Financial statement

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A financial statement (or financial report) is a record of the financial activities of a business or other entity.

In the private sector (including non-profit/not-for-profit entities) there are four basic financial statements: the balance sheet[1], the income statement[2], the statement of retained earnings[3], and the statement of cash flows[4] (in some entities different terms may be used). Of the four, only the balance sheet represents activities at a single point in time (usually as of the end of the entity's fiscal year) whereas the other statements represent activities during a period of time (usually an entire fiscal year).

The statements (including the format) may be specified by law or regulation. Larger companies will also include extensive footnotes (some of which are required by law or regulation) as well as a management discussion and analysis of their contents.

Governmental entities have similar statements (often referred to as Comprehensive Annual Financial Reports), but differ due to specific and unique requirements for governmental accounting.

Balance Sheet

The balance sheet summarizes the financial balances of the entity.[5]

Assets are listed first, followed by liabilities; the difference between the two is the equity or net worth of the entity.

Assets and liabilities are classified as current and non-current.

  • Current assets are those which are cash or are highly liquid (i.e., can easily be converted to cash); these include short-term investments (such as certificate of deposits), accounts receivable, inventories, and prepaid expenses.
  • Non-current assets include property, plant, and equipment (less amounts for accumulated depreciation and amortization), and long-term investments (such as loans made to other entities).
    • For non-profit/not-for-profit entities, this category includes assets which are restricted for use (usually for a specific purpose). The restriction can either be by the donor, or the entity can choose to restrict the asset's use; either way it must be shown separately from unrestricted assets.
  • Current liabilities are those which are expected to be paid within one year or less; these include accounts payable, taxes currently due, and the current portion of long-term liabilities.
  • Non-current liabilities include capital leases and mortgages (excluding the portion due within the current year).

The equity section of the balance sheet includes:

  • The amounts for the company's share capital (usually sale of stock; this includes both the "par value" of the stock and any amounts received in excess of par value), adjusted for treasury shares (stock shares held by the corporation)
  • Minority (non-controlling) interest in other entities
  • Retained earnings (the amounts earned by the company from its operations)

Difference in Standards

Private Sector

Any meaningful analysis of a company's finances must include a review of its balance sheets for the current and past operating cycles. Because of the large amount of information that such a summary can provide, United States law requires that all publicly held and traded companies provide balance sheets at regular intervals (usually four times a year).

Public Sector

Unlike the heavily regulated companies in the private sector, the federal government is not required to publicize any balance sheets it creates internally. However, because some of the financial documents and other information (like current debt, operating expenses in the form of the perennial budget, etc.) are a matter of public record, similar information can be gleaned from the federal records.[6]

State and local governments are also not required to publish this or numerous other financial statements, but as with the federal government, such information can still be obtained through more convoluted means. These bodies are, however, held by federal regulations to more stringent standards, something from which the federal government is exempt.[6]

Financial Analysis

Although the balance sheet is often accompanied by several other financial statements, there are several meaningful ratios (like the debt/equity, working capital, and asset/liabilities ratios) that can be gleaned from the balance sheet alone. In forensic and auditory accounting, the balance sheet is almost always the first statement examined. It is only meaningful, however, if a rigorous "cut-off" date is enforced. For example, if a balance sheet is meant to deal with the information from December 1, 2009, to December 31, 2009, no information about cash received, services rendered, or payments made after December 31, 2009, can be included on the balance sheet. This stringent restriction allows relevant comparisons to be made between financial periods and inconsistencies to be highlighted.

Income Statement

The income statement shows how the revenues of an entity are turned into net income. (In non-profit/not-for-profit entities, the term statement of activities is used instead.)

The statement is divided into three sections: operating, non-operating, and irregular.

The operating section is the most comprehensive as it discusses the profitability of the entity's main line of business. It generally consists of a revenue line (sales price of goods or services) and one or more expense lines. The expense lines consist of:

  • cost of goods sold (COGS), which could be (for a retailer) the purchase price of items held for resale, or (for a manufacturer) costs of raw materials, labor used to turn the materials into saleable items, and overhead (depreciation/amortization of buildings and equipment, utility costs, and such),
  • selling, general, and administrative (SG&A) expenses, which could be sales salaries/commissions, freight on shipped items sold, depreciation on stores and furnishings, and costs to operate overall company management and back-office (accounting, human resources) operations, and
  • research and development (R&D) activities.

For non-profit/not-for-profit entities, income that is restricted for use must be reported separately from unrestricted income.

The non-operating section includes revenue and expenses from sources other than the main line of business. Such items include gains/losses from sales of assets no longer used in the business, income from investments, and interest on borrowings. It also includes taxes payable during the current year as well as deferred taxes.

The irregular section includes items which are not expected to recur. These items are reported net of taxes. The most common item in this category is discontinued operations. A discontinued operation is one where the company either has stopped doing business, or has announced plans to do so. This can mean either a line of business (e.g. a company that customizes and maintains aircraft decides to get out of maintaining aircraft) or a geographical area (e.g. a grocery chain decides to exit the Dallas-Fort Worth market, but continue operations in other parts of the country).

Statement of Retained Earnings

The statement of retained earnings, also called a statement of equity, shows the changes in an entity's equity during a period in time.

Primarily, it takes information from the income statement and provides information to the balance sheet.

The main component is the changes in retained earnings (as a result of net income or net loss) during that period. However, the statement also shows other changes, such as additional stock issued, stock repurchased and held as treasury stock, and dividends paid.

The statement may be shown as a separate schedule, or may be combined with the balance sheet (the most common) or the income statement.

Statement of Cash Flows

The statement of cash flows shows how changes in the income statement and balance sheet affect the cash and cash equivalents of an entity. The statement is broken down into three areas: operating, investing, and financing.

The operating section is the largest of the three, as it shows cash earned from and used by the entity's operations. Items in this section include:

  • Cash sales
  • Receipts from accounts receivable (whether held by the company or received from credit card companies)
  • Purchases of items for resale
  • Purchases of raw materials and other items used in manufacturing
  • Payments on accounts payable
  • Salaries, wages, commissions, and bonuses paid during the year
  • Other general and administrative expenses paid during the year
  • Interest payments (required in this section under United States Generally Accepted Accounting Principles)

The investing section includes such items as:

  • Purchases of property, plant, and equipment
  • Sales of assets no longer used in operations
  • Purchases or sales of entities (or portions thereof) related to mergers, acquisitions, or divestitures

The financing section includes such items as:

  • Loans received from borrowers, and repayments thereon
  • Payments made on capital leases
  • Dividends paid
  • Sales or repurchases of company stock

References