Financial_Statement_Differentiation

Financial Statement Differentiation Vaughan Thompson ACC/561: Accounting March 4, 2013 Venetia N. Pitts, MBA Financial Statement Differentiation It is difficult to envision investors, creditors, and management making informed decisions sans accurate financial information. Consequently, organizations should use financial statements to communicate their financial stability, cash flows, and operational results with external and internal users. The purpose of this paper is to explain information contained in each of the four financial statements and discuss reasons each statement is of interest to investors, creditors, and management. Literature Review Literature review identified four primary financial statements the accounting process creates. They are the income, retained earnings, balance sheet, and cash flow statement (Kimmel, Weygandt, & Kieso, 2009). According to Albrecht, Stice, Stice, and Swain, (2008), each statement has a unique purpose and interrelates with the others. To decipher a company’s complete financial picture, stakeholders should understand how each statement influences the next (Financial Accounting, 2011). The Four Types of Financial Statements Generally accepted accounting principles (GAAP) require publicly held organizations show their earnings, owner investments - distributions to owners, financial position, and cash flow for a given period (Financial Accounting, 2011). The financial statement that satisfies each of the aforementioned (in order) is the income statement, retained earnings statement, balance statement, and statement of cash flows (Albrecht et al., 2008). Income Statement The income statement tells if a business operated at a profit or loss (net income) during a reporting period by subtracting expenses from revenues. Said statement also reports gains and losses resulting from non-operating activities, which differ from daily operational activities that generate revenue and expenses. Net income from this statement helps to generate a retained earnings statement. Retained Earnings Statement The retained earnings statement, usually the most concise, shows alterations to retained earnings and paid-in capital during a period. Financial Accounting posits, “Retained earnings are increased by the amount of net income and decreased by dividends to stockholders (and by any net loss for the period)” (2011, p. 54). A business retains its net income, also called retained earnings. Retained earnings link the income statement to the balance sheet. Balance Sheet The balance sheet is a snapshot of company assets and financial obligations (Sherlock & Reuvid, 2005). This sheet reflects the basic accounting equation: assets = liabilities + stockholder's equity (Peavler, 2013). Assets are the resources a company owns or controls, liabilities are amounts said company owes, and owners’ equity is assets minus liabilities. The equation means organizational assets must balance with its liabilities plus owners’ equity; hence, the name ‘balance sheet.’ Changes in the balance sheet items explain variations in cash flow. Statement of Cash Flows Statements of cash flows show how cash affects a company’s operating, investing, and financing activities during a specified period. This statement reconciles balance sheet cash changes from one years’ end to the following years’ end (Financial Accounting, 2011). A position as investor, creditor, or management plays a key role in determining which financial statement is of interest to stakeholders. Stakeholder Interests Investors would show significant interest in three statements because they provide pertinent information to help make investment decisions. Past net income is a good predictor of future income, so investors buy or sell stock based on such predictors. To help make investment decisions, investors could use retained earnings to monitor dividend payment practices. Investors should also show a keen interest in cash flows to ensure management is managing cash properly and not selling assets to finance daily operations. Creditors use the income statement to predict a company’s future earnings and its ability to repay debts. Lenders scrutinize dividend payments because such payments diminishes a business’ ability to service its debts. To determine repayment possibility, creditors evaluate a business’ balance sheet to ensure it carries an acceptable proportion of common stock-to-debt financing and not mired in debt. Management should show an interest in the four statements because of their interrelatedness. It is imperative they know if the company is making a profit, has a satisfactory debt to owners’ equity ratio, is balancing its books, and managing its cash flow effectively. Conclusion Businesses use four financial statements to communicate their financial stability to external and internal users. They are the income, retained earnings, balance, and cash flow statements. Each statement serves a unique purpose, but interrelates to offer a snapshot of a company’s financial health. Investors, creditors, and management should use one or more financial statements to make prudent investment decisions, approve loans, or manage the business’ financial affairs in ways beneficial to investors and creditors. References Albrecht, W. S., Stice, J. D., Stice, E. K., & Swain, M. R. (2008). Accounting: concepts and applications (10th ed.) Mason, OH: Thomson/South-Western. Financial Accounting (2011). Chapter 2: Financial Statements and Accounting Concepts/Principles. (2011.). Retrieved February 27, 2013 from http://highered.mcgraw- hill.com/sites/dl/free/0073527068/792292/sample_chapter2.pdf Kimmel, P. D., Weygandt, J. J., & Kieso, D. E. (2009). Accounting: Tools for business decision making (3rd ed.). Hoboken, NJ: John Wiley & Sons. Peavler, R. (2013). Financial statement analysis for your small business firm. Retrieved February 28, 2013 from http://bizfinance.about.com/ Sherlock, J., & Reuvid, J. (2005). PART 8: Export finance: Business finance. In Handbook of International Trade (pp. 313-327). Blue Ibex Ltd.