The income statement must always be prepared first.
The income statement, also known as the profit and loss (P&L) statement, is fundamental because it provides a comprehensive overview of a company's financial performance over a specific period, detailing its revenues, expenses, gains, and losses. This initial report is crucial as the net income (or loss) derived from it is directly used in the preparation of other key financial statements, specifically the balance sheet and the statement of cash flows.
Why the Income Statement Comes First
Preparing financial statements follows a logical flow, where the output of one statement becomes an input for another. The income statement initiates this process due to its direct impact on a company's equity and retained earnings.
- Overview of Performance: It summarizes the financial results, showing how profitable a company has been. This helps stakeholders understand the company's operational efficiency and profitability during a fiscal period.
- Foundation for Other Statements: The net income (or loss) calculated on the income statement is a critical component for:
- The Balance Sheet: Net income flows into the retained earnings portion of the equity section on the balance sheet. Retained earnings represent the accumulated profits (minus dividends) that have been kept in the business.
- The Cash Flow Statement: The net income figure is the starting point for the operating activities section of the cash flow statement, especially when using the indirect method. Adjustments are then made to reconcile net income to actual cash generated from operations.
Understanding the Key Financial Statements
To appreciate the sequence, it's helpful to understand what each primary financial statement represents:
- Income Statement:
- Purpose: Shows a company's revenues and expenses over a period (e.g., quarter or year).
- Output: Reveals the net profit or loss.
- Dependency: Prepared first as its net result feeds into other statements.
- Balance Sheet:
- Purpose: Provides a snapshot of a company's assets, liabilities, and owner's equity at a specific point in time.
- Output: Demonstrates the company's financial position.
- Dependency: Relies on the retained earnings figure, which includes net income from the income statement.
- Cash Flow Statement:
- Purpose: Reports the cash generated and used by a company during a period, categorized into operating, investing, and financing activities.
- Output: Shows how changes in balance sheet accounts and income affect cash and cash equivalents.
- Dependency: Often starts with net income from the income statement (indirect method) and uses information from the balance sheet to track changes in assets and liabilities.
The Interconnected Financial Reporting Process
The order of preparing financial statements ensures accuracy and consistency across a company's financial reports.
| Financial Statement | Primary Information Provided | Why It's Prepared First/Next |
|---|---|---|
| Income Statement | Revenues, Expenses, Net Income/Loss | Provides the essential Net Income figure needed for Equity. |
| Statement of Equity | Changes in Retained Earnings and other Equity accounts | Uses Net Income from the Income Statement to update Retained Earnings. |
| Balance Sheet | Assets, Liabilities, Equity (at a point in time) | Incorporates the updated Retained Earnings from the Statement of Equity. |
| Cash Flow Statement | Cash Inflows and Outflows (Operating, Investing, Financing) | Often starts with Net Income (indirect method) and uses changes in Balance Sheet accounts. |
This sequential preparation ensures that the final set of financial statements presents a coherent and accurate picture of a company's financial health and performance.
