Accounting's Four Financial Statements

Understanding balance sheets, income, cash flow, and retained earnings statements.

Although accounting can seem complex and confusing, the purpose is simplistic. The primary purpose of accounting is to provide necessary information to make proper financial decisions. There are two basic forms of accounting: managerial and financial accounting. Managerial accounting is used for internal decision making, whereas financial accounting must follow the General Accepted Accounting Principles (GAAP) rules for the purpose of taxation, investor relations, and creditors.

Accounting like any other practice uses certain tools to accomplish its purpose. These tools are called financial statements. There are four main financial statements:

(1) Income statements
(2) Balance sheets
(3) Cash flow statements
(4) Retained earnings statement

Income statements present the amount of money a company made and spent over a period. The income statement and balance sheet of a company are linked by the net income for a period. As well the relation shows the increase, or decrease, in equity over a period. The income an organization earns during a period is transferred to the equity portion of the balance sheet.

A balance sheet presents a company’s assets, liabilities, and shareholders’ equity. The balance sheet shows the assets, liabilities, and shareholder’s equity at a fixed point in time. The balance sheet, in the same manner, that it is linked to income statements is also linked to the cash flow statement. Changes in net cash in the operating activities area of the cash flow statement also affect the balance sheet.

In the same manner, the cash flow statement shows the exchange of money between a company and external agents. For instance, cash flow is affected by equipment purchases and these purchases if large enough can affect the assets on the balance sheet.

The fourth financial statement, the retained earnings statement shows changes in the interests of the shareholders' ownership over time. The shareholders’ equity is also referred to as capital or net worth. Net worth is the money that remains if a company was to sell all its assets and paid its liabilities. The remaining money belongs to shareholders. Again, the ownership of the company is affected by changes in the balance sheet, income statement, and cash flow statement. Shareholder equity can be altered by any number of factors involving these statements.

One can see the interlacing of these four financial statements. The statements are linked into a series of windows that allow outside viewers to see the viability and strength of a company. As well as financial health, these statements can also be used to track trends in income and profit loss. Without these statements, individuals would be at a loss to make informed and sound financial decisions.

These statements are useful to managers when they need to create budgets or approve expansion or strategic business plans. Investors use these statements to determine if a company is a solid investment and what the return on their investment could be by looking at past performance. Creditors determine whether loans are possible for organizations based upon these statements, without these statements, lending would be far more difficult. Employees use financial statements to determine the viability of an organization. Although not commonly practiced, an employee could use financial statements to make determinations about the company they work for. For instance, by reading the financial statements of a company an employee could determine whether their employer is doing well financially or performing poorly. This could also be determining factor for a potential employee when deciding on a firm to work for.

Financial statements are extremely important to a variety of stakeholders. Anyone having some form of vested interest in a company would desire to understand the financial statements. These statements are prepared by accountants in particular CPAs. These statements, because of their importance must be prepared accurately and timely. Today, accounting statements are of extreme importance because of recent financial laws that require auditing for publically traded companies. For example, the Sarbanes/Oxley Act of 2002 requires a much tighter rein on accounting practices (SOX, 2002). For these reasons, financial statements have become the centerpiece in ethical and legal accounting concerns.

References

SOX. (2002). The sarbanes-oxley act. Retrieved from http://www.soxlaw.com/