Connections Between the Main Structures of Financial Statements

Financial Statements

A financial statement is more than just a snapshot of your business’ health that you provide to shareholders or potential investors: It’s also a powerful diagnostic tool business owners can use to evaluate their firm’s strengths and weaknesses and chart the way forward.

When you do research on different companies by looking at their annual reports, you will typically come across three separate financial statements: the balance sheet, the income statement (also known as the statement of profit and loss) and the cash-flow statement. These three statements are very significant for companies as they can be used to describe the company's health and effectiveness of management.

This objectives should be carried forward as working principles for the financial statements as a whole.

Information should be presented in the financial statements in a manner that will help investors, creditors, and others to assess:

1. An entity's ability to generate future cash inflows

2. An entity's ability to meet its obligations, its ability to pay dividends, and its needs for external financing

3. The difference between cash transactions and accrual accounting

4. The effects of noncash activities during the period on an entity's financial position.

These three statements are interlinked, with changes in one necessarily altering the others, but they measure quite different aspects of a company's financial health. It's hard to say that one of these is more important than another. But of the three, the income statement may be the best place to start.

Income Statement

An income statement, also called profit and loss statement, presents the results of a company's operations for a given period—a quarter, a year, etc. The income statement presents a summary of the revenues, gains, expenses, losses, and net income or net loss of an entity for the period. This statement is similar to a moving picture of the entity's operations during the time period specified. Unlike the balance sheet, the income statement doesn't look at the company's financial health (total net worth). Instead, it looks at how much revenue a company is able to create. If you were to think of the balance sheet as an indicator of net worth, you can think of the income statement as a company's profitability: that is, how much it can make in a given time frame. Along with the balance sheet, the statement of cash flows, and the statement of changes in owners' equity, the income statement is one of the primary means of financial reporting. The key item listed on the income statement is the net income or loss. A company's net income for an accounting period is measured as follows:

Net income = Revenues - Expenses + Gains - Losses.

Within the income statement there is a wealth of information. A person knowledgeable about reading financial statements can find, in a company's income statement, information about its return on investment, risk, financial flexibility, and operating capabilities. Return on investment is a measure of a firm's overall performance. Risk is the uncertainty associated with the future of the enterprise. Financial flexibility is the firm's ability to adapt to problems and opportunities. Operating capability relates to the firm's ability to maintain a given level of operations.

The current view of the income statement is that income should reflect all items of profit and loss recognized during the accounting period, except for a few items that would be entered directly under retained earnings on the balance sheet, notably prior period adjustments (i.e., correction of errors). The main area of transaction that is not included in the income statement involves changes in the equity of owners.

TERMS ON THE INCOME STATEMENT

The Financial Accounting Standards Board provides broad definitions of revenues, expenses, gains, losses, and other terms that appear on the income statement in its Statement of Concepts No. 6. Revenues are inflows or other enhancements of assets of an entity or settlement of its liabilities (or both) during a period, based on production and delivery of goods, provisions of services, and other activities that constitute the entity's major operations. Examples of revenues are sales revenue, interest revenue, and rent revenue.

Expenses are outflows or other uses of assets during a period as a result of delivering or producing goods, rendering services, or carrying out other activities that constitute the entity's ongoing major or central operations. Examples are cost of goods sold, salaries expense, and interest expense.

Gains are increases in owners' equity (net assets) from peripheral or incidental transactions of an entity and from all other transactions and events affecting the entity during the accounting period, except those that result from revenues or investments by owners. Examples are a gain on the sale of a building and a gain on the early retirement of long-term debt.

Losses are decreases in owners' equity (net assets) from peripheral or incidental transactions of an entity and from all other transactions and events affecting the entity during the accounting period except those that result from expenses or distributions to owners. Examples are losses on the sale of investments and losses from litigation.

Discontinued operations are those operations of an enterprise that have been sold, abandoned, or otherwise disposed. The results of continuing operations must be reported separately in the income statement from discontinued operations, and any gain or loss from the disposal of a segment must be reported along with the operating results of the discontinued separate major line of business or class of customer. Results from discontinued operations are reported net of income taxes.

Extraordinary gains or losses are material events and transactions that are both unusual in nature and infrequent in occurrence. Both of these criteria must be met for an item to be classified as an extraordinary gain or loss. To be considered unusual in nature, the underlying event or transaction should possess a high degree of abnormality and be clearly unrelated to, or only incidentally related to, the ordinary and typical activities of the entity, taking into account the environment in which the entity operates. To be considered infrequent in occurrence, the underlying event or transaction should be a type that would not reasonably be expected to recur in the foreseeable future, taking into account the environment in which the entity operates.

Extraordinary items could result if gains or losses were the direct result of any of the following events or circumstances: 1) a major casualty, such as an earthquake, 2) an expropriation of property by a foreign government, or 3) a prohibition under a new act or regulation. Extraordinary items are reported net of income taxes.

Gains and losses that are not extraordinary refer to material items that are unusual or infrequent, but not both. Such items must be disclosed separately and would be not be reported net of tax.