Financial Statements Are Typically Prepared In The Following Order

The story of a company's financial health is told through its financial statements, each offering a unique perspective but ultimately working together to paint a complete picture. While they are often presented as a single package, the creation of these statements follows a specific sequence to ensure accuracy and logical flow. Understanding this order is crucial for anyone seeking to interpret and utilize financial data effectively.

The Orderly Creation of Financial Statements

The creation of financial statements typically follows this order:

1. Income Statement: Unveiling profitability over a specific period.
2. Statement of Retained Earnings: Tracking changes in accumulated profits.
3. Balance Sheet: Presenting a snapshot of assets, liabilities, and equity at a specific point in time.
4. Statement of Cash Flows: Analyzing the movement of cash both into and out of the company.

Let's dive deeper into each of these statements and understand why they are prepared in this particular order.

1. Income Statement: The Starting Point

The income statement, sometimes called the profit and loss (P&L) statement, is the foundation upon which the other financial statements are built. It summarizes a company's financial performance over a specific period, typically a quarter or a year. It reveals whether the company has generated a profit or incurred a loss during that time.

How the Income Statement is Constructed:

The basic formula for the income statement is:

Revenue - Expenses = Net Income (or Net Loss)

Here's a more detailed breakdown of the key components:

• Revenue: This represents the total income generated from the company's primary business activities, such as sales of goods or services.
• Cost of Goods Sold (COGS): This includes the direct costs associated with producing the goods or services sold. Examples include raw materials, direct labor, and manufacturing overhead.
• Gross Profit: Calculated as Revenue - COGS, this represents the profit earned before considering operating expenses.
• Operating Expenses: These are the expenses incurred in running the business, such as salaries, rent, utilities, marketing, and depreciation.
• Operating Income: Calculated as Gross Profit - Operating Expenses, this represents the profit earned from the company's core operations. It is sometimes referred to as Earnings Before Interest and Taxes (EBIT).
• Interest Expense: This is the cost of borrowing money.
• Income Before Taxes: Calculated as Operating Income - Interest Expense.
• Income Tax Expense: The amount of income tax owed to the government.
• Net Income: Calculated as Income Before Taxes - Income Tax Expense, this is the "bottom line" – the company's profit after all expenses and taxes have been paid.

Why it Comes First:

The income statement is prepared first because the net income (or net loss) figure is crucial for creating the statement of retained earnings. Without knowing the net income, we cannot determine how much the company's retained earnings have changed.

2. Statement of Retained Earnings: Tracking Profit Accumulation

The statement of retained earnings explains the changes in a company's retained earnings over a specific period. Retained earnings represent the accumulated profits of a company that have not been distributed to shareholders as dividends.

How the Statement of Retained Earnings is Constructed:

The basic formula for the statement of retained earnings is:

Beginning Retained Earnings + Net Income - Dividends = Ending Retained Earnings

Here's a more detailed explanation:

• Beginning Retained Earnings: This is the amount of retained earnings at the beginning of the period. It is the ending retained earnings from the previous period.
• Net Income: This is the net income from the income statement for the current period. It increases retained earnings.
• Dividends: These are the payments made to shareholders from the company's profits. Dividends decrease retained earnings.
• Other Adjustments: In some cases, there may be other adjustments to retained earnings, such as prior period adjustments (corrections of errors in previous financial statements).
• Ending Retained Earnings: This is the amount of retained earnings at the end of the period. This figure is then carried over to the balance sheet.

Why it Comes Second:

The statement of retained earnings relies on the net income calculated in the income statement. Furthermore, the ending retained earnings balance calculated in this statement is a key component of the equity section of the balance sheet. Therefore, it must be prepared after the income statement but before the balance sheet.

3. Balance Sheet: A Financial Snapshot

The balance sheet provides a snapshot of a company's assets, liabilities, and equity at a specific point in time. It follows the fundamental accounting equation:

Assets = Liabilities + Equity

This equation highlights the core concept that a company's assets are financed by either borrowing money (liabilities) or by investments from owners (equity).

How the Balance Sheet is Constructed:

The balance sheet is typically presented in a classified format, meaning that assets and liabilities are categorized based on their liquidity (how easily they can be converted to cash) and maturity (how soon they are due).

• Assets:
  • Current Assets: These are assets that are expected to be converted to cash or used up within one year. Examples include cash, accounts receivable, inventory, and prepaid expenses.
  • Non-Current Assets: These are assets that are not expected to be converted to cash or used up within one year. Examples include property, plant, and equipment (PP&E), intangible assets (patents, trademarks), and long-term investments.
• Liabilities:
  • Current Liabilities: These are obligations that are expected to be settled within one year. Examples include accounts payable, salaries payable, and short-term loans.
  • Non-Current Liabilities: These are obligations that are not expected to be settled within one year. Examples include long-term loans, bonds payable, and deferred tax liabilities.
• Equity:
  • Contributed Capital: This represents the amount of money invested by shareholders in exchange for stock.
  • Retained Earnings: This is the accumulated profits of the company that have not been distributed to shareholders. As mentioned earlier, the ending retained earnings balance comes from the statement of retained earnings.
  • Other Comprehensive Income: This includes certain gains and losses that are not included in net income, such as unrealized gains and losses on available-for-sale securities.

Why it Comes Third:

The balance sheet is prepared after the income statement and the statement of retained earnings because it relies on information from both of these statements. Specifically, the net income from the income statement is used to calculate the ending retained earnings balance, which is then included in the equity section of the balance sheet.

4. Statement of Cash Flows: Analyzing Cash Movement

The statement of cash flows reports the movement of cash both into and out of a company during a specific period. It categorizes cash flows into three main activities:

• Operating Activities: These are the cash flows that result from the normal day-to-day operations of the business, such as selling goods or services.
• Investing Activities: These are the cash flows that result from the purchase and sale of long-term assets, such as property, plant, and equipment.
• Financing Activities: These are the cash flows that result from borrowing money or issuing stock.

How the Statement of Cash Flows is Constructed:

There are two main methods for preparing the statement of cash flows:

• Direct Method: This method reports the actual cash inflows and outflows from operating activities.
• Indirect Method: This method starts with net income from the income statement and then adjusts it for non-cash items to arrive at the net cash flow from operating activities.

Regardless of the method used, the statement of cash flows ultimately reconciles the beginning and ending cash balances for the period.

Why it Comes Last:

The statement of cash flows often requires information from all three previous financial statements. It uses net income from the income statement (when using the indirect method), changes in balance sheet accounts (such as accounts receivable and accounts payable), and information about dividends paid (which can be found in the statement of retained earnings). While the statement of cash flows can be constructed with information derived independently, the process is streamlined and made more accurate by leveraging the previously prepared statements. This allows for a more complete and accurate picture of the company's cash flow activities.

The Interconnectedness of Financial Statements

It's important to remember that financial statements are not isolated documents. They are interconnected and provide a holistic view of a company's financial performance and position. The order in which they are prepared reflects this interconnectedness, with each statement building upon the information presented in the previous ones.

Here’s a summary of how these statements connect:

• Income Statement to Statement of Retained Earnings: The net income (or net loss) from the income statement is a crucial input for the statement of retained earnings.
• Statement of Retained Earnings to Balance Sheet: The ending retained earnings balance from the statement of retained earnings is included in the equity section of the balance sheet.
• All Three Statements to Statement of Cash Flows: The statement of cash flows often utilizes information from the income statement (net income), balance sheet (changes in asset and liability accounts), and statement of retained earnings (dividends paid).

Why Understanding the Order Matters

Knowing the order in which financial statements are prepared is essential for several reasons:

• Accurate Analysis: Understanding the sequence allows for a more accurate analysis of a company's financial performance and position. By following the flow of information from one statement to the next, you can gain a deeper understanding of the underlying drivers of a company's financial results.
• Identifying Errors: Recognizing the relationships between the statements can help in identifying potential errors or inconsistencies. If the numbers don't "add up" correctly, it could indicate a mistake in one of the statements.
• Effective Decision-Making: Whether you're an investor, creditor, or manager, a solid understanding of financial statements is crucial for making informed decisions. Knowing how the statements are prepared and how they relate to each other will empower you to make better judgments about a company's financial health and future prospects.
• Auditing and Compliance: Auditors rely heavily on the established order of financial statement preparation to ensure accuracy and compliance with accounting standards. Understanding the process is vital for effective auditing procedures.
• Financial Modeling: Building accurate financial models requires a deep understanding of how financial statements are linked. Knowing the proper sequence ensures that your model accurately reflects the company's financial performance.

Exceptions to the Rule

While the order described above is the most common and generally accepted, there can be exceptions in specific circumstances. For example, in the case of a significant prior period adjustment discovered after the income statement has been finalized, the statement of retained earnings might need to be adjusted before the balance sheet is completed. However, these exceptions are rare and usually involve specific accounting complexities.

Deep Dive: The Importance of Accrual Accounting

The order of financial statement preparation is closely tied to the principles of accrual accounting. Accrual accounting recognizes revenues when they are earned and expenses when they are incurred, regardless of when cash is received or paid. This is in contrast to cash accounting, which recognizes revenues and expenses only when cash changes hands.

The income statement is a prime example of accrual accounting. It reports revenues and expenses that may not have involved any cash transactions during the period. For example, a company may recognize revenue from a sale even if it hasn't yet received payment from the customer. Similarly, a company may recognize depreciation expense even though it didn't actually pay any cash for the asset during the period.

The use of accrual accounting necessitates the specific order of financial statement preparation. The net income calculated under accrual accounting is then used to determine the change in retained earnings and ultimately impacts the balance sheet.

Understanding Different Accounting Standards

It's important to note that the specific requirements for preparing financial statements can vary depending on the accounting standards being used. The two main sets of accounting standards are:

• Generally Accepted Accounting Principles (GAAP): Used primarily in the United States.
• International Financial Reporting Standards (IFRS): Used in many other countries around the world.

While the basic order of financial statement preparation is generally the same under both GAAP and IFRS, there can be differences in the specific rules and regulations that apply to each statement. For example, the presentation of certain items on the income statement or balance sheet may differ depending on whether a company is using GAAP or IFRS.

Practical Example: Applying the Order in Real Life

Let's imagine a small business, "Sweet Success Bakery," and how they would prepare their financial statements at the end of the year.

1. Income Statement: First, Sweet Success Bakery would calculate its revenue from selling baked goods. Then, they would subtract the cost of ingredients (COGS) to arrive at their gross profit. Next, they would deduct operating expenses like rent, utilities, and salaries to arrive at their operating income. Finally, they would deduct any interest expense and income taxes to arrive at their net income.
2. Statement of Retained Earnings: Next, Sweet Success Bakery would take their net income from the income statement and add it to their beginning retained earnings balance. They would then subtract any dividends paid to the owner to arrive at their ending retained earnings balance.
3. Balance Sheet: Sweet Success Bakery would then prepare their balance sheet, listing all of their assets (cash, equipment, inventory), liabilities (accounts payable, loans), and equity (owner's equity, retained earnings). The ending retained earnings balance from the statement of retained earnings would be included in the equity section of the balance sheet.
4. Statement of Cash Flows: Finally, Sweet Success Bakery would prepare their statement of cash flows, analyzing the cash inflows and outflows from their operating, investing, and financing activities. They would use information from the income statement and balance sheet to prepare this statement.

By following this order, Sweet Success Bakery can ensure that their financial statements are accurate and consistent.

Common Mistakes to Avoid

Here are some common mistakes to avoid when preparing financial statements:

• Incorrectly Calculating Net Income: An error in calculating net income will have a ripple effect on all subsequent financial statements.
• Misclassifying Assets and Liabilities: Improperly classifying assets or liabilities can distort the balance sheet and make it difficult to assess a company's financial health.
• Failing to Reconcile Cash Flows: The statement of cash flows should reconcile the beginning and ending cash balances. Failure to do so indicates an error in the statement.
• Ignoring Accrual Accounting Principles: Failing to adhere to accrual accounting principles can lead to inaccurate and misleading financial statements.
• Not Following Accounting Standards: Ignoring the specific requirements of GAAP or IFRS can result in non-compliant financial statements.

The Future of Financial Statement Preparation

The world of financial accounting is constantly evolving, driven by technological advancements and changing business practices. Some of the key trends shaping the future of financial statement preparation include:

• Automation: Automation is streamlining many aspects of financial statement preparation, reducing errors and improving efficiency.
• Data Analytics: Data analytics tools are being used to analyze financial data and identify trends and insights that can improve decision-making.
• Real-Time Reporting: There is a growing demand for real-time financial reporting, which would provide stakeholders with up-to-date information about a company's financial performance.
• Blockchain Technology: Blockchain technology has the potential to revolutionize financial accounting by providing a secure and transparent way to record and track financial transactions.
• Increased Focus on Non-Financial Information: There is a growing recognition that non-financial information, such as environmental, social, and governance (ESG) factors, is also important for assessing a company's value and performance.

Conclusion: Mastering the Financial Story

Financial statements are the language of business, and understanding how they are prepared is crucial for anyone seeking to interpret and utilize financial data effectively. By understanding the order in which these statements are created – income statement, statement of retained earnings, balance sheet, and statement of cash flows – you gain a deeper understanding of the interconnectedness of these reports and the story they tell about a company's financial health. Whether you're an investor, creditor, manager, or simply someone interested in learning more about business, mastering the fundamentals of financial statement preparation will empower you to make more informed decisions and navigate the complex world of finance with greater confidence.