Four Basic Financial Statements

Introduction

Financial statements represent a set of various records compiled on the basis of financial accounting data with the purpose of summarizing and collecting information needed for the further planning of the activities of the organization. They serve as a unified system of indicators demonstrating the results of the company’s economic activity for a certain period such as month, quarter or year. Financial statements represent all business operations of the company in particular forms of documentation that are significant elements of accounting. In general, financial statements have a number of meanings. Firstly, from the economic perspective, the content of the documents can determine the solvency of the company and its profitability. Another important meaning is organizational and managerial, as a manager can develop the relations between all management functions such as organization, motivation, planning, control, and coordination. In view of control and analytics, financial statements include thorough monitoring of the correctness of economic transactions because it is possible with their help to reveal any economic violations and their issues. In such a way, financial statements are of paramount importance to the companies. There are four basic financial statements, namely the income statement, the balance sheet, the statement of cash flows, and the statement of retained earnings. Thus, it is crucial to analyze the role of each financial statement in the company’s business operations, while taking into account their interconnection with the generally accepted accounting principle and international financial reporting standards.

The Income Statement

The income statement is one of the most common methods for assessing the state of affairs in the company. Along with the balance sheet, it is one of the two most important forms of accounting since they are usually enough to evaluate and calculate the main indicators and coefficients of the enterprise (Weygandt, Kimmel, Kieso, 2010). The income statement provides comprehensive information on the financial condition of the organization, providing information on the existence of tangible assets in the enterprise’s ownership. The income statement shows a result of the use of these assets and other aspects of the activity. It is composed using the accrual basis for a certain period. The results received are compared with the indexes relating to similar periods in the past. Time intervals that are compared should be equal in duration and other significant conditions (Weygandt et al., 2010). Unlike the balance sheet, where data is presented as of a certain date, the income statement includes figures for a particular period as the cumulative total from the beginning of the year. The major information of the statement includes data on loss and profit of the company, directions of expenditure, and sources of income (Weygandt et al., 2010). Accordingly, this data helps analyze the company’s effectiveness.

To understand the meaning of the income statement, it is necessary to ascertain the addressee of this document. The company’s management is the first recipient that has more detailed information about all the nuances of the activity, while the report usually demonstrates the total expressed in figures. In addition, the income statement becomes an object of scrutiny of different controlling bodies. It is recommended that potential and existing investors of the company should read the income statement, as this document makes it possible to judge the effectiveness of investment allocation (Weygandt et al., 2010). Thus, companies that are interested in attracting investments strive to publish income statements in the media, for example on the Internet.

The statement includes a set of indicators that provide a final financial result. The major indicators of the company’s activities are put at the beginning of the report; these are the cost of sales, revenue, and administrative and commercial expenses (Weygandt et al., 2010). They are the financial result from sales being the most important activity of the organization. After that, there are indicators of other expenses and income such as interest payable and receivable. When the profit tax is subtracted from this ratio and changes in the deferred tax and liabilities and assets are added, it is possible to receive the final financial result, which is net profit or loss for the period (Weygandt et al., 2010). A correctly compiled income statement is the main source of information for the financial analysis of the company.

The Balance Sheet

A balance sheet is a set of information on the value of the liabilities and property of the company presented in the tabular form. It comprises two parts, namely liabilities where the equity of the company is shown and the asset with the property by groups and types (Makoujy, 2010). There should always be equality between asset and liability; for this reason, the statement is called balance sheet. Evidently, the balance sheet is a highly important form of financial statements since it makes it possible to analyze the financial condition of the company, its property, and debts. The balance sheet includes data as of a certain date, usually the end of the quarter or year (Makoujy, 2010).

The main and working capital are reflected in the asset of the balance sheet. The main capital is composed of the whole totality of instruments and means of production. The characteristic feature of this part of the capital lies in the fact that it participates in a number of production processes, transferring its value to the finished product (Makoujy, 2010). The working capital is a complex of all parts engaged in one production cycle, providing their value to the products being manufactured. With the purpose of defining the main and working capital, companies consider the asset of its balance. In fact, such parts of the asset as structures, buildings, and transport constitute the main capital, while the rest forms the working capital.

Liability characterizes a legal status of the company. It shows obligations and defines dependence on those who have provided funds at its disposal. In such a way, the liabilities of the balance serve as the legal dependence of the company on other individuals and organizations. The entire capital of the enterprise, including reserve additional and authorized, is also placed in the passive of the balance (Makoujy, 2010). The presence of capital in the balance of the company demonstrates the degree of dependence on those who have endowed it with capital. The balance sheet represents a unity of quality and quantity; thus, it is a document characterizing a particular company from both legal and economic point of view. In the static position of the company, there can be a condition when the sum of the asset of the balance is equal to the arithmetic sum of the liability of the same balance (Makoujy, 2010). Therefore, such condition of the organization shows that there are assets necessary to pay off all liabilities the company owns.

The balance sheet is generally perceived as a financial component of the company. It is necessary for people who have any relationship with the enterprise or plan to cooperate with it since they can assess its financial position and analyze business condition, establishing whether there will be an early bankruptcy. The balance sheet is also inspected by banks to appraise the creditworthiness of the borrower (Makoujy, 2010). Shareholders receive it as a financial indicator of the work conducted by company’s management. Evidently, the balance sheet is the major source of information for financial analysis that defines the possibility of smooth operation of the organization and stability of its financial position (Makoujy, 2010). The balance sheet is usually analyzed along with the income statement; therefore, there is a possibility to receive the most important coefficients, which characterize the financial state of the enterprise.

The Statement of Cash Flows

The statement of cash flows represents a tabular form of the financial statements. It includes data on the cash flow in the context of the articles of their receipt in the organization and payments. There are two approaches to compose the statement of cash flows in the world practice, namely direct and indirect methods (Warren, Reeve, Duchac, 2016). The direct one includes the articles, on which the cash flow passed. With regard to the indirect method, data of the cash flows is not obtained directly but with the help of the adjustment of the profit by the amount of change in non-monetary items. Importantly, the statement includes three sections (Warren et al., 2016). The first one is cash flows from current operations within the major activity of the organization. The other section includes cash flows from operations connected with the investments in loans, intangible assets, and fixed assets. The third section is cash flows from financial operations to attract financing, both investments by owners and borrowed funds. For the correctness of the statement, it is necessary to complete all three sections.

The statement of cash flows serves as an essential source of information for the analysis of actual cash flows. In contrast to accounting indicators such as profit or revenue that are dependent greatly on accounting rules, cash flow allows investors to define accurately the spending of the organization and what return can be expected from investing in it (Warren et al., 2016). Unlike the income statement and the balance sheet, not all organizations engaged in accounting compose the statement of cash flows. Companies being small business entities may not provide this report if they consider that it does not contain important indicators for their performance evaluation. Moreover, the statement of cash flows refers to the annual forms of financial statements; thus, it is a form that legislation requires one to prepare only by the end of the year (Warren et al., 2016). However, at their discretion, companies can compile a report within a year, namely monthly or quarterly.

The Statement of Retained Earnings

The shareholders equity comprises two parts such as retained earnings and share capital. Retained earnings of the organization are part of the shareholders equity representing claims for assets appearing from the enterprise’s profits. In fact, retained earnings are equal to the total profit of the company from the date of its foundation minus dividends to shareholders, losses, and amounts transferred to equity (Needles, Powers, Crosson, 2014). Retained earnings are the net profit of the organization not distributed to shareholders but directed to reserves and other development needs. Importantly, retained earnings are not assets. On the contrary, they indicate that assets obtained as a result of the profitable activity that were retained in the organization with the purpose of financing growth or for other needs (Needles et al., 2014). The credit balance of the statement of retained earnings does not mean that there is a direct correspondence between undistributed profit and certain assets or cash. Therefore, the fact that the profit was not allocated demonstrates that the assets have increased.

The statement of retained earnings represents all changes, which occurred for undistributed profits during a certain period. It usually has the credit balance. If there is the debit balance, the organization has losses that are indicated in the section of the share capital of the balance sheet, decreasing its value (Needles et al., 2014). The debit balance occurs when dividends and subsequent losses of the organization surpass the accumulated profit from operating activities. In such a way, the company has a deficit under the account of retained earnings (Needles et al., 2014). The deficit is reflected in the section on the equity of the shareholders of the balance sheet as a reduction in share capital. Thus, the statement of retained earnings provides people with detailed information about the amount of accumulated retained earnings presented in the balance sheet.

Generally Accepted Accounting Principles

The major means of providing general financial information to users is a set of accounting information called a financial report. The set of financial reports comprises four interrelated statements that describe liabilities, financial resources, cash transactions, and profitability. Moreover, a full set of financial statements has several pages of notes that contain additional data useful for processing financial statements (Shamrock, 2012). The most important purpose of the financial statements is to assist users in assessing the financial position, prospects, and profitability of the organization. In the United States, quarterly and annual financial statements of all state-owned companies are public information. When deciding where to invest resources, lenders and investors frequently compare financial statements of different enterprises (Shamrock, 2012). For the authenticity of such comparisons, statements of these organizations should be comparable. Therefore, they should give the same information issued in the same way. For this purpose, financial statements are prepared according to the set of general rules called generally accepted accounting principles (GAAP).

GAAP provide a general framework defining what information should be included in the statements and how it should be presented. They cover the basic objectives of financial reporting, a set of detailed rules, and a number of concepts. According to GAAP, all organizations must provide reports on overall financial conditions, cash flows, and profit-making operations. Thus, under generally accepted accounting principles, drafting of the income statement, the statement of retained earnings, the balance sheet, and the cash flow statement is required. Thus, GAAP are used in the standardization and regulation of financial statements.

In the United States, several organizations play an active role in improving the quality of financial reporting and in the development of generally accepted accounting principles. The most influential ones are the Institute of Internal Auditors, the Financial Accounting Standards Board, the American Accounting Association, and the Securities and Exchange Commission (Shamrock, 2012). However, FASB is regarded the most competent source of GAAP (Shamrock, 2012). This is an independent company, which comprises several members, representatives of education, industry, and government, as well as accounting specialists. Moreover, an advisory council and a large research staff assist them. FASB publishes the Regulations on Financial Reporting Standards representing the official expression of generally accepted accounting principles. Today, there are more than 100 publications (Shamrock, 2012). The organization also completed the project description of the conceptual framework for financial reporting. It includes elements of financial statements, objectives of the financial statement, criteria for including information in reporting, desirable characteristics of accounting information such as clarity, reliability, and relevance, and a concept of calculation that relates to the final amounts of financial statements. In fact, FASB is part of the private sector of the economy. Traditionally, the development of accounting principles in the United States has been entrusted to the private sector, although the government has a considerable influence through its organizations (Shamrock, 2012). The work of the Financial Accounting Standards Board helps resolve accounting problems in a consistent and logical way.

Several years ago, the American Institute of Certified Public Accountants was responsible for the determination of GAAP before the appearance of FASB. These days, AICPA actively participates in various spheres of accounting (Shamrock, 2012). The organization developed a code of professional ethics, with which all members of the Institute must comply. Moreover, AICPA established professional audit standards that are compulsory for all auditors. The organization also analyzes accounting problems and shares its results with FASB (Shamrock, 2012). The Securities and Exchange Commission is a government organization that has legal powers, which allow it to establish financial reporting requirements for public corporations. Previously, it followed the recommendations of FASB without its own set of accounting principles (Shamrock, 2012). In such a way, the private sector continues developing principles, but they assume the force of law after the approval by the Securities and Exchange Commission. For new accounting standards become widespread, the Financial Accounting Standards Board needs the support of SEC; therefore, these organizations closely collaborate (Shamrock, 2012). SEC also checks the compliance of financial reports of state corporations with the requirements. When nonconformity was established, the Securities and Exchange Commission can take action against the company and the perpetrators (Shamrock, 2012). Another organization is the American Accounting Association, which is mainly composed of educators (Shamrock, 2012). It supported several publications and research programs, where authors and members of the Association’s committees reported on different accounting issues (Shamrock, 2012). Despite this fact, it cannot dictate its views and has no power. Its strength lies in prestige of the authors and the persuasiveness of the arguments. Rules, standards, and principles formulated by official bodies become common automatically. Nevertheless, unofficial sources also support many principles, for example, the extensive usage of textbooks and other literature on accounting.

IFRS and GAAP

An unconditional advantage of GAAP and IFRS is that they provide truthful and reliable information on users, financial results, and the state of the business entity. In addition, there is an opportunity to retain information in such form, as it is convenient for making managerial decisions and for the purposes of management accounting (Shamrock, 2012). GAAP and IFRS standardize terminology, assumptions, methods, and definitions, thereby making a process of financial reporting transparent. Parties can match financial statements and assume consistency, providing efficient cross-organization matching. GAAP and IFRS offer continuity and transparency so that this fact allows stakeholders and investors to make grounded decisions. In such a way, GAAP and IFRS exclude any attempts of ethical and financial violations.

It is highly necessary to understand that GAAP and IFRS are not only reporting instruments. They also serve as additional possibilities for attaining the strategic goals of the organization and the ability to set new tasks. Enterprises that want to increase efficiency should apply IFRS and GAAP both internally and for communication with an external investor. The principal advantage of the implementation of international standards lies in the increase in the transparency of reporting, its comparability, and understandability for investment institutions and international investors. In such a way, IFRS and GAAP are a single global financial reporting language that specialists all over the world understand.

Conclusion

A financial statement represents a system of indicators that reflect the financial position and property of the company at the reporting date, as well as financial results of its economic activity. It serves as a source of information and gives internal and external users the opportunity to make management decisions. The composition of the financial statement is a process of systematization, generalization, and gathering of current accounting data. The main purpose is to create the final information on the capital, the condition of actives, obligations, and results of company's financial activity. There are four basic financial statements, namely the statement of retained earnings, the income statement, the statement of cash flows, and the balance sheet. They play a highly important role in the financial activity of the organization. The composition of these financial statements according to the principles of GAAP and IFRS make them transparent for investors and authorities. This article was written by Alik Saia . More my works you can see here prime-essay.net