Practical Aspects of Financial Statements - Essay Example

?Introduction This paper focuses on the practical aspects of financial ments. It is written in three parts. The first part examines the components of the income statement and how it can be applied to everyday life in a business. The second part discusses the benefits that a business manager can get if s/he understands the income statement. The final part of this essay evaluates the importance of the balance sheet and income statement to my career as an investment adviser and my future career of banker. The essay will utilize some secondary sources which will be referred to. This will be aided by critical analysis an explanations of components and importance of financial statements to relevant stakeholders identified above. The Income Statement The income statement is “a financial statement listing all revenue and expenses for a fiscal period leading to net income or net loss: a statement that describes the operations of a business over a period of time (fiscal period)” (Kravitz, 1999 p63). The income statement is therefore a financial statement that shows the results of the operations of a business. This involves financial information about the income that a business makes and the expenditure that the business incurs over a given period of time. In effect, the income statement matches the revenue of a business with its expenses and provides the net income or net loss. In other words, the income statement provides an insight into the kind of revenue inflows and outflows that were incurred during the normal trading activity of the business. Another aspect of the income statement is that it is a period statement. In other words, it captures the financial picture of a business's trading activities over a defined period of time. This means that the income statement is mainly concerned with how a business performed in trade over the specified period of time. Tracey (2009) identifies that the main purpose of the income statement is to identify the profit or loss made by a business in a given period of time (p13). This means that the income statement identifies the performance of a business in terms of how much profits or losses that the business made over the specified period for which the accounts were prepared. This shows clearly that the income statement is mainly a tool for the measurement of the financial viability or otherwise of a given business in a stated period of time. “The income statement summarizes the sales revenue and expenses of a business for a period, usually 1 year” (Tracey, 2009 p13). This indicates that most businesses prepare their income statements over a period of 12 months. The GAAP and other legal statutes require businesses to prepare financial statements once every 12 months. However, in some instances, a business might opt to prepare an income statement for periods that are less or more than the 12 month period. If a business began trading in the middle of they year, they many prepare income statements for a period that is less than 12 months. Such a financial statement might be pro-rated for taxation and other financial purposes. This means that the number of months for which the accounts were prepared will be identified and divided by the 12 months period to find out the true worth for certain statutory purposes like tax. Typically, the tax rate that is invoked on such a business is calculated by identifying the number of months for which the accounts were prepared and dividing it by 12 before the figures are multiplied by the annual tax rate. The main motive is that income statements must be prepared over a given period and there should be definite cut offs within which the income and expenditure captured are compared. Tracey (2009 p13) identifies four main steps in the preparation of income statements. In the first step, the sales revenue is matched with the cost of goods or services that were sold. In other words, this involves the matching of income or payments made by customers to the business against the cost the business incurred in producing the goods sold. This provides the gross margin. The gross margin is sometimes called the gross profit. This is because it shows a crude link between the revenue and the cost of the goods and services sold. This provides a rough idea of how much was spent to raise the revenue identified. Step 2 involves the matching up of the gross margin with the general and administrative expense. This usually involves the consideration of overheads and other general costs that were involved in raising gross profits. General expenses include marketing and distribution costs. Administrative expenses include depreciation and other costs that are incurred in the production process. Depreciation is the apportionment of the worth of plant, property and equipment that was used in the production process. This is a notional concept that tries to break down the useful life of plant, property and equipment, formerly known as fixed assets into a number of years [or periods within which the income statement is prepared]. So for each income statement, the useful life of the fixed asset attributed directly to the processing of goods and services for consumers to purchased is factored into the income statement at this second stage. Thus, depreciation and other costs directly attributable to the production process are added at this point of the income statement. The second stage provides Earnings Before Interest and Tax (EBIT). The third step involves the deduction of the cost of capital in financing the production process. At this stage, the cost of capital in the form of interest is deducted from the earnings before interest and tax. This caters for the cost of capital involved in the production process. This leads to Earnings Before Tax (EBT). The fourth step to deduct taxation. This lead to the declaration of profit or loss. Although in some advanced businesses, other elements will be considered in an income statement like unusual income and other things, these four steps form the basis of income statements. Application of The Income Statement in Business The income statement is a fundamental element for the governance and control of businesses. This means that stakeholders can make good use of the income statement to gauge important activities in the business and take relevant decisions with a high degree of accuracy if they rely on the income statements of businesses. First of all, the income statement provides vital information about how the business is being ran. As such, shareholders, directors and other interested parties can use the income statement to get an idea of how their investments are being ran. This way, they can assess the efficiency and effectiveness of the decisions and actions of the people running their businesses. This can be a tool for monitoring and timely interventions to prevent the misuse of resources. Secondly, the income statement can be used to determine the amount of tax that a business is liable to. This is because tax in the normal sense, is based on how much a business earns in a given period of time. As such, the income statement is the main document that can be used as reference point to determine how much a business is due to pay at a given period of time to the tax agencies of the state. The income statement also gives the people charged with governance and stewardship an opportunity to compare the results of a business' operations over different periods of time. This means that the operations of a given year can be compared with another year because income statements are prepared on the basis of accounting conventions that can be varied over different periods of time due to the consistency that these conventions bring. Due to this, owners and investors can compare the results of a business over different periods of time and judge whether the business is making project or not. From there, they can make predictions for the future growth or contraction of the business. Thus, the income statement is a strong predictive tool for businesses. The income statement also gives the opportunity for business to business analysis. This is because statutory requirements make it imperative for businesses to use the same conventions to provide financial statements. Due to this, the financial statements of a business can be compared to another. This offers opportunities to some members of the public like investors in their bid to judge the strengths of different businesses. Benefits of Income Statement to a Business Manager Managers are charged with the day-to-day running of businesses and as such, the income statement and its preparation can become a tool for monitoring, control, planning and decision making (Longenecker et al, 2005 p205). This means that management can always do self assessment of their activities by examining the most recent income statement and compare them to their targets and standards. Through this, they can make adjustments as and when necessary. Managers can make important decisions about their future by examining their income statement. This is because the management can always identify where they are and compare it to where they intend to go by comparing current or recent financial statements with budgets and other plans. This can form the basis for decision making and planning. The income statement provides the basis for the effective and efficient allocation of resources. This is because a business can always do ratio analysis and interpretations to income statements to identify how much they are improving in some important and critical aspects of their operations. Additionally, the income statement provides a holistic view of how resources are used and from that, management can make changes where required. The income statement examines how assets are used through depreciation and also identify the worth of stocks and how it contributes to the wealth generation of the business. Through this, the management can make the necessary changes that is needed. Other situations like the cost of capital and others can always be monitored and changed where necessary. This is because the income statement draws on how these relevant elements of the business work together to meet the expectations and targets of management. Benefits of Balance Sheet & Income Statement to Investment Adviser An investment adviser provides important directions and guidance to clients. Some of these clients include businesses and other corporate entities that seek to invest their extra money in ventures that will bring them optimum returns. An investment adviser will always need to get up-to-date financial information about proposed investment ventures in order to advise clients accordingly. This is because an investment adviser has a duty of care to provide the best services to his or her customers. In this bid, financial statements are the most important and most reliable sources of information to analyze the markets and individual businesses in order to advise prospective clients on which businesses to invest in and which ones to avoid. Aside the Income Statement, the Balance Sheet is an important document that is indispensable to the investment adviser. The Balance Sheet is a statement of the asset position of a given business (Kravitz, 1999 p81). It shows the assets that a business owns and/or controls and the liabilities of the business or entity. An asset is defined as the privileges and rights [measured in monetary terms] that a business is entitled to as a result of past transactions with third parties. This include the benefits and other tangible and intangible rights that a business is entitled to as a result of past transactions. As a major accounting convention, assets must be measurable in monetary terms. This means that an asset must have financial worth if they will be disclosed in the financial statement. On the other hand, liabilities are the obligations owed by a business to third parties as a result of past transactions. These liabilities must also be measured in monetary terms and disclosed on the balance sheet. The Balance Sheet shows to classes of Assets and Liabilities: Current and Long Term. Current Liabilities and Assets are due in a period of 12 months. Long-Term Assets and Liabilities are due in more than 12 months. Current Assets include Cash and Cash Equivalents, Bank Accounts, Receivables [Debtors], and Accruals. Current Liabilities include Creditors, Bank Overdrafts and Payables [Creditors]. Long-Term Assets include Plant, Property and Equipment and Goodwill. Another important components of a Balance Sheet is Capital. Capital includes the initial investments made by the owners of a business as well as shareholders' reserves. Thus, the balance sheet revolves around the Accounting Equation which states that: Asset = Capital + Liabilities. Thus, the balance sheet can be balanced if assets is equal to capital and liabilities. The balance sheet provides a picture of the asset base of a given business. Thus, the balance sheet tells an investment adviser whether a business will survive into the future or not. On the other hand, the income statement shows an investment adviser how profitable a business is and this shows the potential for expansion and growth of capital. In advising prospective investors, an adviser will have to analyze the income statement to give an idea of the return on investment that is likely to come to a prospective investor when s/he invests in a given business. This shows the short-term viability of the business. On the other hand, the asset position of a business gives a clear view of the going concern of a business. In other words, it shows whether a business will continue to sustain its profitability in the longer term. This creates a logical basis for decision making. Benefits of Balance Sheet & Income Statement to a Banker I desire to become a banker in future. Banking has elements of investment and corporate governance. In other words, a top level banker in an executive position will always need to know the financial position and financial performance of the bank. This way, the banker can make decisions about new activities that the business can get involved in and new assets to acquire or dispose off. This can be done by a close monitoring of the financial statements of the bank. Conclusion The income statement is an important document that shows the revenue and expenditure of a given business over a stated period of time. The income statement is an important decision making tool for stakeholders like shareholders, board of directors, prospective investors and tax authorities. The income statement and balance sheet are important financial statements that help businesses to examine and understand the business' financial position and performance. This allows responsible persons in the business to know about the growth potential and current viability potentials of the business. These serve as the basis for decision making and postulations about the future. References Kravitz, W. (1999) Book Keeping The Easy Way New York: Barrons Educational Series Longenecker J. G, Moore, C. Palich, L. & Petty W. (2005) Small Business Management: An Entrepreneurial Emphasis. Mason, OH: Cengage Tracey J. (2009) How To Read A Financial Report: Wringing Vital Signs Out of the Numbers Hoboken, NJ: John Wiley & Sons Read More