4 Common types of financial statements to know

Ready to get on the same page as the financial pros? Read on to learn
more about the purpose of four common types of financial statements:

 Statmemt of Financial Position (Balance sheets)

 Cash flow statements
 Statement of Comprehensive Income (Income statements)
 Statements of changes in shareholder equity

1. What is a Statmemt of Financial Position (balance sheets)?

Balance sheets use a basic formula to report a business’s assets (things it

owns, such as property and cash on hand) versus liabilities (debts and
expenses) and shareholder investments. Businesses rely on balance sheets
to gauge their overall financial health at any given time since it provides a
snapshot of how much they own versus how much they owe.

For example, a company that is seeking a business loan will have to

present a current balance sheet to potential lenders. Banks can use the
balance sheet to determine the company’s debt-to-equity ratio, which
predicts if the company is a high- or low-risk investment.

Balance sheets don’t offer enough data to show financial trends over a
long period of time, so they’re often paired with other “core statements”
(cash flow and income) to give a broader picture of a company’s financial
state.

Classification of Components

Statement of financial position consists of the following key elements:

Assets

An asset is something that an entity owns or controls in order to derive

economic benefits from its use. Assets must be classified in the balance
sheet as current or non-current depending on the duration over which the
reporting entity expects to derive economic benefit from its use. An asset
which will deliver economic benefits to the entity over the long term is
classified as non-current whereas those assets that are expected to be
realized within one year from the reporting date are classified as current
assets.
Assets are also classified in the statement of financial position on the
basis of their nature:

 Tangible & intangible: Non-current assets with physical substance

are classified as property, plant and equipment whereas assets
without any physical substance are classified as intangible assets.
Goodwill is a type of an intangible asset.
 Inventories balance includes goods that are held for sale in the
ordinary course of the business. Inventories may include raw
materials, finished goods and works in progress.
 Trade receivables include the amounts that are recoverable from
customers upon credit sales. Trade receivables are presented in the
statement of financial position after the deduction of allowance for
bad debts.
 Cash and cash equivalents include cash in hand along with any
short term investments that are readily convertible into known
amounts of cash.

Liabilities

A liability is an obligation that a business owes to someone and its

settlement involves the transfer of cash or other resources. Liabilities
must be classified in the statement of financial position as current or non-
current depending on the duration over which the entity intends to settle
the liability. A liability which will be settled over the long term is
classified as non-current whereas those liabilities that are expected to be
settled within one year from the reporting date are classified as current
liabilities.

Liabilities are also classified in the statement of financial position on the

basis of their nature:

 Trade and other payables primarily include liabilities due to

suppliers and contractors for credit purchases. Sundry payables
which are too insignificant to be presented separately on the face of
the balance sheet are also classified in this category.
 Short term borrowings typically include bank overdrafts and short
term bank loans with a repayment schedule of less than 12 months.

 Long-term borrowings comprise of loans which are to be repaid

over a period that exceeds one year. Current portion of long-term
 borrowings include the installments of long term borrowings that
are due within one year of the reporting date.
 Current Tax Payable is usually presented as a separate line item in
the statement of financial position due to the materiality of the
amount.

Equity

Equity is what the business owes to its owners. Equity is derived by

deducting total liabilities from the total assets. It therefore represents the
residual interest in the business that belongs to the owners.

Equity is usually presented in the statement of financial position under

the following categories:

 Share capital represents the amount invested by the owners in the

entity
 Retained Earnings comprises the total net profit or loss retained in
the business after distribution to the owners in the form of
dividends.
 Revaluation Reserve contains the net surplus of any upward
revaluation of property, plant and equipment recognized directly in
equity.

Rationale - Why the balance sheet always balances?

The balance sheet is structured in a manner that the total assets of an

entity equal to the sum of liabilities and equity. This may lead you to
wonder as to why the balance sheet must always be in equilibrium.

Assets of an entity may be financed from internal sources (i.e. share

capital and profits) or from external credit (e.g. bank loan, trade creditors,
etc.). Since the total assets of a business must be equal to the amount of
capital invested by the owners (i.e. in the form of share capital and profits
not withdrawn) and any borrowings, the total assets of a business must
equal to the sum of equity and liabilities.

This leads us to the Accounting Equation: Assets = Liabilities + Equity

Purpose & Importance

Statement of financial position helps users of financial statements to

assess the financial health of an entity. When analyzed over several
accounting periods, balance sheets may assist in identifying underlying
trends in the financial position of the entity. It is particularly helpful in
determining the state of the entity's liquidity risk, financial risk, credit
risk and business risk. When used in conjunction with other financial
statements of the entity and the financial statements of its competitors,
balance sheet may help to identify relationships and trends which are
indicative of potential problems or areas for further improvement.
Analysis of the statement of financial position could therefore assist the
users of financial statements to predict the amount, timing and volatility
of entity's future earnings.

2. What is a cash flow statement?

Cash flow is the movement of money in and out of a business every

month, so a cash flow statement is the report that shows this movement.
Positive cash flow is when more money is coming into a company than
going out; negative cash flow is the opposite.

This movement of money can be more complicated than you might

expect. Imagine a seasonal business like landscaping. The business owner
needs to keep a close eye on cash flow statements to make sure that they
save enough during the positive cash flow months to cover their expenses
during leaner times, when cash flow might be negative. Other industries,
like construction, may need to have enough cash on hand to pay for
expensive building materials when customers won’t be billed until
months later.

Cash flow statements are a good indicator of overall business health. If a

company has a negative cash flow for several months in a row, executives
will need to take action to keep the business from failing, such as cutting
expenses, making more sales, increasing prices or even opening a
business line-of-credit loan to help with temporary cash flow problems.

Basis of Preparation
Statement of Cash Flows presents the movement in cash and cash
equivalents over the period.

Cash and cash equivalents generally consist of the following:

 Cash in hand
 Cash at bank
 Short term investments that are highly liquid and involve very low
risk of change in value (therefore usually excludes investments in
equity instruments)
 Bank overdrafts in cases where they comprise an integral element
of the organization's treasury management (e.g. where bank
account is allowed to float between a positive and negative balance
(i.e. overdraft) as opposed to a bank overdraft facility specifically
negotiated for financing a shortfall in funds (in which case the
related cash flows will be classified under financing activities).

As income statement and balance sheet are prepared under the accruals

basis of accounting, it is necessary to adjust the amounts extracted from
these financial statements (e.g. in respect of non cash expenses) in order
to present only the movement in cash inflows and outflows during a
period.

All cash flows are classified under operating, investing and financing
activities as discussed below.

Operating Activities

Cash flow from operating activities presents the movement in cash during
an accounting period from the primary revenue generating activities of
the entity.

For example, operating activities of a hotel will include cash inflows and
outflows from the hotel business (e.g. receipts from sales revenue,
salaries paid during the year etc), but interest income on a bank deposit
shall not be classified as such (i.e. the hotel's interest income shall be
presented in investing activities).

Profit before tax as presented in the income statement could be used as a

starting point to calculate the cash flows from operating activities.
Following adjustments are required to be made to the profit before tax to
arrive at the cash flow from operations:

1. Elimination of non cash expenses (e.g. depreciation,

amortization, impairment losses, bad debts written off, etc)
2. Removal of expenses to be classified elsewhere in the cash flow
statement (e.g. interest expense should be classified under
financing activities)
3. Elimination of non cash income (e.g. gain on revaluation of
investments)
4. Removal of income to be presented elsewhere in the cash flow
statement (e.g. dividend income and interest income should be
classified under investing activities unless in case of for example
an investment bank)
5. Working capital changes (e.g. an increase in trade receivables
must be deducted to arrive at sales revenue that actually resulted
in cash inflow during the period)

Investing Activities

Cash flow from investing activities includes the movement in cash flow
as a result of the purchase and sale of assets other than those which the
entity primarily trades in (e.g. inventory). So for example, in case of a
manufacturer of cars, proceeds from the sale of factory plant shall be
classified as cash flow from investing activities whereas the cash inflow
from the sale of cars shall be presented under the operating activities.

Cash flow from investing activities consists primarily of the following:

 Cash outflow expended on the purchase of investments and fixed

assets
 Cash inflow from income from investments
 Cash inflow from disposal of investments and fixed assets

Financing activities
Cash flow from financing activities includes the movement in cash flow
resulting from the following:

 Proceeds from issuance of share capital, debentures & bank loans

 Cash outflow expended on the cost of finance (i.e. dividends and
interest expense)
 Cash outflow on the repurchase of share capital and repayment of
debentures & loans

Purpose & Importance

Statement of cash flows provides important insights about the liquidity

and solvency of a company which are vital for survival and growth of any
organization. It also enables analysts to use the information about historic
cash flows to form projections of future cash flows of an entity (e.g. in
NPV analysis) on which to base their economic decisions. By
summarizing key changes in financial position during a period, cash flow
statement serves to highlight priorities of management. For example,
increase in capital expenditure and development costs may indicate a
higher increase in future revenue streams whereas a trend of excessive
investment in short term investments may suggest lack of viable long
term investment opportunities. Furthermore, comparison of the cash
flows of different entities may better reveal the relative quality of their
earnings since cash flow information is more objective as opposed to the
financial performance reflected in income statement which is susceptible
to significant variations caused by the adoption of different accounting
policies.

3. What is an income statement?

Income statements—sometimes called profit and loss or P&L—show a
breakdown of a company’s earnings and expenses in order to see if it
turned a profit. These reports look at all of a company’s revenue streams
during a certain time period, including the sale of a product or service, the
sale of assets, or dividends earned from an investment. It compares these
revenues to expenses, like rent, employee wages and taxes.

At the end of an income statement is a company’s net income, which is

the amount earned after subtracting expenses and other losses. This
number is vitally important for businesses. A company may have high
revenues, but if its expenses are also high, the income statement will
reveal that it’s not making much of a profit—or no profit at all.

Income statements join balance sheets and cash flow statements as a core
financial statement that investors, banks and company executives want to
keep a close eye on. Income statements help executives make strategic
decisions, such as which products to stop offering or which areas to focus
on developing.

Basis of preparation

Income statement is prepared on the accruals basis of accounting.

This means that income (including revenue) is recognized when it

is earned rather than when receipts are realized (although in many
instances income may be earned and received in the same accounting
period).

Conversely, expenses are recognized in the income statement when they

are incurred even if they are paid for in the previous or subsequent
accounting periods.

Income statement does not report transactions with the owners of an

entity.

Hence, dividends paid to ordinary shareholders are not presented as

an expense in the income statement and proceeds from the issuance of
shares is not recognized as an income. Transactions between the entity
and its owners are accounted for separately in the statement of changes in
equity.

Components

Income statement comprises of the following main elements:

Revenue

Revenue includes income earned from the principal activities of an entity.

So for example, in case of a manufacturer of electronic appliances,
revenue will comprise of the sales from electronic appliance business.
Conversely, if the same manufacturer earns interest on its bank account, it
shall not be classified as revenue but as other income.

Cost of Sales

Cost of sales represents the cost of goods sold or services rendered during
an accounting period.

Hence, for a retailer, cost of sales will be the sum of inventory at the start
of the period and purchases during the period minus any closing
inventory.

In case of a manufacturer however, cost of sales will also include

production costs incurred in the manufacture of goods during a period
such as the cost of direct labor, direct material consumption, depreciation
of plant and machinery and factory overheads, etc.

You may refer to the article on cost of sales for an explanation of its
calculation.

Other Income
Other income consists of income earned from activities that are not
related to the entity's main business. For example, other income of an
entity that manufactures electronic appliances may include:

 Gain on disposal of fixed assets

 Interest income on bank deposits
 Exchange gain on translation of a foreign currency bank account

Distribution Cost

Distribution cost includes expenses incurred in delivering goods from the

business premises to customers.

Administrative Expenses

Administrative expenses generally comprise of costs relating to the

management and support functions within an organization that are not
directly involved in the production and supply of goods and services
offered by the entity.

Examples of administrative expenses include:

 Salary cost of executive management

 Legal and professional charges
 Depreciation of head office building
 Rent expense of offices used for administration and management
purposes
 Cost of functions / departments not directly involved in production
such as finance department, HR department and administration
department

Other Expenses

This is essentially a residual category in which any expenses that are not
suitably classifiable elsewhere are included.
Finance Charges

Finance charges usually comprise of interest expense on loans and

debentures.

The effect of present value adjustments of discounted provisions are also

included in finance charges (e.g. unwinding of discount on provision for
decommissioning cost).

Income tax

Income tax expense recognized during a period is generally comprised of

the following three elements:

 Current period's estimated tax charge

 Prior period tax adjustments
 Deferred tax expense

Prior Period Comparatives

Prior period financial information is presented along side current period's

financial results to facilitate comparison of performance over a period.

It is therefore important that prior period comparative figures presented in

the income statement relate to a similar period.

For example, if an organization is preparing income statement for the six

months ending 31 December 2013, comparative figures of prior period
should relate to the six months ending 31 December 2012.

Purpose & Use

Income Statement provides the basis for measuring performance of an

entity over the course of an accounting period.

Performance can be assessed from the income statement in terms of the

following:
  Change in sales revenue over the period and in comparison to
industry growth
 Change in gross profit margin, operating profit margin and net
profit margin over the period
 Increase or decrease in net profit, operating profit and gross profit
over the period
 Comparison of the entity's profitability with other organizations
operating in similar industries or sectors

Income statement also forms the basis of important financial evaluation

of an entity when it is analyzed in conjunction with information contained
in other financial statements such as:

 Change in earnings per share over the period

 Analysis of working capital in comparison to similar income
statement elements (e.g. the ratio of receivables reported in the
balance sheet to the credit sales reported in the income statement,
i.e. debtor turnover ratio)
 Analysis of interest cover and dividend cover ratios

4. What is a statement of changes in shareholder equity?

Shareholder equity is the amount of money that would be given to

shareholders—anyone who owns part of the company—if all of the
business’s assets were sold and their debts were paid off. A statement of
changes in shareholder equity is most often used for publicly held
companies that have many shareholders who own stock.

As you might have guessed, this type of financial statement shows any
changes in shareholder equity over a certain period of time. Changes in
shareholder equity can occur for a number of reasons, including an
increase or decrease in net income or adjusting the value of the
company’s assets, like land or machinery.
Stock owners should pay careful attention to this financial statement. It
provides insight into how their investment is doing so they can decide if
they want to buy or sell their stocks. Financial advisors also monitor these
statements so they can make wise investments on behalf of their clients.

Components

Following are the main elements of statement of changes in equity:

Opening Balance

This represents the balance of shareholders' equity reserves at the start of

the comparative reporting period as reflected in the prior period's
statement of financial position. The opening balance is unadjusted in
respect of the correction of prior period errors rectified in the current
period and also the effect of changes in accounting policy implemented
during the year as these are presented separately in the statement of
changes in equity (see below).

Effect of Changes in Accounting Policies

Since changes in accounting policies are applied retrospectively, an

adjustment is required in stockholders' reserves at the start of the
comparative reporting period to restate the opening equity to the amount
that would be arrived if the new accounting policy had always been
applied.

Effect of Correction of Prior Period Error

The effect of correction of prior period errors must be presented

separately in the statement of changes in equity as an adjustment to
opening reserves. The effect of the corrections may not be netted off
against the opening balance of the equity reserves so that the amounts
presented in current period statement might be easily reconciled and
traced from prior period financial statements.

Restated Balance

This represents the equity attributable to stockholders at the start of the

comparative period after the adjustments in respect of changes in
accounting policies and correction of prior period errors as explained
above.
Changes in Share Capital

Issue of further share capital during the period must be added in the
statement of changes in equity whereas redemption of shares must be
deducted therefrom. The effects of issue and redemption of shares must
be presented separately for share capital reserve and share premium
reserve.

Dividends

Dividend payments issued or announced during the period must be

deducted from shareholder equity as they represent distribution of wealth
attributable to stockholders.

Income / Loss for the period

This represents the profit or loss attributable to shareholders during the

period as reported in the income statement.

Changes in Revaluation Reserve

Revaluation gains and losses recognized during the period must be

presented in the statement of changes in equity to the extent that they are
recognized outside the income statement. Revaluation gains recognized in
income statement due to reversal of previous impairment losses however
shall not be presented separately in the statement of changes in equity as
they would already be incorporated in the profit or loss for the period.

Other Gains & Losses

Any other gains and losses not recognized in the income statement may
be presented in the statement of changes in equity such as actuarial gains
and losses arising from the application of IAS 19 Employee Benefit.

Closing Balance

This represents the balance of shareholders' equity reserves at the end of

the reporting period as reflected in the statement of financial position.
Purpose & Importance

Statement of changes in equity helps users of financial statement to

identify the factors that cause a change in the owners' equity over the
accounting periods. Whereas movement in shareholder reserves can be
observed from the balance sheet, statement of changes in equity discloses
significant information about equity reserves that is not presented
separately elsewhere in the financial statements which may be useful in
understanding the nature of change in equity reserves. Examples of such
information include share capital issue and redemption during the period,
the effects of changes in accounting policies and correction of prior
period errors, gains and losses recognized outside income statement,
dividends declared and bonus shares issued during the period.