Financial statements are reports of an entity to provide its stakeholders with the necessary information for their decision-making needs. The term entity is used to describe any type of organization for which we do accounting e.g. a business, a company, a bank, a charity organization. Financial statements relate to a given period of time, known as the ‘financial year’, ‘accounting period’ or ‘reporting period’. In this article We will learn components of financial statements and elements of financial statements.
Components of Financial Statements
A complete set of financial statements usually comprises:
- A statement of financial position
- A Statement of comprehensive income.
- A statement of changes in equity
- A statement of cash flows
- Notes to the financial statements
Statement of financial position
A statement of financial position (also called a balance sheet) reports the financial position of an entity as of a particular date, usually at the end of a financial year. The financial position of an entity is shown by its assets, liabilities, and equity (owner’s capital).
Statement of Comprehensive Income
This statement provides information about the performance of an entity in a period. It consists of two parts:
- A statement of profit or loss – a list of income and expenses which result in a profit or loss for the period; and
- a statement of other comprehensive income – a list of other gains and losses that have arisen in the period
Elements of Financial Statements
The statement of financial position consists of three elements i.e. assets, liabilities, and equity. These three elements form an accounting equation i.e. Assets = Liabilities + Equity
The statement of comprehensive income consists of two elements i.e. income and expenses. The difference between these two elements determines the profit or loss for an accounting period.
Assets
An asset is defined as:
- a present economic resource
- controlled by the entity
- as a result of past events.
The definition clarifies that the potential economic benefits no longer need to be ‘expected’ to flow to the entity and they do not need to be certain or even likely. An economic resource is a right that has the potential to produce economic benefits.
In simple words, an asset is something the business owns or controls and is available or will be available for use in the business.
The assets are classified into current assets and non-current assets:
- Current assets: assets that provide economic benefits in the short term (usually one year). For example, cash and trade receivables.
- Non-current assets: assets that have a long useful life and provide future economic benefits for an entity over a period of several years. For example, buildings and plant & machinery.
Liabilities
A liability is:
- a present obligation of the entity
- to transfer an economic resource
- as a result of past events.
The definition clarifies that a liability is the obligation to transfer an economic resource and not the ultimate outflow of economic benefits. The outflow also no longer needs to be ‘expected’.
In simple words, a liability is something owed by the business to someone else.
The liabilities are classified into current and non-current, as well:
- Current liabilities: amounts payable by the entity within 12 months. For example, trade payables and utilities bills payable.
- Non-current liabilities: amounts payable more than 12 months after the reporting date. For example, long term bank loan.
Equity (owner’s capital):
Equity is the residual interest in the assets of the entity after deducting all its liabilities. It claims are claims against the entity that do not meet the definition of a liability i.e. the entity has no obligation to pay or distribute its profits to its shareholders but most of the profitable companies distribute it to gain investor confidence. Equity is often referred to as owner’s capital in sole trader businesses.
Income and investing further capital increases the equity while expenses and drawings decrease the equity.
Equity is sometimes referred to as the ‘net assets’ of the business. This is represented by the accounting equation i.e. Equity (net assets) = Assets – Liabilities
Income
Income arises from:
- Increase in assets or decrease in liability, resulting in an increase in equity
- Other than contributions from owners (more capital invested in the business).
It is usually classified into revenue and other items of income:
- Revenue: it is income arising in the course of the ordinary activities of the entity. For example, revenue from the sale of goods and fees for providing services.
- Other income: income arising other than in the course of ordinary activities. For example, interest received on bank deposits and gain from disposal of non-current assets.
Expenses
Expenses arise from:
- Decrease in assets or increase in liability, resulting in a decrease in equity.
- Other than distributions (drawings or dividends) to owners.
It arise in the normal course of activities, such as the cost of goods sold, salaries, rent, and other operational costs. Moreover, It also include losses such as the loss on disposal of a non-current asset, and losses arising from damage caused by fire or flooding.
FAQs on Elements of Financial Statement
What are the elements of financial statements?
There are five main elements of financial statements:
- Assets
- Liabilities
- Equity
- Revenue
- Expenses
How are the elements of financial statements related to each other?
The elements of financial statements are interrelated in a number of ways. For example, assets are financed by liabilities and equity, and revenue is used to pay expenses and generate income for shareholders.
How are assets and liabilities measured?
Assets and liabilities are typically measured at their historical cost, which is the amount that a company pays to acquire the asset or incur the liability. However, there are some exceptions to this rule, such as when an asset is impaired or a liability is revalued.
What is the difference between equity and net income?
Equity is the net portion of a company’s assets that remains after deducting its liabilities. Net income is the amount of profit that a company generates over a period of time. Equity is increased by net income and decreased by dividends and other distributions to shareholders.
How are expenses matched with revenue?
Expenses are matched with revenue in the period in which they are incurred, regardless of when the cash is paid or received. This is known as the accrual basis of accounting.