Question

Estella Osage publishes an online travel magazine. In need of cash, the business applies for a loan with National Bank. The bank requires borrowers to submit financial statements. With little knowledge of accounting, Estella Osage, a stockholder, does not know how to proceed.

Requirements

1. What are the four financial statements that the business will need to prepare?

2. Is there a specific order in which the financial statements must be prepared?

3. Explain how to prepare each statement.

Short answer

The four financial statements are prepared in the order – Income statement, Statement of retained earnings, Balance sheet, and Cash flow statement

Step-by-step solution

Four financial statement

The four financial statements that must be prepared are –

1) Income statement

2) Statement of retained earnings

3) Balance sheet

4) Cash flow statement

Order of financial statement

Financial statements are prepared in a specific order. First of all net income is computed for a certain period. After that, it is ascertained which portion of the net income is to be retained with the business and which is to be distributed. Based on the retained income total assets are equated with total liability and equity.

Based on this process the specific order of the financial statements is as follow –

1) Income statement

2) Statement of retained earnings

3) Balance sheet

4) Cash flow statement

Preparation of financial statements

The description to prepare each statement is as follows –

Income statement – The income statement is prepared by listing all revenues and expenses. First of all, all the revenues and gains are listed at the beginning of the statement. This constitutes the total revenue earned by the business over a certain period.

After this, all expenses and losses are listed. Then from the total revenue, total expenses and losses are deducted. This provides the net income of the business.

Generally, the best practice to prepare an income statement is to list the income and expenses at different levels of activity like operating and non-operating levels.

Statement of retained earnings – The statement of retained earnings is prepared after computing the net income. The beginning retained income is added to the net income and any distribution or withdrawal during the period is subtracted from it. The net result is the ending balance of retained income that is shown on the balance sheet.

Balance sheet – The balance sheet is the summary of all assets, liabilities, and equity. In the reporting form, all the assets are listed first. Assets are listed on a liquidity basis and are also categorized under current or non-current.

All liabilities and equity are listed after listing all assets. Liabilities are listed first than equity. Ending retained income is added to the equity and the total liability and equity are taken at the bottom.

The total of all assets equates to the total of all liabilities and equity.

Cash flow statement – cash flow statement is a statement that is prepared with the help of an income statement and balance sheet. This represents the inflow and outflow of cash during a period. The flow of cash is categorized into three activities – operating, investing, and financing.

Under operating activity, the cash flow relating to production, operating, and selling is shown. This also includes the change in the working capital.

Under investing activity any cash flow for purchase or sale of investment is shown.

Financing activity lists the cash flow relating to borrowings or equity issues or redemption.

The net result of these activities is the change in the cash during a period.