Introduction to Financial Statements

Owners of the business require financial information to know if their wealth in the business is growing. Same is the case with other users of financial information as they need information according to their decision making requirements and wants to know about:

  1. assets and liabilities
  2. incomes and expenses
  3. cash inflows and outflows
  4. gains and losses from activities other than main operation of the business
  5. any other information of financial nature that helps understand financial impact on entity’s assets, liabilities, incomes or expenses.

As information covers a particular period or state of affairs at a particular date, the volume of information tends to be so large that if it is not structured and presented in a particular format then users will not understand it and thus will unable to make inferences. Therefore, instead of issuing a single report containing all the information multiple reports dealing with specific elements of information is prepared and then published or communicated to the user in the form of a set of financial statements. A complete set of financial statements comprise of the following:

  1. Statement of Financial Position or Balance Sheet
  2. Income statement or Profit & loss account
  3. Cash flow statement
  4. Statement of changes in equity
  5. Notes to the financial statements

Statement of Financial Position or Balance Sheet

Statement of Financial Position or as previously known as Balance Sheet reports on entity’s:

  1. resources i.e. assets
  2. obligations i.e. liabilities; and
  3. owners’ residual interest in the entity i.e. equity

The resources that entity use to run its operations and achieve its business objectives are called assets. Whereas the obligations are termed as liabilities. Assets and liabilities are categorized in two classes i.e. non-current and current. Equity on the other hand represent the nominal value of the right the owners have in the assets of the entity once all the liabilities are paid hence “residual interest”.

Assets includes:

  1. tangible assets e.g. land, building, machinery, equipment, inventory
  2. intangible assets e.g. software, patents, copyrights
  3. financial assets e.g. bonds, shares, cash

Liabilities include loans, payables, debentures, promissory notes

Equity includes; share capital, retained profits

Statement of financial position or balance sheet helps users determine the financial position of the entity at a particular date. That is the reason it is titled as: “Statement of Financial Position as at _______________”. By comparing the value of assets and liabilities of the entity users learn about financial strength and prospects of growth of the entity.

For detailed discussion on Statement of Financial Position jump to this page

Income Statement / Trading and Profit or Loss account

While Balance Sheet helps understand about the assets and liabilities of the entity, one needs to know how well these assets are performing or in other words, how well these resources are being utilized by the entity to generate cash flows and whether such cash flows are adding to the wealth (profits) or it is deteriorating (losses). This information is served by another financial statement called Income Statement. Previously for similar purpose accountants used to prepare Trading and Profit or Loss Account but standard require presenting this information in the form of a statement rather than an account.

Income Statement reports on all the different types of incomes and expenses transactions during a particular length of period as opposed to Balance Sheet which relates to particular day. That is the reason the title of Income Statement is: “Income Statement for the period ended ______________”

Income Statement is generally divided in two sections:

  1. gross profit calculation: this section reports on revenues and costs incurred on main trading operations of the business e.g. sale and purchase of inventory.
  2. net profit calculation: this section reports on connected expenses that helped carry out business e.g. admin and selling expenses and other incidental gains and losses that are not really actual activity of the business e.g. gain on sale of non-current asset.

Income Statement help users in understanding by how much equity has increased or decreased as a result of trading activities of the business in the form of profits or losses respectively.

Cash Flow Statement / Statement of Cash Flows

As the name suggests this reports entity’s cash inflows and outflows in specific time period. According to IAS 7 Statement of Cash Flows the cash flows due to business activities can be categorized in three:

  1. Operating activities are core business activities and primary reason for cash generation as they are connected with actual operations of the business
  2. Investing activities represent cash inflows and outflows due to entity’s investments in different assets like non-current assets, short term loans, shares in another entity. This also includes disinvestment of the same mentioned above.
  3. Financing activities includes such activities through which entity raises funds e.g. issuing shares, taking or paying back loans, issuing debentures and bonds etc.

After calculating the cash generated/consumed under each category the total is calculated that gives the net increase or decrease in cash and cash equivalents during the period.

Using this information along side Income Statement enables users understand entity’s ability to generate cash and the sources of cash flows.

Statement of Changes in Equity

Equity as we know as nominal value of owner’s right in the entity. Profit or loss during the period is not the only reason that cause increase or decrease in the owners’ interest. Therefore, it is necessary that owner’s know what has caused the fluctuation in their interest in the entity. For this purpose we have Statement of Changes in Equity.

This statement summarizes the movements in every component that makes up equity. For example reserves, retain profits, share capital etc. This statement also summarize the transactions during specific time period therefore, titled as: “Statement of Changes in Equity for the period _____________”

The main information in this statement is of distribution of profits in different channels e.g. application of profits for particular purpose, movement in reserves and dividends payments.

Notes to the Financial Statements

Notes to the financial statements are the details description of the information contained in all four financial statements and any other material information which is necessary for the understand of the user. These notes form the integral part of financial statements and must not be considered as an annexure.

Usually the word “disclosure” is used to mean notes to the financial statements in business world, however, IAS 1 has used the word disclosure to mean information reported in the financial statements as well.

Hasaan Fazal

Author: Hasaan Fazal

Accountant by heart and took it not just as a profession but as a passion. Founded ACCALIVE and PakAccountants. At ACCALIVE he is a full time teacher and writing regularly for PakAccountants on multiple business related topics including Excel, interview tips and more.
Socialize with him: Facebook | Google+ | Twitter