Question

So far we have examined the four financial statements: Income Statement, Statement of Stockholders' Equity, Balance Sheet and Cash Flow Statement. Briefly discuss the four statements. Which is the most useful to external users and why?

Answer 1

Financial statements are summary record of all activities performed by an entity during the financial year that shows the profitability, financial position and performance of an entity. These records are vital for the effective operations of business and are useful for the intended users of financial statement for making analysis and for taking decisions.

Four types of financial statements are discussed below:

1. Income statement :

Income statement or profit and loss account is used to record all revenue items of expenses or income. Capital items are not recorded on this. There are two elements in income statement viz incomes and expenses. Income statement depicts the operating performance of an entity. The net profit or loss is arrived by deducting all expenses from income and such net profit after payment of dividends is transferred to balance sheet.

2. Statement of stockholders‘ equity:

In this statement the entity records the changes in equity during the financial year. Shareholders equity includes equity capital, retained earnings, dividends payable and such other reserves. Changes in equity can happen due to different reasons like net profit or loss transferred from income statement, issue of new shares or buy back of existing shares, transfers from reserves etc.

3. Balance sheet

Balance sheet or statement of financial position shows the financial position of an entity at a given point of time. A balance sheet is divided into 3 parts viz Assets, Liabilities and Equity. The total of assets shall be equal to the total liabilities plus equity. Equity or networth is simply the difference between assets and liabilities.

Equity = Assets – liabilities

4. Cash flow statement

A cash flow statement shows the movement of cash and cash equivalents between a period of time. It is comprised of three parts viz cash generated from operations, cash generated from investing activities and cash generated from financing activities . The net cash inflow or outflow is the difference between opening cash and cash equivalents and closing cash and cash equivalents. By using this statement the users can understand the movement of cash and cash equivalents.

External users are those outside the business entity who use financial statements to make decisions for investments or divestments by analyzing the profitability and financial position of an entity. Examples include suppliers, customers, banks, statutory authorities, investors etc who are external to an organization. External users should analyze each of the four financial statements to make proper conclusions or decisions. This is because by analyzing only one statement may not help the user to arrive at a proper decision and it might be misleading. However, among the four statements, income statement will be the most important among majority users, since it reveals the ability of a business to generate a profit and the information given on the income statement is mostly in relatively current dollars, and so represents a reasonable degree of accuracy.