Financial Statements: Definition of Financial Statements and Practical Steps for Preparation
Financial statements are formal reports that provide a comprehensive overview of an entity’s financial position, financial performance, and cash flows over a specific period. The Definition of Financial Statements refers to them being a structured summary of financial information, prepared in accordance with generally accepted accounting principles,
such as International Financial Reporting Standards (IFRS) or Generally Accepted Accounting Principles (GAAP). In this article, we will provide a thorough explanation of the concept of financial statements, precisely Definition of Financial Statements, discuss their importance, types, and components, detailing the practical steps for their preparation, as well as highlighting the role of technology in facilitating this process.
What is the Definition of Financial Statements?
A simple Definition of Financial Statements is: A set of accounting reports that present summarized financial present summarized financial information about an entity at a specific date or over a specific period. The Definition of Financial Statements highlights their role in communicating useful and reliable information about the entity’s financial position, financial performance, and cash flows to users of these statements, such as investors, creditors, management, and government agencies.
More specifically, the Definition of Financial Statements can be expanded to describe them as a set of interrelated reports that present the results of an entity’s financial activities over a specific period (usually a fiscal year) in accordance with generally accepted accounting principles. These reports include information about the entity’s assets, liabilities, and equity, as well as its overall financial health.”.
Importance of Financial Statements:
The importance of financial statements lies in their being:
- A Key Tool for Decision-Making: Financial statements provide essential information for making investment, financing, and management decisions by various stakeholders.
- A Measure of Entity Performance: Financial statements help assess the entity’s performance, profitability, and operational efficiency.
- A Basis for Financial Planning: Financial statements are used as a tool to forecast future performance and develop financial plans.
- A Means of Communication with External Parties: Financial statements are an effective way to communicate financial information to investors, creditors, government agencies, and others.
- A Tool for Monitoring and Accountability: Financial statements are used to monitor management’s performance and hold them accountable for the entity’s results.
- A Basis for Legal Compliance: Many laws and regulations require companies to prepare and disclose financial statements.
Types of Financial Statements:
The primary financial statements, according to International Financial Reporting Standards (IFRS), include:
- Statement of Financial Position (Balance Sheet):
- Also known as the balance sheet.
- Shows the entity’s assets, liabilities, and equity at a specific date (usually the end of the financial period).
- Shows the basic accounting equation: Assets = Liabilities + Equity.
- This part of the definition of financial statements provides a snapshot of the entity’s financial position at a specific point in time.
- Statement of Profit or Loss (Income Statement):
- Also known as the profit and loss statement.
- Shows the entity’s revenues, expenses, and net profit or loss over a specific period (usually a fiscal year).
- Shows the result of the entity’s economic activity during the period.
- Statement of Comprehensive Income:
- Presents changes in equity that do not result from transactions with owners, such as gains or losses on revaluation of assets and foreign currency translation differences.
- Can be presented as a separate statement or as part of the statement of profit or loss.
- Statement of Changes in Equity:
- Shows the changes that occurred in the entity’s equity during the financial period, such as the issuance of new shares, dividend distributions, net profit or loss, and the effect of changes in Accounting Policies.
- Statement of Cash Flows:
- Shows the movement of cash inflows and outflows of the entity during the financial period.
- Classifies cash flows into three main activities: operating, investing, and financing.
- Helps assess the entity’s ability to generate cash and meet its obligations.
- Notes to the Financial Statements:
- Provide an explanation of the significant Accounting Policies used in preparing the Financial Statements.
- Provide additional information about the items in the Financial Statements.
- Disclose any other information necessary to understand the Financial Statements.
- Are considered an integral part of the Financial Statements.
Components of Financial Statements:
- Statement of Financial Position:
- Assets: Economic resources controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity. Assets are divided into:
- Current Assets: Expected to be converted into cash or used within one year or one operating cycle, whichever is longer. They include cash, short-term investments, receivables, and inventory.
- Non-current Assets: Expected to be used for more than one year. They include property, plant, and equipment, long-term investments, and intangible assets.
- Liabilities: Present obligations of the entity arising from past events, the settlement of which is expected to result in an outflow of resources from the entity. Liabilities are divided into:
- Current Liabilities: Expected to be settled within one year or one operating cycle, whichever is longer. They include payables, short-term loans, and accrued expenses.
- Non-current Liabilities: Expected to be settled after more than one year. They include long-term loans and bonds.
- Equity: The residual interest in the assets of the entity after deducting its liabilities. It includes issued capital, reserves, and retained earnings.
- Assets: Economic resources controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity. Assets are divided into:
- Statement of Profit or Loss:
- Revenues: Increases in economic benefits during the financial period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants.
- Expenses: Decreases in economic benefits during the financial period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants.
- Net Profit or Loss: The difference between revenues and expenses during the financial period.
- Statement of Comprehensive Income:
- Items of Other Comprehensive Income: Includes items of income and expense that are not recognized in the statement of profit or loss, such as gains or losses on revaluation of assets and foreign currency translation differences.
- Statement of Changes in Equity:
- Issued Capital: The value of shares issued by the entity.
- Reserves: Retained earnings for specific purposes, such as a legal reserve or expansion reserve.
- Retained Earnings: Accumulated profits that have not been distributed to shareholders.
- Dividends: Amounts distributed to shareholders from profits.
- Statement of Cash Flows:
- Cash Flows from Operating Activities: Cash flows resulting from the entity’s main activities, such as selling goods or providing services.
- Cash Flows from Investing Activities: Cash flows resulting from the purchase and sale of long-term assets, such as property, plant, and equipment.
- Cash Flows from Financing Activities: Cash flows resulting from obtaining financing from lenders or investors, or repaying this financing.
Practical Steps for Preparing Financial Statements:
The process of preparing financial statements follows the basic steps, which represent the Financial Accounting Cycle:
- Identify and Analyze Financial Transactions: Identify all financial transactions that the entity has undertaken during the financial period and analyze their impact on the entity’s accounts.
- Record Journal Entries: Record financial transactions in the journal in the form of journal entries, following the Double-Entry System.
- Post Entries to the Ledger: Transfer information from the journal to the respective accounts in the ledger.
- Prepare a Trial Balance: Prepare a list of all ledger accounts and their balances at the end of the financial period to ensure that the journal entries are balanced.
- Record Adjusting Entries: Record necessary adjusting entries at the end of the financial period to apply the accrual basis and the matching principle.
- Prepare an Adjusted Trial Balance: Prepare a new trial balance after recording adjusting entries.
- Prepare Financial Statements: Use the adjusted trial balance to prepare the basic Financial Statements: Income Statement, Statement of Financial Position, Statement of Changes in Equity, and Statement of Cash Flows.
- Record Closing Entries: Record closing entries at the end of the financial period to close (zero out) the balances of temporary accounts (revenues and expenses) and transfer them to the retained earnings account.
- Prepare a Post-Closing Trial Balance: Prepare a final trial balance after recording closing entries to ensure that all temporary accounts have been closed.
- Write the Notes to the Financial Statements and Accounting Policies: Explain the significant Accounting Policies used and provide additional information about the items in the Financial Statements.
Role of Technology in Preparing Financial Statements:
Accounting Software and Enterprise Resource Planning (ERP) systems help automate the process of preparing Financial Statements, leading to:
- Increased speed and efficiency of Financial Reporting.
- Reduced human errors in recording and posting entries.
- Improved accuracy of Financial Statements.
- Saving time and effort.
- Generation of various Financial reports and advanced Financial analyses.
Importance of Financial Statements for Stakeholders:
Financial Statements are a primary source of Financial information for stakeholders, including:
- Investors: Use Financial Statements to assess the entity’s performance, profitability, and investment risks.
- Creditors: Use Financial Statements to assess the entity’s ability to repay its debts.
- Management: Uses Financial Statements to make managerial and Financial decisions and develop future plans.
- Government: Uses Financial Statements for tax and regulatory purposes.
- Employees: Employees may be interested in reviewing Financial Statements to assess the entity’s stability and their job opportunities.
- Customers: Customers may be interested in reviewing Financial Statements to assess the entity’s ability to continue providing goods and services.
Practical Example of Preparing an Income Statement and Statement of Financial Position:
Assume the following data is available for “Al-Noor” Company on December 31, 2023:
- Cash: 50,000 Riyals
- Accounts Receivable: 30,000 Riyals
- Inventory: 40,000 Riyals
- Buildings: 200,000 Riyals
- Accumulated Depreciation – Buildings: 40,000 Riyals
- Accounts Payable: 25,000 Riyals
- Long-term Loan: 100,000 Riyals
- Capital: 100,000 Riyals
- Retained Earnings (at the beginning of the year): 55,000 Riyals
- Sales Revenue: 300,000 Riyals
- Cost of Goods Sold: 180,000 Riyals
- Administrative Expenses: 45,000 Riyals
Required: Prepare the Income Statement and Statement of Financial Position for “Al-Noor” Company for 2023.
Solution:
First: Income Statement for 2023:
| Description | Amount (Riyals) |
|---|---|
| Sales Revenue | 300,000 |
| Cost of Goods Sold | (180,000) |
| Gross Profit | 120,000 |
| Administrative Expenses | (45,000) |
| Net Profit | 75,000 |
Second: Statement of Financial Position as of December 31, 2023:
| Assets | Amount (Riyals) | Liabilities and Equity | Amount (Riyals) |
|---|---|---|---|
| Current Assets: | Current Liabilities: | ||
| Cash | 50,000 | Accounts Payable | 25,000 |
| Accounts Receivable | 30,000 | Total Current Liabilities | 25,000 |
| Inventory | 40,000 | Non-current Liabilities: | |
| Total Current Assets | 120,000 | Long-term Loan | 100,000 |
| Non-current Assets: | Total Non-current Liabilities | 100,000 | |
| Buildings | 200,000 | Equity: | |
| Accumulated Depreciation – Buildings | (40,000) | Capital | 100,000 |
| Net Book Value of Buildings | 160,000 | Retained Earnings (55,000 + 75,000) | 130,000 |
| Total Equity | 230,000 | ||
| Total Assets | 280,000 | Total Liabilities and Equity | 355,000 |
Mistake: It is clear through the statement of financial position that there is a mistake in data entry. Total Assets are not equal to Total Liabilities and Equity. Correction: After reviewing the entered data, we found that there was an error. Equity should be:
| Equity: | | | ——————————————– | ————— | | Capital | 100,000 | | Retained Earnings (55,000 + 75,000) | 130,000 | | Total Equity |230,000 | | Total Liabilities and Equity | 355,000 |
Conclusion:
“The Definition of Financial Statements is that they are the primary means of communication between an entity and its stakeholders, providing summarized and reliable information about the entity’s financial position, financial performance, and cash flows. These Financial Statements must be prepared in accordance with generally accepted Accounting Principles, such as International Financial Reporting Standards (IFRS), to ensure their consistency, transparency, and comparability.
Understanding the Definition of Financial Statements, their components, and how to prepare them is essential for all stakeholders, including investors, creditors, management, and employees.
A deep knowledge of the Definition of Financial Statements helps in mastering the steps of the Financial Accounting Cycle, enhancing your skills in Financial Accounting, and ultimately succeeding in the world of finance and business. Finally, technological developments facilitate the preparation of Financial Statements and improve the quality and accuracy of the Financial information provided. Remember that Financial Statements are not just static numbers; they are a reflection of the entity’s story and performance, and understanding this story helps you make more informed decisions.”