Lesson Objectives:- Understanding the purpose of financial statements.
- Explaining the general purpose financial statements.
- The order in which the statements are prepared.
Users look at financial data in order to make business decisions. Financial statements present a snapshot of all of the relevant data which ultimately is the end result for all accounting data. This makes it easy to see the performance of the company without sifting through thousands of transactions.
Businesses adhere to the generally accepted accounting principles (GAAP) by preparing financial data in a standardized format across the various types of financial statements. As the information accumulates, the company summarizes the financial data, normally on a quarterly and annual basis.
You can easily remember the 4 different types of financial statements by using the following acronym: BRIC.
Think of the combination of financial statements as the weight of a brick, as the combination of financial information in these 4 types of statements are full of information. In this acronym, we are using BRIC instead of BRICK as there are only 4 main types to remember.
While you will use the BRIC acronym to remember the names of the financial statements, keep in mind the order that these items are prepared in is slightly different. They flow in the order below; each statement is a precursor for the next. For example, to prepare the retained earnings statement, you will need income data from the income statement.
1. Income Statement
2. Retained Earnings
3. Balance Sheet
4. Cash Flow Statement
Picture a measuring stick. Similar to how the measuring stick measures size, the income statement measures how a company is performing financially.
The revenue and expense transactions are summarized into categories that best represent their purpose. All income statements are organized in the same way, providing a standardized format for users to review the total revenue, profits, expenses and net income of a company.
Take a look at the example above: the revenue is summarized in one category, while the expenses are listed in categories such as research development, interest expenses and non-recurring
Let's break down some of the important sections of the income statement.
Total Revenue accounts for the total amount of income the company earned in the given time period. Sometimes this figure is broken down into multiple categories such as sales revenues, interest revenues and gains on the sale of assets.
The Cost of Revenue, also known as the cost of goods sold is deducted to provide the gross profit.
Expenses are further deducted in groupings and subcategories, leaving you with the final net income figure at the bottom of the statement. If the revenue does not exceed expenses, you are left with a net loss figure instead.
The income statement will tell you whether a company is profitable or losing money which ultimately defines their performance. Running a solvent business requires revenue in order to pay debts, taxes and expenses. After all of these items are paid, the money left over is the net income.
Think about the retained earnings statement as a large pie chart, it defines the amount that is issued to shareholders and owners in the form of dividends or retained earnings.
The retained earnings statement adds in the net income figure from the income statement to the current retained value. This figure is then deducted by the amount that is paid out to shareholders. In short, this statement answers how profit is distributed. It answers the fundamental question of how much of the income is being distributed to owners, and how much is kept within the company.
The company may decide to retain all of their earnings in order to position themselves for growth, in which case no dividends would be paid out.
As you can see from the sample retained earnings statement above, the net income figure is added to the amount of retained earnings. This figure is then deducted by the dividends that are paid out to stock holders to conclude with the final balance of retained earnings.
This is a very simple example to demonstrate the concept. Many retained earnings statements break down additional values such corrections to the previous period retained earnings value to account for depreciation.
The balance sheet is best thought of as a snapshot that speaks to the financial position of the company and whether they can pay their bills on time. It also shows their ability to acquire additional cash flow and payout dividends to their shareholders.
The example for Microsoft Corporation above represents their assets, liabilities and shareholders equity with each entry recorded on a specific point in time.
Take note of each section on the balance sheet:
The assets shown in the top section are financial items such as investments, equipment and inventory. They are everything that the corporation owns summarized in groupings.
The liabilities section in the middle represents every obligation they are responsible for; how much money they are owe to various debts.
Equity is what remains in residual interest after the liabilities are deducted from the assets; essential what is left to pay the shareholders.
The cash flow statement can be pictured as the veins and arteries of the human body. The money is flowing constantly, flowing in and out of the company. This statement provides a real-time view of how the cash flow is affected by business activities.
We talked about the three types of business activities (operating, investing and financing) in one of the previous lessons. The cash flow statement looks at the same activities to measure the amount of cash that enters and leaves the company.
Often, the income statement may reflect revenues but there can be a difference in timing of when the cash is actually received. Investors often look more at the cash flow statement because it is the most transparent view of a company's cash flow.
Looking at the sample cash flow statement above, you can see that there are two directions of cash flow:
Sources of income flowing in, such as net earnings and notes payable.
Uses of income flowing out, such as inventory and equipment purchases.
The cash flow statement integrates information from the other three financial statements to reflect all cash flowing through the business.