Financial Statements Defined: An Expert Guide Blog Credit: Kristina Russo, February 11, 2022 (Financial Statements Defined: An Expert Guide | NetSuite)
Introduction to Financial Statements
Financial statements are like a company’s report card, giving investors and managers a clear picture of its financial health. Special software now makes creating these reports faster and easier.
What Is a Financial Statement?
- Financial statements gives the company’s accounting data in a standardized manner, enabling comparisons over time and with other companies.
- Components: Financial statements include the income statement, balance sheet, and statement of cash flows.
- Standards: Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS) dictate the formats and conventions for financial statements.
- Compliance: Public companies must adhere to either GAAP or IFRS, depending on their listing location.
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Key Takeaways:
- Core Financial Statements: The income statement, balance sheet, and statement of cash flows are standalone but interrelated reports.
- Stakeholder Use: Lenders, investors, and compliance agencies rely on financial statements to assess a company’s profitability, net worth, liquidity, and solvency.
- Internal Processes: Financial statements serve as a foundation for internal processes like financial modeling, budgeting, and forecasting.
- Standardization: Standard accounting rules facilitate comparisons across companies, but compiling financial statements can be resource-intensive.
- Importance of Accuracy: Accurate and auditable financial statements are essential for all companies.
Financial Statements Explained:
- Income Statement: Also known as the profit and loss statement, the income statement summarizes a company’s revenues, expenses, and net income over a specific period.
- Balance Sheet: The balance sheet presents a snapshot of a company’s financial position by detailing its assets, liabilities, and shareholders’ equity at a given point in time.
- Statement of Cash Flows: This statement tracks the flow of cash in and out of a company, categorizing cash activities into operating, investing, and financing activities.
- Additional Financial Statements: Besides the core statements, other financial reports may include the statement of retained earnings and the statement of comprehensive income.
- Customization for Private Companies: While private companies have more flexibility in adjusting financial statements, they should adhere to conventions expected by finance professionals for future scrutiny.
Overview of Financial Statements:
Financial statements are essential documents that provide insight into a company’s financial health. They include the balance sheet, income statement, statement of cash flows, statement of retained earnings, and footnotes.
Components of Financial Statements:
- Balance Sheet: Shows assets, liabilities, and shareholder equity at a specific point in time.
- Income Statement: Presents revenues, expenses, gains, and losses over a reporting period to determine profitability.
- Statement of Cash Flows: Illustrates cash inflows and outflows during a given period.
- Statement of Retained Earnings: Tracks changes in a company’s equity due to retained profits.
- Footnotes: Provide additional context, such as accounting methods and supporting details.
Use and Importance of Financial Statements:
- Internal Decision-Making: Financial statements aid managers in making informed decisions, financial analysis, and modeling.
- External Communication: External stakeholders like lenders, investors, and regulatory bodies rely on financial statements for decision-making, compliance, and evaluation.
- Regulatory Compliance: Compliance agencies, including the SEC, require financial statements from companies, ensuring transparency and accountability.
Advantages of Financial Statements:
- Summary of Financial Profile: Financial statements neatly summarize a company’s financial position, performance, and cash flow.
- Internal Management Tool: Serve as a decision-making tool for management, facilitating analysis, forecasting, and planning.
- External Decision-Making: Assist lenders, investors, and suppliers in assessing a company’s creditworthiness, performance, and stability.
- Regulatory Compliance: Fulfill regulatory requirements set by various agencies, ensuring legal and financial compliance.
Disadvantages of Financial Statements:
- Technical Limitations: Technical accounting rules, such as historical cost accounting and ignoring inflation, may lead to outdated values.
- Comparative Challenges: Comparing financial statements from different time periods or companies using different accounting methods can lead to inconsistencies.
- Conceptual Limitations: Financial statements may not capture intangible assets like brand value or predict future performance accurately.
Overview of Major Types of Financial Statements:
The three major types of financial statements for businesses are the income statement, balance sheet, and statement of cash flows. These statements organize financial data to highlight relationships and gives relevant information to users. While the income statement and statement of cash flows depict activity over a specific reporting period, the balance sheet reflects values at a particular point in time.
1. Income Statement:
- Also known as the “statement of operations” or “P&L” (profit and loss).
- Presents a company’s revenue, expenses, gains, and losses for a given period, culminating in net income or loss.
- Components include revenue, gains, expenses, losses, and net income/(loss).
- Typically includes current period results and comparative figures, such as the same period in the prior year or year-to-date results.
2. Balance Sheet:
- Shows a company’s assets, liabilities, and owner equity accounts at a specific date.
- Presents current-period balances alongside comparative figures from the prior fiscal year end.
- Assets are categorized as current or non-current, while liabilities are divided into current and non-current categories.
- Equity section reflects the company’s net worth, retained earnings, and ownership interests.
3. Statement of Cash Flows:
- Summarizes sources and uses of cash in a business over a reporting period.
- It Provides company’s liquidity, solvency, and financial cushion.
- Begins with net income/(loss) from the income statement and adjusts for non-cash activities.
- Cash flows are categorized as operating, investing, or financing activities.
Elements of Financial Statements: Financial statements encompass various elements derived from a company’s general ledger:
- Assets: Resources providing future economic benefit.
- Income: Profit generated by the sale of goods or services.
- Distributions: Payments of profit made to company owners.
- Equity: Company value shared by owners after subtracting liabilities.
- Expenses: Company spending related to operations.
- Gains: Positive impacts of incidental events.
- Investments: Company or owner’s transfer of value for equity investment.
- Liabilities: Obligations owed to outsiders at a future date.
- Losses: Negative impacts of incidental events.
- Revenue: Sales of goods and services.
Using Financial Statements in Modeling: Financial statements serve as the foundation for financial modeling, which includes purposes such as mergers and acquisitions modeling and budget preparation.
- Pro-forma financial statements model potential outcomes of mergers and acquisitions based on various assumptions.
- Budget preparation utilizes financial statements as templates to forecast future fiscal periods.
- Finance team use statements and operating data to identify latest  trends and support projections during the forecasting process.
Comparison of Core Financial Statements:
- Balance Sheet: Presents a snapshot of a company’s financial position at a specific point in time, listing assets, liabilities, and shareholder equity.
- Income Statement: Highlights a company’s revenue, expenses, gains, and losses during a specified reporting period, determining its profitability.
- Statement of Cash Flows: Illustrates the inflows and outflows of cash over a given period, providing insights into a company’s liquidity.
Utilizing Financial Statements in Modeling:
- Financial Modeling: Involves using financial statements or data from them for various purposes, such as creating pro-forma statements for mergers and acquisitions or preparing budgets.
- Forecasting: Finance teams use financial statements combined with operating data to identify trends and support projections for future fiscal periods.
Financial Statement Auditing:
- Purpose: External readers like lenders and investors often require audited financial statements for decision-making.
- Process: Certified public accountants investigate and test the accounting data to provide reasonable assurance of accuracy.
- Regulations: Generally Accepted Auditing Standards (GAAS) guide financial audits, ensuring compliance and accuracy.
Financial Management Software:
- Challenges for Small Businesses: Shortages in staff, inadequate expertise, changing regulations, and insufficient technology hinder managing financial reporting for small and midsize organizations.
- Solution: Financial management software like NetSuite Financial Management automates statement production, integrates information from other systems, and addresses challenges faced by smaller enterprises.
- Importance: Financial statements are crucial for internal management, investors, and lenders. Standardized accounting guidance ensures consistency across businesses, but specialized expertise is necessary for compliance.
FAQs
1. What are the four basic financial statements?
2. What are the five financial statements?
These are five key financial statements: income statement, balance sheet, cash flow statement, retained earnings statement, and footnotes. Those footnotes are like financial CliffsNotes – they explain the nitty-gritty details behind the numbers.
3. What is the purpose of the three major financial statements?
The purpose of the three major financial statements are (income statement, balance sheet, and statement of cash flows) which is to provide a standardized summary of a company’s financial position, performance, and cash flow. It consist of essential insights for stakeholders to assess the company’s health and make informed decisions.
4. How do you prepare financial statements in accounting?
Financial statements are prepared following standardized formats defined by Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS). Financial statement summarizes accounting data in a meaningful and intuitive manner, providing a snapshot of a company’s financial health. Certified public accountants may audit financial statements to ensure they are free of material errors and misstatements, providing assurance to stakeholders.