Introduction to The Financial Statements

The financial statements

Introduction to The Financial Statements

The financial statements are used to present the results of operations, financial position, and cash flows of a business. They are used by the shareholders, management, and lenders of a business, and could be perused by a large number of people. The bookkeeper is responsible for the financial statements since they essentially aggregate the results of all of the recordkeeping activities of the accounting department.

The income statement presents the results of operations for a reporting period and is usually the most closely-reviewed of the financial statements.

The balance sheet presents the financial position of an organization, usually as of the end of a month, quarter, or year. A common financial reporting package is to issue the income statement and balance sheet, along with supporting materials. The statement of cash flows reveals the sources and uses of cash. Though quite useful, the statement of cash flows is the least-distributed of the financial statements, and may not be issued at all for internal financial reporting purposes.

In this article, we introduce several different reporting formats for each of these elements of the financial statements, and also walk through the steps needed to create them.

Income Statement Overview

The income statement is an integral part of an entity’s financial statements and contains the results of its operations during an accounting period, showing revenues and expenses, and the resulting profit or loss.

The Singapore Financial Reporting Standards (International) – SFRS(I) 1-1 paragraph 99 states that an entity shall present the income statement either based on their nature or function, whichever is more relevant.

There are two ways to present the income statement. One method is to present all items of revenue and expense for the reporting period in a statement of comprehensive income. Alternatively, it is possible to split this information into an income statement and a statement of comprehensive income.

Other comprehensive income contains all changes that are not permitted in the main part of the income statement. These changes are beyond the scope of this article, but it includes unrealized gains and losses on available-for-sale securities, cash flow hedge gains and losses, foreign currency translation adjustments, and valuation of pension plan gains or losses. Smaller companies tend to ignore the distinction and simply aggregate the information into a document that they call the income statement; this is sufficient for internal reporting, but auditors will require the expanded version before they will certify a company’s financial statements.

There are no specific requirements for the line items to include in the income statement, but the following line items are typically used, based on general practice:

  • Revenue
  • Tax expense
  • Post-tax profit or loss for discontinued operations and their disposal
  • Profit or loss
  • Other comprehensive income, subdivided into each component thereof
  • Total comprehensive income

 A key additional item is to present an analysis of the expenses in profit or loss, using a classification based on their nature or functional area; the goal is to maximize the relevance and reliability of the presented information. If expenses are presented by their nature, the format looks similar to the following:

Alternatively, if expenses are presented by their functional area, the format looks similar to the following, where most expenses are aggregated at the department level:

Of the two methods, presenting expenses by their nature is easier, since it requires no allocation of expenses between functional areas. Conversely, the functional area presentation may be more relevant to users of the information, who can more easily see where resources are being consumed.

Add additional headings, subtotals, and line items to the items noted above if doing so will increase the user’s understanding of the entity’s financial performance. An example follows of an income statement that presents expenses by their nature, rather than by their function.

EXAMPLE

Lowry Locomotion presents its results in two separate statements by their nature, resulting in the following format, beginning with the income statement:

Lowry Locomotion then continues with the following statement of comprehensive income:

The Single-Step Income Statement

The simplest format in which an income statement can be constructed is the single-step income statement. In this format, present a single subtotal for all revenue line items, and a single subtotal for all expense line items, with a net gain or loss appearing at the bottom of the report.

A sample single-step income statement follows:

The single-step format is not heavily used, because it forces the reader of an income statement to separately summarize information for subsets of information within the income statement. For a more readable format, try the following multi-step approach.

The Multi-Step Income Statement

The multi-step income statement involves the use of multiple sub-totals within the income statement, which makes it easier for readers to aggregate selected types of information within the report.

The usual subtotals are for the gross margin, operating expenses, and other income, which allow readers to determine how much the company earns just from its manufacturing activities (the gross margin), what it spends on supporting operations (the operating expense total) and which components of its results do not relate to its core activities (the other income total).

A sample format for a multi-step income statement follows.

The Multi-Period Income Statement

A variation on any of the preceding income statement formats is to present them over multiple periods, preferably over a trailing 12-month period. By doing so, readers of the income statement can see trends in the information, as well as spot changes in the trends that may require investigation.

This is an excellent way to present the income statement to the management.

The following sample shows the layout of a multi-period income statement over a four-quarter period.

The report shown in the sample reveals several issues that might not have been visible if the report had only spanned a single period. These issues are:

  • Cost of goods sold. This cost is consistently 35% of sales until Quarter 4, when it jumps to 40%.
  • Advertising. There was no advertising cost in Quarter 2 and double the amount of the normal $30,000 quarterly expense in Quarter 3. The cause could be a missing supplier invoice in Quarter 2 that was received and recorded in Quarter 3.
  • Rent. The rent increased by $10,000 in Quarter 3, which may indicate a scheduled increase in the rent agreement.
  • Interest expense. The interest expense jumps in Quarter 3 and does so again in Quarter 4, while interest income declined over the same periods. This indicates a large increase in debt.

In short, a multi-period income statement is an excellent tool for spotting anomalies in the presented information from period to period.

How to Construct the Income Statement

If an accounting software such as Xero is being used, it is quite easy to construct an income statement. Just access the reports module, select the time period for which you want to print the income statement, and print it.

To ensure that the income statement is correct, compare it to the default income statement report that is usually provided with the accounting software, or compare the net profit or loss on the report to the current year earnings figure listed in the equity section of the balance sheet. If there is a discrepancy, there is an incorrect income statement report.

The situation is more complex if it is necessary to create an income statement by hand. This involves the following steps:

  1. Create a trial balance.
  2. List each account pertaining to the income statement in a separate column of the trial balance.
  3. Aggregate these line items into those to be reported in the income statement as a separate line item.
  4. Shift the result into the preferred format of the income statement.

The following example illustrates the construction of an income statement.

EXAMPLE

The accounting software for Lowry Locomotion breaks down at the end of July, and the bookkeeper has to create the financial statements by hand.

He has a copy of Lowry’s trial balance, which is shown below.

He transfers this information to an electronic spreadsheet, creates separate columns for accounts to include in the income statement, and copies those balances into these columns. This leaves a number of accounts related to the balance sheet, which he can ignore for the purposes of creating the income statement.

In the “Aggregation” columns of the extended trial balance, the bookkeeper has aggregated the expenses for salaries and payroll taxes into the salaries expense line, and aggregated the rent expense and other expenses into the other expenses line. He then transfers this information into the following condensed income statement:

Overview of the Balance Sheet

A balance sheet (also known as a statement of financial position) presents information about an entity’s assets, liabilities, and shareholders’ equity, where the compiled result must match this formula:

Total assets = Total liabilities + Equity

The balance sheet reports the aggregate effect of transactions as of a specific date. The balance sheet is used to assess an entity’s liquidity and ability to pay its debts. There is no specific requirement for the line items to be included in the balance sheet.

The following line items, at a minimum, are normally included in it:

Current Assets:

  • Cash and cash equivalents
  • Trade and other receivables
  • Short-term Investments
  • Inventories

Non-Current Assets:

  • Property, plant, and equipment
  • Intangible assets
  • Investments
  • Goodwill

Current Liabilities:

  • Trade and other payables
  • Accrued expenses
  • Current tax liabilities
  • Current portion of loans payable
  • Other financial liabilities

Non-Current Liabilities:

  • Loans payable
  • Deferred tax liabilities
  • Other non-current liabilities

Equity:

  • Capital stock
  • Additional paid-in capital
  • Retained earnings

An asset on the balance sheet should be classified as current when an entity expects to sell or consume it during its normal operating cycle or within 12 months after the reporting period. If the operating cycle is longer than 12 months, use the longer period to judge whether an asset can be classified as current. Classify all other assets as non-current.

Classify all of the following as current assets:

  • Cash. This is cash available for current operations, as well as any short-term, highly liquid investments that are readily convertible to known amounts of cash and which are so near their maturities that they present an insignificant risk of value changes. Do not include cash whose withdrawal is restricted, to be used for other than current operations, or segregated for the liquidation of long-term debts; such items should be classified as longer-term.
  • Accounts receivable. This includes trade accounts, notes, and acceptances that are receivable. Also, include receivables from officers, employees, affiliates, and others if they are collectible within a year. Do not include any receivable that will not be collected within 12 months; such items should be classified as longer-term.
  • Marketable securities. This includes those securities representing the investment of cash available for current operations, including trading securities.
  • Inventory. This includes merchandise, raw materials, work-in-process, finished goods, operating supplies, and maintenance parts.
  • Prepaid expenses. This includes prepayments for insurance, interest, rent, taxes, unused royalties, advertising services, and operating supplies.

A liability is classified as current when the entity expects to settle it during its normal operating cycle or within 12 months after the reporting period, or if it is scheduled for settlement within 12 months. Classify all other liabilities as non-current.

Classify all of the following as current liabilities:

  • Payables. This is all accounts payable incurred in the acquisition of materials and supplies that are used to produce goods or services.
  • Prepayments. This is amounts collected in advance of the delivery of goods or services by the entity to the customer. Do not include a long-term prepayment in this category.
  • Accruals. This is accrued expenses for items directly related to the operating cycle, such as accruals for compensation, rentals, royalties, and various taxes.
  • Short-term debts. This is debts maturing within the next 12 months.

Current liabilities include accruals for amounts that can only be determined approximately, such as bonuses, and where the payee to whom payment will be made cannot initially be designated, such as a warranty accrual.

How to Construct the Balance Sheet

When using an accounting software such as Xero, it is quite easy to construct the balance sheet. Just access the reports, select the time period for which you want to print the balance sheet, and print it.

If the balance sheet will be constructed manually, follow these steps:

  1. Create a trial balance report.
  2. List each account pertaining to the balance sheet in a separate column of the trial balance.
  3. Add the difference between the revenue and expense line items on the trial balance to a separate line item in the equity section of the balance sheet.
  4. Aggregate these line items into those to be reported in the balance sheet as a separate line item.
  5. Shift the result into the preferred format of the balance sheet.  

EXAMPLE

The accounting software for Lowry Locomotion breaks down at the end of July, and the bookkeeper has to create the financial statements by hand. He has a copy of Lowry’s trial balance, which is shown below. He transfers this information to an electronic spreadsheet, creates separate columns for accounts to include in the balance sheet, and copies those balances into the designated columns.

This leaves a number of accounts related to the income statement, which he can ignore for the purposes of creating the balance sheet. However, he does include the net loss for the period in the “Current year profit” row, which is included in the equity section of the balance sheet.

In the “Aggregation” columns of the extended trial balance, the bookkeeper has aggregated the liabilities for accounts payable and accrued liabilities in the accounts payable line, and aggregated equity and current year profit into the equity line. He then transfers this information into the following condensed balance sheet:

Overview of the Statement of Cash Flows

The statement of cash flows contains information about the flows of cash into and out of a company; in particular, it shows the extent of those company activities that generate and use cash.

The statement of cash flows also incorporates the concept of cash and cash equivalents. A cash equivalent is a short-term, very liquid investment that is easily convertible into a known amount of cash, and which is so near its maturity that it presents an insignificant risk of a change in value because of changes in interest rates.

The direct method or the indirect method can be used to present the statement of cash flows. These methods are described in the following sections.

The primary activities are:

Operating activities

These are an entity’s primary revenue-producing activities. Examples of operating activities are cash receipts from the sale of goods, as well as from royalties and commissions, amounts received or paid to settle lawsuits, fines, payments to employees and suppliers, cash payments to lenders for interest, contributions to charity, and the settlement of asset retirement obligations.

Investing activities

These involve the acquisition and disposal of long-term assets. Examples of investing activities are cash receipts from the sale of property, the sale of the debt or equity instruments of other entities, the repayment of loans made to other entities, and proceeds from insurance settlements related to damaged fixed assets. Examples of cash payments that are investment activities include the acquisition of fixed assets, as well as the purchase of the debt or equity of other entities.

Financing activities

These are the activities resulting in alterations to the amount of contributed equity and the entity’s borrowings. Examples of financing activities include cash receipts from the sale of the entity’s own equity instruments or from issuing debt, and cash payments to buy back shares, pay dividends, and pay off outstanding debt.

The Direct Method

The direct method of presenting the statement of cash flows presents the specific cash flows associated with items that affect cash flow. Items that typically do so include:

  • Cash collected from customers
  • Interest and dividends received
  • Cash paid to employees
  • Cash paid to suppliers
  • Interest paid
  • Income taxes paid

The format of the direct method appears in the following example.

Lowry Locomotion’s bookkeeper constructs the following statement of cash flows using the direct method:

The Singapore Financial Reporting Standards (International) 7 paragraph 18 allows us to choose the use of the direct method or the indirect method. The direct method is rarely used, for the reason that the information in it is difficult to assemble; companies simply do not collect and store information in the manner required for this format. Instead, they use the indirect method, which is described in the following section.

The Indirect Method

Under the indirect method of presenting the statement of cash flows, the presentation begins with net income or loss, with subsequent additions to or deductions from that amount for non-cash revenue and expense items, resulting in net income provided by operating activities. The format of the indirect method appears in the following example.  

Lowry Locomotion’s bookkeeper constructs the following statement of cash flows using the indirect method:

How to Prepare the Statement of Cash Flows

The most commonly used format for the statement of cash flows is the indirect method (as described in the preceding section). The general layout of an indirect method statement of cash flows is shown below, along with an explanation of the source of the information in the statement.

A less commonly-used format for the statement of cash flows is the direct method. The general layout of this version is shown below, along with an explanation of the source of the information in the statement.

As can be seen from the explanations for either the indirect or direct methods, the statement of cash flows is much more difficult to create than the income statement and balance sheet. In fact, a complete statement may require a substantial supporting spreadsheet that shows the details for each line item in the statement.

If the accounting software contains a template for the statement of cash flows, then use it! The information may not be aggregated quite correctly, and it may not contain all of the line items required for the statement, but it will produce most of the needed information, and is much easier to modify than the alternative of creating the statement entirely by hand.

Summary

Of the income statement formats presented in this article, the most commonly used is the multi-step income statement. This format reveals expenses by nature, not by department.

However, it is customary to create additional department-level statements that break down the expenditures for individual departments for management accounts. So that department managers can see the results of the entire business on the income statement. And then review the results pertaining only to their departments on a separate document.

Though a number of formats for the balance sheet were shown in this chapter, the most common one by far for internal reporting purposes is to present it only as of the end of the accounting period being reported. Nonetheless, we recommend reporting using a multi-period balance sheet, so that readers can gain some perspective on changes in the financial structure of a business over time.

If the statement of cash flow is created, we strongly recommend using the indirect method, since this format can be much more easily assembled from the general ledger than the direct method.

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