The Importance of Financial Statements Essay Example
The importance of financial statements is paramount for numerous parties. They provide vital information about a company’s revenue, expenses, profitability, liability load, and most importantly their ability to meet short and long-term financial obligations. Investors can view these statements to help make intellectual decisions on who they give their money to. This is a big part as to why faithful representation is crucial for any company. With all companies using these financial recording structures, it allows businesses to work together smoothly and without any blurred lines one side wouldn’t understand
The multiple step Income Statement is a vital part of any corporation as it provides a detailed report of their revenues and expenses which concludes at the net income. It allows stakeholders to gain an understanding of profitability and their different business activities. It begins with Net Sales minus Cost of Goods Sold to arrive at the gross profit. Which leads to calculating all the operating expenses to find the total operating expenses. The company must check if there are any other revenues and gains or expenses and losses, and if so input it following the total operating expenses.
Once any gains or losses are added or subtracted from the total operating expenses, the company must show their income before income taxes. The last step is simply subtracting the income tax expense to arrive at the net income. Multiple step income statement has certain aspects outside itself that it relies on, one being the accounting period, such as a monthly, quarterly, or yearly income statement periods. A trial balance must also be prepared during the same period. Not to mention how the net income found will be used in the Statement of Retained Earnings.
In terms of doing an Income Statement yourself, you’ll need to understand how numbers become what they are. Net sales consist of sales revenue less sales returns and allowances and sales discount to arrive at net sales. Operating expenses include all expenses including freight-out. Gross profit is from subtracting net sales and cost of goods sold as discussed earlier. The other revenues and gains includes interest revenue or rent revenue while expenses and losses includes interest expense. The income tax expense can be calculated by multiplying Income before income taxes by the tax rate.
The last thing I deem necessary to discuss regarding the income statement, is the main differences between the multiple step income statement and single step income statement. The single step can be summarized as the equation Net Income = (Revenues + Gains) – (Expenses + Losses). The biggest one is that single step groups all revenues and expenses together without calculating subtotals. This gives the multiple step an advantage, as it allows large complex business with multiple sources of revenue to separate their primary business activities from non-essential activities. All public traded companies are also required to use it given the scrutiny their under from the public, who demand a detailed financial report that they can analyze.
Following the Income Statement is the Statement of Retained Earnings, which surprisingly has nothing to do with surplus earnings. It is used to build confidence with investors and the market of the company, it basically determines the health of a company. The actual statement begins with the beginning retained earnings from the trial balance. The company then adds the net income previously calculated through the income statement, followed by subtracting the dividends to result in the ending retained earnings for the period.
This leads to the Balance Sheet, the largest and most complex of the 3, which is used to represent how much a company is worth, also called “book value”. It reports their assets, liabilities, and stockholders’ equity in their entirety. It show’s exactly what a company owns and owes, along with the capital allowed by shareholders. The sheet follows the simple equation, assets = liabilities + stockholders’ equity, with assets on the left side and liabilities + stockholders’ equity on the other. Both sides will always balance out because the company must pay for all things it owns.
The first part of the balance sheet is the current assets portion. This is all a company’s assets that are expected to be converted to cash within one year of the date written in the heading of the balance sheet. They are highly important as they are used in day-to-day funding of the business and pay for ongoing operating expenses. The current assets include Cash, all Receivable accounts, Inventory, Supplies, and Prepaid Expenses and are normally listed in order of liquidity. The allowance for Doubtful Accounts must first be subtracted from Accounts Receivable before totaling.
Property, Plant, and Equipment follow the current asset section as they are long term assets, which include intangible assets (trademarks/patents), equipment, and land/buildings. Intangible assets greatly improve a company’s long term worth, as they have legal or intellectual rights. The intangible assets are then added to show the total intangible assets on the balance sheet. It’s important to make sure accumulated depreciation is being subtracted from the total of the long-term assets before adding the three groups for total assets.
The next section of the balance sheet is the current liabilities. These are obligations a company owes that must be paid off in less than a year from the date listed in the balance sheet heading. Current liabilities include Accounts Payable, Unearned Revenue, Notes Payable (if maturity of less than a year), Dividends Payable, Income Tax Withholding Payable, Income Taxes Payable, Interest Payable, Medicare Taxes Payable, Salaries Payable, Sales Taxes Payable, Social Security Taxes Payable, and Unemployment Taxes Payable, which are all totaled. The long-term liabilities follow the current liabilities and are obligations that can be paid off over a year. These include Notes Payable (if maturity of more than a year), Mortgage Payable, and Bonds Payable. If there is a discount on bonds payable, then it must be subtracted from Bonds Payable before totaling the long-term liabilities. The final step is to add the current and long-term liabilities to arrive at the total liabilities.
The final section of the balance sheet is stockholders’ equity. This is how much of a company’s assets remain after settling all liabilities and the claim shareholders have on their assets. The first part is Paid-in Capital, which is the amount of capital stock (preferred and/or common) a company has from investors. Once the total Paid-in Capital is calculated, we add our ending retained earnings and subtract treasury stock to get the total stockholders’ equity. This total can alternatively be found through subtracting the total liabilities from the total assets. Finally, we add total liabilities and total stockholders’ equity to reveal the total liabilities and stockholders’ equity.
In conclusion, I’ve discussed the three main financial statements, the Income Statement, Statement of Retained Earnings, and the Classified balance sheet. All of which have their own key role to the business world and their own strict standard that work together. Understanding these is a monumental part in understanding the complex language of business. Once you grasp the genuine simplicity in it, the retaining of the information becomes easy. In all honesty, concocting this paper is something I’m truly thankful for doing. As I wrote and researched to attempt it perfectly, I was able to see more visually how they are all connected and ended up coming out with a much more confident understanding of them.
