Financial Statements of a Company Chapter Notes | Accountancy Class 12 - Commerce PDF Download

Introduction

• Once we grasp how a company secures its capital, the next step is to delve into the nature, objectives, and types of financial statements that the company is required to prepare. This includes understanding their contents, format, uses, and limitations.
• Financial statements represent the final output of the accounting process. Their preparation is guided by accounting policies, accounting standards outlined in the Companies Act, and fundamental accounting concepts and principles. Additionally, these statements must adhere to legal regulations governing business operations.
• These statements are the result of summarizing accounting data and serve as crucial sources of information for assessing a company's profitability and financial position. Therefore, it is essential to organize them in a clear and structured manner, making it easier for shareholders and other users to comprehend and utilize the information for informed economic decisions.

Meaning of Financial Statements

• Financial statements are formal annual reports that corporate management uses to communicate financial information to owners and various external parties such as investors, tax authorities, the government, and employees.
• These statements include the balance sheet (position statement) as of the end of the accounting period, the statement of profit and loss, and the cash flow statement.

Nature of Financial Statements

• Financial statements are based on chronologically recorded facts expressed in monetary terms for a specific period.
• These statements reveal the financial position at a specific date and the financial results achieved during the period.
• The American Institute of Certified Public Accountants describes financial statements as tools for presenting a periodic review of management's progress, reflecting the status of investment in the business and the results achieved.
• They combine recorded facts, accounting principles, and personal judgments.

Recorded Facts:

• Financial statements rely on recorded facts in the form of cost data from accounting books.
• Transactions are recorded based on original or historical cost.
• Figures for accounts like cash, trade receivables, and fixed assets are taken from accounting records.
• Assets purchased at different times and prices are shown at their historical costs.
• Since these figures are not based on current market prices, financial statements may not reflect the current financial condition of the business.

Accounting Conventions:

• Certain accounting conventions are followed in preparing financial statements.
• Inventory is valued at the lower of cost or market price.
• Assets are valued at cost less depreciation in the balance sheet.
• The convention of materiality is applied to small items like stationery, treating them as expenses in the year of purchase.
• Using accounting conventions makes financial statements comparable, simple, and realistic.

Postulates:

• Financial statements are prepared based on certain fundamental assumptions known as postulates.
• The going concern postulate assumes the enterprise will continue to operate for the foreseeable future, leading to the historical cost basis for asset valuation.
• The money measurement postulate assumes the value of money remains constant over time, despite changes in purchasing power.
• The realization postulate recognizes revenue in the year of sale, regardless of when payment is received.

Personal Judgments:

• Financial statements often involve personal opinions, estimates, and judgments.
• Depreciation is calculated based on the estimated useful life of fixed assets.
• Provisions for doubtful debts are made based on estimates and personal judgments.
• Valuing inventory involves deciding between cost and market value, requiring personal judgments.
• Personal opinions and estimates aim to avoid overstating assets, liabilities, income, and expenditure, in line with the conservatism principle.

In summary, financial statements are concise reports of recorded facts, prepared following accounting concepts, conventions, policies, standards, and legal requirements.

Objectives of Financial Statements

Financial statements serve as essential sources of information for shareholders and external parties to comprehend the profitability and financial position of a business. They offer insights into the business's performance over a specific period concerning its assets and liabilities, facilitating informed decision-making. The primary aim of financial statements is to aid users in their decision-making processes. The specific objectives include:

• Information on Economic Resources and Obligations: Financial statements are designed to provide adequate, reliable, and periodic information about a business's economic resources and obligations. This information is crucial for investors and external parties who may have limited access to such data.
• Earning Capacity Assessment: Financial statements aim to offer useful financial information that can be employed to predict, compare, and evaluate a business's earning capacity.
• Cash Flow Information: These statements are intended to provide information that is useful to investors and creditors for predicting, comparing, and evaluating potential cash flows in terms of amount, timing, and associated uncertainties.
• Management Effectiveness Evaluation: Financial statements supply information that is useful for assessing management's ability to effectively utilize a business's resources.
• Societal Impact Reporting: Financial statements report on a business organization's activities that impact society, focusing on aspects that are measurable and significant within its social environment.
• Disclosure of Accounting Policies: Financial statements include disclosures about significant accounting policies and concepts followed during the accounting process, as well as any changes made during the year. This helps users understand the statements more clearly.

Types of Financial Statements

• Financial statements commonly include two main documents: the balance sheet and the statement of profit and loss. These are essential for both external reporting and internal management purposes, such as planning, decision-making, and control.

• In addition to the balance sheet and profit and loss statement, there is a need to understand the movement of funds and changes in the financial position of the company. For this reason, a cash flow statement is also prepared.

• Every company registered under The Companies Act 2013 is required to prepare its balance sheet, statement of profit and loss, and accompanying notes per the revised Schedule III of the Act. This ensures alignment with accounting standards and compliance with new reforms.

Balance Sheet as of 31st March, 20.....

Important Features of Presentation

• Applicability: Schedule III applies to all Indian companies preparing financial statements under the Companies Act, 2013.
• Exemptions: It does not apply to insurance or banking companies, or to companies with specific balance sheet or income statement formats required by other Acts.
• Accounting Standards: Accounting standards take precedence over Schedule III.
• Mandatory Disclosures: Disclosures on the financial statements face or in the notes are essential and mandatory.
• Terminology: Terms in Schedule III have the meanings defined by applicable accounting standards.
• Detail Balance: A balance must be maintained between excessive details and the provision of important information.
• Current/Non-Current Bifurcation: Bifurcation of assets and liabilities into current and non-current categories is required.
• Rounding Off: Rounding off requirements is mandatory.
• Presentation Format: A vertical format for presenting financial statements is prescribed.
• Profit and Loss Statement: Debit balances in the statement of profit and loss should be disclosed as negative figures under "Surplus."
• Share Application Money: Mention of share application money pending allotment is mandatory.
• Terminology Changes:‘Sundry Debtors’ and ‘Sundry Creditors’ are replaced with ‘Trade Receivables’ and ‘Trade Payables’.

Shareholders Fund:

The shareholders’ funds are sub-classified on the face of the balance sheet.

• Share Capital
• Reserves and Surplus
• Money received against Share Warrants

Share Capital:

Disclosures related to share capital should be included in the notes to accounts. The following additions or modifications are important:

• For each class of shares, it is necessary to recognize the number of shares outstanding at the beginning and end of the reporting period.
• Details about the rights, preferences, and restrictions attached to each class of shares must be provided, including any limitations on the distribution of dividends and repayment of capital.
• To clarify the identity of the ultimate owners of the company, the following disclosures are required:
• Disclosure of shares held by the holding company or ultimate holding company: Include shares held by subsidiaries or associates of the holding company or ultimate holding company in aggregate for each class of shares.
• Disclosure of shares held by major shareholders: Specify the number of shares held by each shareholder owning more than 5% of the shares.
• Disclosure for the past 5 years: Provide information on the following:
• Aggregate number and class of shares allotted as fully paid up without payment in cash.
• Aggregate number and class of shares allotted as fully paid up by way of bonus shares.
• Aggregate number and class of shares bought back.

It is important to note that information about shareholders' funds is presented on the face of the financial statements only for broad and significant items, while details are provided in the Notes to Accounts.

• For each class of share capital, the following information should be disclosed:
• Authorized share capital: Number and amount of shares authorized.
• Issued and subscribed shares: Number of shares issued, subscribed, fully paid, and subscribed but not fully paid.
• Par value: Par value per share.
• Reconciliation: Reconciliation of the number of shares outstanding at the beginning and end of the accounting period.
• Rights and Restrictions: Rights, preferences, and restrictions attaching to each class of shares, including restrictions on dividend distribution and capital repayment.
• Shareholding by holding company: Aggregate number of shares held by the holding company, ultimate holding company, and subsidiaries or associates of the holding company or ultimate holding company for each class.
• Shares reserved for issue: Shares reserved for issue under options and contracts/commitments for the sale of shares/disinvestment, including terms and amounts.
• Past 5 years disclosures: For the past 5 years, disclose:
• Shares are reserved under contracts/commitments.
• Number and class of shares bought back.
• Number and class of shares allotted for consideration other than cash and bonus shares.
• Convertible securities: Terms of any securities convertible into equity/preference shares issued, along with the earliest date of conversion in descending order.
• Calls unpaid: Aggregate amount of calls unpaid.
• Forfeited shares: Amount originally paid up on forfeited shares.

Reserve and Surplus:

• Capital Reserve
• Capital Redemption Reserve
• Securities Premium Reserve
• Debenture Redemption Reserve
• Revaluation Reserve
• Share Options Outstanding Account
• Other Reserves(specifying nature and purpose)
• Surplus: balance in statement of profit and loss, disclosing allocations and appropriations such as dividends, bonus shares, transfer to/from reserve, etc.

Significant additions/modifications regarding disclosure of reserve and surplus are as follows:

• A reserve specifically represented by earmarked investments shall be termed a “Fund”. 
•  The ‘Debit’ balance of the statement of profit and loss shall be shown as a negative figure under the ‘Surplus’ head. 
•  The balance of “Reserve and Surplus” after adjusting the negative balance of Surplus, if any, shall be shown under “Reserve and Surplus” read even if the resulting figure is ‘negative’. 
•  Share options outstanding account has been recognised as a separate item under ‘Reserve and Surplus’. 
•  ICAI’s Guidance Note on Accounting for Employee share-based payments requires a credit balance in the ‘Stock option outstanding Account’ to be disclosed in the balance sheet under the separate heading between share capital and reserves and surplus as a part of shareholders fund. 

Money Received Against Share Warrants:

• Money received by a company against share warrants is the amount that will be converted into shares at a specified date and rate.
• The company issues share warrants as an instrument against the money received.
• This amount is disclosed as a separate line item under "shareholder's fund."

Example: Dinkar Ltd. has an authorised capital of Rs. 50,00,000 divided into equity shares of Rs. 100 each. The company invited applications for 40,000 shares, applications for 36,000 shares were received. All calls were made and duly received except for 500 shares on which the final call of Rs. 20 was not received. The company forfeited 200 shares on which final call was not received. Show how share capital will appear in the balance sheet of the company. Also prepare ‘Notes to Accounts’ for the same.
Ans: 

Current and Non-current Classification:

• In a classified balance sheet, assets and liabilities are divided into current and non-current categories.
• Current assets and current liabilities have specific criteria for classification, while non-current items are residual.

Current/Non-current Distinction:

• An item is classified as current if it meets any of the following criteria:
• Involved in the entity’s operating cycle.
• Expected to be realized or settled within twelve months.
• Held primarily for trading.
• Cash and cash equivalents.
• The entity does not have unconditional rights to defer settlement of the liability for at least 12 months after the reporting period.
• Items that do not meet these criteria are classified as non-current.

Important Points:

• Preliminary expenses should be written off completely in the year they are incurred. These expenses should first be deducted from securities premium, and any remaining balance should be written off from the statement of profit and loss.
• Borrowing costs, such as the discount on the issue of debentures, should be written off in the same year the debentures are issued.

Share application money pending allotment:

• Share application money not exceeding the issued capital and to the extent non-refundable shall be classified as non-current. It will be shown on this face of the balance sheet as share application money pending allotment.

Borrowings:

Total borrowings are categorised into long-term borrowings, short-term borrowings and current maturities to long-term debt.

(i) Loans that are repayable in more than twelve months/operating cycle are classified as long-term borrowings on the face of the balance sheet.

(ii) Loans repayable on demand or whose original tenure is not more than twelve months/operating cycle are classified as short-term borrowings on the face of the balance sheet.

(iii) Current maturities to long-term loans include the amount repayable within twelve months/operating cycle under other current liabilities with Note to Account.

Deferred tax assets/liabilities are always non-current. This is in accordance with Schedule III of the Companies Act.

Trade payables:

• Sundry creditors have been replaced with the term Trade payables and are classified as current and non-current. 
•  Trade payables to be settled beyond 12 months from the date of the balance sheet or beyond the operating cycle are classified under “other long-term liabilities” with Note to Account. 
•  For example, the purchase of goods and services in the normal course of business. 
•  The balance of trade payables is classified as current liabilities on the face of the balance sheet. 

Proposed Dividend:

• The proposed dividend is proposed by the Board of Directors and declared (approved) by the shareholders in their Annual General Meeting. 
•  The Board of Directors propose the dividend after the annual accounts for the year have been prepared. 
•  Annual General Meeting of the shareholders is held thereafter meaning it is held in the next financial year. 
•  Shareholders may reduce the amount of the proposed dividend but cannot increase it. 
•  Since the declaration of the proposed (final) dividend is contingent upon shareholders' approval, the proposed dividend is shown as a contingent liability. 
• AS-4, Contingencies and Events Occurring after the Balance Sheet Date prescribes that the proposed dividend will be shown in the Notes to Accounts. 
•  After the proposed dividend is declared by the shareholders, it becomes a liability for the company and is accounted in the books. 
•  As a consequence, the proposed dividend of the previous year will be declared (approved) by the shareholders in the current year and this declared (approved) proposed dividend will be accounted for during the year. 
•  The proposed dividend for the current year will be relevant for the next financial year. 
•  Briefly, a proposed dividend of the previous year will be accounted for in the current year after it is declared (approved) by the shareholders in their annual general meeting. 

Provisions:

• If a provision is expected to be settled within 12 months from the balance sheet date or within the operating cycle period from the date of recognition, it is classified as a short-term provision and shown under current liabilities on the balance sheet.
• Provisions that do not meet these criteria are classified as long-term provisions and shown under non-current liabilities.

Fixed Assets:

• There is no change in the treatment of fixed assets. Both tangible and intangible assets are considered non-current.
• Even if the useful life of an asset is less than 12 months, it still falls under non-current assets.

Investments:

• Investments are classified into current and non-current categories.
• Investments expected to be realized within 12 months are considered current investments under current assets.
• Investments not expected to be realized within 12 months are classified as non-current investments under non-current assets.
• Both types of investments are shown on the face of the balance sheet.

Inventories:

• All inventories are always treated as current assets.

Trade Receivables:

• Trade receivables expected to be realized beyond 12 months from the reporting date or beyond the operating cycle from the date of recognition are classified as “Other non-current assets” under non-current assets with a note to accounts.
• Trade receivables expected to be realized within 12 months are classified as current assets and shown on the face of the balance sheet.

Cash and Cash Equivalents:

• Cash and cash equivalents are always classified as current assets.
• Amounts qualifying as cash and cash equivalents as per AS-3 are shown here.
• Disclosure of cash and cash equivalents is done in accordance with AS-3, taking precedence over Schedule III.

Example: Show the following items in the balance sheet of Sunfill Ltd. as at March 31, 2017:

Ans: 

Form and content of Statement of Profit and Loss

Statement of Profit and Loss for the year ended ______________

The items of the statement of profit and loss are discussed as follows:

Revenue from operations This includes:

• Sale of products
• Sale of services
• Other operating revenues

Other income:

• Interest income (in the case of a company other than a finance company),
• Dividend income,
• Net gain/loss on sale of investments,
• Other non-operating income (net of expenses directly attributable to such income).

Expense:

Uses and Importance of Financial Statements

Financial statements are crucial for various users such as management, investors, shareholders, creditors, government, bankers, employees, and the public. They provide essential information about the company's performance, helping these parties make informed economic decisions. Financial statements are a key part of the company's annual report, alongside the directors' report, auditors' report, corporate governance report, and management discussion and analysis.

• Report on stewardship function: Financial statements show how well management is performing to the shareholders. They highlight any gaps between what management achieves and what shareholders expect.
• Basis for fiscal policies: The government's fiscal and taxation policies are influenced by the financial performance of companies. Financial statements provide crucial information for shaping industrial, taxation, and economic policies.
• Basis for granting of credit: Banks and financial institutions rely on financial statements to decide whether to grant credit to corporate undertakings. These statements are essential for assessing the financial health of the borrowing entity.
• Basis for prospective investors: Both short-term and long-term investors use financial statements to evaluate the security, liquidity, and profitability of their investments. These statements help assess the company's solvency and potential returns.
• Guide to the value of the investment already made: Shareholders use financial statements to gauge the status, safety, and returns on their investments. This information aids in deciding whether to continue or discontinue their investment in the company.
• Aids trade associations in helping their members: Trade associations analyze financial statements to support and protect their members. They may establish standard ratios and develop uniform accounting systems based on this analysis.
• Helps stock exchanges: Financial statements enable stock exchanges to assess the transparency of companies' financial reporting. This information helps protect investors' interests and assists stockbrokers in evaluating companies' financial positions for pricing decisions.

Limitations of Financial Statements

• Financial statements are prepared with great care and provide detailed information to users, but they have several limitations:
• Do not reflect current situation: Financial statements are based on historical cost, which does not consider the changing purchasing power of money. As a result, the values of assets and liabilities may not reflect the current market situation.
• Assets may not realize: Accounting is done based on certain conventions, and some assets may not realize their stated values if liquidation is forced. The assets shown in the balance sheet reflect only unexpired or unamortized costs.
• Bias: Financial statements are influenced by recorded facts, accounting concepts, conventions, and personal judgments made by accountants. This can lead to bias in the results, making the financial position depicted in the statements less realistic.
• Aggregate Information: Financial statements provide aggregate information rather than detailed information, which may limit their usefulness for decision-making.
• Vital information missing: The balance sheet does not disclose important information such as loss of markets or cessation of agreements, which can significantly impact the enterprise.
• No qualitative information: Financial statements contain only monetary information and lack qualitative information such as industrial relations, labour relations, and the quality of work.
• Interim reports: The statement of profit and loss reflects profit or loss for a specific period, not indicating earning capacity over time. Similarly, the financial position in the balance sheet is accurate only at that point in time, with potential future changes not depicted.