Financial Statements All Publicly-Traded Firms Are Required

Financial Statements

All publicly-traded firms are required to produce financial statements. These statements are produced according to standardized guidelines, and their production is an essential component to the efficient function of modern capital markets in the west. This paper will discuss the nature of financial accounting statements, and will provide insight into how these statements provide a benefit to different stakeholder groups, both internal and external.

The production of consistent, reliable financial statements is essential to the function of modern capital markets. Financial accounting statements, which are constructed according to Generally Accepted Accounting Principles, are designed to meet the needs of multiple stakeholders, both internal and external, including regulators, investors, managers, competitors and creditors. There are four major types of financial accounting statements -- the income statement, the balance sheet, the cash flow statement and the statement of changes in owner's equity (SEC.gov, n.d.).

The income statement tracks the accounting income earned by the company. Accounting income is defined according to its own set of rules, governed by the GAAP and by the Financial Accounting Standards Board. The underlying principle of the income statement is that the items measured reflect the nature of the business. For example, capital investments are depreciated over a number of years, reflecting the useful life of the asset. This provides stakeholders with a more accurate picture of the health of the business in a given year.

The balance sheet measures the firm's assets, liabilities and owner's equity. The assets must balance with the combined liabilities and equity. This illustrates the firm's capital structure, which reflects the degree to which the owners of the firm are entitled to the firm's assets. The greater the percentage of liabilities, the less of the firm that the company's owners actually own.

The cash flow statement measures the changes in cash flow. Because accounting income (from the income statement) contains many lines that are not cash-oriented, the cash flow statement provides a better picture of the firm's solvency, and where it gets its money from. There are three types of cash transactions that are aggregated on the cash flow statement: from operations, from investments and from financing. The statement of changes in owner's equity breaks down the difference in equity level from one period to the next. This helps the investor to understand why the equity level has changed.

The statements are all interrelated, so the analysis of the statements must also be interrelated. The statements are all aggregates of the individual transactions that are recorded by the organization. Thus, all of the information on the statements derives directly from the normal course of business in which the company is engaged. The statement of cash flows acts as a companion primarily to the income statement. The former breaks out the cash components of the income statement into the "cash flow from operations," and this can provide perspective to the income statement. An example would be a firm that recorded a steep writedown, bringing net income below zero and creating a strong deviation from the years before and after. The cash flow statement might show that this company's cash flow from operations changed little in all three years, providing the insight that the loss was primarily related to the writedown.

The statement of changes in owner's equity is a companion to the balance sheet. Owner's equity is one of the key categories on the balance sheet and is probably the most important for the firm's owners. Thus, a more comprehensive breakdown of the change in equity is valuable to further analyze where the changes in equity that are on the balance sheet come from. In addition, there are other points where the statements relate to one another. Net income, if not distributed in the form of dividends, will become retained earnings. This provides a linkage between the income statement and both the balance sheet and the statement of changes in owner's equity. The statement of cash flows begins with the net income and removes from that figure non-cash items, then adds back other cash items. All told, a change in one statement is likely to result in a change to the others, as they are all closely connected to one another.

The financial statements also contain information in written form, as notes. The notes to the financial statements are often as important as the numbers in the statements. It is the notes that outline how and why certain numbers come about, and point out the assumptions and accounting techniques that lie behind the numbers. When a stakeholder is analyzing the financial statements, the notes to the statements must be given due attention, as each of the four major statements will have a number of notes that provide critical perspective to the figures contained within.

Financial statements are produced specifically for the benefit of different stakeholder groups. For managers, they are a means to measure changes in performance over time. Managers are often evaluated on financial statement measures as well, and the statements provide managers with the ability to identify problems and derive solutions. There are other forms of financial information available to managers -- managerial accounting data -- so for managers the financial statements are primarily complementary in nature.