This article describes financial statement preparation.
After all adjustments are made, the final trial balance can be used to prepare the balance sheet and income statement. GAAP also requires the preparation of two other financial statements: the Statement of Cash Flow and the Statement of Owner’s Equity.
The balance sheet follows the fundamental accounting equation:
Assets = Liabilities + Equity.
Joint Ventures’ Balance Sheet is shown below.
The balances shown are the amounts in the accounts at the end of the reporting period. GAAP prefers a classified format, which classifies assets and liabilities as current or non-current. An asset is deemed current if it is likely to be converted to cash within one year. This usually includes accounts receivable and inventory. Assets not considered current are deemed non-current. Current assets are generally listed in order of liquidity. Liquidity refers to the ability to be converted to cash. Liabilities are also classified as current and non-current.
Current liabilities are those expected to be paid off within a year.
All other liabilities are classified as non-current.
The income statement shows the revenue and expense account balances at the end of an accounting period, and reflects income and expenses over the entire accounting period. Joint Ventures’ income statement follows. If revenue exceeds expenses, a business has net income or profit. If expenses exceed revenue, the business shows a loss.
The form of the income statement is usually dictated by the nature of the business. A simple service business income statement usually is divided into two sections, one for income and one for expenses. Retail and wholesale businesses usually show sales, cost of goods sold, and gross profit together, and show other expenses separately. Manufacturing companies follow a similar format, but may separate marketing from general and administrative expenses.
Many businesses use accrual accounting to reflect a reasonably complete picture of their economic performance over the accounting period. Nonetheless, at some point all accrual assets and liabilities must be reducible to cash. Assets that could not be converted into cash would have limited value. A firm’s ability to convert assets to cash is critical to its long-term survival. Because of the importance of cash flow, GAAP requires that companies prepare a financial statement that shows cash flows for the accounting period. Joint Ventures’ Statement of Cash Flow follows.
The statement divides cash flows into three components: cash flows from operations, cash flows from investing activities and cash flows from financing activities.
Operating activities are the ordinary buying and selling activity of a business. Investing activities comprise the purchase and retirement of fixed assets, as well as investments in other businesses. Financing activities are cash flows derived from the issuance and repayment of long-term debt, and cash flows from equity contributions and draws from owners.
These cash flow categories prevent the users of financial statements from drawing false conclusions about a business, simply because of the net cash increase or decrease over the accounting period. A business always seeks a positive cash flow, particularly from operating activities. However, short-term negative cash flows from operating activities do not necessarily mean that a business is unhealthy.
In fact, during periods of rapid expansion it is not uncommon for companies to experience negative cash flow, because as credit sales increase, so do accounts receivable. Similarly, economic growth often is accompanied by increases in inventory, which also uses up cash. For these reasons, a user of financial statements must be careful not to jump to conclusions about the meaning of positive or negative cash flows.
The income statement represents those changes in an owner’s equity derived from the selling and buying activities of the business. Changes in owner’s equity also reflect cash contributions from, and distributions to, the owners. The Statement of Owner’s Equity reflects a summary of all components of the changes in owner’s equity during the year. The Statement of Owner’s Equity for Joint Ventures follows.