Why Having 3 Financial Statements?
By reading chapters in this guide, you will learn why we need three financial statements. Once a company exceeds a certain level of complexity, we cannot just use a simple income statement: We must use two other financial statements – Balance Sheet and Cash Flow Statement – to capture everything. In this guide, we use a fictitious retail shop “Organic Food Everyday” to illustrate some accounting items in the Income Statement, Balance Sheet, and Cash Flow Statement.
In the income statement, revenues and expenses are recorded only in the period in which the corresponding product or service is delivered. Balance Sheet is needed to track Assets, Liabilities, and Equity where these items represent differences between Net Income and Cash Generated. The Cash Flow Statement is to track adjustments to a company’s net income. Positive adjustments on the Cash Flow Statement mean that the company has generated more cash than its net income would suggest; Negative adjustments mean the company has generated less cash than its net profit would suggest.
Show me the money!
Financial statements show you where a company’s money (cash flow) came from, where it went, and where it is now. The big challenge is the cash flow a company generates is quite different from its profit.
Introduction of cash-basis accounting - When we sell something, we receive the exact amount of money; when we make an expenditure, we pay it in cash. The net income is roughly equal to the cash flow generated each year.
Introduction of accounts receivable - We recognise revenue in advance based on the delivery of our services, but we have not yet received full cash payment from customers.
Introduction of prepaid expenses as an asset in the Balance Sheet because they provide us with a future benefit.
Accounts payable represents bills the company owes for goods or services it hasn't paid for yet. Accounts Payable is a liability on the balance sheet because they will result in less cash in the future.
Introduction of deferred revenue as a liability where we collect cash in advance, but we must provide the services in the future.
Introduction of inventory as an asset on the Balance Sheet because we can sell inventory to make money in the future.
Revenues are recognized when an economic exchange occurs, while expenses are recognized when the associated revenues are recognized, not necessarily when cash is exchanged. The way we treat these situations is called Accrual Accounting.