Q: The financial statements must be prepared in a particular order. Which statements are prepared first, second, and third? What is their chronological order? Why do we have to do them in that order?
A: Good questions Stephen. Actually, most people don't know that there's a chronological order to the different types of financial statements.
The statements are prepared in this order:
1. Income Statement 2. Statement of Changes in Equity 3. Balance Sheet
The reason the income statement is first is because it is used to calculate the net profit or loss for the year.
That profit or loss figure is needed for the statement of changes in equity.
The statement of changes in equity is used to calculate the final balance of owner's equity for the year.
This closing balance of the owner's equity is shown in the balance sheet (also known as the statement of financial position). This balance is obtained only after calculating it in the statement of changes in equity.
So the balance sheet is the final statement.
Balances of assets and liabilities are, of course, also shown in the balance sheet.
What about the cash flow statement?
Well, the cash flow statement only reports flows of cash going in and out of the business, which is different to any other report. In my opinion, the cash flow statement should be prepared after the income statement, since one of the two most commonly used methods of preparing the cash flow statement, called the indirect method, begins with the net profit figure.
However, the cash flow statement could be prepared before or after the statement of changes in equity or balance sheet (it doesn't matter - as long as it's after the income statement).
But most important is the order of the first three statements I listed above.
In summary, the chronological order of the financial statements:
Income & Expenses --> Income Statement (calculate Net Profit or Loss) --> Statement of Changes in Equity (calculate the Closing Balance of Owner's Equity) --> Balance Sheet (place the Owner's Equity figure here)
Do you think that this order of financial statements is correct? Have more questions about it? Give us your opinion in the comments below.
Best, Michael Celender Founder of Accounting Basics for Students