Key Financial Statement Concepts Explained

What is a financial statement?

It is a document intended to provide information about a company's financial situation to support decision-making.

What is the financial situation of a company?

It reflects the company's performance based on its operations up to a specific date or period, as shown in its financial statements.

How are financial position and income statements linked?

The primary link is the net profit or loss for the period, calculated on the income statement, which impacts the equity section of the statement of financial position (balance sheet).

What are common financial statements?

Common financial statements include:

• Income Statement (or Profit and Loss Statement)
• Statement of Financial Position (or Balance Sheet)
• Statement of Cash Flows
• Statement of Changes in Equity
• Statement of Cost of Production (for manufacturers)

How is the cost of sales determined?

The basic calculation for cost of sales in a trading company is:

Initial Inventory
+ Purchases
= Goods Available for Sale
- Final Inventory
= Cost of Sales

How are cost of production and cost of sales determined?

The cost of sales represents the direct costs attributable to the production or acquisition of the goods sold by a company. For manufacturers, this involves the cost of production; for retailers, it's primarily the cost of purchasing inventory.

Difference between production cost and cost of sales?

Production cost includes direct materials, direct labor, and manufacturing overhead incurred by a manufacturing company. Cost of sales refers to the cost of goods *sold* during a period, which for a manufacturer is the cost of production of those specific goods, and for a retailer is the purchase cost of the goods sold.

Why is depreciation shown on the income statement?

Depreciation is shown on the income statement because it is an operating expense. It represents the allocation of the cost of a tangible asset over its useful life and is matched against the revenue generated during the period (e.g., monthly or annually).

What are 'other expenses' and 'other income'?

These accounts record income (other income or other products/revenue) or expenses (other expenses) that arise from activities outside the company's primary business operations. Examples include gains or losses from selling fixed assets or interest income.

What are deferred assets like organization expenses?

Deferred assets represent expenditures paid in advance for benefits that will be received over future periods. Organization expenses, the legal and setup costs incurred to form a company, are an example. These costs are initially recorded as assets and then amortized (expensed) over a relevant period.

What are long-term liabilities?

Long-term liabilities are a company's financial obligations that are due more than one year from the balance sheet date. Examples include long-term loans, bonds payable, and deferred tax liabilities.

What do financial expenses on the income statement cover?

Financial expenses (or finance costs) typically include costs related to borrowing funds and managing finances. Common examples are:

• Interest expense on loans and debt
• Bank service charges
• Fees for money transfers

What is a transfer to legal reserve?

A transfer to legal reserve is an appropriation of a company's profits into a specific equity reserve account, as mandated by law (e.g., the General Law of Commercial Companies in some jurisdictions). This reserve is created to cover unforeseen losses or contingencies. Typically, a percentage (e.g., 5%) of annual net profit is allocated until the reserve reaches a legally specified minimum level. This transfer only occurs when the company reports a profit.