To be able to understand a business, a common recommendation is to read the financial statements of that business. It is a summary of the accounting transactions during the year and gives you a summary or snapshot of the business at a glance (or in a few pages).
Before we dig into the HOW of accounting, this section will discuss the OUTPUT of accounting processes – the financial statements. Coverage here is somewhat basic since these topics are accorded much greater detail in future chapters and the subsequent book to this one (Accounting, Business and Society – forthcoming).
The four financial statements
Are you a fan of books, movies, or sports? If so, chances are you have heard or said the phrase “spoiler alert.” It is used to forewarn readers, viewers, or fans that the ending of a movie or book or outcome of a game is about to be revealed. Some people prefer knowing the end and skipping all of the details in the middle, while others prefer to fully immerse themselves and then discover the outcome. People often do not know or understand what accountants produce or provide. That is, they are not familiar with the “ending” of the accounting process, but that is the best place to begin the study of accounting.
Accountants create what are known as financial statements. Financial statements are reports that communicate the financial performance and financial position of the organisation. In Australia, the Australian Accounting Standards Board prescribe the financial statements that most businesses must prepare. They are listed in AASB 101. The table below sets out the name of the financial statement as prescribed by the standard, common alternative names and a plain English description.
|#||Financial statement name from AASB 101||Common names (if applicable)||Plain English description|
|1||Statement of profit and loss and other comprehensive income for the period||Profit and loss statement
|A summary of the revenues and expenses of a business over the financial period (usually a year)|
|2||Statement of financial position||Balance Sheet||A snapshot of the assets, liabilities and equities of the business at a specific date in time.|
|3||Statement of changes in equity||A summary of the change in the value of equity in the business. Equity is essentially the value of the business after debts are paid.|
|4||Statement of cash flows||A summary of the cash coming into and going out of the business over the financial period (usually a year).|
In addition to the 4 financial statements, entities must also provide”
- notes, comprising significant accounting policies and other explanatory information;
- comparative information in respect of the preceding period – that is, they must show this year’s information, plus last year. This allows users to evaluate changes between years without having to find the financial statements from the previous year.
We will delve into what exactly are revenues, expenses, assets, liabilities and equity in future sections of this chapter.
In essence, the overall purpose of financial statements is to evaluate the performance of a company, governmental entity, or not-for-profit entity. Each financial statement listed has a unique function, and together they provide information to determine whether a company generated a profit or loss for a given period (such as a month, quarter, or year); the assets, which are resources of the company, and accompanying liabilities, which are obligations of the company, that are used to generate the profit or loss; owner interest in profits or losses; and the cash position of the company at the end of the period.
Purpose of financial statements
Before exploring the specific financial statements, it is important to know why these are important documents. To understand this, you must first understand who the users of financial statements are. Users of the information found in financial statements are called stakeholders. A stakeholder is someone affected by decisions made by a company; this can include groups or individuals affected by the actions or policies of a business or organisation, including include investors, creditors, employees, managers, regulators, customers, and suppliers. The stakeholder’s interest sometimes is not directly related to the entity’s financial performance. Examples of stakeholders include lenders, investors/owners, vendors, employees and management, governmental agencies, and the communities in which the businesses operate. Stakeholders are interested in the performance of an organisation for various reasons, but the common goal of using the financial statements is to understand the information each contains that is useful for making financial decisions. For example, a banker may be interested in the financial statements to decide whether or not to lend a business money.
Likewise, small business owners may make decisions based on their familiarity with the business – they know if the business is doing well or not based on their “gut feeling.” By preparing the financial statements, accountants can help owners by providing clarity of the business’s financial performance. In current times, businesses are recording most of their transactions in real time and can access accounting information without their accountant with clever accounting systems that integrate seamlessly into their everyday business processes.
It is important to understand that, in the long term, every activity of the business has a financial impact, and financial statements are a way that accountants report the activities of the business. Stakeholders must make many decisions, and the financial statements provide information that is helpful in the decision-making process.
Business owners as decision makers
Think of a business owner in your family or community. Schedule some time to talk with the business owner, and find out how they use financial information to make decisions.
Business owners will use financial information for many decisions, such as comparing sales from one period to another, determining trends in costs and other expenses, and identifying areas in which to reduce or reallocate expenses. This information will be used to determine, for example, staffing and inventory levels, streamlining of operations, and advertising or other investment decisions.
Not for profit organisations
There are many organisations who we class as not-for-profit (NFPs) – making a profit may be a goal (they certainly don’t want to make a loss) but it might not be the primary objective of the organisation. Are financial statements still useful for decision making for these entities? Absolutely! They still need to understand how much money is flowing in (revenue) from government grants and donations, and how much is flowing out from expenditure. They also need to keep track of their assets, liabilities (debts) and equity. The information is the same, but the way it might be used, or combined with non-financial measures is likely to be different in NFPs that in for-profit businesses.