Understanding the interplay between the key financial reports

Australian Accounting Standards (and the international equivalents) require any compliant financial report to include the following statements for the current financial period and the comparative prior financial period, along with explanatory notes and a directors’ declaration:

• the statement of profit or loss and other comprehensive income (sometimes referred to as a profit and loss statement);
• the statement of financial position (sometimes referred to as a balance sheet,)
• the statement of changes in equity, and
• the statement of cash flows.

It should be noted that not all financial reports are required to comply with the Australian Accounting Standards (such as those prepared for internal management purposes).

It is crucial to comprehend the interplay between the statements, as it allows us to see the broader impact of accounting principles. For instance, a movement in the statement of profit or loss may have a corresponding movement in the statement of financial position.  This is due to the application of double entry which is a fundamental concept in accounting.

Some examples of this are:

A debit to record cash received may result in a credit to:

• income, thereby hitting the statement of profit or loss and other comprehensive income;
• a liability for income received in advance (where services are yet to be delivered);
• a liability reflected the need to repay the amount received (borrowings); or
•  equity where it is an injection of share capital. 

Noting the positive outcome (net cash increase) in the statement of cash flows in isolation may not provide the full picture.

A credit to record cash paid may result in a debit to:

• an expense account, thereby hitting the statement of profit or loss and other comprehensive income;
• an asset as a prepayment (where services are yet to be received) or non-current assets where long-term economic benefits are expected to be received;
• a liability reflected the repayment of such an amount; or
•  equity, where it is a return of share capital or a dividend.

As before, the movement in the statement of cash flows in isolation may not provide the full picture.

A credit to income may result in a debit to:

• cash received (recording income on a cash basis);
• a work-in-progress account (thereby reflecting work expected to be billable in the future);
• account receivable; or
• a liability for income received in advance (where services previously paid for are delivered);

When the statement of profit or loss and other comprehensive income are viewed in isolation, there is a danger of creating large unrecoverable WIP or accounts receivable balances that are unlikely to turn into cash in the future (as customers don’t have the willingness or capacity to pay).  There is also a danger of misrepresenting the cash impact of the income recorded where cash for the services delivered had already been received and recorded as income in advance.

I encourage those new to financial reporting to examine and understand this interplay to strengthen their ability to read financial information.

By James Dickson
Stanards, Director

www.stannards.com.au