The Role of the Main Financial Statements - Income Statement, Balance Sheet, Statement of Retained Earnings, and Statement of Cash Flow – Term Paper Example
One of the most important financial reports prepared by corporations is the financial ments. The four financial ments are the income ment, balance sheet, statement of retained earnings, and statement of cash flow (Weygandt & Kieso & Kimmel). The financial statements are prepared at the conclusion of the accounting cycle. The normal accounting cycle is for a period of one year. Publicly traded corporations are mandated by the Securities and Exchange Commission (SEC) to release an annual report each year which among other things it must contain the financial statements of the firm. Most public firms publish financial statements each trimester. Ever since the creation of the Sarbanes Oxley Act the financial statements of public firms must be audited by an independent auditor. This act also raised the accountability of the statements by making the executive officers including the CEO liable in case of fraud.
The income statement is a financial report that analyses the profitability of a firm. The income statement at the top shows the revenues a firm generated during an accounting period. Revenues are the most important metric for companies because they provide the money that is used for operating expenses and other business costs. The last output of the income statement is the net income generated by a company. Users of financial information pay close attention to the income statement because this report provides information regarding the operating results of a firm including whether a company had gains or losses. When a company has net losses for more than one accounting period the firm may run out of business and file bankruptcy. All financial statements including the income statement are prepared by accountants following the generally accepted accounting principles (GAAP). The employees of firms are often interested in the income statement because many compensation packages such as employee bonuses are calculated based on information derived from the income statement.
The second major financial statement is the balance sheet. The balance sheet is often referred to as a statement of position because it illustrates the financial standing of a firm at a specific point in time. The balance sheet was created based on the basic accounting equation. The basic accounting equation states that assets equal liabilities plus stockholders equity (Avercamp). The balance sheet lists the assets, liabilities, and equity of a firm. The assets are listed from top to bottom based on liquidity. The most liquid asset owned by a corporation is the cash account. The financial statements particularly the income statement and balance sheet are very useful to managers and other users of financial information for the purpose of performing ratio analysis. Ratio analysis is a tool that can be used to evaluate the financial performance of a firm. Four ratios whose formulas are based on input from financial statements are the net margin, return on assets, return on equity, and the current ratio. Financial ratios revealed a lot important information that can be used to make better operating decisions. For instance the current ratio can be used to determine a company’s ability to pay off its short term debt.
The third financial statement is the statement of cash flow. Cash is the most liquid asset of a firm and the most important one as well. The reason that cash is so valuable is because it is used to pay off a firm’s obligations including its payroll. When a firm runs out of cash it cannot continue to operate because it will default all its debt. A firm that goes one cycle without paying its employees will run in major troubles as the employees will stop reporting to work and will file complaints at governmental offices to protect their rights. The three sections of the statement of cash flow are operating, financing, and investing. These three categories divide the inflows and outflows of cash which helps managers evaluate the movement of cash of a firm.
The final financial statement is the statement of retained earnings. The statement of retained earnings outlines the changes in retained earnings during an accounting period (Investopedia). Retained earnings are a consequence of the net income created by a firm. Net income can either be distributed to shareholders in the form of dividends or it stays in the firm and is converted into retained earnings. When a company obtains retaining earnings it increases the total equity of the firm. The financial statements are interrelated and the preparation of them depends on the data from each other.
The four financial statements are very important financial documents that are used by different stakeholders to evaluate the financial performance of an enterprise. Lenders rely on financial statement to make decisions whether to give credit to a company. Investors make buy and sell decisions based on the results from the financial statements. Governments use the results the income statements of a company to determine the amount of taxes that the government collects from corporations. These reports are also very useful for internal purposes as managers rely on that information to make operating decisions. When firms reflect bad results in the income statement managers are forced to make tough decisions such as firing employees to lower costs.
Work Cited Page
Averkamp, H. 2011. “Accounting Equation” 14 July 2011. < http://www.accountingcoach.com/online-accounting-course/14Xpg01.html>/
Investopedia, 2011. “Statement of Retained Earnings.” 14 July 2011.
Weygandt, J., Kieso, D., Kimmel, P. 2002. Accounting Principles (6th ed.). New York: John Wiley & Sons.