Financial Statements: What, Why and How

Financial statements are the end result of a process of summarising, classifying and structuring large quantities of data.  Financial statements present useful information that helps in the efficient running of an organisation, indicate how successful its management is performing and provide users with information about its resources and activities. 

This article will focus on the main financial statements, it will look at what these statements are, introduce some key terms the basis of their preparation, and how one should view and interpret them. 

Accounting has developed over a number of centuries and with it has evolved a framework with accepted guidance and ‘rules’ as to how accounts should be prepared.  The accounting framework allows for flexibility of interpretation and judgment, this allows accountants to be ‘creative’, albeit not in an artistic sense.

Two of the main financial statements produced by organisations are a profit statement (or income statement) and a balance sheet.  The profit statement shows income generated and the costs incurred in generating that income; the balance sheet lists all assets owned or controlled by an organisation and all of its debts (liabilities) at that same point in time;  Examples of assets would include buildings, plant and machinery, office furniture, computer equipment, money owed by customers and cash,; examples of liabilities include bank overdrafts, taxes owed, money owed to suppliers for goods and services purchased but not yet paid for. 

Accounting statements are presented in monetary terms therefore they only include items that can be measured with certainty and reliably, for example a monetary value can be placed on the purchase of computer.  However skilled and loyal members of staff cannot be valued reliably and therefore would not appear in a set of financial accounts. 

Assets are items of value that are sub-divided into those that have been acquired for long term use by an organisation (fixed assets), this is part of its infrastructure and helps it generate its income and carry out its work; current assets are another category are intended to be turned into cash within one year.  For example, a restaurant will have ovens, tables and chairs, these will be considered its fixed assets; however, the food and drink that it buys will be classified as current assets

Another important classification and distinction to be aware of is that between capital and revenue costs, if an item is classified as capital then it will appear in the balance sheet, if it is classified as revenue costs it appears in the profit statement and is used to calculate profit.     

Capital costs are those that normally arise from acquiring fixed assets or in improving them; revenue costs are those incurred in:

1. Obtaining assets for turning into cash
2. The day to day running costs of an organisation, for example wages, rent
3. Maintaining fixed assets

Capital costs usually have associated revenue costs, for example a delivery truck would be classified as a fixed asset (balance sheet), the associated revenue costs would be the fuel, repairs, insurance and road tax (profit statement); the building owned by the above company would be classified as a fixed asset (balance sheet), if the building were to be painted or broken window replaced then this would normally be classified as revenue (profit statement), if the building were to have an extension then this would be classified as capital (balance sheet). 

A profitable organisation does not necessarily mean it is cash rich; it is not that unusual for an organisation to be profitable for a period of time and have a shortage of cash.  The next article will explain how profit is calculated, explain depreciation, introduce the cash flow statements and discuss the strengths and limitations of financial statements.