Purpose of accounting and basic financial statements

Financial Statements

Accounting is a means of keeping track of a firm's financial transactions. There are two different types of accounting, financial and managerial. Financial accounting focuses on the construction of financial statements with the intention of providing an accurate overview of the firm's financial condition. The four major financial statements are the income statement, the balance sheet, the statement of changes in owner's equity and the statement of cash flows (Singer, 2007). Each of these four serves its own purpose. The income statement and balance sheet are the main statements, but the cash flow statement is important because sometimes it is valuable and necessary to separate out the non-cash transactions from the income statement; additionally the cash transactions are broken down into different types. For shareholder's, the statement of changes in owner's equity is a valuable statement to illustrate what happened to the book value of the owner's equity over the course of the period.

The four basic financial statements are related to one another for the user but they are also related to one another in their construction. The four statements are aggregate reports of financial activity. Each transaction that a firm undertakes is noted, and the all of this activity is compiled in the financial statements. So underlying each of the different financial statements are the total transactions that the firm has undertaken over the period in question (SEC, 2007). As an example, if a firm takes out a bond to buy a piece of machinery, this can be recorded as two transactions. Those transactions, however, impact the statement of cash flows, the balance sheet and the income statement (interest expense and depreciation expense).

When reading the statements, it is important to keep this interrelationship in mind. Changes to one statement will have an impact on the other statements, in part because they are all based on underlying journal entries. Some of the more direct links between the statements are that "Net income" from the income statement, less "dividends" from the same statement, becomes "retained earnings" on the balance sheet. "Net income" is also used as the starting point for the statement of cash flows under the Operating Cash Flows section. From the statement of cash flows, interest expense appears under "Financing" cash flows, and it also appears on the income statement. There are other examples as well of instances where information flows across the statements. Financing flows such as dividends are also recorded on the income statement, for example. Each underlying transaction that takes place can be recorded on any number of different statements, depending on the type of the transaction.

Another connection between the statements is found in the interpretation of the statements. Some of the important financial ratios that are used to analyze the financial health of the company will use multiple statements. For example, the efficiency ratios such as inventory turnover, asset turnover and receivables turnover use a numerator from the income statement and a denominator from the balance sheet. In another example, sometimes net income has significant non-cash charges that distort a firm's true performance for the year. An analyst in that situation would instead substitute cash flow from operations from the cash flow statement, to gauge the strength of the firm's business.

The financial statements are useful to stakeholders such as managers, investors, creditors and employees for a number of reasons. The financial statements are compiled according to a set of standards known as Generally Accepted Accounting Principles, or GAAP. These standards mean that the statements of different firms are compiled in roughly the same way, and this makes it easy to compare statements across companies and over time. This makes the information contained in the statements more useful than if the statements were constructed in an ad hoc manner.

Creditors and investors have an interest in the financial health of the firm, as they are putting money into the firm. For the creditor, it is important to understand the health of the firm's cash flows and what other obligations the firm may have for those cash flows. For the investor, those obligations are also important as debt cash flows must be paid before the firm's equity can improve. Thus, both of these stakeholders benefit from being able to gauge the short and long run financial health of the company.

Internal stakeholders such as managers and employees benefit from financial statements because the statements can help to understand the company's financial position and can be used to provide valuable metrics of performance. Managers in particular are often measured on their ability to deliver on metrics such as profit, margin, earnings per share, turnover and liquidity metrics. The statements allow managers to analyze the performance of their firm against previous years or against the performance of competitors, allowing for better benchmarking.