Every business organization maintains the proper record of all its transactions during the year in order to keep proper track of its expenses and incomes. At the end of an accounting year, these organizations measure their business performance in terms of profits or losses. Apart from profits or losses, it is also interested in knowing the actual position of its assets and liabilities at the end of an accounting period. Thus, the records maintained by the organizations to ascertain the profits and losses and to assess the financial position of a firm on a particular date are referred to as Financial Statements. The accounting Process ends with the preparation of Financial Statements.
In other words, financial statements reveal the profitability and financial position of a business at the end of the accounting year. It provides financial information to various accounting users that help them in the decision-making and the policy designing process. It should be noted that the financial statements of an organization are prepared on the basis of Trial Balance. The financial statements include mainly the following two statements
- Income Statements or Trading and Profit and Loss Account
- Balance Sheet
Income Statements: These statements are popularly known as Trading and Profit and Loss Account. These statements disclose the financial performance of an enterprise. Trading Account records all the direct incomes and expenses and reveals the gross profit earned or gross loss incurred during a particular period. On the other hand, the Profit and Loss Account records all the indirect incomes and expenses and shows the net profit or loss during the year.
Balance Sheet: This statement discloses the true financial position of an enterprise on a particular date. It reveals the actual position of the assets and liabilities of an organization.
Nature of Financial Statements
The nature of these statements depends upon the following aspects.
Recorded Facts: Financial statements contains only those facts and data that are recorded in the accounting books and the data that is not recorded in the accounting books is excluded (irrespective of whether such facts are significant or not).
Conventions: The preparation of financial statements is based on some accounting conventions such as Prudence Convention, Materiality Convention, Matching Concept, etc. The adherence to such accounting conventions makes financial statements easy to understand, comparable, and reflect the true and fair financial position of an organization.
Accounting Assumptions: The basic accounting assumptions such as Going Concern Assumption, Consistency Assumption, and Accrual Assumption, etc., are known as postulates. While preparing the statements such postulates are adhered to. Therefore, the nature of these postulates is reflected in the nature of the financial statements.
Personal Judgement: Personal value judgment plays an important role in deciding the nature of financial statements. Different judgments are attached to different practices of recording transactions in financial statements. For example, the method of charging depreciation requires personal value judgment (i.e. it entirely depends on the concerned accountant). Some accountants may use the written-down value method of depreciation, while, some may use the original cost method. Similarly, provision on various assets, a period chosen to write-off intangible assets, etc. depend on personal judgment. Thus, personal judgment determines the nature of the financial statements to a great extent.
Purpose or Importance of preparing Financial Statements
The following are the purposes and importance of preparing financial statements.
Determining Profits or Losses: It helps in finding out the profit earned or loss incurred by a business during an accounting period. This is estimated by preparing the Trading and Profit and Loss Account. With the help of the Trading Account gross profit or loss is determined. By using this gross profit or loss in the Profit and Loss Account the net profit earned or net loss incurred during the year is determined.
Determining the Financial Position: These statements exhibit the true financial position of an enterprise for a specific period. This is reflected by the Balance Sheet which records the various assets and liabilities of a firm at its book value.
Enable Comparison: These statements help in comparing the current year’s profits and financial performance with that of the previous years, i.e., intra-firm comparisons. Besides this, it also enables to compare the firm’s own performance with that of the other firms in the same industry, i.e., inter-firm comparisons.
Assessing Solvency and Credit Worthiness: With the help of these statements the solvency, soundness, and creditworthiness of the organizations can be easily determined.
Helps in providing Provisions and Reserves: These statements help to provide various provisions and reserves out of its profits to meet the unforeseen future conditions and to strengthen the financial position of the business.
Provides Information: These statements also provide vital information to facilitate its various users of accounting information in the decision-making process.
Limitations of Financial Statements
Historical Data: The items recorded in the financial statements reflect their original cost i.e. the cost at which they were acquired. Consequently, financial statements do not reveal the current market price of the items. Further, financial statements fail to capture the inflation effects. Thus, it can be concluded that these statements reflect the data and information of historical nature.
Ignorance of Qualitative Aspects: Financial statements do not reveal the qualitative aspects of a transaction. The qualitative aspects such as colour, size, and brand position in the market, employees’ qualities, and capabilities are not disclosed by the financial statements. These statements record only those transactions that are quantitative in nature and can be expressed in monetary terms.
Biased: Financial statements are based on personal judgment regarding the use of methods of recording. For example, the choice of practice in the valuation of inventory, method of depreciation, amount of provisions, etc. is based on the personal value judgments, which may differ from person to person. Thus, these statements reflect the personal value judgments of the concerned accountants and experts.
Inter-firm Comparison: Usually, it is difficult to compare the financial statements of two companies (either in the same business or in different businesses). This is basically because of the difference in the methods and practices followed by them in preparing their respective financial statements.
Window Dressing: The possibility of window dressing is highly probable. This might be because of the motive of the company to overstate or understate its assets and liabilities to attract more investors or to reduce taxable profits. For example, Satyam showed high fixed deposits in the Assets side of its Balance Sheet for better liquidity that gave false and misleading signals to the investors.
Difficulty in Forecasting: Since the financial statements are based on historical data, so they fail to reflect the effect of inflation. This drawback makes forecasting difficult.
Users of Financial Statements
The financial statements provide useful information to its various users such as management, owners, investors, creditors, etc. The users of financial statements can be broadly classified as
- Internal Users: These are the users who have direct access to the financial statements of an organization and who are directly related to the business. For example, owners, management, employees, workers, etc. They require financial information in their decision-making process.
- External Users: These are the users who do not have any direct access to the financial statements of an organization but are interested in knowing the financial position of an organization. They need this information in order to judge the profitability and soundness of the business which helps them in making their investment decision.
The owners, management, employees, and other workers are the internal accounting users who are directly related to a company. The following points describe the different motives of each of the internal users and how financial statements are helpful for each of them.
Owners: The owners are interested in the profit earned or loss incurred during an accounting period. They are interested in assessing the profitability and viability of the capital invested by them in the business. The financial statements prepared by the business concerns enable them to have sufficient information to assess the financial performance and financial health of the business.
Management: Management is an integral part of an organization. They are interested in planning, decision-making process, evaluating past performances, etc. The financial statements enable the management not only in drafting policies, measures, and planning but also inefficient implementation of the plans. With the help of the financial statements, management can not only enhance the efficiency of the business but also exercises various cost controlling measures to remove inefficiencies.
Employees and Other Workers: They are interested in the timely payment of wages and salaries, bonuses, and appropriate increment in their wages and salaries. With the help of the financial statements they can know the amount of profit earned by the company and can demand a reasonable hike in their wages and salaries. The financial statements also help them to assess their individual career scope and their growth prospects.
These are outside users who are interested in the financial affairs of a business. The following points describe the different motives of each of the external users and how financial statements are helpful for each of them.
Banks and other Financial Institutions: Banks provide finance in the form of loans and advances to various businesses. Thus, they need information regarding liquidity, creditworthiness, solvency, and profitability to advance loans. The financial statements enable the banks and other financial institutions to access such information
Creditors: These are those individuals and organizations to whom a business owes money on account of credit purchases of goods and services. Hence, the creditors require information about the creditworthiness and liquidity position of the business.
Investors and Potential Investors: These are the parties who have invested or who are planning to invest in the business of an enterprise. Hence, in order to assess the viability and prospects of their investments, they need information about the profitability and solvency position of the business.
Tax Authorities: They are interested in knowing whether the number of sales, production, profits, revenues, etc. are correctly calculated and shown unambiguously in the books. This is very important so that appropriate and correct tax rates (of taxes such as sales tax, excise duty, etc.) are levied on the business. These authorities also evaluate whether the financial statements have been prepared in accordance with the legal provisions or not.
Government: It needs information to determine various macro-economic variables such as national income, GDP, industrial growth, etc. The accounting information assists the government in the formulation of various policies measures and to address various economic problems such as unemployment, poverty, etc.
Researchers: Various government, non-government research institutes, and other independent research institutions such as CRISIL, Stock Exchanges, etc. undertake various types of research projects. Correct information provided by the financial statements acts as an input for these research works and makes the research authenticate.
Consumers: Every business tries to build up a reputation in the eyes of consumers, which can be created only by supplying better quality products and post-sale services at reasonable and affordable prices. The business that has transparent financial records, assists the customers to know the correct cost of production and accordingly assess the degree of reasonability of the price charged by the business for its products. Thus, the unambiguous and transparent financial statements help in the repo-building of the business.
Public: The public is keenly interested to know the portion of the profit that a business spends on various public welfare schemes; for example, charitable hospitals, funding schools, etc. Such type of information revealed by the financial statements helps in promoting the reputation and goodwill of an organization.
Revenue Income: Revenue incomes are those incomes that are earned in the conduct of ordinary and day-to-day business activities.
Capital incomes are those incomes that do not arise in the normal course of business operations. Such incomes arise from the capital itself, without involving any production work. For example, the premium received from the issue of shares or debentures.
The capital loss is made good or settled against the capital profits. In case the amount of capital losses is more than the capital profit, then the excess amount is shown on the Assets side
Sole Proprietorship Meaning: Sole Proprietorship is a situation where only a single person manages the affairs of the whole business.
A promissory note is an unconditional promise in writing given by the buyer (or creditor) to the seller (or debtor) to pay the amount of money specified therein to the seller or to the order of seller or to bearer.
Meaning of Bill of Exchange: A Bill of Exchange is something that reduces our credit risk, Let’s understand this concept better with the help of an example