Management Notes

Reference Notes for Management

Financial Statements – Meaning, Nature, Objectives, Attributes, Importance, Limitations and Trends | Introduction to Cost Accounting

Financial Statements

The term ‘financial statements’ refers to a series of reports and schedules prepared by an accountant at the end of a given period of time for a business enterprise. Financial statements are used by the accounting system as a means to provide summarised information about the financial affairs of the business. They include the Balance Sheet, Profit & Loss Statement, and Income Statement. To give a complete picture of the financial affairs of an organization, an organization may also prepare a Statement of Retained Earnings and a Cash Flow Statement.

Components of Financial Statements

Components of Financial Statements

a) Balance Sheet or Position Statement

The balance sheet is a statement that shows a company’s assets on the one hand and its liabilities and capital on the other. As a result, the balance sheet shows the financial position of the company at a particular point in time, usually at the end of a year. A balance sheet shows how the company’s money has been used by its business and how it has been employed.

b) Statement of Profit & Loss or Income Statement

An enterprise’s primary goal is to earn profit, and a Statement of Profit and Loss or Income Statement indicates the extent to which the enterprise has succeeded in achieving this goal. A company’s profits are of primary importance to the Board of Directors in assessing management, to shareholders or potential shareholders in making investment decisions, and to banks and other creditors in assessing loan repayment capabilities and abilities. Therefore, the profit and loss statement or income statement is viewed as the most important statement and must be closely scrutinized by all interested parties. These statements are prepared for a particular period which is mentioned along with the title, which includes the name of the business firm.

c) Cash Flow Statement

A cash flow statement shows a summary of the cash available to finance an organisation’s activities and how it has been used. The cash flow statement reports the organization’s cash receipts and payments according to its major activities, such as its operating, investing, and financing activities. Each activity and the overall business are represented by the net cash inflows or outflows in this statement.

Nature of Financial Statements

Nature of Financial Statements

The financial statements are prepared for the purpose of providing a periodic report or review of the business’ progress and show (a) the status of the investments made in the business and (b) the results achieved. Based on the combination of (i) recorded facts; (ii) accounting conventions; (iii) assumptions made to apply conventional procedures; (iv) personal judgements used to apply conventions and postulates; and (v) accounting standards and guidance notes, the financial statements are prepared. The following factors are explained:

a) Recorded Facts

According to the definition of recorded facts, these are facts that have been entered into the accounting books, such as cash on hand, cash on deposit, bills receivable, bills payable, debtors, creditors, fixed assets, sales, purchases, wages, capital, etc. Based on historical records of the transactions, these items are listed and valued at the price at which the transactions occurred. Even if they are material, facts that are not recorded in the accounting books are not included in the financial statements.

b) Accounting Conventions

The application of certain accounting principles has been sanctified through long usage of accounting conventions. Due to the convention of conservation, provisions are made for expected losses, but expected profits are ignored. For example, these conventions are applied for the valuation of inventory, allocation of expenditure between capital and revenue for asset valuations, etc.

c) Postulates

Accounting conventions are based on various assumptions. The first assumption is that the enterprise will continue as a going concern beyond the period covered by the financial statements. Under this assumption, the assets of the business are valued at cost less depreciation. The business may be considered a going concern if the assets are valued at their realisable value, which may not be significant. A monetary postulate is used by accountants as well. A tacit assumption is that money’s value, that is its purchasing power, remains constant over time. Accountants do not take into account changes in price levels when valuing assets across different periods. Accountants in the west, however, have recently become more aware of the importance of incorporating price-level changes when preparing financial statements. Thirdly, the realisation postulate takes into account the time lag between production and sales. Using this postulate, revenue is considered to be earned at the time of sales, not at the time of production. It is this postulate that explains the convention of matching costs with revenues, whereby the costs incurred in the past are carried forward to be accounted for against the revenues earned at a later date.

d) Personal Judgements

Generally, the application of conventions, assumptions, or postulates is based on the accountant’s personal judgment. Accountants choose the methods of depreciation, the method of amortization of fictitious assets, the method of stock valuation, and the method of provision for doubtful debt, for example, according to their own personal judgments. The existence of consistency principle, however, serves as a check on the accountant’s ability to use his own judgment. Accounting is governed by past practices, so the accountant’s use of personal judgment is limited.

e) Accounting Standards and Guidance Notes

The preparation of financial statements is guided by a variety of accounting standards and guidance notes. Accounting standards are policies and practices that are used to standardize bookkeeping and other accounting activities across firms and over time. In addition to assets, liabilities, revenue, expenses, and shareholders’ equity, accounting standards also apply to a company’s financial picture. Accounting standards ensure that an entity’s information is relevant and accurate for banks, investors, and regulatory agencies. Transparency in financial reporting is improved through accounting standards.

Attributes of Financial Statements

Attributes of Financial Statements

To serve meaningfully the purpose and objectives for which they are prepared, financial statements prepared for an enterprise must possess the following attributes:

a) Relevance

Financial statements should be relevant to the purposes for which they are intended. Disclosures that are irrelevant and confusing should be avoided, but nothing relevant and material should be withheld. The accountant preparing such statements should have a clear understanding of the relevance and materiality or otherwise of the various information on which they are based. In various countries, the Companies Act provides for the non-disclosure of certain material information.

b) Accuracy and Freedom from Bias

A company’s financial statements should provide a complete and accurate picture of its progress, position, and future. They must therefore be prepared accurately. In addition to causing legal consequences, inaccuracy may also undermine the objectives for which the statements are intended. One may observe, however, that absolute accuracy is not always possible, but this does not imply intentionally providing rash and inaccurate data. The least that can be expected is that those who prepare and present financial statements should not allow their personal biases to bias their work.

c) Comparability

Financial statements are more useful when they can be compared with one another. It is important to compare current statements with previous ones in order to assess the enterprise’s progress and position. Comparing the enterprise with other similar concerns or the industry demonstrates its strengths.

d) Analytical Presentation

To perform a meaningful analysis, the financial statements should be prepared in a classified format. These statements illustrate the importance of proper classification when tracing and understanding the causes of results. Information that is detailed and classified can reveal inefficient performance and wasteful activities. These classifications make it easier to analyze documents more quickly.

e) Promptness

There is no doubt that preparing financial statements can be complicated, but undue delay in their preparation reduces the significance and utility of these statements. As soon as possible after the end of the period for which they are intended, they should be prepared. Due to the time lag between the end of the period and the preparation of these statements, training the causes of the results disclosed in the statements may be difficult. In the long run, these delays and delayed actions may cause more harm than good to an enterprise.

f) Generally Accepted Principles

The financial statements are meant for a wider audience, so they must be widely accepted and easily understood. Generally Accepted Accounting Principles must be followed in order for these statements to be acceptable and understandable. These statements are also more reliable and give users more confidence.

g) Consistency

Financial statements for a certain period are impacted by decisions made by the accountant. Different opinions and procedures may result in materially different statement data. Accounting rules require that once procedures have been selected, they must be strictly followed in subsequent periods, unless the situation otherwise calls for it. Inconsistency affects comparability directly. When inventories are valued differently in different periods (LIFO to FIFO to Replacement Cost), this generates doubt and comparison becomes difficult.

h) Authenticity

The financial statements must be reviewed and authenticated by a qualified and independent third party, commonly known as the auditor, in order to be accepted as reliable. A statement whose audit has been carried out and certified by an established auditor is accepted at face value and regarded as more reliable. Those statements that have not been audited can be questioned.

i) Compliance with Law

The format, contents, disclosures, procedures, and methods of financial statements should comply with any legal requirements. In addition to enforcing penalties, non-compliance with legal provisions undermines investor confidence. The Companies Act, 2013 requires Indian companies to present their financial statements according to Section 129.

Objectives of Financial Statements

Objectives of Financial Statements

In recent years, the number and types of people interested in financial statements have changed dramatically. The financial statements are important for shareholders and potential shareholders as well as for management and creditors. Companies’ financial statements are relevant to the following groups: Suppliers and potential suppliers of funds, i.e., shareholders, debt holders, employees, customers, suppliers of goods and services on credit, tax authorities, etc. Moreover, a number of groups have an indirect interest in these statements, including financial analysts and advisors, stock exchanges, academicians, lawyers, regulatory authorities, trade associations, and labour unions.

A financial statement that contains all the information required by all the parties interested in it is virtually impossible. As a practical matter, one cannot prepare financial statements for different parties interested in them. The preparation of financial statements must be based on a compromise – there will be and can only be one set and it has to be oriented towards the needs of the shareholders, but it must give as much significant and material information as possible for the benefit of other parties, specially those who have to decide on the future of the concern firm, such as debenture holders, institutional lenders, stock exchange holders, etc. The information needs can be grouped under three headings: (i) profit and profitability; (ii) short-term financial position (liquidity); and (iii) long-term financial position. Those interested in a firm naturally want to know how much cash they can expect in the timeframe of their interest.

For example, a shareholder wants to know how much cash dividends his shares will bring as well as how much he can get on the sale of the shares – for the dividend, he needs to know within one year – while a supplier of goods on credit wants to know if it will be paid within a month or two. Having a set of financial statements that meets these broad needs of information is a good idea. The objectives of financial statements can be summarized as follows:

  • To provide reliable financial information about the economic resources and obligations of a business enterprise.
  • To provide reliable information about the net resources (resources less obligations) of an enterprise.
  • To estimate a business’ earning potential by using financial information.
  • To deliver other information relevant to changes in economic resources or obligations.
  • To disclose, to the extent possible, other relevant information about the financial statements that will assist users in understanding them.

A financial statement must be consistent, complete, and fair in order to meet the above objectives and meet the needs of the diverse users. The accountant entrusted with the task of preparing and presenting financial statements must adhere to a set of guidelines in order to ensure these objectives will be met. Generally accepted accounting principles constitute this set of guidelines. The statements prepared without these ‘generally accepted accounting principles’ may be difficult to understand and potentially misleading for the various groups of users. Furthermore, financial statements prepared should also be verified for accuracy and fairness in order to establish the confidence of users. An independent auditor, often referred to as an auditor, is required to review and certify these statements.

Importance of Financial Statements

Importance of Financial Statements

Financial statements present information for different categories of users as follows:

a) The Management

The scope and multiplicity of factors that affect modern business operations demand a scientific and analytical approach to management of such businesses. An organization’s management team can only achieve this when it has access to accurate, up-to-date and systematic financial records. An understanding of the progress, position, and prospects of the business within the industry is greatly aided by financial accounts and statements. The financial statements enable the management to formulate appropriate policies and courses of action for the future by enabling them to know the reasons for the business results. Not only do such financial statements – which are generally published – play a major role in policy-making and planning, but also unpublished subsidiary accounts and statements. This type of information is more detailed, frank, and revealing than financial statements. Management can make appropriate adjustments in policies to avert unfavourable situations by comparing the financial statements to see trends in progress and position. Management communicates their performance and activities to various parties through the release of such financial statements.

b) The Public

Organizations play an important role in society. The progress and prospects of a business enterprise are of interest to many groups of society, even though they are not directly involved with it. The groups include financial analysts, lawyers, trade associations, labour unions, financial journalists, students, and teachers. They can only assess, judge, and comment on a business enterprise based on its published financial statements. In the case of joint stock companies, these financial statements are publicly available. Ownership and partnership statements are not made public or available to the general public in the case of proprietorships or partnerships.

c) The Shareholders and the Lenders

Financial statements provide helpful guidance to the shareholders and probable shareholders, the suppliers, as well as the lenders of a company. These groups can determine how efficient and effective the management is and determine the company’s position, progress, and prospects through a critical examination of the financial statements. The financial statements should contain accurate, complete and systematic information so that these people can get a clear perspective of the company’s current state and future. There have been reports of some managements using “window dressing” in the presentation of financial statements, in order to project a “better” picture than the actual position of the company.

d) The Labour and Trade Unions

Employees in India are entitled to bonuses under the Payment of Bonus Act, based on the size of the profit as disclosed by the audited Statement of Profit & Loss. Therefore, workers place a great deal of importance on the Profit & Loss Statement. Profits and profitability are important factors in wage negotiations as well.

e) The Country and Economy

The rise and growth of joint stock companies has a significant impact on the economic progress of a country. In a significant way, however, unscrupulous acts have an affect on the regional economy and on the people there. By engaging in such fraudulent activities, public confidence in joint stock companies as forerunners of economic progress is impaired, and thus economic progress is retarded. It is necessary to raise the business and financial ethics of promoters and managements, and to provide financial knowledge to the public, so they can understand the true value of a company and avoid being cheated by unscrupulous people. Through the law, companies are compelled to create clear, systematic financial statements and disclose certain minimum information in order to raise the level of business morality. These provisions help increase the confidence of the public in joint stock companies, thereby enabling the country to advance economically more quickly. Developing and underdeveloped countries are particularly affected by these provisions. Capital is scarce and cautious in such countries. Promoter and management misconduct increase scarcity and shyness of capital, thus blocking economic progress. Financial statements provide the opportunity to assess a company’s value critically, protecting the public, increasing their confidence, and assisting faster economic progress.

Financial statements are also useful to various regulatory agencies. By evaluating the financial statements submitted by the companies, they can assess whether the regulations are being followed in word and spirit and whether they are having the desired effect.

Limitations of Financial Statements

Limitations of Financial Statements

The accounting process begins with the recording of transactions, which leads to financial statements. Recording, categorizing, and summarizing business transactions are part of the accounting process. Financial statements are the result of the third process viz. summarising. Certain accounting concepts and conventions are used to prepare the financial statements, but they can’t be said to be foolproof. They include the following limitations:

  • Financial statements are essentially interim reports, and therefore cannot be considered final because the final gain or loss can only be computed at the end of the business. Throughout the life of a business, financial statements can only reflect the progress and position of the business. The period that these statements cover is a matter of personal judgment and it complicates the allocating of expenditures over different periods. Contingent liabilities and deferred revenue expenditures further impair their precision.
  • Financial statements are not absolutely exact, even though they are expressed in exact monetary terms. Asset valuation is neither the realisable value nor the replacement cost on the balance sheet because it is prepared on the basis of a going concern. Furthermore, they rely on the judgement of the management regarding various accounting policies.
  • The values assigned to assets in the statements are determined by who is handling them. Accounting methods such as depreciation, amortization of fixed assets, and deferred revenue expenditures are all determined by the accountant’s personal judgment. His competence and integrity will determine the soundness of this judgement.
  • Financial statements only consider the financial factors. In addition, they fail to emphasize the importance of non-financial factors that may have considerable bearing on an enterprise’s financial results and operating conditions. These include, for example, the public image of the enterprise, the calibre of its management, and the efficiency and loyalty of its employees.
  • Financial statements are not always accurate. When preparing such statements, unscrupulous managements generally resort to window dressing.
  • The primary purpose of financial statements is to benefit investors. It generally takes a lot of adjustments for other interested parties to use them profitably.
  • Many financial statements fail to disclose how much the business is worth today. Only historical information is presented and the true current value of the company is not disclosed.
  • As financial statements are compiled based on historical costs, while the value of the monetary unit falls and prices rise, the balance sheet loses its value as an indicator of current economic conditions. Additionally, the financial statements include both historical and current costs, so the figures are distorted. It can be seen that holding gains and operating gains are added together, there is no differentiation between these two.

Recent Trends in Presenting Financial Statements

Recent Trends in Presenting Financial Statements

With the complexity of statutory forms in the Companies Act, it has become common practice nowadays to add some voluntary supplementary information in the form of a simple balance sheet and statement of profit and loss in a statutory form. Voluntary information includes:

a) Statement of Profit and Loss and Balance Sheet

In accordance with Schedule III to the Companies Act, 2013, every company registered under the Companies Act shall prepare its balance sheet, statement of profit and loss, and notes thereto. Nevertheless, the Schedule III requirements do not apply to companies described in the proviso to Section 129 (1) of the Act, that is, companies engaged in the provision of insurance, banking, or electricity, or in any other class of company for which a specific form of Balance Sheet and Statement of Profit and Loss is prescribed by or under any other Act.

b) Highlights

In most annual reports, highlights are shown at the beginning, so that the user can immediately see the most important facts of the company. The report may include data about sales, production, profit before and after taxes, capital projects, working capital, fixed assets, share capital, important milestones, etc.

c) Cash flow statements

Today, the preparation of cash flow statements has become a necessity. A cash flow statement reports the cash receipts, payments, and changes in cash as a result of operating, investing, and financing activities of an organization during a period. It reconciles the beginning and ending cash balances. For each activity and for the entire company, it displays a net cash inflow or outflow.

d) Provision of important accounting ratios

These ratios provide insight into the inter-relationships between various accounting data. The balance sheet is substantiated by the important ratios of the current year and of the last two years.

e) Disclosure of accounting policies

The accounting policies on which financial statements are prepared are disclosed in the published accounts of progressive companies. The purpose of this is to provide the public with a better understanding of the financial statements.

f) Use of charts, graphs and diagrams

The purpose of this is to provide the public with a better understanding of the financial statements. It is called a graphic presentation of information. This captures the users’ attention more quickly and forcefully. In recent years, graphs and diagrams have become very popular as they are considered to be the most effective media for revealing trends and comparing things within a short time frame. It can be used to represent production costs, fluctuations in output and sales, costs and income components, taxes, dividends, other appropriations, and retained profits, among other things.

g) Use of schedules

Various schedules are prepared for the various heads (e.g. share capital, reserves, surplus, unsecured loans, current liabilities and provisions, fixed assets, investments, current assets, loans and advances, miscellaneous expenditures, etc.) to make them as compact as possible. In accordance with the Companies Act, these schedules give details pertaining to these various heads. Due to space limitations, the balance sheet and Statement of Profit & Loss are combined. The balance sheet and Profit and Loss Statement refer to these schedules, which are properly numbered.

h) Impact of price level changes

Due to the fact that prices change every day, financial statements based on historical costs do not show the effects of price level changes on a company’s financial position or profitability. Nowadays, many companies have started including a supplementary statement in addition to conventional financial statements in order to accommodate the effect of changes in price levels on financial statements.

i) Rounding off of figures

According to the Sachhar Committee, companies must be able to round off the figures on financial statements to the nearest thousand and/or hundred or ten rupees. Companies are now rounding off figures as a result of this recommendation.To emphasize the importance of the digits, financial statements often round the amounts. Rounding results in a more appealing appearance for the financial statements, which in turn makes them more inviting to read. Rounding is important because corporations have to present three years’ worth of figures on their income statements and cash flow statements, and two years’ worth of figures on their balance sheets.

Example: Imagine looking at the income statement with the following sales amounts over the past three years: $1,512,989.63 $1,321,026.98 $1,265,876.22. Round these amounts to the nearest thousand: $1,513 $1,321 $1,265. Round figures make it easier to focus on the relevant digits. We can also more easily assess trends with rounded amounts. To ensure that the reader understands the amounts shown on the financial statement, you should label it with words such as “Amounts rounded to 000’s.”

Due to accountants’ materiality principle or guideline, rounding is acceptable for the less important digits. As long as the rounded amounts will not mislead a current or potential investor, lender, or other person making a decision based on the reported information, rounding is acceptable.

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