Four Basic Financial Statements - Research Paper Example

 The four basic Financial Statements, their relationships and uses to stakeholders Abstract This paper explores the four basic financial statements used by companies to analyze company performance. These four basic financial statements are the Balance Sheet, Statement of Cash Flows, Statement of Retained Earnings and the Income Statement. Furthermore, this paper also examines the uses of these financial statements to both internal and external stakeholders of the corporation. This paper also includes the inter-relationships between the four financial statements. The four basic financial statements in accounting are the balance sheet, statement of cash flows, statement of retained earnings and the income statement. Each of these four statements constitute a major part of the accounting system and are thus, inter related to each other. First, we would consider the most important financial statement of all, the Balance Sheet. A Balance Sheet is a report which lists the assets, liabilities, and the owner’s equity of a business. It is usually prepared once a year and shows the financial structure of the business as of the specific date. Another useful way of understanding the contents of a balance sheet is the accounting equation. Assets= Liabilities + Owner’s Equity/Capital The Balance Sheet of any business or corporation starts off by listing the assets. Assets are further reported as fixed and current assets on the Balance Sheet. Assets are reported on the Balance Sheet in the order of liquidity. That is, assets which can be most easily converted to cash are reported first. Then, all the liabilities are reported and the difference between the total assets and the total liabilities show the net resources of the corporation. A statement of cash flow is a statement reporting only cash transactions. It is a very simple form of reporting and is a part of the single entry system. A statement of cash flow shows all the cash inflows and outflows. In order to make the statement more presentable and organized, the statement of cash flows is divided into three sections: Cash Flows from Operating Activities: This section represents all cash transactions resulting from operations of the business. For instance, cash received from sale of goods etc. Cash Flows from Investing Activities: This section deals specifically with the purchase and disposal of fixed assets. For example, purchase of a premises etc. Cash Flows from Financing Activities: The most common financial activities of a corporation constitute of issuance of stocks and dividend payments. The Statement of Cash Flows is very important in today’s ever changing economic climate. The Statement of Cash Flows does not cover every transaction, but it is one of the most important statements for financial analysis. For example, a company may report $10 million in profits, but may only have $10,000 in its pocket to operate. All in all, it provides investors with valuable information to assess the financial viability of the corporation and whether the corporation is liquid enough to survive uncertain market conditions. The statement of retained earnings is prepared to show the change in retained earnings over a period of time. For instance, Reeve wrote (2008), “The retained earnings statement is a connecting link between the income statement and the balance sheet.”( p.20.). The income statement presents the results of the entity's operations during a period of time, such as one year. The simplest equation to describe income is: Net Income = Revenue – Expenses The excess of revenue over expenses is known as net profit, whereas the excess of expenses over revenue is reported as net loss. Now, let’s look at how these financial statements are inter-related to each other. The financial statements are related in such a way that every figure in each of the financial statements affects the other. Hence, no financial statement can be accurate without accurate figures on the other. For instance, the end of the period cash in the Statement of Cash Flows is reported as cash on the Balance Sheet. Retained earnings are also reported on the Balance Sheet. If the retained earnings are not calculated properly, the Balance Sheet will not balance. All of these inter-relationships serve a very good purpose for auditors as they can easily identify whether the financial statements are prepared correctly. All of the above mentioned financial statements are useful to both internal and external stakeholders of the business. Financial statements serve an objective to make informed decisions. According to Wikipedia, “The objective of financial statements is to provide information about the financial position, performance and changes in financial position of an enterprise that is useful to a wide range of users in making economic decisions.” Internal stakeholders are those people who have a direct interest in the way the business is run. These people are the owners, employees and managers. On the other hand, external stakeholders are those people who are not directly involved in the operation of the business, but would affect and would be affected by the activities of the business. These include the government, creditors, and potential investors etc. All of these stakeholders use financial statements for different purposes. Let’s analyze a few of those. Owners/Managers: The owners and managers of the corporation use financial statements to make better decisions regarding investment and operation of the business. Financial Statements are of a huge concern to owners as they seek high profits. Managers require financial statements to assess the health of the corporation and thus, it enables them to set new targets and look at future growth options. Employees: Many people would think that employees don’t have a lot of interest in the corporation, but employees are some of the most important stakeholders. Employees need a reward for their hard work and so, they analyze financial statements so that they can negotiate higher pay and more job security for themselves. Creditors: Creditors are interested in a corporation’s financial statement because it enables them to identify the financial viability of the business. Creditors also decide whether to expand or contract credit to companies based on their financial statements. For instance, a lending institution would look at a company’s cash flow to determine whether the company would be able to make payments. Investors: The most important stakeholder in a corporation is an investor. Investors look at financial statements in detail to find out if their investment would give good returns. If a company’s balance sheet shows negative worth, investors would be reluctant to invest in the company. Furthermore, investors also look at other statements to make an informed decision. For example, a potential small investor would want to look at the company’s income statement to determine whether an investment would be worthwhile. References 1) Financial Statements. (n.d.). Retrieved August 4, 2009, from Wikipedia: http://en.wikipedia.org/wiki/Financial_statements 2) Warren, C., & Reeve, J. (2008). Financial and Managerial Accounting: Introduction to Accounting and Business.(9th edition). ThomsonNow Read More