In What Order Are Financial Statements Prepared?

Financial reports offer a structured overview of an entity’s financial standing and operational results, providing insights for various parties, including lenders, owners, and managers. The information within these reports follows a deliberate sequence, ensuring data from one report informs the next, building a comprehensive financial picture.

Preparing the Income Statement

The income statement, sometimes referred to as the profit and loss (P&L) statement or statement of operations, is the initial financial report prepared. It functions to summarize a company’s financial performance over a defined period, such as a fiscal quarter or an entire year. This statement shows how much revenue a business generated and the expenses it incurred to earn that revenue. Revenues are amounts earned from normal business activities, while expenses are the costs of operating the business. Gains and losses from activities outside the normal course of business are also included. The calculation combines all revenues, expenses, gains, and losses to arrive at a net income or net loss for the reporting period.

Preparing the Statement of Retained Earnings

Following the income statement, the statement of retained earnings is prepared. This report illustrates changes in a company’s accumulated profits over a specific time frame. It begins with the retained earnings balance from the start of the reporting period, reflecting undistributed profits accumulated from previous periods. The net income or net loss from the income statement is added to or subtracted from this beginning balance. Net income increases retained earnings, while a net loss decreases it. Any dividends declared or paid to shareholders during the period also reduce retained earnings, as they represent a distribution of profits back to the owners. These components are combined to determine the ending balance of retained earnings for the period.

Preparing the Balance Sheet

The balance sheet, also known as the statement of financial position, is constructed after the statement of retained earnings. This report offers a snapshot of a company’s financial condition at a precise moment in time, rather than over a period. It organizes financial data into three main categories: assets, liabilities, and equity. Assets are resources owned by the company that have future economic benefit, such as cash, accounts receivable, or property. Liabilities are obligations owed to other parties, like accounts payable or loans. The ending balance of retained earnings, derived from the statement of retained earnings, is incorporated into the equity section of the balance sheet. Equity represents the owners’ residual claim on the company’s assets after liabilities are satisfied. The fundamental accounting equation, which states that Assets must equal Liabilities plus Equity, serves as the underlying principle for this statement, ensuring that it always balances.

Preparing the Statement of Cash Flows

The statement of cash flows is the final financial statement developed. This report details how a company generates and uses its cash over a specific period. It provides transparency into the movement of cash, which is distinct from net income, as net income includes non-cash items. The statement is divided into three sections: cash flows from operating activities, investing activities, and financing activities. Operating activities relate to core business operations, such as cash received from customers and cash paid to suppliers. Investing activities involve the purchase or sale of long-term assets like property or equipment. Financing activities include transactions with owners and creditors, such as issuing stock or repaying loans. This statement reconciles the beginning and ending cash balances reported on the balance sheet, providing a comprehensive view of cash movements.

Understanding the Interconnections

The specific order of financial statement preparation ensures accuracy and consistency. Net income or net loss from the income statement directly updates the statement of retained earnings. The ending balance of retained earnings then flows into the equity section of the balance sheet. Finally, information from both the income statement and balance sheet is used to construct the statement of cash flows. This sequential method provides a cohesive and complete picture of a company’s financial health, as each statement builds upon the preceding one.