Essential Components of Financial Statements

Financial statements are important sources of financial information that can be used to make sound business decisions. This means that every component of financial statements is important. Components of a financial statement can be described as the building blocks used for constructing the financial statement and these items represent, in words and numbers, various resources, claims to those resources, and any transactions that create changes in those resources and claims.

This blog discusses the components of the most important financial statements – balance sheet, profit and loss (P&L) statement, and cash flow statement - and their importance.

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Statement of Changes in Equity

Notes to the Financial Statements

Segment Reporting

Major Components of Financial Statements

The essential components of financial statements are designed to provide a clear and accurate picture of an entity's financial position, performance, and cash flows. These components are standardized under various accounting frameworks like International Financial Reporting Standards (IFRS) or Generally Accepted Accounting Principles (GAAP). Here are the key components:

1. Balance Sheet

A Balance Sheet is a statement of an organization's assets, liabilities, and capital at one particular time. This statement gives an idea of what the business owns and owes and the shareholding amount. The critical components of this statement are as below.

• Assets:

An asset can be tangible or intangible and is often owned or controlled with the belief that it would provide some future benefit and can be tangible or intangible. While the former includes current and fixed assets, the latter refers to rights and other non-physical resources that provide value to the business. Current assets consist of inventory, accounts receivables, and other short-term investments. Fixed assets could be buildings, equipment, and other physical resources. Intangible assets usually include goodwill, copyright, trademarks, and patents.

• Liabilities:

Liabilities are a business's legal debts or obligations that might arise during business operations. These are usually settled over time by transferring economic benefits like cash, goods, or services. Liabilities include accounts payable, salaries or wages payable, interest due, customer deposits, and other obligations to third parties. Liabilities might be of two types - current or long-term. While the former could be liquidated within a year, the latter can be repaid only in the long term (more than a year). Long-term liabilities include long-term bonds issued by the firm, notes payables, leases, pension obligations, and long-term product warranties.

• Equity or owner's equity:

It is the residual assets of an entity that remain after deducting liabilities. Theoretically, this is the capital available for distribution to shareholders. Hence, from a business's liquidation perspective, equity is the residual claim on the assets of a business, available to shareholders after liabilities have been paid. For instance, if business X has $3,000,000 as assets and $800,000 as liabilities, equity would be $2,200,000 (= $3,000,000 - $800,000). Equity usually comprises funds contributed by shareholders, reserves, and retained earnings. Therefore, the only way to increase the amount of owners' equity is by either getting more funds from investors or increasing profits.

2. Profit and Loss Statement:

This statement is a summary of the financial performance of a business over time. This is usually prepared after every quarter or year. The components in this statement include:

• Revenues:

The amount of cash a business receives during a specific period through the sale of goods or services is the business's revenue. This would include discounts and deductions for returned merchandise. Revenues would also include the amount received as a result of using the capital or assets of the business as part of the operations of the business. Revenue is the "top line" or "gross income" of the business.

• Expenses:

The business's expenses are the outflow of money or incurring of liabilities (or a combination of both) through producing goods, rendering services, or carrying out any activity that would form a part of the business's operations. Typical business expenses include wages or salaries, utilities such as rent, depreciation of capital assets, and interest paid on loans. Purchasing an asset, such as a building or equipment, is not an expense. Expenses also include the Cost of Goods Sold (COGS), which is the cost incurred for selling goods during the period and includes import duties, freight, handling, and other costs for converting inventory to finished goods.

• Gains:

A business's gain is an increase in equity through peripheral or incidental transactions by a firm other than those from revenue or owner's (shareholders) investments. It refers to any economic benefit outside a business's normal operations. Typically, gains refer to unusual and nonrecurring transactions, such as a gain on the sale of land, a change in a stock's market price, or a gift. It is often shown in the P&L statement as non-operating income.

• Losses:

A business's losses are decreases in equity through peripheral or incidental transactions carried out by the firm other than those from expenses or distributions to owners. This could be lost on the sale of an asset, writing down of assets, or a loss from lawsuits. It could also include costs that give no benefit. It is often shown in the P&L statement as a non-operating expense.

3. Cash Flow Statement:

This statement summarizes the actual or anticipated inflows and outflows of cash in a firm over an accounting period. This could be prepared at the end of a month, quarter, or year. The cash flow statement would reflect the liquidity position of the business. This is used as the basis for budgeting and business planning. The components in this statement include:

• Cash Flow from Operating Activities:

Operating activities of a business refer to the production, sales, and delivery of the finished product and collection of customer payments. Cash outflows here could include purchasing raw materials, advertising, and the cost of shipping the product. They might not include payments to suppliers, employees, and interest payments. Depreciation and amortization are also included in the cash flow statement. Cash inflows here consist of receipts from the sale of goods and services and interest received.

• Cash Flow from Investing Activities:

These are cash flows related to investments, including the purchase of assets, gains or losses through investments in the financial market or subsidiaries, and other related items.

• Cash Flow from Financing Activities:

This would account for activities that aid a firm in raising capital and repaying investors. The cash flow might include cash dividends, adding or changing loans, or stock issues. Cash flow from financing activities reveals the business's financial strength. Financing activities that produce positive cash flow include cash from issued stocks and bonds. Financing activities that produce negative cash flow include:

• Cash for repurchasing stock.
• Paying off debt or interest.
• Payment of dividends to shareholders.

Every item in financial statements is important and provides insights into the workings and performance of the firm. These components are useful to all stakeholders, including the management, employees, suppliers, and shareholders, for setting sound business plans and following a financially viable strategy.

4. Statement of Changes in Equity

The Statement of Changes in Equity provides detailed information about the changes in the company's equity over an accounting period. This statement bridges the beginning and ending equity balances, highlighting factors such as profits, losses, and shareholder transactions. The primary components include:

• Share Capital Transactions: Issuance or buyback of shares that affect the company's equity.
• Retained Earnings: Changes due to profit allocation or dividend payments.
• Reserves and Other Comprehensive Income (OCI): Increases or decreases in reserves or gains and losses directly transferred to equity without impacting the profit and loss statement (e.g., revaluation surplus, foreign currency translation).

This statement is particularly useful to investors and stakeholders for understanding how equity evolves due to operational performance and strategic decisions.

5. Notes to the Financial Statements

The Notes to the Financial Statements provide supplementary details that enhance the transparency and comprehensibility of the main financial statements. These notes include qualitative and quantitative information that explains the accounting policies, methods, and assumptions used to prepare the financial statements. Key components include:

• Accounting Policies: Disclosure of methods (e.g., depreciation, inventory valuation) and any changes made during the period.
• Contingent Liabilities and Commitments: Details of obligations that are not yet realized but could impact the company's finances.
• Breakdown of Revenue and Expenses: Clarifications on major revenue streams or expense categories.
• Related Party Transactions: Disclosure of transactions with entities or individuals connected to the business.

These notes are essential for stakeholders to gain a deeper understanding of the numbers presented in the financial statements.

6. Segment Reporting

For larger entities operating in multiple sectors or regions, Segment Reporting provides a breakdown of financial performance by business segment or geographical area. This is particularly relevant under IFRS 8 (Operating Segments) or similar frameworks. The report typically includes:

• Revenue, Expenses, and Profits: Data segmented by product line, service, or geography.
• Assets and Liabilities: Information regarding the allocation of resources to different segments.
• Key Performance Indicators (KPIs): Additional metrics such as market share or customer growth per segment.

Segment reporting helps stakeholders evaluate the relative performance and potential of different areas of the business.‍

Conclusion

‍The future of financial statements lies in automation, AI integration, and real-time data analysis. These advancements will provide businesses with more accurate and timely insights but also introduce complexities in data management, security, and compliance. Handling the growing volume of financial data, ensuring proper categorization, and adapting to regulatory changes are major challenges for businesses. To overcome these hurdles, many companies turn to third-party providers for bookkeeping services. These experts offer specialized software solutions and ensure compliance, saving businesses time and reducing the risk of errors.

‍Invensis delivers comprehensive bookkeeping services with cutting-edge software designed for efficiency and accuracy. We offer tailored solutions that manage everything from day-to-day bookkeeping to financial reporting and compliance. With our platform, businesses can focus on growth while we handle their financials with precision, ensuring that all accounting needs are met seamlessly and reliably.