Why Is the Income Statement the First Financial Report Prepared?

Financial statements serve as important tools for understanding a company’s financial performance and overall health. These reports provide a comprehensive view of a business’s operations, assets, liabilities, and equity. The primary financial statements include the Income Statement, the Balance Sheet, the Statement of Cash Flows, and the Statement of Retained Earnings or Changes in Equity. These reports are interconnected, forming a cohesive picture of a company’s financial story. This relationship dictates a specific sequence in their preparation, ensuring accuracy and consistency across all reported figures.

What the Income Statement Reveals

The income statement, often known as the profit and loss (P&L) statement, provides a clear picture of a company’s financial performance over a defined period. Its purpose is to show how much revenue a company generated from its operations and what expenses it incurred to earn that revenue. The statement begins with total revenues, from which various operating and non-operating expenses are deducted. The outcome of this calculation is the net income or net loss, often referred to as the “bottom line,” which indicates whether the company achieved profitability or experienced a financial deficit. This figure is a foundational element that directly influences other interconnected financial reports.

The Interconnectedness of Financial Statements

The financial statements are intrinsically linked, with the net income from the income statement serving as a bridge connecting a company’s performance to its financial position. The net income or net loss calculated on the income statement directly flows into the Statement of Retained Earnings, or the Statement of Changes in Equity. Retained earnings represent the cumulative profits a company has elected to keep and reinvest in its business operations, rather than distributing them to shareholders as dividends. When a company generates net income, this increases the retained earnings balance; a net loss reduces this figure. This updated retained earnings balance, reflecting the period’s profitability and dividend decisions, is carried forward and presented within the equity section of the Balance Sheet, which provides a snapshot of a company’s assets, liabilities, and equity at a specific point in time, and cannot be accurately completed without incorporating the period’s net income and its impact on the retained earnings component of equity.

The Sequential Preparation Process

The preparation of financial statements adheres to a precise, logical sequence that underpins the reliability and consistency of financial reporting.

The Income Statement is the first report prepared because it provides the net income or net loss for the period. This foundational figure is necessary for all subsequent financial statements, as without it, other reports would lack an important input.

Once the net income or net loss is established, the Statement of Retained Earnings, or the Statement of Changes in Equity, is prepared second. This statement takes the beginning retained earnings balance, adds the net income, and subtracts any dividends declared or paid, culminating in the ending retained earnings balance. This updated figure then flows directly into the next report.

The Balance Sheet is prepared third, directly incorporating the ending retained earnings figure as a component of the equity section. This ensures the Balance Sheet accurately reflects the company’s financial position at a specific point in time, with all equity components properly updated to include current period profitability. This interdependency guarantees the accounting equation remains balanced.

Finally, the Statement of Cash Flows is prepared last. This statement relies on information from both the income statement, using net income as a starting point for operating activities, and changes in various asset and liability accounts found on the Balance Sheet. This systematic flow ensures each financial statement accurately builds upon the results of the preceding one.

Why Other Statements Cannot Be Prepared First

Attempting to prepare any other financial statement before the Income Statement is not feasible due to the inherent interdependencies of the reports.

The Balance Sheet, for instance, cannot be finalized without the updated retained earnings figure, which is directly impacted by the net income or loss generated during the period. This important profitability measure is solely determined by the Income Statement, making its prior completion necessary for an accurate equity section.

Similarly, the Statement of Retained Earnings or Changes in Equity cannot precede the Income Statement. Its primary purpose is to reconcile beginning and ending retained earnings balances, explicitly requiring the net income (or loss) for the period as a direct input. Without this necessary information from the Income Statement, calculating the current period’s change in equity would be impossible.

The Statement of Cash Flows also depends heavily on the Income Statement and the Balance Sheet. It begins with net income from the Income Statement for operating activities and analyzes changes in balance sheet accounts for investing and financing cash flows, thus requiring a completed Balance Sheet. Therefore, preparing it first is logically impossible, as it relies on figures from both preceding statements.