Financial Statements

What Are Financial Statements?

Financial statements contain summarised information about the firm’s financial affairs. It’s main purpose is to present the firm’s financial situation to the users. The financial statements are the end-product of the financial accounting process.

These statements present financial information in concise and capsule form. Financial statements are prepared by top management and these should be prepared in a very careful manner.

Manager of every firm is engaged in the process of planning and decision making. In order to take right decision at right time, he should have sufficient informations of past and future. Information that is mostly used by a manager is known as financial information and this is taken from financial statements.

[su_quote cite=”Hampton John J.”]A financial statement is an organised collection of data according to logical and consistent accounting procedures. It’s purpose is to convey an understanding of some financial aspects of business firm. It may show a position at a moment of time as in the case of a balance sheet, or may reveal a series of activities over a given period of time, as in the case of an Income Statement[/su_quote]

Thus, the term ‘financial statements’ generally refer to basic statements prepared for the purpose of external reporting to owners, investors and creditors are:

  • profit and loss or income statement
  • balance sheet or statement of financial position.

Two other key financial statements which are usually prepared by corporate firms are:

  • Statement of retained earnings
  • Statement of changes in financial position

The meaning, nature, and characteristics of these financial statements are being explained as under:

Income Statement

According to S.N. Maheshwari “The income statement (also termed as profit and loss account) is normally recognized to be the most useful of all financial statements. The income statement gives a report of operations over a specified period of time, summarises the revenue or income and the expenses or costs attributed to that period and indicates the net profit or loss for a specified period of time.

The income statement explains what has happened to a business as a result of operations between two balance sheet dates. For this purpose it matches the revenue and costs incurred in the process of earning revenues and shows the net profit earned or loss suffered during a particular period.

The nature of “Income” which is the focus of the income statement can be well understood if a business is taken as an organization that uses ‘inputs’ to ‘produce’ output. The outputs are the goods and services that the business provides to its customers. The values of these outputs are the amounts paid by the customers for them.

These amounts are called ‘revenues’ in accounting. The inputs are the economic resources used by the business in providing these goods and services. These are termed as ‘expenses’ in accounting.”

Balance Sheet

Balance sheet is the most significant and basic financial statement of any firm. A firm prepares Balance sheet to present a summary of financial position at a particular moment of time.

In the language of accounting, balance sheet communicates information about assets of the firm (i.e. the resources of the firm) and the liabilities (i.e. obligations of the firm towards outsiders) and owner’s equity of the firm as on a specific date. It may be noted that it depicts snapshot of the financial position of the firm at the close of the firm’s accounting period.

Statement of Retained Earning

It is also known as the Profit and Loss Appropriation A/C. According to the provisions of the companies Act, 1956 it is not mandatory to prepare this statement but most of the companies prepare income statement into two parts i.e. first part is income statement and second part is P.&L. Appropriation A/C.

The net profit amount depicted by Profit and Loss account is transferred to P.&L. Appropriation A/C wherein it will be divided in two parts i.e. dividend to the shareholders and profit retained in the firm. The Proforma of P.&L. Appropriation A/C is as follows:-

Statement of Changes in Financial Position

Traditionally balance sheet and income statement are two common financial statements. As it has been explained earlier that the Balance sheet shows financial position at a particular moment of time and the income statement discloses the net result of operations of business over a period of time. But, both these statements do not depict the information related to the changes in financial position and cash position over the period.

For better understanding of the financial position of the business, it is necessary to know the movement of working capital/ cash of the business. For this purpose, statement of changes in financial position may be prepared. This statement shows how the firm generated different sources of funds and how these funds were used during the period.

The statement of changes in financial position can be prepared on two bases which are:

  • Working capital basis-Funds Flow Statement
  • Cash basis- Cash Flow Statement

Objectives of Financial Statements

The financial statements are prepared to present an accurate picture of firm’s financial position and operating results in a summarized manner. The financial statements are prepared by the firm to fulfil the following objectives:

  1. To communicate with different parties regarding the financial position of the business (These parties include the shareholders, creditors, investors, management, government, financial institutions, financial analysts, labour etc.)

  2. To analyse the operations and performance of the firm for planning.

  3. To give necessary information for optimum utilisation of resources of the companies.

  4. To provide necessary information for taking actions relating to public and social welfare.

Nature of Financial Statements

American Institute of Certified Public Accountants described the nature of financial statements as follows: “Financial Statements are prepared for the purpose of presenting a periodical review or report on progress by the management and deal with the status of the investment in the business and results achieved during the period under review.

They reflect a combination of recorded facts, accounting conventions, postulates and personal judgements, and the judgements and conventions applied them materially.

The soundness of judgements necessarily depends on the competence and integrity of those who make them and on their adherence to generally accepted accounting principles and conventions”.

Important terms used in the above statements are being described as follows:

  • Recorded Facts: Recorded facts means the data contained in statement which have been drawn from the accounting records. Such data may be the amount of cash in hand and in bank, the amount due form customers, the cost of fixed assets, the amount payable to creditors, amount of sales etc.

    Some data or facts which are not recorded in financial books, might be material will not be depicted in the financial statements. For example, fixed assets are recorded at acquiring cost not at replacement cost. Therefore, the balance sheet does not present the financial position of a business in terms of current economic conditions.

  • Accounting Conventions: Accounting conventions imply certain assumptions and procedures which have been sanctioned by long usage. Some of the important situations to use the conventions are assets valuation, distribution of expenditure between capital and revenue, method to be followed for calculation of depreciation, valuation of stock etc.

    For example, according to convention of conservatism, provision is made for expected losses but expected profits are ignored.

  • Personal Judgement: According to May George O., “the accounts of a modern business are not entirely statement of fact, but are to a large extent expression of opinion based partly on accounting conventions, partly on assumptions explicit or implicit and partly on Judgement .”

    Personal Judgement are taken in deciding to use one of the several methods for the determination of the depreciation, evaluation to inventory at cost or at the cost or market price whichever is less etc.

  • Postulates: Accountant depends upon some postulates at the time of preparing financial statements. For example: – an accountant assumes that the value of money will remain constant during whole the year, so there will be no difference on transactions of different dates.

Importance of Financial Statements

Financial statements are useful for different related parties as given below:

  1. Importance to Management: In the words of Gerstenberg Charles W., ‘Management can measure the effectiveness of its own policies and decisions, determine the advisability of adopting new policies and procedures and document to owners the result of their managerial efforts’. For effective and controlling the company’s activities, management can get necessary data from financial statements.

  2. Importance to Investors: Investors are mainly interested with the safety of their investment and to earn profit from these investments with the help of financial statements. Investors create their opinion about the company before investing. For example, some factors they considered are price earning ratio, earning per share, future earning potential, trend of sales of past years, financial strength of the company etc.

  3. Importance to Creditors: Creditors lent their money for short period and they are keen interested in the company’s ability to repay the loan amount on time. A creditor can compute various ratios like current ratio, quick ratio etc. to know the company’s ability to repay. If a company earns less than paid amount of interest, it is not safe to lend money to this company.

  4. Importance to Government: Various ratios like turnover ratios, earning ratios indicate the health of the company. To regulate various economic activities, government analyse the various ratios of companies in one industry.

  5. Importance to Others: Other related parties like labour, stock exchanges, economists, news agencies, trade unions etc. are interested in analysis of financial statements to know the detail position about the company and industry.

Limitations of Financial Statements

Financial statements are prepared to present a report on:

  • Status of the investments in the business
  • Results achieved during the review period.

The above objectives suffer from the following limitations:

  1. Financial Statements are Only Interim Reports: According to this, it can be said that financial statements can not be final because exact amount of profit or loss of a business can be determined after closing down the business. So profit depicted by Profit and Loss account and financial position shown by Balance Sheet is not exact.

    So, it is necessary to prepare financial statement at relatively short accounting period. But this cutting off the balance sheet dates gives the problem of allocation of cost and income. Financial statement data can not afford to remain exact under such conditions.

  2. Depend Upon Accounting Concepts and Conventions: Financial statements are prepard on the basis of certain accounting concepts and conventions. Financial position presented by these statements may not be real. For example, the value of an asset represents the amount of asset which is valued on the basis on “going concern concept”. This means value of fixed assets may not be same which can be realise after the sale of asset.

  3. Based on Historical Cost: The financial statements are based upon historical cost. They do not give present value of business and any information regarding the future.

  4. Disclose Only Monetary Items: Financial statements do not give true picture of the business because they do not show those items which can not be expressed in monetary terms. For example, goodwill of the firm, health of workers, efficiency of management etc.

  5. Affected by Personal Judgement and Knowledge: Many items of financial statements are affected by personal judgement and knowledge of accountant. Some of items e.g. stock valuation methods, method of depreciation, capital and revenue expenditure are decided by personal decision.

Characteristics of Financial Statements

  1. Financial statements must be in simple and attractive manner to understand and draw conclusion easily from them.

  2. The figures related with previous year must be given for comparison of financial statements

  3. Financial statements must give perfect information to present true picture of the concern.

  4. Irrelevant informations should be ignored.

  5. Various required tables, footnotes, appendices must be given in financial statements

  6. The financial statements must be in brief and summarised manner.

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