FINANCIAL STATEMENTS OF A COMPANY
The financial statements of a company are the end-products of financial accounting. These are prepared for the purpose of presenting a periodical review or report on the progress made by the management. Balance Sheet and Profit and Loss Account are the two most important elements of financial statements. Balance Sheet is prepared in order to know the financial position of the business on a particular date, whereas the Profit and Loss accounts or Income Statement shows the results of the business operations during the year.
Hence, the financial statements-Balance Sheet and Income statement are prepared mainly to know the state of economic affairs and operating results of any concern. In case of sole proprietorship and partnership firm, the preparation and publication of financial statement is not compulsory. But in case of joint stock companies they are required, under law to maintain the records of their transactions and publish the statements for the information of the investors, creditors and others.
Financial statements may refer to any formal and original statements which disclose financial information relating to any business concern. These are the outcome of summarising process of accounting. The financial statements are also called as financial reports.
According to Himpton Johar
“A financial statement is an organised collection of data according to logical consistent accounting procedures.”
According to Anthony
Financial statements, essentially, are interim reports, presented annually and reflect a division of the life of an enterprise into more or less arbitrary accounting period-frequently a year.”
According to W.B. Meig
“Financial statement thus, are organised summaries of detailed information and are thus a form of analysis. The type of statements accountants prepare, the way they arrange items on these statements and their standards of disclosure are all influenced by a desire to provide information in a convenient way.”
According to Myers
“Financial statement analysis is largely a study of relationship among the various financial factors in a business as disclosed by a single set of statements and a study of the trends of these factors as shown in series of statements.”
Thus, the above definitions of financial statements indicate that these are prepared to provide a rich information about the operational results of a business unit and much can be learnt from a careful examination of these statements. On the basis of the information provided in the financial statements, management, investors and creditors make a review of the progress of the company and decide about the future course of action.
NATURE OF FINANCIAL STATEMENTS
Financial statements are the end-product of accounting system. Monetary transactions and events are the inputs, recording, classifying and summarizing are the processes and financial statements are the output of the accounting system, According to the American Institute of Certified Public Accountants (AICPA) Financial statements “reflect a combination of recorded facts, accounting conventions and personal judgements.
This implies that data exhibited in the financial statements are affected by recorded facts, accounting conventions and personal judgements.
The following features shall help in explaining the nature of financial statements:
1. Preparation of reports: Financial statements are the reports produced by accounting system and got prepared by the management depicting the true and fair view of the state of affairs of the entity for the period under review.
2. Summarised reports: Financial statements are summarised reports. Details are shown in various schedules, notes etc., appended thereto.
3. Preparation at the end of the year: Financial statements are prepared, usually at the end of the accounting period, generally, one year so that various parties may take decisions of their future actions in respect of their relationship with the business.
4. Recorded Facts: Financial statements are based on recorded facts. The term recorded facts means facts which have been recorded in the accounting books. Facts which have not been recorded in the financial books are not depicted in the financial statements, however material they might be. For example cash in hand, cash at bank, sundry debtors, sundry creditors etc. are shown in the balance sheet at values shown by respective ledger accounts. But fixed assets are shown at cost irrespective of their market or replacement price since such price is not recorded in the books.
5. Preparation as per accounting conventions: Financial statements are prepared as per accounting conventions practices and as per generally accepted accounting principles. Accounting conventions are those financial accounting principles whose application has been sanctioned by long usage and, almost, universal acceptance. For example, the convention of conservatism is responsible for accounting practice anticipate no profit but provide for all possible losses.” This means that real financial position of the business may be much better than what has been shown by financial statements. This explains why stock is valued at cost price or market price whichever is lower.
6. Influenced by Personal judgements: Financial statements are influenced by the personal judgements of the policy-makers. For example issues like, selection of the method of pricing out issue of materials, method of depreciation, writing off of intangible assets are decided as per the personal judgement of the person who matters.
QUALITIES (ATTRIBUTES) OF FINANCIAL STATEMENTS/ CHARACTERISTICS OF IDEAL FINANCIAL STATEMENT
Financial statements if they are to serve meaningfully the purpose and objectives for which they are meant then should possess following qualities or attributes:
- Understandability: Information provided by the financial statements should be understood by those who have a reasonable understanding of the business and economic activities and are willing to study the information with reasonable diligence.
- Relevance: Information should be relevant i.e. logically related to decision. It must be Capable of making a difference in a decision by helping users to form predictions about the outcome of past, present and future events or to confirm or correct expectations.
- Reliability: Reliability is the faithfulness of the information with which it represents what it purports to represent and the assurance to the user that it is representational. Information is reliable to the extent users can depend upon it.
- Timeliness: Timeliness means having information available to decision makers before it looses its Capacity to influence decision.
- Verifiability: Verifiability contributes to the usefulness of financial statements because the purpose of Verification is to provide assurance that accounting measurement represent what they purport to represent. Verifiability minimizes bins of the measurer and its lends credibility to the valuations made in the financial statements.
- Comparability: Information about an enterprise becomes more useful if it can be compared with similar information about other enterprises and with similar information about the same enterprise for some other period.
- Analytical presentation: The financial statements should be prepared in a classified Form so that a better and meaningful analysis can be made. Proper classification helps in tracing and understanding the cause of the results as shown in these statements.
- Authenticity: Financial statements shall be accepted as reliable if reviewed and authenticated by an independent and capable person known as auditor. Statements duly audited and certified are deemed to be authentic.
- Compliance with law: Financial statements must meet the requirements of law in the matter of form, content and disclosures, procedures and methods. Non compliance with the legal provisions attracts penal action and confidence of the public and investors is also lost.
- Accuracy and freedom from bias: Financial statements should convey full and correct Idea about the progress, position and prospects of an enterprise. For this purpose, these must be Accurately prepared. Moreover, the persons responsible for preparing these statements must not Allow their personal prejudices to colour the facts.
- Promptness: Financial statements should be prepared as soon as possible, after the end Of the period to which they relate otherwise the information shall be out-dated and will loose much of its value.
- Confirm to generally accepted principles: Financial statements should have wider Acceptability. Acceptability is achieved only if the statements are prepared in accordance with the generally accepted accounting principles.
- Consistency: Accounting policies followed should remain, the same over the years to Render comparability meaningful.
USERS OF FINANCIAL STATEMENTS
Financial statements constitute valuable piece of information to various users in different ways. Their importance to the following user-groups may be stated as follows:
1. Management: Management is interested in knowing the existing profits, earnings per share, chances of survival, possibility of growth and diversification, relative performance, cost information etc.. from the financial statements so that it can chalk out suitable strategy for its entity.
2. Managers: Managers (as a professional class) are interested in knowing the social image, chances of promotion and the capacity of the entity to compensate them. For this they want to know Profitability and chances of growth of the company.
3. Employees: Employees are interested in job satisfaction, job security, promotion avenues, bonus declarations, employee’s welfare schemes etc. Of their unit. So they want information on Profitability and future prospects of the company.
4. Creditors: Creditors are interested in knowing entity’s capability to repay the amount and interest As and when repayment becomes due. So, they are interested in finding out profitability, flows etc. Of the entity.
5. Bankers: Bankers and other financial institutions are interested in the security of the loan, Cash Advanced, entity’s capacity to repay the principal interest as per terms. So, institutional lenders shall find out profitability, cash in flows, total commitment of the borrower, future prospects etc.
6. Government: Government is interested in levying taxes on revenue, in regulating legal compliance, in knowing employment generated, in contribution of the entity towards national policies such as employee welfare, regional development, pollution control, import substitution etc. So the relevant information is sought to be collected by the government from financial statements and Reports.
7. Customers: Customers are interested in new product research, product safety and socially responsible policies of the entity. Information is sought to be collected from financial statements and accompanying reports.
8. Society: Society is interested in economic progress of the country as a whole. This in turn depends upon the performance of individual economic entities, Society attempts to raise the level of business morality by compelling the entities to draw financial statements according to law and to disclose relevant information. Financial statements enable critical analysis of the real worth of an entity and thus protect innocent public from the malpractices of promoters or management.
9. Potential Investors: The potential investors are keen to know the earning potential of the business. They want to know how safe the investment already made is and how safe the Proposed investment will be.
10. Research scholars: The financial statements being a mirror of the financial position of a firm are of immense value to the research scholar who wants to make a study into financial operations of a particular firm.
11. Shareholders: Shareholders or proprietors of the business are interested in the well being of the business. They are likely to know the earning capacity of the business and its prospects of future growth. Since they are not involved in the day to day working, they come to know the results of operations and financial position of the business only through financial Statements.
12. Debenture holders: Debenture holders are interested to know whether the financial position of the company is sound or not. They are interested to know this on two accounts only
(a) to know whether the company will be able to pay the interest when due or not and
(b) to know Whether the company will be able to redeem the debentures when due or not.
13. Taxation authorities: Income tax authorities are interested in knowing the profits of the business so that income tax can be imposed thereon. Similarly, sales tax is interested in the sales and excise authorities in the production of goods. Financial statements help them a great Deal in determining the taxes payable.
LIMITATIONS OF FINANCIAL STATEMENTS
Most people believe that financial statements are precise and authentic. This belief is Strengthened by the certificate given by the auditor “…true and fair view of the state of affair..” of late financial statements have attracted lot of criticism.
It shall be useful for the analyst to be aware of the limitations from which financial statements suffer:
- Records only monetary facts: Financial statements disclose only monetary facts i.e. those transactions are recorded in the books of accounts which can be measured in monetary terms. Those transactions which cannot be measured in monetary terms such as conflict between production manager and marketing manager may be very important for a business concern but not recorded in the business books.
- Financial statements are historical in nature: Financial statements are prepared from the accounting records relating to the period which is already over. Naturally, they disclose the post results and the position of the entity of the past. Such information can help us in conducting the post morterm and are not likely to be of much help in planning and forecasting.
- Financial statements are only interim reports: Financial statements are popularly Known as “final accounts” but it is a misnomer. Results and position disclosed is only interim because these statements have been prepared on “accounting period concept”. Final results can’t be known until the life of the entity is over. Necessity to prepare the statements for shorter period (say one year) creates problems of matching revenues with costs, determination of unexpired portion of expenses and income etc. Also, existence of contingent assets, liabilities and deferred revenue expenses render the information less accurate and more subjective.
- Financial statements are influenced by accounting concepts etc.: Preparation of financial statements is based on basic accounting concepts, conventions etc. In some cases, it results in unrealistic information. For example, “going concern concept” is responsible for showing assets at cost less depreciation. It is known as “written down value” or “book value”. This value neither represents the realisable value nor replacement value. On account of the convention of conservatism the income statement may not disclose true income of the business since probable losses are considered while probable incomes are ignored.
- Financial statements are influenced by personal judgement: Accounting is based on “generally accepted accounting principles.” (GAAP). On many issues more than one method is permitted by GAAP. For example, method of depreciation, mode of amortization, treatment of deferred expenses, valuation of stock, valuation of goodwill etc., all depend upon the personal judgement of the policy maker of the unit. Following different method affects the ascertainment of profit. This creates suspicion in the minds of outsiders. Credibility of accounting has also suffered. However, the convention of consistency acts as a controlling factor on making indiscreet Personal judgements.
- Financial statements do not make use of standardized terminology: Even to-day financial statements have not achieved uniform terminology. For example, “cash in hand” is the item appearing as an asset in the balance sheet. Whether it is actual cash in the office or it includes temporary I.O.Us also or still it may include stock of postage as well. Similarly, ‘cash at bank’ may represent balance shown by cash book or by pass book or as per corrected cash book.
- Financial statements fail to disclose adequate information: Accounting information Is of interest to various parties such as owners, managers, shareholders, creditors, prospective Investors, employees, government agencies, consumers, financial press and researchers. Different parties use financial statements to take decisions from their respective view point. Different parties have different view points hence need information in different context. Present Day financial statements do not satisfy the needs of various users.
- Financial statements ignore the effect of changing prices: Traditional accounting is based on “stable monetary unit concept”. In accounting we presume that the purchasing power of monetary unit always remains constant. In present times of inflation this is unreal. Ignoring price-level changes has rendered financial statements unrealistic and unbelievable. Some attempts are now being made to improve the situation.
- Scope of manipulations: These statements are sometimes prepared according to the needs of the situation or the whims of the management. A highly efficient concern may conceal its real profitability by disclosing loss or minimum profit where as an inefficient concern may declare dividend by wrongly showing profit in the profit and loss account. For this under or over valuation of inventory, over or under depreciation, excessive or inadequate provision for anticipated losses and other such manipulation may be resorted to. Window dressing may also be resorted to in order to show better financial position of a concern than its real position.
- Financial statements fail to signify non-financial factors: These statements are based on financial factors only. It is quite likely that non-financial factors having considerable bearing on the operating results and financial position of an enterprise are ignored. For example, the public image of an enterprise, the calibre of management, efficiency and loyalty of the workers etc.
- Financial statements are prepared primarily for shareholders: Other parties interested in the information like creditors, investors: employees etc. Have to make adjustments before they can make use of these statements.