Financial Statements (Explanation Part 1)

Introduction to Financial Statements

In this topic you will learn about the five financial statements that a U.S. corporation should include when it distributes its annual financial statements to anyone outside of the corporation. The five financial statements are:

1. Income statement
2. Statement of comprehensive income
3. Balance sheet
4. Statement of stockholders’ equity
5. Statement of cash flows

The annual financial statements should also include notes to the financial statements. The notes (which are to be referenced on each financial statement) disclose important information regarding the amounts appearing or not appearing on the financial statements.

The financial statements that are distributed by a U.S. corporation must comply with the common rules known as generally accepted accounting principles or GAAP or US GAAP. If the corporation’s stock is traded on a stock exchange, the corporation is also required to comply with the reporting requirements of the Securities and Exchange Commission (SEC), an agency of the U.S. government.

It is important to understand that most of the amounts contained in the financial statements resulted from recording past transactions. Hence the amounts may not be relevant for future decisions and will not indicate the corporation’s fair market value.

Where the Amounts Come From

Generally, the amounts reported on the financial statements originated from the corporation’s business transactions that were recorded and stored in the general ledger accounts. The accounting records are often referred to as the corporation’s books.

In addition to recording the business transactions, accountants will also record adjusting entries before issuing the financial statements. The following are three examples of why adjusting entries are necessary:

1. Some of the transaction amounts that were recorded pertain to more than one accounting period. (An accounting period could be a year, quarter, month, 13 weeks, etc.) An adjusting entry is necessary so that only the pertinent amounts appear in each period’s financial statements.

   To illustrate, let’s assume that a corporation purchased an asset for $60,000 that is expected to be used in the business for 60 months. If the corporation issues monthly financial statements, an adjusting entry will be necessary so that each income statement will report a monthly expense of $1,000 ($60,000 of cost divided by the useful life of 60 months). The adjusting entry will also cause the asset section of the balance sheet to decrease by $1,000 per month.

2. Some expenses may occur so late in an accounting period that they were not processed and recorded in the general ledger accounts. In order for these expenses and related obligations to be included in financial statements, the accountant will record accrual-type adjusting entries. (Similarly, an adjusting entry may be required if revenues were earned, but were not yet recorded.)

3. US GAAP will likely require additional adjusting entries. Two examples include:
   • an adjustment for uncollectible accounts receivable
   • an adjustment for some marketable securities where the fair market value has changed

To learn more about recording adjustments, see our free Explanation of Adjusting Entries.

Accrual Method of Accounting

The adjusting entries we mentioned are needed to comply with the accrual method (or basis) of accounting, which is required for most corporations. (Individuals and very small companies may be allowed to use the cash method of accounting.)

Under the accrual method of accounting the financial statements will report sales and receivables when products or services have been delivered (as opposed to reporting sales when the corporation receives money from its customers). It also means that expenses and liabilities will be reported on the financial statements when they occur (as opposed to reporting expenses when the corporation remits payment).

The accrual method of accounting results in more complete and accurate financial statements than the cash method of accounting for the following reasons:

• All of the revenues that were earned during the accounting period will be included
• All of the expenses that were incurred during the accounting period will be included
• All of the assets as of the end of the accounting period will be included
• All of the liabilities as of the end of the accounting period will be included

When the accrual method of accounting is used, you will see the following balance sheet accounts:

• Accounts Receivable
• Interest Receivable
• Prepaid Expenses
• Accounts Payable
• Accrued Expenses Payable
• Deferred Revenues