Components of financial statements

The idea

Financial statements are the formal year-end records a business produces to show what it owns, owes and has earned. The main components are the income statement (profit and loss account), which records revenue, cost of sales, expenses and profit over a period, and the statement of financial position (balance sheet), which lists assets, liabilities and equity at a single date. Assets are resources owned, such as inventory or machinery; liabilities are amounts owed, such as loans or trade payables; equity is the owner's stake.

For example: A retailer's income statement shows revenue of £200 000 and cost of sales of £120 000, giving gross profit of £80 000; its statement of financial position then shows inventory of £15 000 as a current asset and a bank loan of £40 000 as a non-current liability.

What earns the marks

• Identifies the income statement as the component covering a period of time, showing revenue, cost of sales, expenses and resulting profit or loss.
• Identifies the statement of financial position as the component showing assets, liabilities and equity at a stated date.
• Classifies assets correctly, distinguishing non-current assets such as premises from current assets such as inventory and trade receivables.
• Classifies liabilities correctly, distinguishing non-current liabilities such as long-term bank loans from current liabilities such as trade payables.
• Explains the purpose of each component, for example that the income statement measures trading performance while the statement of financial position measures financial position.
• Uses a numerical example, such as revenue minus cost of sales giving gross profit, to show how a component is constructed.

Common mistakes and how to put them right

• Treating the statement of financial position as covering a period rather than a single date.

  Put it right: State that it is a snapshot at one point in time, whereas the income statement covers a period.

• Listing a bank loan repayable in five years as a current liability.

  Put it right: Classify it as a non-current liability because it is not due within the coming year.

• Confusing profit with cash, assuming a profitable business must hold more cash.

  Put it right: Note that profit is an accounting measure of performance while cash is a separate resource shown among assets.

Exam tips

• Learn the two main components by name and be ready to state what each one shows and over what time frame.
• When asked to classify an item, decide first whether it is owned (asset), owed (liability) or the owner's stake (equity), then decide current or non-current.
• Use figures from a given statement to support each point, for example quoting revenue and cost of sales when explaining gross profit.