Financial Management Terminologies - Guilma Moore, Argosy Un

Financial Management Terminologies Guilma Moore Argosy University March 28,2015

Explain which order the four major financial statements need to be prepared, and why. There is a sequence in which the four major financial statements should be used. The reason behind preparing the financial statements using a given sequence is that information obtained in one financial statement is needed in preparing the other financial statement for an organization within a given period of time. The first statement to be prepared is the income statement. The Income statement is prepared with an intention of showing the firm’s revenue, income within a given accounting period (Revsine et al, 2005).

The net income obtained in this statement is used during the preparation of the retained earnings financial statement. The second statement to be prepared is the retained earnings report, which indicates the changes in the firm’s retained earnings from the company’s net loss or income within a given accounting year under review. The statement details are used in preparing the company balance sheet, such as retained earnings and dividends. The next statement to be prepared is a balance sheet, which uses retained earnings information from the previous statement of retained earnings in order for it to be prepared. It shows the company's financial position by indicating its assets, liabilities, as well as shareholders’ equity within a financial year under analysis.

The last statement to be prepared is the cash flow statement, which indicates the changes in the firm’s generated cash flow from investing, operating, and financing activities. It depends on the information generated from the other three financial reports in order for it to be accurately prepared. Therefore, it is quite evident that it is impossible to prepare a balance sheet before first preparing an income statement as well as a statement of retained earnings.

Paper For Above instruction

The sequence of preparing the major financial statements—namely, the income statement, statement of retained earnings, balance sheet, and cash flow statement—is fundamental to effective financial analysis and reporting. Each document relies on data from the preceding statements, creating a logical progression that ensures consistency and accuracy in financial reporting for organizations.

Preparation Sequence of Financial Statements

The initial step in the financial reporting process involves preparing the income statement. This statement is critical because it summarizes the company’s revenues and expenses over a specific period, providing insights into profitability (Revsine et al., 2005). The net income or net loss derived from this statement serves as the foundation for subsequent financial statements and feeds directly into the statement of retained earnings. Specifically, net income increases retained earnings, while net losses decrease them. This interconnected relationship underscores the importance of accuracy in the income statement because errors here can cascade into other financial reports.

Following the income statement, the company prepares the statement of retained earnings. This statement reconciles the beginning retained earnings balance with the net income or loss from the income statement, subtracting dividends paid to shareholders. It delineates how much profit has been retained by the company versus distributed, providing critical information about the company's reinvestment strategy and dividend policy. The data from the retained earnings statement are essential for preparing the balance sheet because retained earnings are a component of shareholders' equity. Accurate reporting here ensures that the balance sheet correctly reflects the company's financial position.

The third step involves preparing the balance sheet, also known as the statement of financial position. This statement provides a snapshot of the company's assets, liabilities, and shareholders' equity at a specific point in time. It relies on information from both the income statement (via retained earnings) and previous records of assets and liabilities. The balance sheet offers insights into the company's financial stability and liquidity, which are crucial for stakeholders, investors, and management to make informed decisions.

Finally, the cash flow statement is prepared. This statement elucidates how cash has moved within the organization during the accounting period across three categories: operating, investing, and financing activities (Chaudhry et al., 2015). Its preparation depends heavily on the data collected from the income statement, balance sheet, and retained earnings. For instance, net income from the income statement is adjusted for non-cash transactions like depreciation, and changes in working capital are derived from balance sheet accounts. The cash flow statement provides valuable information about a company's liquidity and cash management, which cannot be gauged solely from the other financial statements.

The Necessity of the Preparation Sequence

Preparing the financial statements in this order is essential because of the dependencies among them. Attempting to prepare the balance sheet before the income statement and the retained earnings statement would omit critical data necessary to accurately reflect the company's financial standing. Conversely, generating the cash flow statement first would lack the context of net income, accounts receivable, and payable changes, impairing its accuracy. This sequential approach ensures consistency, reduces errors, and provides a comprehensive view of the organization’s financial health.

Categories of Cash Flows and Their Significance

The statement of cash flows divides cash activities into three principal categories: operating activities, investing activities, and financing activities. Understanding these categories helps stakeholders evaluate how a company generates and uses cash, which is vital for assessing liquidity and financial flexibility.

Operating activities include cash flows related to the core business operations, such as receipts from customers and payments to suppliers and employees. This category reflects the company's ability to generate cash from its primary functions. Items like net income, depreciation, changes in accounts receivable and payable, inventories, and accruals fall under this category (Chaudhry et al., 2015). For example, an increase in accounts receivable indicates that more sales are on credit, representing a use of cash, whereas an increase in accounts payable suggests the company is delaying cash payments, functioning as a source of cash temporarily.

Investing activities encompass cash flows resulting from the acquisition or disposal of long-term assets such as property, plant, equipment, and investment securities. Purchases of property and equipment are typically cash outflows, representing uses of cash, whereas sales or redemptions of bonds are inflows, representing sources of cash. These activities are crucial for understanding how the company invests in future growth or divests assets to improve liquidity (Chaudhry et al., 2015).

Financing activities relate to transactions involving the company's equity and debt. Issuance of stock or borrowing funds through notes payable are sources of cash, indicating external financing to fund operations or growth. Conversely, repayment of debt or dividend payments are uses of cash, reflecting cash outflows. These activities provide insights into how the company finances its operations and manages capital structure (Revsine et al., 2005).

Sources and Uses of Cash

Within the given data, certain transactions serve as sources of cash, such as issuance of stock, increase in net income, and decreases in accruals. These influxes strengthen the company’s liquidity position. Conversely, outflows like property purchased, bonds redeemed, and inventory increase denote uses of cash, highlighting expenditures or reductions in available cash reserves. Recognizing these transactions aids managers and investors in understanding the company's cash management strategies and operational efficiency.

Conclusion

In conclusion, adhering to the sequence of preparing the financial statements—the income statement, statement of retained earnings, balance sheet, and cash flow statement—is vital for producing accurate and coherent financial reports. Each statement informs the next, creating a comprehensive and reliable picture of the company’s financial health. Correct categorization of cash flows into operating, investing, and financing activities enhances understanding of how a company generates and utilizes cash, ultimately supporting better financial decision-making and strategic planning.

References

• Chaudhry, A., Coetsee, D., Bakker, E., Varughese, S., McIlwaine, S., Fuller, C., & Balasubramanian, T. V. (2015). Statement of Cash Flows. In Interpretation and Application of International Financial Reporting Standards (pp. 95-111).
• Revsine, L., Collins, D. W., Johnson, W. B., & Collins, D. W. (2005). Financial reporting and analysis. Pearson/Prentice Hall.
• Ross, S. A., Westerfield, R. W., Jaffe, J., & Jordan, B. (2018). Corporate Finance (12th ed.). McGraw-Hill Education.
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