The financial statements are reports of a company’s finances over a period. Usually, companies prepare these at every financial period end. This period may differ between companies. Some companies report their progress quarterly, while others may do it annually. Either way, companies can use financial statements to present stakeholders with financial information. This information summarizes the financial transactions for a period.
Companies use four primary financial statements to report their finances. These include the balance sheet, income statement, cash flow statement, and statement of changes in equity. Apart from these, companies also prepare notes to the financial statements which support the above reports. Each report within these plays a specific role in presenting the information. Similarly, they follow a specific format provided by accounting standards.
Companies prepare financial statements using information obtained from their accounting system. This process usually involves preparing general ledgers and the trial balance. Once ready, companies can use the trial balance to prepare financial statements. However, they must use a specific order. It involves preparing the income statement first. Before discussing why that is the case, it is crucial to understand the income statement.
What is the Income Statement?
The income statement is a fundamental financial statement that presents a company’s revenues and expenses. This statement focuses on the profitability aspect of operations. Primarily, it shows how a company generates profits from various areas. Usually, it divides those profits into several categories based on the calculation. Apart from profits, companies also report their losses on the income statement.
The income statement starts with the revenues a company generates. These revenues come from the sales of products or services. Once companies report that, they present their expenses on the report. These expenses include any spending on generating the related revenues. Companies also segregate expenses into various heads. For example, they may consist of the cost of sales, operating expenses, financial expenses, etc.
Once companies report their revenues and expenses, they can calculate their profits or losses. These amounts come from the difference between those revenues and expenses. Usually, companies also classify those profits into several categories. This categorization occurs through the segregation of expenses under several heads. Companies can report gross, operating and net profits on the income statement.
The income statement helps companies divide their operations into several periods. This way, it helps present a logical flow that users can understand. Usually, companies use a monthly or quarterly period to report their financial performance. However, the former presentation may relate to internal reporting. Apart from these, companies always prepare their income statements annually. Usually, the results for this presentation comes from the monthly or quarterly statements.
The income statement is a crucial report and helps users understand how profitable a company is. This statement reports three critical aspects of a company’s operations, revenues, expenses and profits. For most companies, it is the primary communication tool with investors. When preparing the various financial statements, the income statement is the first to get reported.
Why should the Income Statement be prepared before other statements?
As mentioned above, the income statement reports a company’s profits. This statement starts with revenues and deducts expenses to reach those profits. In some cases, it can also report losses if the expenses are higher. At the end of the income statement, companies calculate the net profits. These net profits are crucial for the preparation process for other financial statements.
The net profit becomes a part of the other financial statements. All other statements depend on this figure to present a complete picture. The other three financial statements include the balance sheet, cash flow statement and statement of changes in equity. Usually, companies prepare all financial statements in order. Based on that order, given below are some reasons why the income statement gets reported first.
Statement of Changes in Equity
The statement of changes in equity reports a company’s equity throughout the period. This statement highlights the movements in various equity balances for the accounting period. Usually, these balances include share capital, share premium and retained earnings. Once companies prepare this statement, the information becomes a part of the balance sheet.
Retained earnings include the accumulated profits and losses for a company throughout the period. It consists of any profits that companies make from their operations. On top of that, it also reduces any payments made to shareholders through dividends. The statement of changes in equity reconciles this balance by taking the opening balance and making adjustments to it.
While dividends play a role in retained earnings, net profits are also crucial. As mentioned, these profits come from the income statement. If companies don’t prepare the income statement first, they cannot obtain this figure for the statement of changes in equity. On top of that, the income statement may also include other comprehensive income. This figure is also crucial in the statement of changes in equity.
The statement of changes in equity requires crucial figures from the income statement. As mentioned above, these include the net profits and other comprehensive income. Since these figures come from the income statement, preparing it first is crucial. Once companies report these figures, they can put them in the statement of changes in equity.
Once companies prepare the statement of changes in equity, they can move toward the balance sheet. The balance sheet presents three aspects of a company’s financial position, assets, liabilities and equity. Usually, companies can prepare the first two parts without the income statement. However, the latter area requires the income statement and figures in it.
The balance sheet requires figures from the statement of changes in equity. This statement includes an equity section termed shareholders’ equity. Under this section, the company reports its equity balances. These balances may consist of share capital, share premium and retained earnings. As mentioned, the statement of changes in equity reports on movements for those balances during the period.
The balance sheet considers the closing balances from the statement of changes in equity. It obtains those figures and reports them under the equity section. As mentioned above, however, the latter requires the income statement to report those figures first. Therefore, the balance sheet also depends on the income statement for those amounts.
The balance sheet requires net profits/losses and other comprehensive income. When it obtains those figures, it can report them under equity balances. Therefore, preparing the income statement before the balance sheet is crucial. On top of that, the income statement may also include calculations, such as taxes, which can increase liabilities.
Cash flow statement
Usually, the last financial statement prepared is the cash flow statement. As the name suggests, this statement includes cash flow details for a period. The cash flow statement includes details of the movements in cash and cash equivalent balances for a financial period. This statement requires critical figures from the income statement.
The cash flow statement starts with the net profits obtained from the income statement. This method of preparing the cash flow statement is called the indirect method. Once it takes those figures, the cash flow statement also requires other items from the income statement. Usually, it includes non-cash expenses, for example, depreciation and amortization.
Apart from those, the cash flow statement also obtains interest and financial expenses from the income statement. These are crucial in differentiating between cash and non-cash items. The cash flow statement depends on the income statement for various figures. Therefore, preparing the income statement before the cash flow statement is crucial.
Apart from the income statement, the cash flow statement also requires figures from the balance sheet. These figures usually include movements in assets and liabilities. On top of that, it also obtains items from the statement of changes in equity. These may consist of dividend payments and receipts from issuing shares. The cash flow statement is the last financial statement to get prepared.
The income statement is one of the four primary financial statements. It details the profits a company makes through its revenues and expenses. Usually, companies prepare the income statement first. The other financial statements require figures from this statement. Therefore, reporting those figures first is crucial.