Which Financial Statement Is Prepared First? And Why?

Financial statements offer a comprehensive view into a company’s financial health and operational performance. These reports provide stakeholders, including investors, creditors, and management, with organized data to make informed decisions. Understanding how these statements are prepared and relate to each other is important for anyone seeking to interpret a company’s financial narrative.

The Income Statement

The Income Statement, also known as the Profit and Loss (P&L) Statement, details a company’s financial performance over a specific accounting period, such as a quarter or a year. It summarizes all revenues earned and expenses incurred during that time. This statement includes sales of goods or services, the cost of those sales, and various operating expenses like salaries, rent, and utilities. The primary purpose is to calculate the business’s net income or net loss, which represents the company’s profitability. Gains from non-operating activities, such as selling an asset above its book value, and losses, such as from lawsuits, are also included.

The Statement of Retained Earnings

Following the Income Statement, the Statement of Retained Earnings illustrates the changes in a company’s retained earnings balance over an accounting period. Retained earnings represent the cumulative profits a company has kept within the business, rather than distributing them as dividends to shareholders. This statement begins with the prior period’s ending retained earnings balance, to which the net income (or net loss) derived from the Income Statement is then added (or subtracted). Dividends declared and paid to shareholders during the period are subsequently subtracted, reducing the retained earnings. The final figure, the ending retained earnings balance, is carried forward to the equity section of the Balance Sheet.

The Balance Sheet

The Balance Sheet presents a snapshot of a company’s financial position at a specific moment in time, typically at the end of an accounting period. It adheres to the fundamental accounting equation: Assets equal Liabilities plus Equity. Assets are what a company owns, such as cash, accounts receivable, inventory, and property, plant, and equipment. Liabilities represent what a company owes to others, including accounts payable, loans, and deferred revenue. The equity section reflects the owners’ stake in the company, encompassing common stock and the ending retained earnings balance calculated from the previous statement.

The Statement of Cash Flows

The Statement of Cash Flows reports the cash generated and used by a company during an accounting period, categorizing these movements into three main activities. Cash flows from operating activities relate to the primary revenue-generating operations of the business; investing activities involve the purchase or sale of long-term assets and investments in other companies. Financing activities include transactions with owners and creditors, such as issuing or repurchasing stock, borrowing money, or repaying debt. This statement is typically prepared last as it draws information from both the Income Statement and the Balance Sheet. It reconciles the beginning and ending cash balances, providing insights into a company’s liquidity.

Understanding the Interconnectedness

The specific order of financial statement preparation stems from the inherent dependencies of the information presented, as the net income or loss from the Income Statement is a direct input for the Statement of Retained Earnings, representing profit available for retention or distribution. Without this figure, the retained earnings balance cannot be accurately updated. The updated ending balance of retained earnings then becomes a component of the equity section on the Balance Sheet. Finally, the Statement of Cash Flows utilizes data from both the Income Statement and the Balance Sheet to provide a comprehensive view of cash movements. This methodical preparation ensures accuracy, consistency, and completeness across all financial reports.