Organizations world over are increasingly perfecting the quality of their products and services. This has been occasioned by increased competition among firms and an increasing rate of globalization, which has increased the scope of competition among firms. To have a competitive edge over other firms, organizations must ensure that proper and informed decisions are made. The decision-making process in an organization must, therefore, be guided by information. This mainly comes from financial statements, which are products of accounting procedures. Accounting can, therefore, be defined as the keeping of financial statements to aid managers in decision making, which in turn helps in the management of resources (Houston and Brigham, 2009). This paper defines the purpose of accounting, identifies the four basic accounting statements and their use, and looks into the interrelation between the aforementioned statements.
Basic financial statements
The four basic financial statements include the income statement, the balance sheet, the cash flow statement, and the statement of retained earnings. Let us have a look at each one of them.
This is an annual document t is prepared to show the profit that the organization has made in a year. The profit is normally shown as net profit, and as gross profit. Financial experts consider it the most important financial statement. The importance of any financial statement however depends on who is using it. For instance, a creditor may not be interested in exactly the same information as a shareholder of a company. The reason why so much importance is attached to the income statement is that other financial statements depend on its data for preparation. The balance sheet, for example, uses the net profit from the income statement to come up with a balanced accounting model.
Although not considered the most important, the balance sheet is an equally important financial statement because it shows the net worth of an organization at a given point in time. This is achieved by showing the organization’s financial position, which is the objective of the balance sheet. The balance sheet achieves its objectives by showing the capital of the organization and its assets and liabilities (Weygandt, 2008). The balance sheet is perhaps the most important financial statement to creditors. As mentioned above, the balance sheet cannot be prepared before the income statement because it has to balance the accounting equation using data from the income statement.
Cash flow statement
The cash flow statement is also a basic financial statement. Its objective is to show the cash in the possession of an organization for settling bills and other short-term liabilities. This objective is achieved by tracking the inflow and outflow of cash in the organization. The cash flow statement, therefore, relies on the balance sheet and the income statement during its preparation, and thus it is prepared after both the balance sheet and the income statement have been prepared.
Statement of retained earnings
The statement tracks changes in owner’s equity. That is, it shows the changes in earnings retained by the owner in a given year. Thus, the statement of retained earnings must be prepared after the preparation of the income statement. This is because, in order to prepare it, one has to check the earnings and see if they were spent or retained by the owner. For instance, dividends paid to a company’s shareholders should not form part of the owner’s equity because they have been spent.
Importance of financial statements
Financial statements are prepared for use by the organization and the stakeholders of the organization. After completion of their preparation, they are presented to the senior managers who use them to make strategic decisions for the organization. The main aim of any firm is profit maximization and thus the managers use the information contained in the financial statements to make decisions in a bid to maximize the profits of the organization.
The information contained in financial statements is also useful to investors. They usually check the balance sheets of organizations in which they want to invest in in order to know the value of the organizations. This can be backed up by an analysis of subsequent income statements (Weygandt, 2008). By doing this, an investor will be able to know if an organization is making losses or profits in the short term.
Before giving financial assistance to an organization, a creditor must assess the liquidity of the organization. Even after giving a loan to such an organization, a creditor must keep on checking the liquidity of the organization to make informed decisions. The financial statements stated above help creditors in achieving this objective. An organization’s employees also use the financial statements to establish the ability of the firm to pay their dues. They also use the statements to gauge if their remuneration is reasonable by comparing their salaries with the profits they help to generate.
From this discussion, it is apparent that financial statements are very useful. First, they help the organization to plan on how to make more profits, and they help other stakeholders like creditors, investor’s and employees of the organization to make informed decisions. The financial statements are designed such that each serves a certain purpose. They, however, rely on each other for data during their preparation.
Houston, F., and Brigham, E. (2009). Fundamentals of Financial Management. Cincinnati, Ohio: South-Western College Pub.
Weygandt, J. (2008). Financial accounting, Sixth Edition. New York. John Wiley & John Wiley & Sons.