Financial statements are crucial for the smooth operations of an organization. To understand what is meant by financial statements, in-depth understanding of the economic activity of any business is of paramount importance. Financial statements are prepared after the data is collected from the organization’s accounting database.
Economic activity of a business deals with the purchase, sales, credit, debit, drawings, capital investments, shareholders, stakeholders, etc. A record (ledger accounts, journals, subsidiary books, etc.) of every economic and non-economic transaction of the business is maintained in order to determine the future steps to be taken.
Financial statements of an organization are its prime source of advice. Decisions, policies, amendments in objectives and other such crucial business-related strategies are formulated after intense scrutiny of the organization’s annual financial statement.
What are financial statements?
Financial statements refer to an official report on the financial position of the business. Financial reports are not restricted to businesses alone. They are prepared for persons, HUF’s and other entities (which have physical or conceptual existence). Financial statements are presented for the sole purpose of studying the financial activities and operations of the business (or any other economic entity).
Moreover, appropriate financial information is presented in a well-thought-out and organized format with the main aim of facilitating and enabling effective decision-making. Financial statements once prepared and presented to the top management of a firm, is closely analyzed before formulating policies and strategies either for an immediate change or for the next financial year.
What are the objectives/importance/benefits of financial statements?
The main purpose of preparing financial statements is to:
- Provide information about the financial status and financial position of the organization (or other entities).
- Provide information to analyze and assess the economic and business performance of the organization (or other entities).
- Serve as an accounting database for future references.
- Facilitate effective, accurate and well-thought-out policies and strategies for the organization (or other economic entities).
- Serve as an important tool to promote effective decision making.
- Act as an important source of crucial business information.
- Ascertain the results of various business operations such as income, expenditure, debtors, payables, receivables, profits, losses, etc.
How do you prepare financial statements?
There is a very famous method of preparing the financial statement. Many companies have adopted financial statements due to its:
- Ease to comprehend
- Ease of following
- Accurate and effective
There are 6 key steps in preparing an effective financial statement.
- Prepare a journal entry which debits every revenue account created by the organization’s activities.
- Close all of the revenue accounts after preparing the journal entry.
- Prepare a journal entry which credits every expenditure account created by the organization’s activities.
- Close all of the expenditure accounts after preparing the journal entry.
- Transfer the summary of the income balance into a capital accounting.
- Finally, close the drawings A/C
What are the elements of financial statements?
Financial statements are an amalgamation and blend of a total of 9 core elements:
- Assets – are physical resources that are in ownership of a company. The assets have both future as well as present economic values. These values can be expressed in monetary form. Examples of assets are inventory, land, building, furniture, cash, receivables, etc.
- Liabilities – are obligations of the company. When the company owes monetary aspects to another entity, it is considered as the company’s liabilities. Examples of liabilities are payable, loans, debenture interests, equity interests, payment of the loan, etc.
- Equity – refers to the privilege of owning an asset or part of the business. Equity yields interest and grants the right to be a part of decision making.
- Distribution to owners – is the payment made to business owners in the form of dividends. These payments are usually made in cash.
- Revenues – refers to the fees or payment earned by an entity for a good sold or a service offered. Revenues are recorded in the accounting database at the time of delivering the product or service.
- Investments by owners – is also known as owner investment or capital investment. It is the owner’s contributed capital investment into the business at its initial stage to kick-start the operations.
- Expenditures – refers to expenses incurred by the organization against entities outside the organization
- Gains – are the additional incomes apart from revenues and receivables. Another word for gains is profit.
- Losses – are the additional expenses apart from expenditure and payable.
What are the basic financial statements?
The 4 basic, formally accepted financial statements that have proven to be accurate, effective and suitable for all economic entities are as follows:
- Balance Sheet
- Cash Flow Statement
- Income Statement
- Statement of Retained Earnings
Each of the above financial statements explicitly presents and analyze specific aspects of the business activities. Financial statements are presented to the top management for the purpose of decision making. Each of the above mentioned financial statement specifically provides effective information on varied elements of the business activities.
What is the normal order of preparing financial statements?
Furthermore, the official order of preparing financial statements are as follows:
- First is to prepare the income statement – to present the organization’s incomes, revenues, losses, expenses, expenditures and profits for a particular financial year (also known as accounting year). Income and expenditure statement is another name for the income statement.
- Then, prepare the statement of retained earnings – to explain and study to increase or decrease in the retained earnings of the organization for a particular financial year. Incomes that are ready to be reinvested into the business rather than paid as dividends are known as retained earnings.
- Followed by, preparing the balance sheet – in order to present and explain the organization’s status with its assets and liabilities. The balance sheet portrays the overall comprehensive financial position of the business.
- Finally, preparation of the statement of cash flows – with the major aim of identifying the increase or decrease in the cash flow generated from either operational, investment or financing activities. The cash flows statement, in fact, accurately measures the organization’s financial stability for that particular financial year.