balance sheets, and are not particularly interesting or illuminating in connection with monthly balance sheets. In fact, it should not be inferred from what follows that it is recommended that every balance sheet be analyzed as completely as is here indicated, but that each executive should select those statistics which are of real value in connection with the administration of his business. 1. Sources from which Capital is Drawn — The percentages shown on the credit side of the balance sheet indicate just what proportion of the total capital used by the organization is supplied by its 13 stockholders, represented by the capital stock held by them and the surplus earnings left in the business; how much capital is drawn from long-term bor- rowings and how much of it from short-term borrowings; that is, what pro- portion of the total funds are obtained from notes payable, accounts payable and such short-term liabilities. 2. In What Manner Capital is Invested — The percentages on the debit side of the balance sheet indicate the propor- tion of capital that is kept in the current turnover of the business, being rep- resented in current assets such as cash, accounts receivable, inventories, etc., and how much of it is invested in the plant and equipment in which the business is carried on and how much is represented in investments in other companies, and intangible capital, etc. I 3. Volume of Business and Profits — Shown at the foot of the statement are the important facts which the income statement should develop, the sales, the operating profits, the profits available for payment of dividends, and the balance left in surplus. These statistics taken in connection with the balance sheet aboye them make possible the development of many facts indicating the relation between the financial structure of the organization and the business that is carreid on with it. 4. Sales to Accounts Receivable — This indicates in a broad way the relation between the accounts outstanding and the volume of business being done. It is important in figuring the relation between sales and accounts receivable to get the actual amount due from cus- tomers and its relation to the charge-sales for the period. The amount of profit is fixed when the sale is made. It never grows greater no matter how long the account is carried. On the other hand, it incurs the costs of carrying the investment and the possibility of loss increases as time passes. 5. Relation of Sales to Inventories — In a broad way this indicates whether or not the amount of capital tied up in goods is growing larger or smaller in relation to the volume of business done. This may not represent the real turnover of stocks, but the relationship between sales and inventories is sufficiently intimate to make this analysis sound for all general purposes. 6. Sales to Fixed Assets — The purpose in emphasizing this relationship is to develop information as to the amount of business being done with the given fixed investment and to 14 indicate whether or not the expansion in fixed investment has been faster than the expansion in the volume of business done. 7. Sales to Total Assets — The purpose of bringing this out, — the relationship between sales and total assets used, — is to emphasize the expansion of the business as compared to the expansion of the financial structure of the organization. The point is that the greater the volume of business which can be done on a given amount of capital, the larger will be the return upon the amount of capital used. One of the prime objects in watching the finances of a company, is to obtain the maximum volume of business on a conservative use of capital. The volume of business done in dollars naturally increased in most businesses very greatly during the past five or six years, owing largely to advancing prices, and in the periods that are to come, considerable contraction may be expected as prices decline. This rela- tionship emphasizes the amount of capital used as compared to the volume of business done. 8. Percentage of Operating Profits to Total Assets Used — This is a fair measure of earnings on all of the assets used. The operating profits should represent the total profits earned by the organization before pay- ing interest or dividends, — that is, before paying any return for the capital used. These profits represent the return which the organization has earned on all of the capital used, regardless of where such capital came from, — whether it was invested by stockholders, bondholders, note-holders or otherwise. 9. Percentage of Profits Available for Dividends to Net Worth — After paying for the use of all borrowed capital, the percentage of profits remaining for the stockholders should be figured to the net worth or stock- holders’ investment, which is represented by capital stock, appropriated surplus and free surplus. This is the fair measure of return on the stockholders’ in- vestment. The percentage of earnings on capital stock so often figured, may give an indication of dividend-paying possibilities, but is not a fair measure of the return which the business has earned on the stockholders’ investment, because the real investment of the stockholders is represented by their original investment in stock and the earnings which they have seen fit to leave with the company. 10. Percentage Earned on Common Stock — This should be figured by dividing the net earnings available for dividends on common stock, — after deducting preferred stock dividend requirements, — by the amount of common stock outstanding. 15 11. Book Value of Common Stock — The book value of common stock should be figured by dividing the shares of common stock outstanding into the total equity of the common stockholders in the business, which is represented by the common stock, appropriated surplus, and free surplus, subject to any claims which the preferred stockholders might have against this surplus. 1 12. Proportion of New Money Required, — Borrowed and Drawn from Stockholders’ Investments — Consideration of the sources from which new money requirements of a con- cern should be drawn is highly important. As new capital is required to take care of expansion of the business, part of it may be borrowed and part of it must be drawn from stockholders. At all times the organization should show favorable margins of fixed assets over long-term borrowings, and favorable mar- gins of total assets over all borrowings. The stockholders should be called upon to furnish their fair proportion of new money requirements either for fixed investments or for current working capital purposes. This may be accomplished in a measure through leaving a proportion of current earnings in the business from year to year. 13. Disposition of Profits — The disposition of the profits of a concern, as between those left in the business and those disbursed in the form of dividends, is always a timely sub- ject. In such periods as the past few years, a much larger proportion of the profits of each year should be left in the business, first, because they are in a measure unrealized, and secondly, because they represent a part of the new cap- ital requirements which should naturally be drawn from the stockholders. The profits left in the business within any period should be sufficient to maintain the working capital and to protect it against withdrawals for construction pur- poses not covered by long-term borrowings, or withdrawals for retirement of long-term debt through operation of sinking funds, etc., and for any other fixed investments not otherwise provided for. 14. Net Working Capital and Ratio — The net working capital is the difference between the current assets of the business and its current liabilities. This represents the net current invest- ment of the organization, used in the daily turnover of the business. The ratio * represents the number of dollars of current assets on hand compared to the dollars of current liabilities owing. The ratio which obtains in different indus- tries ranges from $1.75 to $2.00 common to some, to $4.00 to $5.00 common in other industries. 16 The importance of following the net working capital in a business from period to period throughout the future, cannot be over-emphasized because the contraction which the period of readjustment will bring must occur very largely in the current assets, especially inventories and accounts receivable, and any shrinkages absorbed in these accounts directly reduce the margin of net working capital and the ratio. These easy or unrealized profits of the past few years have tended to greatly expand the net working capital of most companies, for that is the first effect of profits, — to increase the working capital. In the same manner readjustments ♦ in the values in the years ahead and narrowing margins of profits will tend to reduce the net working capital. Liabilities created in the borrowing of cheap money will have to be repaid in the future with dearer money. Such factors as dividends paid in cash, additions and improvements to plants and equipment, long-term debt retired, etc., all tend to decrease the net working capital in the business, and the importance of protecting this net work- ing capital of a business cannot be over-emphasized in such periods as the present. Following is an exhibit showing the method of analyzing a representative Balance Sheet so as to bring out these important factors, and to show the trend of the financial affairs of a company. Analyses of this character may be made of any concern’s balance sheets. For the purpose of getting a “far-away look” at the financial affairs of a concern — and this is important — the balance sheet of earlier years may be compared to the present. Most interesting facts may be developed by comparing balance sheets of 1914 and 1920 for most any organization. 17 E-t E H < H - 1 X © H O 5 <1 kQ <5 PQ * < X < Eh O S o Eh w © © CD ® cd a3 © © t- *- © © © d Q HH *“• «3 © .2 § a o h a o o o o © o CO CO * e£ CO t> lA* o o o o o o O rH rH LA ^ OO CO CO • o ; o CO LA t> LA tH CQ o o o o o o o o o o ^ °® LA t> O o o o o o OO o> o o o o O O o o O LA rH CD w © © © © cd X © © E-* J-. © © © so £ © Cd © © § is o h a << © 03 © ^ - 4 J ^ S 3 © 3 “* O S o o o O O O O o o o O O o O o o o o o o o t>- t- r CD t- 05 OO o rH 05 o rH CO 05 o CQ T}« * CD LA tH CQ CO VS- oe- VS- LA l> CO CQ 00 LA 05 I rH t- CO CO rH CQ c- O O o O O o O o o o O O o O o o o°. n °. o o CD O 00 o rtH O o OO LA CD LA t- CD o c— Cl CQ LA LA 00 CO CQ rH CQ 60- 09- 69 c- c- 05 CQ CQ c— CO tH rH CQ CQ h* c— o o o O O o o o o o «§§ o o o o o o o 05 CO CQ - M t-*<3 CQ*" OO CO CO L '“ ^ LA 05 o c- H}1 1-1 OO CQ OO o' 00 rH rH vs- 69- 69- rH 00 GO H 42 H cw 3 W O /-N * © © © * O © © : S’Stf •Km . a> .2 .2 ® ® 3 to o g “ « O K E> o • 2 - 0 a k. o a 2 ? o n ^ © M cd cj ► w d d ® © m a H ® a ^ © _ cd ■3 1| fil a © j- t- o © Eh J-. 03 © >H © cd OCJO . . • 1 & O t> LA o rH : : : O O O o o o a o o O o o o X ° O OO o rH O O' CQ fl 05 O O CQ CD rH w CD LA CD CO LA C-* < rH CQ*' rH CO 69 - 69 - o O CO dorji : : : 1 o rH o o O o o o HJ o o O o o o X o o_ o o o X CD OO 00 o CQ CO CO CQ 00 CO a OO 00 CO CO CQ I> < O rH rH CO 69 - €9 © fci 03 2 © o 3 H. © © y > £ © _ _ c 'a « 2 #r _ © ca --h C r© PL, !3 cd bo > .2 ^ 5 © G 3 1 fe 10 2 o a >h OIX a S a ■o ® - >2 a .£ >CQ °S o Si $ CO 18 It should be noted that all of the important points about the affairs of a concern are developed in the analytical balance sheet presented. This method of analysis may readily be applied to any concern’s financial statement. In addition to the points already developed, this comparative balance sheet gives ready answer to the usual question of what were the changes in financial position during the period. For convenience these may be summarized very 1 briefly from the foregoing exhibit as follows : New Funds Coming Into the Business During the Year: I — By increasing the Common Stock Outstanding $1,500,000.00 II — By increasing the amounts of Bonds Outstanding 500,000.00 III — By Surplus Net Profits left in the Business 712,000.00 IV— By Profits withheld in the Business by Reserves 50,000.00 Total $2,762,000.00 Which Were Used for the Following Purposes: I — Additional Investments in Plant and Equipment $ 582,000.00 II — Additional Investments in Other Companies, etc 500,000.00 III— Balance remaining as Increase in the Net Working Capital 1,680,000.00 Total as above $2,762,000.00 '1 A simple statement of this character may be readily prepared from com- parative balance sheets of any concern, and tells in an understandable way the information which any business man wants to know about his business. It is a simple and readily understood answer to the questions, what new money did we bring in and how was it disposed of. * 19 l I % UNIVERSITY OF ILLINOIS-URBAN A 657 IL6P C001 Preparation and uae ol financial stateme