Unit 3: Financial Statements of a Company

The nature of financial statements are

1. A financial statement records facts about the items at the original price at which they were purchased. It does not take into account the prevailing market price and also does not include price fluctuations due to inflation.

2. The financial statements are created based on various accounting conventions such as the Prudence convention, matching concept, etc. and adhering to such conventions results in the statements being easy to understand, compare and reflect the fair and true financial situation of the organisation.

3. A financial statement is based on many concepts, such as the going concern concept, realisation concept, and money measurement concept. A financial statement adheres to all these concepts when financial statements are prepared.

4. In preparing financial statements, personal judgements play an important role. For example, when determining which method to charge depreciation and recording of stock at market value or cost price. All these are based on personal judgement.

Importance of financial statements

1. They provide information to various users of accounting information which can be both internal and external. Users derive information as per their needs from such statements. For example, they provide shareholders with an idea about the viability of the business while the same statement can be used by tax authorities to determine the tax payable by an organisation.

2. They help management in comparing performance which can be on both inter and intra-firm basis, it helps in determining the viability of the business and also is helpful in the framing of policies for business. It enhances the decision-making capabilities of the management.

3. Financial statements help creditors and investors determine the state of solvency of a business which influences the decision to offer loans and credit.

4. Financial statements help provide information on different policies, methods, best practices and accounting processes. Disclosing accounting policies simplifies financial statements and gives users of accounting information.

5. The government uses accounting information to determine various parameters of national growth like GDP, National Income, Industrial growth, etc.

6. Investors need information on business solvency and profitability to offer further loans and invest in the business, and such information is obtained from financial statements.

The limitations are

1. Financial statements reflect historical data, i.e., they reflect the original price of the items or the price at which items were acquired. It fails to highlight the current price of items as per market and also inflated prices due to rising inflation in the market. Hence, data and information are historical in nature.

2. Financial statements do not portray the qualitative aspects of any transaction, the aspects such as size, colour, quality and capabilities. Only quantitative data which can be expressed in monetary value are considered.

3. Financial statements are biased in nature, as they are dependent on personal judgement regarding the way transactions are recorded

4. It becomes difficult to assess the financial performance of one company with another due to differences in practices and methods adopted by each company.

5. It will be difficult to forecast, as the statement is prepared based on historical data, as it fails to capture inflation rates.

6. The company can manipulate the data to show a better liquidity position, which can give a false impression to the investors leading to project cancellation.

Items of the Profit and Loss Statement are

1. Revenue from Operations: Revenue is earned from the basic operating activities of an organisation. The source of revenue varies for financing and non-financing companies. For financing companies, the revenue sources are Interest, dividends and other types of financial services while for a non-financing company, it includes revenues earned from sales of products and services and other operating activities.

2. Other Incomes: Refers to incomes that are earned separately and not from any operating activity. These are the sources: Gain on the sale of investments, income from interest, and dividends as such.

3. Expenses: These include all the expenses, such as the cost of materials consumed, purchasing of stock in trade, also changes in inventories, stock in trade and work in progress.

The elements of a balance sheet consist of

A. Shareholder Funds

1. Share Capital consists of Authorised capital, Subscribed capital, Issued capital equity and preference share.

2. Reserves and Surplus consists of Capital Reserve, Debenture Redemption, Capital Redemption Reserve, Tax Reserve, General Reserve and Share warrants. Share warrants provide the holder to have ownership of equity shares of a company. When money is received from selling share warrants, it is called as money received against warrants.

B. Share Application money pending allotment: It refers to an application on which allotment is pending, but the amount is received. It takes place when a company issues equity shares publicly in order to raise funds.

C. Non-Current Liabilities: These consists of the following items: long-term borrowings, deferred tax liabilities, long-term provisions and other long-term liabilities.

D. Current liabilities: These consist of the following items: short-term liabilities, trade payables, short-term provisions

E. Assets which include Non-current and Current Assets. Non-current assets can be long-term loans, plant, machinery, furniture, goodwill etc., while current assets are investments in shares and debentures, finished goods, raw materials, cash and cash equivalents, bank balance, cheques not encashed, and short-term.

The various parties interested in the financial statements of a company can be broadly classified as 1. Internal and 2. External

Internal Users

1. Owners: The interest of an owner is towards knowing whether profit is earned or loss is incurred by the business. They are more interested in knowing about the viability of the capital that is invested in the business.

2. Management: Financial statements help management in devising new policies for the growth of business and also provide management with the insights required for implementing various cost-cutting measures.

3. Employees: They are interested in timely payments, bonuses and appraisals at the decided time. Financial statements help employees to learn about the financial position of the organisation so that appropriate salaries can be demanded.

External Users

1. Banks and Financial Institutions: Such institutions provide credit, so it is necessary to understand the liquidity, solvency and creditworthiness of the organisation for loan requirements in future.

2. Creditors: Businesses owe money to creditors, and hence, it is important for them to have information about the creditworthiness of the business.

3. Investors or potential investors: These are people who will provide funds by means of investment in the business. Hence, the viability and solvency of an organisation will help in making investment decisions.

4. Tax Authorities: Information is required by them for determining the types of taxes that can be charged to the organisation.

5. Government: Government needs information to determine National Income, GDP and industrial growth. Financial statements help the government formulate various policies and address issues like poverty and unemployment.

6. Consumers: An organisation publishing a financial statement makes consumers aware of the profits they are earning and the relative expenses that go into providing services at affordable prices, thus helping to gain a good name among consumers.

7. Public: Public knowledge of financial statements is about how the business is spending money for social welfare.

8. Researchers: Researchers use financial statements to predict market trends and undertake research projects.

Financial statements reveal the true financial position of a company and help in formulating various decisions and policy making. The nature of financial statements is dependent on these aspects:

1. Financial statement records facts about the items at the original price at which they were purchased. It does not take into account the prevailing market price and also does not include price fluctuations due to inflation.

2. The financial statements are created based on various accounting conventions such as the Prudence convention, matching concept etc., and adhering to such conventions results in the statements being easy to understand, compare and reflect the fair and true financial situation of the organisation.

3. A financial statement is based on many concepts, such as the going concern concept, realisation concept, and money measurement concept. A financial statement adheres to all these concepts when financial statements are prepared.

4. In preparing financial statements, personal judgements play an important role. For example, when determining which method to charge depreciation and recording of stock at market value or cost price. All these are based on personal judgement.

The process of preparing the income statement and balance sheet is as follows:

Income Statement

1. Prepare a trial balance as per the balance of different accounts in the ledger.

2. Determine revenue received from the business operation, which is achieved by subtracting sales return from sales conducted.

3. Add incomes received other than revenue (such as cash discount and profit earned from the sale of assets.)

4. Deduct expenses from total revenue to determine profit before tax.

5. Deduct tax paid by the company from the amount determined as profit before tax to arrive at Net Profit or Loss.

Balance Sheet

The balance sheet consists of two parts: Equity and Liabilities and Assets.

1. The equity and liabilities contain shareholder funds, non-current liabilities, current liabilities and share application money pending allotment are recorded.

2. Assets are recorded next, and they contain all non-current and current assets

3. Tally the total of both sides. It must be equal for the total to tally.