Which Of The Following Financial Statements Should Be Prepared First

Which Financial Statement Should Be Prepared First? The Order of Preparation and its Importance

Determining which financial statement to prepare first might seem like a trivial question, but understanding the order of preparation is crucial for accuracy and efficiency in financial reporting. While there's no universally mandated order enforced by accounting standards like GAAP (Generally Accepted Accounting Principles) or IFRS (International Financial Reporting Standards), a logical sequence exists that ensures consistency and minimizes errors. This article will delve into the recommended order of preparing financial statements, exploring the interdependencies between them and highlighting the reasons behind the preferred sequence.

The Interdependency of Financial Statements

Before diving into the optimal preparation order, it's essential to understand how the various financial statements relate to each other. They are not independent documents; rather, they are interconnected, with information flowing from one to another. This interconnectedness dictates the most efficient and accurate preparation sequence.

The three primary financial statements are:

• Income Statement: Shows a company's financial performance over a specific period (e.g., a quarter or a year). It reports revenues, expenses, and the resulting net income or loss.
• Statement of Changes in Equity: Details the changes in a company's equity accounts over a specific period. This includes retained earnings, contributed capital, and other comprehensive income.
• Balance Sheet: Presents a snapshot of a company's assets, liabilities, and equity at a specific point in time. It follows the fundamental accounting equation: Assets = Liabilities + Equity.

The Statement of Cash Flows, although not directly involved in the fundamental accounting equation, is also a critical financial statement, reporting the movement of cash both into and out of the business during a specific period.

These statements are interconnected because:

• The Income Statement's net income flows into the Statement of Changes in Equity. Net income increases retained earnings.
• The ending balances of equity from the Statement of Changes in Equity are used on the Balance Sheet. This ensures the balance sheet accurately reflects the company's equity position.
• The Balance Sheet's ending cash balance is reconciled with the Statement of Cash Flows. The net change in cash should align with the cash flows reported.

The Recommended Order of Preparation: A Step-by-Step Guide

Given these interdependencies, the most logical and efficient order for preparing financial statements is as follows:

1. Income Statement: This should be prepared first because it forms the foundation for many subsequent calculations. Accurately determining revenues and expenses is paramount. The income statement provides the crucial net income figure.

   • Detailed Revenue Recognition: Carefully review all revenue streams, ensuring accurate recognition based on the relevant accounting standards (e.g., revenue recognition principle).
   • Comprehensive Expense Categorization: Systematically categorize all expenses, matching them to the appropriate revenue periods (matching principle).
   • Accurate Net Income Calculation: Calculate the net income (or net loss) by subtracting total expenses from total revenues. This figure is crucial for subsequent statements.

2. Statement of Changes in Equity: With the net income figure from the income statement in hand, preparing the Statement of Changes in Equity becomes straightforward. This statement tracks changes in the different equity components:

   • Beginning Equity Balance: Use the ending equity balance from the previous period's balance sheet.
   • Net Income/Loss: Insert the net income (or net loss) calculated from the income statement.
   • Other Comprehensive Income: Include any other comprehensive income items, such as unrealized gains or losses on available-for-sale securities.
   • Dividends Paid: Deduct any dividends paid to shareholders during the period.
   • Ending Equity Balance: Calculate the ending equity balance, representing the company's equity at the end of the reporting period. This figure is crucial for the balance sheet.

3. Balance Sheet: The balance sheet is next, utilizing the ending equity balance from the Statement of Changes in Equity. This ensures consistency and accuracy:

   • Assets: List all assets, ensuring their valuation is accurate and in accordance with accounting standards.
   • Liabilities: List all liabilities, classifying them as current or non-current liabilities, and ensuring accurate valuation.
   • Equity: Use the ending equity balance calculated from the Statement of Changes in Equity.
   • Balance Sheet Equation: Verify that the fundamental accounting equation (Assets = Liabilities + Equity) balances. Any discrepancies necessitate a review of the previous statements.

4. Statement of Cash Flows: Finally, the Statement of Cash Flows is prepared. It reconciles the beginning and ending cash balances, providing a detailed breakdown of cash inflows and outflows:

   • Operating Activities: Determine the net cash flow from operating activities, often using the indirect method, starting with net income from the income statement and adjusting for non-cash items.
   • Investing Activities: Report cash flows from investments, such as purchases and sales of long-term assets.
   • Financing Activities: Report cash flows related to financing, such as issuing debt or equity, and repayment of debt.
   • Reconciliation: Ensure that the net increase or decrease in cash shown on the statement matches the change in the cash balance between the beginning and ending balance sheets.

Why This Order is Preferred: Accuracy and Efficiency

This sequential approach offers several key advantages:

• Data Flow and Consistency: Information flows logically, minimizing errors and ensuring consistency. Each statement builds upon the preceding one.
• Error Detection: The sequential nature allows for easier detection of errors. Any discrepancies can be identified and corrected early in the process, saving time and resources.
• Efficient Resource Allocation: The process is more efficient because it avoids unnecessary back-and-forth adjustments between statements.
• Improved Auditability: This order simplifies the audit process, as auditors can easily trace the flow of information between the statements.

Exceptions and Considerations

While this is the recommended order, certain situations might require adjustments:

• Specific Industry Requirements: Some industries might have specific reporting requirements that necessitate a different sequence.
• Data Availability: The availability of data might influence the order. If certain data is readily available, starting with a different statement might be more efficient.
• Software Usage: Accounting software can automate many aspects of financial statement preparation, potentially altering the perceived optimal order.

Conclusion: A Foundation for Accurate Financial Reporting

Preparing financial statements in a logical order is not just a matter of preference; it's a crucial aspect of accurate and efficient financial reporting. Following the sequence outlined above—Income Statement, Statement of Changes in Equity, Balance Sheet, and Statement of Cash Flows—ensures data consistency, facilitates error detection, and ultimately enhances the overall quality and reliability of a company's financial reporting. By prioritizing this structured approach, businesses can build a stronger foundation for sound financial decision-making. This meticulous process contributes significantly to the credibility of the company's financial health and strengthens its position in the market. Understanding and adhering to this best practice is essential for maintaining transparency and building trust with investors, creditors, and other stakeholders.