INTRODUCTION TO FINANCIAL STATEMENTS

A financial statement is simply a declaration of what is belived to be true communicated in terms of a monetary unit, such as the dollar. When accountants prepare financial statements, they are describing in financial terms certain attributes of the enterprise that they believe fairly represent its financial activities.
Time is an important factor in preparing and understanding an entrprise’s financial statements. Statements might cover a period as short as a week or as long as a year. Annual financial statements of companies include information for a year. Financial statements prepared for periods of time shorter than one year (for example, for three months or one month) are referred to as interim financial statements.
We discuss three primary financial statements:

• Statement of financial position (commonly referred to as the balance sheet.)
• Income statement.
• Statement of cash flows.
  
  1. Statement of financial position

All three financial statements contain important information, but each includes different information. For that reason, it is important to understand all three financial statements and how they relate to each other. The way they relate is sometimes referred to as articulation.
A logical starting point for understanding financial statements is the statement of financial position, also called the balance sheet. The purpose of this statement is to demonstrate where the company stands, in financial terms, at a specific point in time. The other financial statements relate to the statement of financial position and show how important aspects of a company’s financial position change over time. Beginning with the statement of financial position also allows us to understand certain basic accounting principles and terminologies that are important for understanding all financial statements.
Every business prepares a balance sheet at the end of the year, and many companies prepare one at the end of each month, weed, or even day. It consists of a listing of the assets, the liabilities, and the owners’equity of a business. The date is important, as the financial position of a business may change quickly.

Assets
Assets are economic resources that are owned by a business and are expected to benefit future operations. In most cases, the benefit to future operations comes in the form of positive future cash flows. The positive future cash flows may come directly as the asset is converted into cash (collection of a receivable) or indirectly as the asset is used in operating the business to create other assets that result in positive future cash flows (building and land used to manufacture a product for sale). Asset may have definite physical form such as buildings, machinery, or tangible form, but in the form of valuable legal chaims or rights; examples are amounts due from customers, investments in government bouns, and patent rights.

Liabilities
Liabilities are debts. They represent negative future cash flows for the enterprise. The person or organization to whom the debt is owned is called a creditor.
All businesses have liabilities; even the largest and most successful companies often purchase merchandise, supplies, and services ‘on account’ The liabilities arising form such purchases are called accounts payable. Many business borrow money to finance expansion or the purchase of high-cost assets. When obtaining a loan, the borrower usually must sign a formal note payable. A note payable is a written promise to repay the amount owed by a particular date and usually calls for the payment of interest as well.

Owners’ Equity
Owners’equity represents the owners’claim on the assets of the business. Because creditors’claims have legal priority over those of the owner, owners’equity is a residual amount. If you are owner of a business, you are entitled to assets that are left after the claims of creditors have been satisfied in full. Therefor, owners’equity is always equal to total assets minus total liabilities.

The Accounting Equation
A fundamental characteristic of every statement of financial position is that the total for assets always equals the total of liabilities plus owners’equity. This agreement or balance of total assets with the total of liabilities and owners’equity is the reason for calling this financial statement a balance sheet. But why do total assets the total of liabilities and owners’equity?
The dollar totals on the tow sides of the balance sheet are always equal because these two sides are tow views of the same business. The listing of assets shows us what things the business owns; the listing of liabilities and owners’ equity tells us who supplied these resources to the business and how much each group supplied. Everything that a business owns has been supplied to it either by creditors or by the owners. Therefore, the total claims of the creditors plus the claims of the owners equal the total assets of the business.
The equality of assets on the one hand and of the claims of the creditors and the owners on the other hand is expressed in the following accounting equation :
Assets = Liabilities + Owners’ Equity

2. Income statement

The income statement is a summarization of the company’s revenue and expense transaction for a period of time. It is particularly important for the company’s owners, creditors, and other interested parties to understand the income statement, Ultimately the company will succeed or fail based on its ability to earn revenue in excess of its expenses. Once the company’s assets are acquired and business commences, revenues and expenses are important sources of cash flows for the enterprise. Revenues are increases in the company’s assets from its profit-directed activities, and they result in positive cash flows. Net income is the difference between the two. Should a company find itself in the undersirable situation of having expenses greater than revenues, we call the difference a net loss

3. Statement of cash flows

We already have established the importance of cash flows to investors and creditors and that the cash flows of the company are an important consideration in investors’ and creditors’ assessments of cash flows to them. As a result, a second set of information that is particularly important concerning how the financial position changed between two points in time (that is, the beginning and end of a month or year) is cash flow information.