Preparing a classified Income Statement, Balance Sheet and Cash Flow Statement for a trading business, and explaining the relationships between the three general purpose financial reports

What this dot point is asking

VCAA wants you to prepare a classified Income Statement, Balance Sheet and Cash Flow Statement, and to explain how the three general purpose financial reports relate to each other. Classification means grouping items so the reports are easier to interpret.

The classified Income Statement

The Income Statement reports financial performance over a period. The classified version separates trading activity from other items:

• Sales (revenue) less Cost of Sales gives Gross Profit.
• Gross Profit less Adjusted Gross Profit items such as inventory loss or gain, plus other revenue, gives a subtotal.
• Other expenses (selling, administrative and finance) are deducted to give Net Profit.

Classifying expenses by function helps owners see where costs are concentrated and supports decision making.

The classified Balance Sheet

The Balance Sheet reports financial position at a single point in time and must satisfy Assets = Liabilities + Owner's Equity. Items are classified by how quickly they will be converted to cash or settled:

• Current assets are expected to be converted to cash or used within 12 months (cash, accounts receivable, inventory, prepaid expenses).
• Non-current assets provide benefits beyond 12 months (equipment, premises, vehicles).
• Current liabilities are due within 12 months (accounts payable, accrued expenses, GST clearing if owing, bank overdraft).
• Non-current liabilities are due beyond 12 months (long term loans, mortgage).
• Owner's equity is capital plus net profit less drawings.

The Cash Flow Statement

The Cash Flow Statement reports the inflows and outflows of cash over a period, classified into three activities:

• Operating activities: cash from day to day trading (receipts from customers, payments to suppliers and for expenses, GST and interest).
• Investing activities: cash for buying or selling non-current assets.
• Financing activities: cash from capital contributions and loans, and cash paid for drawings and loan repayments.

The net of these three equals the change in cash, which is added to the opening bank balance to reconcile to the closing bank balance.

How the three reports link

The reports are interdependent:

• Net profit from the Income Statement is added to owner's equity in the Balance Sheet.
• The closing bank balance in the Cash Flow Statement equals the cash figure in the Balance Sheet.
• Because of accrual accounting, net profit and net cash flow from operations differ. Credit sales raise profit without cash, while a loan raises cash without profit.

Reporting requirements and characteristics

General purpose financial reports must be relevant, faithfully represented, comparable, verifiable, timely and understandable. Classification supports understandability and comparability. The reports are prepared on the going concern assumption, meaning the business is expected to continue operating into the future, so non-current assets are reported at carrying amount rather than liquidation value.