A Guide to Financial Statements for Businesses: Part 2

Financial statements provide a condensed, standardized view of a company’s activities to help both internal managers and external stakeholders analyze the business's health and its potential for growth.
The three primary financial statements – balance sheet, income statement, and statement of cash flows – provide the core information in most financial reporting packages. But there are other statements and supplements to the big three that provide additional information, context, and insights. 

Other types of financial statements include:

• The statement of equity
• Notes to the financial statements
• Management’s discussion and analysis (often called “MD&A”)
• Various versions and types of financial statements, such as audited, internal, consolidated, and pro forma

Financial statements usually adhere to standard rules and formats set out in the Generally Accepted Accounting Principles (GAAP) – which public companies in the U.S. must adhere to. As a result, they provide a useful way to compare the performance of similar businesses. 

Financial statements communicate a business’s financial performance in a standardized way, helping business leaders analyze, forecast, and run their business. 

The Statement of Equity

The statement of equity dives deeper into the equity accounts found on a company’s balance sheet. It highlights changes in each equity account – stock, capital contributions/withdrawals, and retained earnings – over a period of time.

For accounting purposes, equity is defined as the difference between a company’s total assets and total liabilities. It's essentially the residual value of the business that belongs to the owners. The statement of equity comes in several varieties, reflecting different forms of company ownership, including:

• Statement of owners’ equity, which relates to sole proprietorships or partnerships
• Statement of shareholders’ (or stockholders’) equity, which is for companies that issue common or preferred stock

A statement of equity is formatted like a reconciliation, showing the beginning equity balance, changes during the period, and the ending balance.

Transactions that increase or decrease the equity balance include:

• Issuing common stock, which increases the equity balance by the amount of money paid to the company for the stock before shares begin trading
• Partner capital contributions, which increase equity
• Paying dividends, which reduces equity
• Distributions to owners, which reduces equity

Note: Adjustments made to correct an error on a prior period’s income statement can either increase or reduce equity depending on their nature. These tend to be infrequent.

The retained earnings account is a key part of the statement of equity because it reflects all of a company’s accumulated profits that are not distributed to owners or shareholders. At the end of each fiscal period, the amount of a company’s undistributed net income (or loss) is “swept” from the income statement into the retained earnings account.

Retained earnings are particularly interesting to external stakeholders to provide clues about a company’s ability to self-fund expansion, new product launches, or owner dividends.

The Notes to the Financial Statements

The notes to the financial statements are written supplements to all the other financial statements. They are either presented as footnotes on the financial statement or as a separate statement.

This supplemental information provides context and more detailed information about the balances on the financial statements. For example, the notes might explain the depreciation methods used in the income statement or list the details of individual leases that were consolidated into a single amount on the balance sheet.

Notes are prepared to coincide with the same date of the financial statements, and they also follow GAAP guidelines and are part of any external audit. Don’t skip reading the notes!

Management’s Discussion and Analysis (MD&A)

The MD&A is a narrative included in a company’s annual report. For U.S. public companies, it's included in form 10-K, which must be filed to the Securities and Exchange Commission (SEC).

The MD&A is a way for management to tell the company’s story for the period covered in the statements. It discusses unusual events, trends, and the business outlook, such as the impact of COVID-19 shutdowns and related supply chain challenges.

Additionally, it might discuss upcoming commitments to buy, sell, or merge business units and  expectations on how that will affect the company’s future earnings. Most include charts, graphs, and other easily digestible data.

The MD&A can be highly informative, but readers should keep in mind that it reflects the opinions of company management. While it must adhere to some basic guidelines, the information is not externally audited.

Common Versions of Financial Statements

Financial statements come in several varieties. Versions and types of statements can vary based on who’s going to read them, the issuing process, and the scope of coverage.

When reviewing financial statements from international companies, it's important to keep in mind that they likely follow International Financial Reporting Standards (IFRS) rules, which are similar to GAAP in many areas, but not all. That’s something that you’d find in the notes.

Common types of financial statements include:

Audited

When financial statements are audited, they’ve been reviewed by external experts who issue an opinion on them. There are various types of opinions experts can issue.

An “unqualified” opinion means they are free of material misstatement – that’s the best opinion you can get. An unqualified opinion doesn’t guarantee perfection, though – it means the auditor uncovered no significant errors relative to a company’s size.

A “qualified” opinion means that auditors have noted some exception, such as not being able to count a small amount of inventory in a particular location.

If a scope limitation is significant, auditors might issue a “disclaimed” opinion, which is to say they give no opinion.

When auditors believe that the financial statements contain significant material errors or are misleading, they issue an “adverse” opinion. Pervasive departures from GAAP can lead to adverse opinions. 

Internal

Financial statements meant for “internal use only” can be prepared and presented with a certain amount of latitude, which can lead to analytical value more quickly. Lenders, investors, and other external stakeholders rely more on external financial statements that are prepared with more rigor.

Consolidated and Divisional

In companies with multiple divisions or legal entities, a consolidated financial statement accumulates information from all parts into one, eliminating duplication.

In contrast, divisional financial statements are prepared by limiting the scope of accounting data to a particular business unit.

Comparative

These financial statements show information for multiple time periods side by side. Comparative statements help draw conclusions about a company’s year-over-year results.

For example, an income statement might show the results for the first quarter ended March 31, 2022 next to the results for the same quarter in the prior year, March 31, 2021.

Interim

Financial statements that reflect part of a company’s fiscal year, such as a month or a quarter, are considered interim. Most often, interim financial statements do not undergo the same audit process as full-year financial statements.

Pro Forma

This type of financial statement follows the same guidelines and conventions for preparation but is not based on historical accounting data. Pro forma means “as if,” and usually applies to hypothetical future situations such as a merger, acquisition, or divestiture. The notes to pro forma financial statements describe the assumptions used to develop these scenarios.

The Takeaway

Financial statements communicate a business’s financial performance in a standardized way, helping business leaders analyze, forecast, and run their business. They also help investors and lenders to make better-informed decisions and compare similar businesses more insightfully. Understanding each financial statement’s purpose and components, along with the various types of statements, helps stakeholders get more value out of them. Financial statements can make business managers and owners feel more comfortable running their businesses and investing in others.

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