Financial Statements

A set of financial statements is a structured representation of the financial performance and financial position of a business and how its financial position changed over time. It is the ultimate output of an accounting information system and has following six components:
  1. Income Statement
  2. Balance Sheet
  3. Statement of Cash Flows
  4. Statement of Changes in Equity
  5. Accounting Policies and Notes
Financial statements are better understood in context of all other components of the financial statements. For example a balance sheet will communicate more information if we have the related income statement and the statement of cash flows too.
Following the time-period principle, financial statements are prepared after a specified period; say a quarter, year, etc.

Interim Financial Statements

Quarterly and semiannual financial statements are called interim financial statements and are normally prepared in a condensed form. It means that the disclosures required in them are far less than those required in annual financial statements. Quarterly financial statements are normally unaudited but semiannual reports need to be at least reviewed by an auditor who is a qualified professional accountant authorized to attest the authenticity of financial statements.

Annual Financial Statements

Financial statements prepared for a period of one year are called annual financial statements and are required to be audited by an auditor (a chartered accountant or a certified public accountant). Annual financial statements are normally published in an annual report which also includes a directors' report (also called management discussion and analysis) and an overview of the company, its operations and past performance.

Income Statement
Income statement communicates the company's financial performance over the period while a balance sheet communicates the company's financial position at a point of time. The statement of cash flows and the statement of changes in equity tells us about how the financial position changed over the period. Disclosure notes to financial statements cover such material information which is not appropriate to be communicated on the face of the main financial statements.
The income statement is an important component of a set of financial statements. It measures the performance of a business during an accounting period by calculating one or more of the following:
  1. Gross Profit
  2. Operating Income
  3. Net Income
  4. Earnings per Share (EPS)
There are four basic elements of a typical income statement. These are:
Revenues: Revenues are the earnings from usual business activities. In most cases, revenues are earned from sales of goods and services.
Gains: Gains are the enhancements in the assets or the reductions in liabilities caused by activities outside the usual course of business and which are eligible to be recorded according to acceptable accounting practices.
Expenses: Expenses include consumption of assets or the creation of liability against the business in the course of normal business activities.
Losses: Losses are the reductions in assets or the enhancements in liabilities caused by activities other than those in the main course of business.
Income statement can be prepared in either of two formats namely single-step income statement and multi-step income statement. The following example shows a simple single-step income statement. It has been prepared from the adjusted trial balance of Company A.
Company A
Income Statement
For the year ended 2010, Dec 31

Less: Expenses:
Wages Expense
Supplies Expense
Rent Expense
Miscellaneous Expense
Electricity Expense
Telephone Expense
Depreciation Expense
Interest Expense
Total Expenses
Net Income




There are certain incomes and expenses which are not reported on income statement but are credited or debited directly to equity, for example, the gain or loss on revaluation of fixed assets, unrealized gains on investments, foreign currency gains and losses, etc. A statement of comprehensive income includes all these debits and credits to equity besides the contents of a normal income statement.

Balance Sheet
A balance sheet also known as the statement of financial position tells about the assets, liabilities and equity of a business at a specific point of time. It is a snapshot of a business.
A balance sheet is an extended form of the accounting equation. An accounting equation is:
Assets = Liabilities + Equity
Assets are the resources controlled by a business, equity is the obligation of the company to its owners and liabilities are the obligations of parties other than owners.
A balance sheet is named so because it lists all resources owned by the company and shows that it is equal to the sum of all liabilities and the equity balance.
A balance sheet has two formats: account form and report form.
An account form balance sheet is just like a T-account listing assets on the debit side and equity and liabilities on the right hand side. A report form balance sheet lists assets followed by liabilities and equity in vertical format.
The following example shows a simple balance sheet based on the post-closing trial balance of Company A.

Company A
Balance Sheet
As on December January 31, 2011

Current Assets:
Accounts Receivable
Office Supplies
Prepaid Rent
Total Current Assets
Non-Current Assets:
Less: Accumulated Depreciation
Total Assets
Liabilities & Equity:
Accounts Payable
Utilities Payable
Unearned Revenue
Interest Payable
Notes Payable
Total Liabilities
Common Stock
Retained Earnings
Total Liabilities & Equity








Statement of Cash Flows
The statement of cash flows is prepared to measure the cash in-flows and cash out-flows from the operating, investing and financing activities of a business during a period. It is a summary of all the transactions that affect cash. It shows how the cash moved during the period. The term cash as used in the statement of cash flows refers to both cash and cash equivalents. Cash flow statement provides relevant information in assessing a company's liquidity, quality of earnings and solvency.
A Statement of Cash Flows comprises of three sections:
  1. Cash Flows from Operating Activities
This section includes cash flows from the principal revenue generation activities such as sale and purchase of goods and services. Cash flows from operating activities can be computed by two methods. One is the Direct Method and the other Indirect Method.
  1. Cash Flows from Investing Activities
Cash flows from investing activities are in-flows and out-flows related to activities that are intended to generate income and cash flows in future. This includes cash in-flows and out-flows from sale and purchase of long-term assets.
  1. Cash Flows from Financing Activities
Cash flows from financing activities are the cash flows related to transactions with stockholders and creditor such is issuance of share capital, purchase of treasury stock, dividend payments etc.
Following is a cash flow statement prepared using indirect method:

Company A, Inc.
Cash Flow Statement
For the Year Ended Dec 31, 2010
Cash Flows from Operating Activities:
Operating Income (EBIT)
Depreciation Expense
Loss on Sale of Equipment
Gain on Sale of Land
Increase in Accounts Receivable
Decrease in Prepaid Expenses
Decrease in Accounts Payable
Decrease in Accrued Expenses
Net Cash Flow from Operating Activities

Cash Flows from Investing Activities:
Sale of Equipment
Sale of Land
Purchase of Equipment
Net Cash Flow from Investing Activities

Cash flows from Financing Activities:
Payment of Dividends
Payment of Bond Payable
Net Cash Flow from Financing Activities
Net Change in Cash
Beginning Cash Balance
Ending Cash Balance





Statement of Changes in Equity
A statement of changes in equity summarizes the movement in the equity accounts during the year namely share capital, share premium, retained earnings, revaluation surplus, unrealized gains on investments, etc.
A statement of changes in equity is an important component of financial statements since it explains the composition of equity and how has it changed over the year. Typical information we can get from a statement of changes in equity include:
  1. The amount of new share capital issued
  2. The amount of dividend paid during the year to shareholders
  3. The amount by which PPE is valued up or valued down
  4. The amount of net income earned during the year
  5. The amount of net income retained during the year
  6. Any movement in the unrealized loss or gain reserve and reserve for changes in foreign exchange gain or loss, etc.
Accounting Policies and Notes
Notes to the financial statement present all such information which cannot be presented on the face of income statement, balance sheet, statement of cash flows and statement of changes in equity.
Typical notes to the financial statement are:
  1. An introduction of the business outlining its legal status, its country of incorporation and the name of its parents if any and a statement about the company's areas of business and its operations.
  2. A summary of accounting policies related to revenue recognition, inventories, property, plant and equipment, financial instruments, etc.
  3. A schedule of property plant and equipment showing the addition and deletion of assets, related movement in the accumulated depreciation account and book value.
  4. A breakup of cost of sales, selling expenses and administrative expenses.
  5. A detailed disclosure of different classes of financial instruments and their related risks.
  6. A breakup of the gross amounts and present values of lease obligations of the business.
  7. A detail of transactions with related parties.
  8. A detail of contingencies that may affect the business in future, for example legal proceedings against the business.
  9. A description of major events that occurred after the balance sheet date, etc.