Financial Reporting: Each Financial Statement Explained
Financial reporting is a vital accounting process that communicates your company’s financials to internal stakeholders (management) and external stakeholders (customers, investors, lenders, regulators, etc.).
There are four main financial reports — also called financial statements — used to communicate your financial data.
- Balance sheet
- Income statement
- Statement of retained earnings
- Cash flow statement
These financial statements are often issued quarterly and annually. Many companies issue monthly statements as well during month-end closing for internal analysis.
What is GAAP?
Generally Accepted Accounting Principles (GAAP) is a set of accounting principles, procedures, rules, and standards governing how public companies must report their financials in the United States. The Financial Accounting Standards Board (FASB) is responsible for issuing and updating GAAP.
Private companies do not have to follow GAAP — but doing so brings you many benefits.
Adhering to GAAP makes for better communication. Entrepreneurs, investors, lenders, and other parties are all familiar with GAAP. By following GAAP in your financial reporting, you can convey your company’s financial information to these parties more easily.
GAAP makes it easier to compare performance against competitors for the same reason. Since GAAP is so widespread, reporting according to its standards provides you ample opportunity to analyze how you stack up against similar companies.
GAAP Vs. IFRS
The International Financial Reporting Standards (IFRS) is the international counterpart to GAAP. IFRS standardizes financial reporting around the world so that financial statement users can make informed analyses and decisions.
IFRS is often confused with the set of standards it replaced — International Accounting Standards (IAS). IAS was retired in 2001 in favor of IFRS when the International Accounting Standards Board (IASB) replaced the International Accounting Standards Committee (IASC).
The SEC has discussed merging GAAP with IFRS. As of now, however, GAAP remains a separate set of standards.
Like with GAAP, private companies in the US do not have to adopt IFRS. IFRS guidelines may make sense for some private entities, but we’ll cover GAAP financial statements in this article.
Now, on to the four financial statements.
The Balance Sheet
The balance sheet provides a snapshot of your business’s financial positions at one point in time. For that reason, it is sometimes called the statement of financial position.
Balance sheets display information on three types of accounts:
- Assets: Resources of the company with future economic value. Assets can be current (short-term, assets you will hold for less than one year) or long-term (assets you will hold for longer than one year). Examples of assets include cash, accounts receivable, equipment, building, land, vehicles, and intangible assets (goodwill and patents).
- Liabilities: These are the future sacrifices of economic benefits. Liabilities can be current or long-term. Examples of liabilities include accounts payable, notes payable, other payables (wages, taxes, utilities, etc.), mortgages, and credit cards.
- Shareholder’s Equity (aka Owner’s Equity): The amount that company owners have invested in the business. You can calculate owner’s equity by subtracting liabilities from assets.
Knowing the balance sheet formula — also called the accounting formula — can help you understand how each category plays off the others. This formula is as follows:
Assets – Liabilities = Shareholder’s Equity
In other words: you, the owner, own any assets left over after you fulfill your debts.
The Income Statement
The income statement — colloquially known as the profit & loss statement, or P&L statement — demonstrates your profitability over an accounting period.
Income statements are split into several categories that shine a light on your business’s performance.
- Revenues: The total amount of income you earned.
- Cost of Goods Sold (COGS): The total cost of creating your products. Not applicable to service businesses.
- Gross Profit: Revenue – COGS. Gross profit informs you of the profitability of your products. As you’d expect, a higher gross profit means a more profitable product and vice-versa.
- Operating Expenses: Any other costs of running your business not associated with creating the product (marketing, supplies, maintenance/repairs, utilities, legal fees, etc.).
- Income From Operations: Gross profit – operating expenses. Income from operations informs you of the profitability of your business’s operations — not just your products.
- Interest Revenue/Expense: Interest revenue – interest expenses. A positive number means interest revenue, while a negative indicates interest expense.
- Operating Profit Before Taxes: Income from operations +/- interest revenue/expense.
- Taxes: Self-explanatory.
- Net Profit/Loss: Operating profit before taxes – taxes. This tells you the true amount you earned or lost in an accounting period.
Income statements are excellent tools for identifying why you are not profitable and how to improve.
For example, you could be selling a product with a low COGS at a high price, yet have narrow profit margins. However, upon closer inspection of your operating expenses, perhaps you are spending a fortune on advertising.
Knowing this, you could explore ways to streamline your advertising campaigns and cut costs. Even if revenues drop a bit, you could increase profits if your advertising costs decrease by a significant amount.
The balance sheet and the income statement work well enough together for many smaller businesses to use them exclusively. Their balance sheet summarizes their financial health, while their income statement helps them boost profits and cut costs.
But you may need other financial statements based on how you do your financial reporting.
The Cash Flow Statement
If your business follows the accrual method of accounting, you’ll need a cash flow statement. The cash flow statement shows you how cash actually moved during the period — whereas the income statement illustrates income/expenses earned/incurred but not received/paid.
Quick example: if you sold Widget X for $100 on credit, you would list $100 in revenue on your income statement. However, since you have not received the cash yet, you would record nothing on the cash flow statement.
Say the customer paid you in the next accounting period. You’d record a positive $100 cash flow on the cash flow statement, but you wouldn’t record anything on the income statement.
There are three parts to a cash flow statement. Each one describes a different type of activity that can cause a cash flow.
- Operating Activities: Cash that flows in and out of your business from normal operations — in other words, selling your product or service. In terms of accounting, these are any cash flows that are related to net income.
- Investing Activities: Cash flows generated from any investments. This can include the principal amounts of loans made to other entities, long-term investments, and investments in fixed assets. In short, these are cash flows related to noncurrent assets.
- Financing Activities: Cash flows generated from activities you undertake to provide financing for your business — in other words, activities related to noncurrent liabilities and owner’s equity. Financing activities include taking out loans, selling or repurchasing shares of your company’s stock, and dividend payments.
In accrual accounting, the cash flow statement is an essential companion to the balance sheet and income statement — because those reports don’t tell the whole story.
You could be making a substantial amount of sales on credit. Additionally, you earn $50 in interest on a loan you made to another business.
The balance sheet and income statement look nice, as you have plenty of accounts receivable and revenue.
However, upon viewing the cash flow statement, you see that you only brought in $50. That may indicate that you need to be more aggressive in A/R collections.
The Statement of Retained Earnings
Companies often hold onto some profits to invest in future projects for growth. That’s where the statement of retained earnings, or the statement of owner’s/shareholder’s equity, comes in.
This report outlines the change in a company’s retained earnings — profits left over after distributing dividends to shareholders — over a period.
External parties, such as investors or lenders, use the statement of retained earnings to understand how you plan on using your profits to grow your business.
The statement of retained earnings is relatively simple.
- Beginning Retained Earnings: This is the amount of retained earnings you have from the previous period.
- Net Income/Loss: You then add/subtract your net income/loss.
- Dividends: Subtract dividends paid to investors.
- Ending Retained Earnings: After performing the above calculation, you’ll arrive at retained earnings for the end of the period. You’d then use this number for the next period’s beginning retained earnings.
You can prepare the statement of retained earnings as a standalone report, but many add it to the bottom of the balance sheet.
Financial statements are complicated enough as is. If you’re switching over to GAAP for the first time, preparing your financial statements can be quite daunting.
CFO Hub’s experts are here to help. Whether you’re adjusting to GAAP or a long-time GAAP user, our team of experts will create accurate financial statements that are helpful to your stakeholders and enable you to make better business decisions.