Financial statements, as used in corporate business houses, refer to a set of reports and schedules which an accountant prepares at the end of a period of time for a business enterprise. The financial statements are the means with the help of which the accounting system performs its main function of providing summarised information about the financial affairs of the business. These statements comprise Balance Sheet or Position Statement and Statement of Profit & Loss or Income Statement. Of course to give a full view of the financial affairs of an undertaking, in addition to the above, the business may also prepare a Statement of Retained Earnings and a Cash Flow Statement. In India, every company has to present its financial statements in the form and contents as prescribed under Section 2(2), 129 & 133 of the Companies Act 2013. The significance of these statements are given below:
- Balance Sheet or Position Statement: Balance sheet is a statement showing the nature and amount of a company’s assets on one side and liabilities and capital on the other. In other words, the balance sheet shows the financial position on a particular date usually at the end of one year period. Balance sheet shows how the money has been made available to the business of the company and how the money is employed in the business.
- Statement of Profit & Loss or Income Statement: Earning profit is the principal objective of all business enterprises and Statement of Profit & Loss or Income Statement is the document which indicates the extent of success achieved by a business in meeting this objective. Profits are of primary importance to the Board of directors in evaluating the management of a company, to shareholders or potential shareholders in making investment decisions and to banks and other creditors in judging the loan repayment capacities and abilities of the company. It is because of this that the profit and loss or income statement is regarded as the primary statement and commands a careful scrutiny by all interested parties. It is prepared for a particular period which is mentioned alongwith the title of these statements, which includes the name of the business firm also.
- Cash Flow Statement: This is a statement which summarises for the period, the cash available to finance the activities of an organisation and the uses to which such cash have been put. A statement of cash flow reports cash receipts and payments classified according to the organisation’s major activities i.e., operating activities, investing activities and financing activities. This statement reports the net cash inflow or outflow for each activity and for the overall business. The cash flow statement is to be prepared according to the Accounting Standard 3 (Revised) “Cash Flow Statement”. The details of this statement have been discussed in a separate study.
Nature of Financial Statements
Financial statements are prepared for the purpose of presenting a periodical review or report on the progress by the management and deal with the
(a) status of the investments in the business and
(b) results achieved during the period under review.
The data exhibited in these financial statements are the result of the combined effect of
(i) recorded facts;
(ii) accounting conventions;
(iii) postulates or assumptions made to implement conventional procedures;
(iv) personal judgements used in the applications of conventions and postulates and
(v) accounting standards and guidance notes.
These factors are explained below:
- Recorded Facts: The term ‘recorded facts’ means, facts which have been recorded in the accounting books such as cash in hand, cash at bank, bills receivables, bills payable, debtors, creditors, fixed assets, sales, purchases, wages, capital and so forth. These items are listed on the basis of historical records of the transactions and valued at the price at which such transactions took place. Facts which have not been recorded in the accounting books are not depicted in the financial statements, however, material they might be.
- Accounting Conventions: Accounting conventions have reference to certain fundamental accounting principles, the applications of which has been sanctified by long usage. For example, on account of the convention of conservation, provision is made for expected losses but expected profits are ignored. These conventions are applied for the valuation of inventory, allocation of expenditure between capital and revenue for the purpose of assets valuations etc.
- Postulates: Accountants make various assumptions for the conventions adopted. One of these assumptions or postulates is to the effect that the enterprise will continue in business beyond the period which is covered by the financial statements, i.e., business is a going concern. This assumption is referred to as the permanency postulate, and the assets of the business are valued under this assumption at cost less depreciation. In absence of this assumption, the assets may have to be valued at realisable value which may be negligible if the business is not a going concern. Another postulate which accountants make is the monetary postulate. It is the tacit assumption that the value of money, that is its purchasing power, remains constant over different periods. The accountants do not take into consideration the price-level changes while valuing various assets in different periods. Of late, however, accountants in the west have shown growing consciousness for incorporating price-level changes while preparing financial statements. A third postulate is the realisation postulate which takes cognizance of the time lag between production and sales affected. Under this postulate entire revenue is considered to be earned at the moment the sales take place and not at the time when the production took place. This postulates forms the basis for the convention of matching costs with revenues, whereunder, the costs incurred in the past period are brought forward to be accounted for against the revenues earned at a later period.
- Personal Judgements: It may be noted that the application of conventions, assumptions or postulates depends on the personal judgements of the accountant. For example, the choice of selecting methods of depreciation, the mode of amortisation of fictitious assets, the method of valuation of stock, calculation of provision for doubtful debts etc. depend on the personal judgements of the accountant. However, the existence of consistency principle serves as a check on the power of the accountant to use his personal judgement. Since the accountant is guided by the past practices, the area of application of his personal judgement is reduced.
- Accounting Standards and Guidance Notes: Accountants are guided by various accounting standards and guidance notes in preparing the financial statement.
Objectives of Financial Statements
The number and types of people interested in financial statements have changed radically in recent times. Financial statements are necessary for shareholders and potential shareholders, in addition to management and creditors.
The following groups have a direct interest in the financial statements of companies: Suppliers and potential suppliers of funds, i.e., shareholders, debentureholders, employees, customers, suppliers of goods and services on credit, tax authorities, etc. In addition, there are groups which have an indirect interest in these statements: Financial analysts and advisors, stock exchanges, academicians, lawyers, regulatory authorities, trade associations, and labour unions.
It is to be readily conceded that firstly it is not feasible to prepare sets of financial statements for the different parties interested in them and secondly, it is virtually impossible to prepare such a financial statement as will provide all the information required by all the interested parties. There has to be a compromise in the preparation of financial statements - there will be and can be only one set and it will have to be oriented towards the needs of the shareholders but it must give such significant and material information as is practicable for the benefit of the other parties specially those who have to make decisions about the future of the concerned firm, specially debenture-holders, institutional lenders, operators on the stock exchange etc.
Fortunately, the needs of information may be grouped under the heads
(i) profit and profitability;
(ii) shortterm financial position (liquidity); and
(iii) long-term financial position.
Every one interested in a firm directly wants to know the extent of cash flows, as far as he is interested, expected in the time-span of interest to him. For example, a shareholder wants to estimate the cash dividend that his shares will bring as well as the amount that he can realise on sale of the shares - for the dividend, his time-span is one year; a supplier of goods on credit wants whether his dues will be paid within say a month or two. These broad needs of information can well be satisfied by a single set of financial statements.
The objectives of financial statements can be summarized as follows:
- To provide reliable financial information about economic resources and obligations of a business enterprise.
- To provide reliable information about the net resources (resources less obligations) of an enterprise that results from its activities.
- To provide financial information that assists in estimating the earning potentials of a business.
- To provide other needed information about changes in economic resources or obligation.
- To disclose, to the extent possible, other information related to the financial statements that is relevant to the needs of the users of these statements.
In order to meet the above objectives and to suit the needs of the varied users, the accountant entrusted with the task of compiling and presenting financial statements must follow a set of guidelines to ensure consistency, completeness, and fairness of the statements. These guidelines are called “generally accepted accounting principles”. In absence of these ‘generally accepted accounting principles’ statements prepared may be un-understandable and misleading for the various groups of users. In addition to this, the financial statements prepared must also be authenticated as to their accuracy and fairness so that the confidence of the users is invoked. For this purpose it is necessary that these statements be reviewed and certified by an independent reviewer, commonly known as auditor.