Understanding of the Financial Statements – Principles of Accounting

Financial Statements Accounting is a function by which users can understand the internal financial workings of a company. Use of public accounting dates as far back as the late nineteenth century (Hendrickson, 2007) and continues today under the set guidelines that accounting professionals refer to as generally accepted accounting principles. These principles are set in the United States by the Financial Accounting Standards Board and the Securities and Exchange Commission (Weygandt, p. 9, 2008). The International Financial Standards Board collaborates on ways to standardize these principles globally.

Through accounting, an entity methodically identifies financial transactions, chronologically records and analyzes the transactions, and communicates this information to interested users (Weygandt, p. 4, 2008). In this paper, the subject is to identify the four basic financial statements, how they interrelate, and how both internal and external users make use of these statements. Companies prepare the four basic financial statements in the following sequence; income statement, retained earnings statement, balance sheet, and statement of cash flows (Weygandt, p. 1, 2008). The reason for the order is each statement supplies an important piece of financial information the next statement needs. Further examination of each of the financial statements clarifies the flow of information from statement to statement. Preparation of the income statement comes first. The income statement examines only the revenues and expenses of the entity over a certain period. If the revenues exceed the expenses within the period, the result is a net income (Weygandt, p. 21, 2008).

If expenses exceed the revenues, a net loss results for the period. The next financial statement, the retained earnings statement, needs the net loss or net income figure. The second basic financial statement is the retained earnings statement. This statement reflects why there is an increase or decrease in the retained earnings of an entity over a period (Weygandt, p. 21, 2008). The period is the same as the income statement. The retained earnings statement carries over the ending balance of the prior period retained earnings statement.

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If it is the first statement of this kind for the entity, it begins with a retained earnings amount of zero. At this point, the net income or net loss carries from the income statement. A net income balance increases retained earnings; a net loss decreases retained earnings. The last item a retained earnings statement takes into consideration is dividends. If the entity decides to pay out a dividend, the retained earnings statement shows the dividend, which decreases the ending balance of retained earnings. The balance sheet comes third in the sequence of financial statements.

The balance sheet reports the assets, liabilities, and stockholder’s equity of an entity on a specific date (Weygandt, p. 23, 2008). This date correlates with the ending date of the periods for the prior statements. The total of assets must equal the total of liabilities and stockholder’s equity on the balance sheet. Stockholder’s equity consists of the total of common stock, revenue, retained earnings, dividends, and expenses. The retained earnings balance above carries to the balance sheet. The last of the four basic financial statements is the statement of cash flows.

This statement summarizes the inflow and outflow of cash over the same period as the income statement and retained earnings statement. The cash flow statement shows the cash effects on company operations, investing transactions, financing transactions, net increase or decrease of cash, and the ending cash balance (Weygandt, p. 24, 2008). The cash balance (under assets) from the balance sheet flows into the statement of cash flows. Internal and external users both make use of the four basic financial statements.

Managers, employees, directors, and owners are examples of internal users; people within a company that use the information for daily operations. An income statement can help determine where expenses need to be cut or where expansion would be wise because of revenue generation. The retained earnings statement helps with decisions to make dividend distributions or invest excess earnings back into the business. A director could use the balance sheet quickly to review if liabilities are too far exceeding the equity of the company. Employees could use cash flow statements as proof of performance for compensation requests.

Investors and creditors are examples of external users because they are persons outside of a company using the financial statements. Investors review these statements when making investment decisions. They need to see profitability and dividend distributions. The information is also used in making calculations such as return on assets or debt to total assets. Creditors also use the information on these statements to calculate ratios for determining whether or not to lend money, interest rates at which to lend, or even the length of the term for which they are lending. In ummary, one can see how accounting and the four basic financial statements it produces (income statement, retained earnings statement, balance sheet and statement of cash flows) are an integral part of any business entity. Businesses use these statements both internally and externally to function. The fact that public accounting has been part of the business structure for over a century shows its true value. References Hendrickson, H. S. (2007). Encyclopedia of business and finance (2nd ed. ). Detroit, MI: Macmillan. Weygandt, J. J. (2008). Financial accounting (6th ed. ). Retrieved from The University of Phoenix eBook Collection database.

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