Accounting is the system used for presenting and making sense of a company’s operations in financial terms. In doing this, the company records information on all of the business’ financial transactions. Such transactions are documented using a double-entry accounting system.
Financial reporting aims to provide information which is useful to the investors, lenders, suppliers, creditors, and other business stakeholders. Since accounting information is concerned with individual transactions that are complex and detailed, it should be presented in an aggregate manner in the financial statements ( Marshall, McManus & Viele, 2011) . So, the financial statements omit detail for understandability.
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Preparing financial statements is ranked as the sixth stage in the accounting cycle. The adjusted trail balance is used to prepare the statement of retained earnings, the income statement, and the balance sheet. A worksheet is a tool that aids in making these financial statements, although it is in itself not a financial statement.
Based on the FASB Concept Statement No. 8, financial statements have four components – disclosure, presentation, measurement, and recognition ( Whittington, 2008) . The key questions one should ask while preparing financial statements include:
When should a change in liability, asset, expense, revenue or the like be recorded in the financial statements?
How should this item be measured?
How should the financial statements be presented?
What material information is not recognized on the financial statements but should be disclosed along with the financial statements?
According to the US GAAP, businesses must prepare four major financial statements:
The Income Statement
This financial statement records revenue and expenses. Revenue is gotten from the sale of goods, while expenses are incurred during the sale of goods (cost of goods sold). The difference between the income and cost of goods sold is the profit. The profit is used for covering other expenses like overhead, and the amount of profit kept by a company after deducting all expenses is known as income. Income is abstract theory representing a change in a business’ capital over the period ( Williams & Dobelman, 2017) . Operating income is gotten from operating activities like ordinary sales. Other incomes, such as gains from the sale of property and interest from investments, are part of the company’s income. If a negative income is recorded, it is called loss. An income statement reports all this information, which represents a company’s net income or a net loss.
The Statement of Owner’s Equity
The capital of a business comprises two parts. A company acknowledges the contributed capital as the money invested by shareholders over time in the firm through the purchase of the company’s shares. Retained earnings are the amount accumulated by the firm over time and can be reinvested. The ending balance of retained earnings is calculated by adding the beginning balance of retaining earnings to income from the current period and deducting dividends ( Minnis & Sutherland, 2017) . The importance of the income statement is that it presents the change in the capital due to the business operations. The shareholders’ value is derived from the earnings. The statement of owners’ equity presents the accumulated income over a company’s life.
The Balance Sheet
The balance sheet represents the firm’s financial position on a certain time. Through the double-entry accounting system, the credit and debit sides should be equal. This means that each accounting transaction follows the accounting equation, in which Assets = Liabilities + Owner’s Equity. For instance, an entry which increases cash should as well increase a liability (when the cash is borrowed) or owner’s equity (when the cash is earned) ( Minnis & Sutherland, 2017) . All transactions are recorded this way. The balance sheet lists down the firm’s assets, liabilities, as well as Owners’ equity. The name balance sheet means that the assets should always balance out the owners’ equity and liabilities.
The Cash Flow Statement
Every business needs cash to survive. Businesses earn or spend money from investing activities like purchase of properties, operating activities like sales, and financing activities like sell of shares of borrowing of cash. To determine the cash at the end of a given period, the cash from the balance sheet from the start of the period is added or subtracted to the cash from all the three business activities mentioned ( Williams & Dobelman, 2017) . This amount must equal to the cash amount at the end of the period in the bank account. This information is useful to financial managers for showing how the business generates and utilizes the cash to make sure that appropriate financing decisions are made to prevent the company from running out of cash.
References
Marshall, D. H., McManus, W. W., & Viele, D. F. (2011). Accounting: what the numbers mean . McGraw-Hill/Irwin.
Minnis, M., & Sutherland, A. (2017). Financial statements as monitoring mechanisms: Evidence from small commercial loans. Journal of Accounting Research , 55 (1), 197-233.
Whittington, G. (2008). Fair value and the IASB/FASB conceptual framework project: an alternative view. Abacus , 44 (2), 139-168.
Williams, E. E., & Dobelman, J. A. (2017). Financial statement analysis. World Scientific Book Chapters , 109-169.
