Financial statements are prepared by all business firms. Even non-profit organizations, associations, clubs etc. prepare financial statements. This term is heard very often. But not many people may understand what these statements are and why we need them.
Any business or other activity that has transactions involving receipt or payment of money should have records. The records will show the income earned, expenditure incurred, assets purchased and liabilities incurred. But if you want to know how much income has been earned and how much profit has been made during a particular year and what the values of assets and liabilities as on a particular day are, it will be very difficult to extract the information from the books of accounts. So, we need a summary of financial activities at intervals.
Financial statements provide a summary of the monetary transactions during a period. These statements are prepared once in a year but they can also be prepared for shorter periods. We can have monthly, quarterly and half-yearly statements as well. But preparing the statements at the end of a year has become both the norm and a legal requirement. However companies are free to choose their own financial year. Though many companies follow the calendar year, some companies may choose July to June or any other period of twelve months as their financial year.
Financial statements mainly comprise of two statements but there could be other supplementary statements as well. The two main components are the Income Statement and the Balance Sheet. The Income Statement is prepared for a period. This statement lists the revenues earned and expenses incurred during the period and arrives at the net income. The purpose of this statement is to compute the amount of net income earned by a firm during a period. This statement is the most fundamental requirement for a business since without preparing this statement; you won't even know whether a firm is making a profit or incurring a loss.
The second statement is the Balance Sheet. The Balance Sheet is prepared as at a particular day. This statement lists the Assets, Liabilities and the Owners' equity as on a specific date. The Balance Sheet shows the balances as on the last day of the year for which the income statement is prepared. Thus if the Income Statement is for the year ending December 2011, the Balance Sheet will be as at December 31, 2011. Only by looking at both the Income Statement and the Balance Sheet, you will have a good understanding of the financial health of a firm. A company may have earned a large net income but if it has huge liabilities, the financial health of the company should be a cause for concern. On the other hand, a firm with a strong asset base and small liabilities may look strong on its Balance Sheet but its Income Statement may show that the firm is not earning a good income. Thus, reading the Income Statement together with the Balance Sheet will help anyone understand the value of a business better.
Both these statements are prepared from the ledgers which are the financial records of day to day transactions. Thus these statements should be considered summaries of the financial statements. While the sales ledger lists every sale, the Income Statement shows the total sales figure extracted from the Sales ledger. Therefore, preparation of the financial statements is preceded by checking the accuracy of the ledgers through a Trial Balance. The Trial Balance is an intermediary statement. This lists the balances of all the accounts. This statement facilitates correction of errors, making adjustment entries etc. so that the ledger accounts are made error free and complete. An Adjusted Trial Balance is prepared after making all adjustments required. The Income Statement and the Balance Sheet are prepared from this Adjusted Trial Balance. After preparing the Income Statement, the Statement of Owners' Equity is prepared before preparing the Balance Sheet. This is also an intermediary statement.
Financial Statements are prepared in specified formats. While corporations have to prepare these statements as per the norms prescribed by FASB (Financial Accounting Standards Board), other organizations also follow established standards. A Statement of Cash Flows is also often prepared based on these two statements, to analyze the sources and uses of cash. This statement will give a deeper insight into the operations of a firm.
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