Financial Statements | Financial Accounting | (2024)

Financial statements are how companies communicate their story. Thanks to GAAP, there are four basic financial statements everyone must prepare. Together they represent the profitability and strength of a company. The financial statement that reflects a company’s profitability is the income statement. The statement of retained earnings - also called statement of owners equity shows the change in retained earnings between the beginning and end of a period (e.g. a month or a year). The balance sheet reflects a company’s solvency and financial position. The statement of cash flowsshows the cash inflows and outflows for a company over a period of time.

There are several accounting activities that happen before financial statements are prepared. Financial statements are prepared in the following order:

  1. Income Statement
  2. Statement of Retained Earnings - also called Statement of Owners' Equity
  3. The Balance Sheet
  4. The Statement of Cash Flows

The following video summarizes the four financial statements required by GAAP.

Remember the transaction analysis we were working on for Metro Courier? Let's use those numbers to prepare the financial statements for Metro Courier Inc. The final balances for January were:

CashAsset$ 66,800
Accounts ReceivableAsset$ 5,000
SuppliesAsset$ 500
Prepaid rentAsset$ 1,800
EquipmentAsset$ 5,500
TruckAsset$ 8,500
Accounts PayableLiability$ 200
Common StockEquity$ 30,000
Retained EarningsEquity$ 0
Service RevenueRevenue$ 60,000
Salary ExpenseExpense$ 900
Utilities ExpenseExpense$ 1,200

Income Statement

The income statement, sometimes called an earnings statement or profit and loss statement, reports the profitability of a business organization for a stated period of time. In accounting, we measure profitability for a period, such as a month or year, by comparing the revenues earned with the expenses incurred to produce these revenues. This is the first financial statement prepared as you will need the information from this statement for the remaining statements. The income statement contains:

  • Revenues are the inflows of cash resulting from the sale of products or the rendering of services to customers. We measure revenues by the prices agreed on in the exchanges in which a business delivers goods or renders services.
  • Expenses are the costs incurred to produce revenues. Expenses are costs of doing business (typically identified as accounts ending in the word "expense").
  • REVENUES - EXPENSES = NET INCOME. Net income is often called the earnings of the company. When expenses exceed revenues, the business has a net loss.
Metro Courier Inc.
Income Statement
Month Ended January 31
Revenue:
Service Revenue$ 60,000
Total Revenues$ 60,000
Expenses:
Salary Expense900
Utility Expense1, 200
Total Expenses2,100
Net Income ($60,000 - 2,100)$ 57,900

The net income from the income statement will be used in the Statement of Equity.

Statement ofRetained Earnings (or Owner's Equity)

Thestatement of retained earnings, explains the changes in retained earnings between two balance sheet dates. We start with beginning retained earnings (in our example, the business began in January so we start with a zero balance) and add any net income (or subtract net loss) from the income statement. Next, we subtract any dividends declared (or any owner withdrawals in a partnership or sole-proprietor) to get the Ending balance in Retained Earnings (or capital for non-corporations)

Metro Courier Inc.
Statement of Retained Earnings
Month Ended January 31
Beginning Retained Earnings, Jan 1$ 0
Net income from month (from income statement)57,900
Total increase$ 57,900
Dividends (or withdrawals for non-corporations)- $0
Ending Retained Earnings, January 31$ 57,900

The Ending balance we calculated for retained earnings (or capital) is reported on the balance sheet.

Balance Sheet

The balance sheet, lists the company’s assets, liabilities, and equity (including dollar amounts) as of a specific moment in time. That specific moment is the close of business on the date of the balance sheet. Notice how the heading of the balance sheet differs from the headings on the income statement and statement of retained earnings. A balance sheet is like a photograph; it captures the financial position of a company at a particular point in time. The other two statements are for aperiod of time. As you study about the assets, liabilities, and stockholders’ equity contained in a balance sheet, you will understand why this financial statement provides information about the solvency of the business.

Metro Courier Inc.
Balance Sheet
January 31
AssetsLiabilities and Equity
Cash$ 66,800Accounts Payable200
Accounts Receivable5,000 Total Liabilities200
Supplies500
Prepaid Rent1,800Common Stock30,000
Equipment5,500Retained Earnings57,900
Truck8,500 Total Equity87,900
Total Assets$ 88,100Total Liabilities + Equity$ 88,100

Remember in the transaction analysis, our final accounting equation was: Assets $88,100 (Cash $66,800 + Accounts Receivable $5,000 + Supplies $500 + Prepaid Rent $1,800 + Equipment $5,500 + Truck $8,500) = Liabilities $200 +Equity $87,900 (Common Stock $30,000 + Net Income $57,900 from revenue of $60,000 – salary expense $900 – utility expense $1,200). The balance sheet is the same equation in an easier to read format.

Statement of Cash Flows

The statement of cash flows shows the cash inflows and cash outflows from operating, investing, and financing activities. Operating activities generally include the cash effects of transactions and other events that enter into the determination of net income. Management is interested in the cash inflows to the company and the cash outflows from the company because these determine the company’s cash it has available to pay its bills when due. We will examine the statement of cash flows in more detail later but for now understand it is a required financial statement and is prepared last. The statement of cash flows uses information from all previous financial statements.

You should be able to update the Financial Statements column of our chart of accounts spreadsheet (need another copy, click Chart of Accounts)

Key Points

There are four financial statements produced by accountants, including

  • The income statementreports the revenues and expenses of a company and shows the profitability of that business organization for a stated period of time. The net income (or loss) calculated is used in the statement of retained earnings.
  • The statement of retained earningsshows the change in retained earnings between the beginning of the period (e.g. a month) and its end. The ending retained earnings is used by the balance sheet.
  • The balance sheetlists the assets, liabilities, and equity (including dollar amounts) of a business organization at a specific moment in time and proves the accounting equation.
  • The statement of cash flows which shows the cash inflows and cash outflows for a company for a stated period of time. The statement of cash flows uses information from all previous financial statements.

Licenses and Attributions

CC licensed content, Shared previously

  • Financial Statements - An Introduction. Authored by: Accounting WITT. License: All Rights Reserved. License terms: Standard YouTube License
  • Accounting Principles: A Business Perspective. Authored by: James Don Edwards, University of Georgia & Roger H. Hermanson, Georgia State University. Provided by: Endeavour International Corporation. Project: The Global Text Project . License: CC BY: Attribution
Financial Statements | Financial Accounting | (2024)

FAQs

What is financial accounting answers? ›

What Is Financial Accounting? Financial accounting is a specific branch of accounting involving a process of recording, summarizing, and reporting the myriad of transactions resulting from business operations over a period of time.

Why is a careful reading of the financial statements not enough? ›

Simply reading financial statements may not be enough because they only show numbers without explaining the full story. To understand better one needs to analyze the numbers, compare them over time, and consider other factors like market trends and company goals.

What are the 3 important financial statements in accounting? ›

The income statement, balance sheet, and statement of cash flows are required financial statements. These three statements are informative tools that traders can use to analyze a company's financial strength and provide a quick picture of a company's financial health and underlying value.

Are financial statements hard? ›

It depends on your background if Financial Statement Analysis will be difficult for you. For the majority of Level I candidates, Financial Statement Analysis is one of the harder topics.

Is financial accounting hard? ›

Generally speaking, accounting is overall a difficult major, but financial accounting is a very straightforward class in the beginning. Financial accounting class teaches you the fundamentals of accounting.

What are the 5 limitations of financial statements? ›

There are 8 limitations: Historical Costs, Inflation Adjustments, No Discussion on Non-Financial Issues, Bias, Fraudulent Practices, Specific Time Period Reports, Intangible Assets, and Comparability.

What financial statements don't tell us? ›

Financial statements only provide a snapshot of a company's financial situation at a specific point in time. They also don't consider non-financial information, such as the health of the broader economy, and other factors, such as income inequality or environmental sustainability.

Which of the financial statements is most important? ›

Typically considered the most important of the financial statements, an income statement shows how much money a company made and spent over a specific period of time.

What are the golden rules of accounting? ›

The three golden rules of accounting are (1) debit all expenses and losses, credit all incomes and gains, (2) debit the receiver, credit the giver, and (3) debit what comes in, credit what goes out. These rules are the basis of double-entry accounting, first attributed to Luca Pacioli.

How to tell if a company is profitable from a balance sheet? ›

The two most important aspects of profitability are income and expenses. By subtracting expenses from income, you can measure your business's profitability.

What does a balance sheet tell you? ›

The balance sheet provides information on a company's resources (assets) and its sources of capital (equity and liabilities/debt). This information helps an analyst assess a company's ability to pay for its near-term operating needs, meet future debt obligations, and make distributions to owners.

What is the hardest topic in financial accounting? ›

Financial Statement Analysis

It is typically considered one of the most challenging courses in Accounting. Complexity: Requires a solid understanding of accounting principles and financial statement components. Analytical Skills: Develops the ability to analyze financial data and draw meaningful conclusions.

Is financial accounting a lot of math? ›

Basic arithmetic—addition, subtraction, multiplication and division—is at the core of the accounting math skills that accountants need. Companies rely on accountants to square their balance sheets, ensuring that the organization stays in the black.

What makes a strong financial statement? ›

Strong balance sheets will possess most of the following attributes: intelligent working capital, positive cash flow, a balanced capital structure, and income generating assets.

What is financial accounting in simple words? ›

Financial Accounting is the process of recording, summarizing and reporting transactions and revenue-expense generations in a time period. For example, investors or sponsors need to verify an account statement before showing interest in associating with the business.

What is financial short answer? ›

Finance is a term broadly describing the study and system of money, investments, and other financial instruments. Finance can be divided broadly into three distinct categories: public finance, corporate finance, and personal finance. More recent subcategories of finance include social finance and behavioral finance.

What is accounting in short answer? ›

Accounting is the process of recording financial transactions pertaining to a business. The accounting process includes summarising, analysing, and reporting these transactions to oversight agencies, regulators, and tax collection entities.

What is a financial accounting quizlet? ›

Financial Accounting. Providing information about the financial resources, obligations, and activities of an economic entity that is intended for use primarily by external decision makers-investors and creditors. Financing Activities.

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