Introduction to Financial Statements

Recently updated on April 13th, 2023 at 06:37 pm

Preparing general-purpose financial statements; including the balance sheet, income statement, statement of retained earnings, and statement of cash flows; is the most important step in the accounting cycle because it represents the purpose of financial accounting.

Preparation of your financial statements is one of the last steps in the accounting cycle, using information from the previous statements to develop the current financial statement.

The preparation of financial statements involves the process of aggregating accounting information into a standardized set of financials. The completed financial statements are then distributed to management, lenders, creditors, and investors, who use them to evaluate the performance, liquidity, and cash flows of a business. The preparation of financial statements includes the following steps (the exact order may vary by company).

In other words, the concept financial reporting and the process of the accounting cycle are focused on providing external users with useful information in the form of financial statements. These statements are the end product of the accounting system in any company. Basically, preparing these statements is what financial accounting is all about.

Preparing general-purpose financial statements can be simple or complex depending on the size of the company. Some statements need footnote disclosures while other can be presented without any. Details like this generally depend on the purpose of the financial statements.

For instance, banks often want basic financials to verify a company can pay its debts, while the SEC required audited financial statements from all public companies.

Financial statements are prepared by transferring the account balances on the adjusted trial balance to a set of financial statement templates. We will discuss the financial statement form in the next section of the course.

Step 1: Verify Receipt of Supplier Invoices

Compare the receiving log to accounts payable to ensure that all supplier invoices have been received. Accrue the expense for any invoices that have not been received.

Step 2: Verify Issuance of Customer Invoices

Compare the shipping log to accounts receivable to ensure that all customer invoices have been issued. Issue any invoices that have not yet been prepared.

Step 3: Accrue Unpaid Wages

Accrue an expense for any wages earned but not yet paid as of the end of the reporting period.

Step 4: Calculate Depreciation

Calculate depreciation and amortization expense for all fixed assets in the accounting records.

Step 5: Value Inventory

Conduct an ending physical inventory count, or use an alternative method to estimate the ending inventory balance. Use this information to derive the cost of goods sold, and record the amount in the accounting records.

Step 6: Reconcile Bank Accounts

Conduct a bank reconciliation, and create journal entries to record all adjustments required to match the accounting records to the bank statement.

Step 7: Post Account Balances

Post all subsidiary ledger balances to the general ledger.

Step 8: Review Accounts

Review the balance sheet accounts, and use journal entries to adjust account balances to match the supporting detail.

Step 9: Review Financials

Print a preliminary version of the financial statements and review them for errors. There will likely be several errors, so create journal entries to correct them, and print the financial statements again. Repeat until all errors have been corrected.

Step 10: Accrue Income Taxes

Accrue an income tax expense, based on the corrected income statement.

Step 11: Close Accounts

Close all subsidiary ledgers for the period, and open them for the following reporting period.

Step 12: Issue Financial Statements

Print a final version of the financial statements. Based on this information, write footnotes to accompany the statements. Finally, prepare a cover letter that explains key points in the financial statements. Then assemble this information into packets and distribute them to the standard list of recipients.

Qualitative Characteristics of Financial statement

Comparability

Comparability is the degree to which accounting standards and policies are consistently applied from one period to another. Financial statements that are comparable, with consistent accounting standards and policies applied throughout each accounting period, enable users to draw insightful conclusions about the trends and performance of the company over time. In addition, comparability also refers to the ability to easily compare a company’s financial statements with those of other companies.

  • Financial statement of an enterprise through time to identify trends in financial position and performance
  • Financial statement of different enterprise to evaluate financial position, performance and change in financial position.
  • Consistent measurement and display of financial effect of like transactions and other events
  • Implementation users must be informed of accounting policies employed, any changes in those policies an defects of such changes
  • Annual statements must show corresponding information for preceding periods.

Relevance:

The predictive and conformity role of information is interrelated. The information has the quality of relevance when it influences the economic decision making of the users by helping them:

  • Evaluate past, present or future events.
  • Confirming or correcting their past evaluations.
  • Reliability
  • Users must be able to depend on it being faithful representation.
  • The information has the quality of reliability when:
  • Financial statement are free from material error and bias
  • Can be depended by the users
  • Reliability comprises
  • Faithful representation
  • Substance over form: Substance and economic reality, not merely the legal form

Neutrality free from biasness

Prudence: Including a degree of caution in making estimates under conditions of un-certainty such that assets or income are not overstated and liabilities or expenses are not understated.

Understandability

Users must be able to understand the financial statements

For this user are assumed to have reasonable knowledge of business and economic activities and accounting and a willingness to study information with reasonable diligence. Understandability is the degree to which information is easily understood. In today’s society, corporate annual reports are in excess of 100 pages, with significant qualitative information. Information that is understandable to the average user of financial statements is highly desirable. It is common for poorly performing companies to use a lot of jargon and difficult phrasing in its annual report in an attempt to disguise the underperformance.

Financial statement Fundamental

Financial Statement: Statement of Changes in Equity

If you are interested in how much of the income a shareholder retains in the company, this is the place to be. The Statement of changes in equity describes the change in owner’s equity over an accounting period. The main things included on this statement are net income or losses that will be added or subtracted from the equity, any dividend payments to owners, as well as the previous and new shareholder equity balance.

Financial Statement: Cash Flow Statement

Where did the organization’s cash and cash equivalents go? That’s what you are likely to see in the statement of cash flow (or cash flow statement). It’s derived from the balance sheet and income statement. It shows how each balance sheet account and income affects a company’s cash flow.

When prepared using the direct method, the cash flow statement is divided into operating, investing and financing activities. This way you’re able to determine which type of activity generates or consumes the most cash.

Financial Statement: Income Statement

The income statement is perhaps one of the most common financial statements that you will be encountering in fundamental analysis. An income statement encompasses the organization’s revenue and expenses together with its gains/profits and losses. Unlike the balance sheet that’s a snapshot of financial health in time, the income statement is more like a change in financial health over a specific time period. The standard is that there are monthly, quarterly, annual income statements. However, technically a company can create an income statement for any time period.

For non-accountants, revenue and income may seem the same but they are not.

Revenue is the gross amount that a company earns from its principal operations such as a bakery selling bread and pastries. It includes all the funds that are coming in from these operations without accounting for any expenses.

Expenses are the costs of conducting business. Some examples include cost of goods sold, administrative costs, legal fees, insurance costs, office supplies, rent, repair, maintenance costs, and many more. When you subtract all expenses from revenue you arrive at the net profit or net income.

Net Income is the net of everything or revenue minus all expenses, including taxes.

Financial Statement: Balance Sheet

The balance sheet, otherwise known as the statement of financial position, shows the financial standing of a company. It’s a snapshot in time of a company’s financial health. This financial statement is organized into three sections, including assets, liabilities, and equity.

Assets = liabilities + equity.

Assets Section on a Balance Sheet

The assets section on a balance sheet includes the totals of all types of assets. Assets are the property and items that a company owns. There are three main types of assets. They include current assets, fixed assets, and intangible assets. Current assets are cash and other assets that can easily be converted into cash within a year. Current assets include cash equivalents, marketable securities, inventory, account’s receivables, and other liquid assets. Fixed assets are property plant and equipment that cannot be easily liquidated or sold. Intangible assets are not physical items such as patents, goodwill, company recognition, trademarks, copyright, and other similar things.

Liabilities Section on a Balance Sheet

Liabilities are debts and obligations a company owes to its creditors and customers. Every company incurs liabilities at one point of its operations. They can be broken down into current liabilities and long-term liabilities. Current liabilities are those debts and obligations which are due within a year. Examples include accounts payable, customer deposits, interest payable, the current due portion of long term debt and other short term debt. Whereas, long-term liabilities are those that are due after one year. They include multi-year loans, bonds payable, deferred revenue, pension obligations, mortgages, and other long term debt.

The important thing to remember for company health analysis is that the company should be able to meet its short-term and long-term obligations in a timely manner. If a company is unable to meet these obligations, it has a risk of becoming insolvent and could go bankrupt.

Equity Section on a Balance Sheet

Equity is the owner’s interest or residual claim in the business after deducting the company’s liabilities from its total assets. The amount of equity in the balance sheet will give you an idea of the net worth of a company or its value to its owners. Though, often it’s merely just book value in the balance sheet, especially for publicly traded companies (i.e. stocks).

Financial statement Assumptions

The period assumption

This assumption describes the time interval between financial statement reports.

Going concern

The financial statements are prepared under the going concern basis, which assumes that the business will continue its operations as normal into the foreseeable future.

Accrual basis

The financial statements are prepared under the accrual basis, which is a method of financial reporting that measures all cash relating to the business as it comes in and as it goes out, called ‘cash accounting’.

Fair presentation

Fair presentation is an assumption to ensure that the financial statements are prepared and presented fairly the financial position, performance and cash flows in accordance with all relevant International Accounting Standard (IASs)/International Financial Reporting Standard (IFRSs). This means that an entity need to disclose about the compliance with the IASs/IFRSs and all relevant IASs/IFRSs must be followed if the entity is in compliance with IASs/IFRSs.

The economic entity

The financial statements are prepared under the economic entity assumption, meaning that the business itself is separate from the owners of the business and any other businesses.

Consistency

Consistency of presentation refers to the presentation and classification of items in the financial statements should be in the same way from one period to another. There are two exceptions where an entity can depart from this consistency principle. First, when there is a significant changes in the nature of operations or a review of financial statements indicate to be more appropriate presentation. Last but not least, when the changes in presentation is required by IFRS.

Users of financial statements

Customers

When a customer is considering which supplier to select for a major contract, it wants to review their financial statements first, in order to judge the financial ability of a supplier to remain in business long enough to provide the goods or services mandated in the contract.

Company Management

The management team needs to understand the profitability, liquidity, and cash flows of the organization every month, so that it can make operational and financing decisions about the business.

Competitors

Entities competing against a business will attempt to gain access to its financial statements, in order to evaluate its financial condition. The knowledge they gain could alter their competitive strategies.

Governments

A government in whose jurisdiction a company is located will request financial statements in order to determine whether the business paid the appropriate amount of taxes.

Investment Analysts

Outside analysts want to see financial statements in order to decide whether they should recommend the company’s securities to their clients.

Investors

Investors will likely require financial statements to be provided, since they are the owners of the business and want to understand the performance of their investment.

Debenture Holders

The debenture holders are interested in the short-term as well as the long-term solvency position of the company. They have to get their interest payments periodically and at the end the return of the principal amount.

Rating Agencies

A credit rating agency will need to review the financial statements in order to give a credit rating to the company as a whole or to its securities.

Employees

A company may elect to provide its financial statements to employees, along with a detailed explanation of what the documents contain. This can be used to increase the level of employee involvement in and understanding of the business.

Suppliers

Suppliers will require financial statements in order to decide whether it is safe to extend credit to a company.

Prospective Investors

Prospective Investors are interested in the future prospects and financial strength of the company.

Unions

A union needs the financial statements in order to evaluate the ability of a business to pay compensation and benefits to the union members that it represents.

Shareholders

Divorce between ownership and management and broad-based ownership of capital due to dispersal of shareholdings have made shareholders take more interest in the financial statements with a view to ascertaining the profitability and financial strength of the company.

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