What are the three financial statements?
The three financial statements are: (1) the Income Statement, (2) the Balance Sheet, and (3) the Cash Flow Statement. These three core statements are intricately linked to each other and this guide will explain how they all fit together. By following the steps below you’ll be able to connect the three statements on your own.
Overview of the three financial statements:
#1 Income statement
Often, the first place an investor or analyst will look is the income statement. The income statement shows the performance of the business throughout each period, displaying sales revenue at the very top. The statement then deducts the cost of goods sold (COGS) to find gross profit. From there, the gross profit is affected by other operating expenses and income, depending on the nature of the business, to reach net income at the bottom – “the bottom line” for the business.
Shows the revenues and expenses of a business
Expressed over a period of time (i.e. 1 year, 1 quarter, Year-to-Date, etc.)
Uses accounting principles such as matching and accruals to represent figures (not presented on a cash basis)
Used to assess profitability
#2 Balance sheet
The balance sheet displays the company’s assets, liabilities, and shareholders’ equity. As commonly known, assets must equal liabilities plus equity.
What is the Revenue Recognition Principle?
The revenue recognition principle dictates the process and timing by which revenue is recorded and recognized as an item in the financial statements. Theoretically, there are multiple points in time at which revenue could be recognized by companies. Generally speaking, the earlier revenue is recognized, it is said to be more valuable to the company, yet a risk to reliability.
In accounting, revenue recognition is one of the areas that is most susceptible to manipulation and bias. In fact, it is estimated that a significant portion of all accounting fraud stems from revenue recognition issues, given the amount of judgment involved. Understanding the revenue recognition principle is important in analyzing financial statements.
Revenue recognition criteria
According to IFRS standards, all of the following five conditions must be met for a company to recognize revenue:
- There is a transfer of significant risks and rewards associated with ownership
- There is a loss of continuing managerial involvement or control to the degree usually associated with ownership
- The amount of revenue inflow can be measured reliably
- It is probable that economic benefits will flow to the seller
- The costs incurred or the cost to be incurred can be measured reliably
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Revenue recognition for the sale of goods
For the sale of goods, most of the time, revenue is recognized upon delivery. This is because, at the time of delivery, all the five criteria are met. An example of this may include Whole Foods recognizing revenue upon the sale of groceries to customers.
Revenue recognition at delivery will look like this:
DR Cash or Accounts Receivable a
CR Revenue a
When revenue is recognized, according to the matching principle, expenses must also be considered for:
DR Cost of Goods Sold b
CR Inventory b
Revenue recognition before and after delivery
For the sale of goods, IFRS standards do not permit revenue recognition prior to delivery. IFRS does, however, permit revenue recognition after delivery.