Financial statements are specialized reports that are universally recognized. The GAAP (generally accepted accounting principles) state what needs to be included in these reports. These reports are the income statement, balance sheet and statement of cash flows. These statements are used by people within the business (internal users), and people outside the business (external users).
Statements contain information for a period of time. A business will “close the books” each month and create financial statements. The information can be reported for a month, for a quarter, for six months, for year-to-date, or for any period desired. The term “close the books”, refers to the act of accurately collecting all the information that occurred during the month and reporting it.
Many larger businesses and public companies use an accrual system to report financial information. An accrual system involves creating accrual entries to bring transactions into the correct period.
For example: if a business pre-pays the rent on a factory for a year, it would not record the expense for the entire payment in the month it paid the bill. It would recognize the rent payment as pre-paid rent (an asset), and each month would expense one month of rent expense, and reduce the asset by this amount also. Another example is revenue earned. A business on the accrual system will recognize revenue when the sale is transacted, not when the payment is received.
It’s important to recognize all events and be sure that each event is accounted for properly. The reason behind accrual accounting is so that a useful analysis of a business can be made and compared to other businesses. If one business recognized revenue when payment was received and recognized revenue when the sale was made, it would make any kind of comparative analysis useless.
Financial statements Uses:
Internal users use financial statements to analyze the business and make decisions based on this information. For example: if labor costs have been increasing for the last 3 months, but sales have been decreasing for the same time, management would take action to correct this.
External users are banks that lend money, outside investors, auditors, IRS, etc. These users look at financial statements for various reasons. A lender would be looking for sales growth and good cost management. Auditors would be looking for information that is in line with GAAP& IFRS.