22 Financial Statements: Meaning, Nature and Types of Financial Statements

Deepika Gautam

LEARNING OBJECTIVES:

By studying this module students will be able to gain clarity on the financial statements and assist in decision making. In addition to this, financial statements are the sources of information on the basis of which conclusion are drawn about the profitability and financial position of a concern and on the basis of which decision are taken. The students will also be able to understand the general guidelines in preparing the financial statements which is useful for investors, creditors, owners and general public.

INTRODUCTION:

Accounting is the process of identifying, measuring and communicating economic information to permit informed judgments and decisions by users of the information. It involves recording, classifying and summarising various business transactions. The end products of business transactions are the financial statements comprising primarily the position statement or the balance sheet and the income statement or the profit and loss account. These statements are the outcome of summarising process of accounting and are therefore the sources of information on the basis of which conclusions are drawn about the profitability and the financial position of a concern. Financial statements are the basis for decision making by the management as well as all other outsides who are interested in the affairs of the firm such as investors, creditors, customers, suppliers, financial institutions, employees, potential investors, government and general public. The analysis and interpretation of financial statements depend upon the nature and type of information available in these statements.

OBJECTIVES OF FINANCIAL STATEMENTS:

Financial statements are the sources of information on the basis of which conclusions are drawn about the profitability and financial position of a concern. They are the major means employed by firms to present their financial situation of owners, creditors, and the general public. The primary objective of financial statements is to assist in decision making. The accounting principles Board of America states the following objectives of financial statements:

(i)  To provide reliable financial information about changes in such economic resources and obligations of a business firm.

(ii)  To provide other needed information about changes in such economic resources and obligations.

(iii)  To provide reliable information about changes in bet resources and obligations of a business activities.

(iv)  To provide financial information that assists in estimating the earning potentials of business

(v) 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.

MEANING OF FINANCIAL STATEMENTS:

Financial statements are the depiction of the financial position of a business firm. The financial statements are prepared by the business firm. Thus, the term “financial statements” generally refers to two statements .(i) the position statement or the balance sheet (ii) income statement or the profit and loss account. These statements are prepared by the business firm (a) to communicate with different

parties about the financial position of the business firm. (These other parties who are the user (have a interest) of financial information like shareholders, creditors, banks, financial institutions, financial analysts, investor and government etc.) and (b) to analyse the operations and performance of the firm for further planning.

Authors View

“Financial statements are prepared for the purpose of presenting a periodical review or report by the management and deal with the status of the investment in the business and the results achieved during the period under review.”

-American Institute of Certified Public Accounts

NATURE OF FINANCIAL STATEMENTS:

The financial statements are prepared on the basis of recorded facts. The recorded facts are those which can be expressed in monetary terms. The financial statements, by nature, are summaries of the items recorded in the business and these statements are prepared periodically generally for the accounting period.

The following points explain the nature of financial statements:

1. Recorded facts: The term „recorded facts‟ refers to the data taken out from the accounting records. The records are maintained on the basis of actual cost data. The original cost or historical cost is the basis of recording various transactions. The figures of various accounts such as cash in hand, cash in bank, bills receivable, sundry debtors, and fixed assets etc., as per the figures recorded in the accounting books.

2. Accounting conventions: certain accounting conventions are followed while preparing financial statements. The convention of valuing inventory at cost or market price, whichever is lower, is followed. The valuing of assets at cost less depreciation principal for balance sheet purpose is followed. The convention of materiality is followed in dealing with small items like pencils, pens, postage stamps, etc.

3. Postulates: The accountant makes certain assumptions while making accounting records. One of these assumptions is that the enterprise is treated as a going concern. The other alternative to this postulate is that the concern is to be liquidated, this, is untenable if management shows an intention to liquidate the concern. So the assets are shown on a going concern basis. Another important assumption is to presume that the value of money will remain the same in different periods. Though there is a drastic change in purchasing power of money the assets purchased at different times will be shown at the amount paid for them.

4. Personal judgements: even though certain standard accounting conventions are followed in preparing financial statements but still personal judgement of the accountant plays an important part. For example, in applying the cost or market value whichever is less to inventory valuation the accountant will have to use his judgement in computing the cost in a particular case. There are number of methods for valuing stock, viz; last in first out, first in first out, average cost method, standard cost, base stock method etc.

QUICK REVISION

·         Financial accounts provide a summary of assets.

·         Financial statements are recorded facts.

·         Retained earnings statement depicts appropriation of profits

·         A company is required to prepare publish its accounts every year

·         Certain assumptions are necessary to prepare financial statements.

TYPES OF FINANCIAL STATEMENTS:

Financial statements primarily comprise two basic statements.(i) the position statements or the balance sheet; and (ii) the income statement or profit and loss account however, generally accepted accounting principles (GAAP) specify that a complete set of financial statements must include:

(i)    A balance sheet

(ii)   An income statement

(iii)  A statement of changes in owner‟s accounts, and

(iv)    A statement of changes in financial position

(i) Balance sheet: The balance sheet is one of the important statements depicts the screen picture of financial position of a going business at certain moment.” It shows on the one hand the properties that it utilises and on the other hand the sources of those properties. The balance sheet shows all the assets owned by the concern and all the liabilities and claims it owes to owners and outsiders. The balance sheet is prepared on a particular date. The right hand side shows properties and assets.

There are no specific forms for the perception of balance sheet in the case proprietary concerns and partnership firms. The balance sheet is divided into three parts, i.e, assets, liabilities and capital. Table:1 presents the Performa of the balance sheet of a company as per schedule VI of Indian companies Act,1956.

Horizontal form of balance sheet

Balance sheet of ————

as on ————-

Liabilities	Amount	Assets	Amount
Share capital		All fixed assets
Reserve and surplus		Less : depreciation
Debentures		Investment
Current liabilities		All current assets

Explanation of balance sheet items:

Share capital: The share capital is shown as a first item on the liabilities side of the balance sheet. Authorised and issued capital is shown giving the number of shares and their amount. The number of shares for which public has applied are mentioned along with the type of capital i.e. preference share capital, equity share capital. If the capital is issued for other than cash, the amount of such capital is mentioned.

Reserves and surplus: under this heading all those reserves which have been created out of undistributed profits are shown. Capital reserves are classified as capital reserves and revenue reserves. Capital reserves are those reserves which are not free for distribution as profits whereas revenue reserves are created out of appropriations of profits. It includes (a) capital reserves (b) capital redemption reserve (c) share premium account (d) other reserves (e) surplus.

Secured loans: all those loans against which securities are given are shown under this category.

Debentures are shown under this heading. Loans and advances banks, subsidiary companies etc.

should also be mentioned.

Unsecured loans: these are the loans and advances against which the company has not given any security. The items included here are deposits, loans and advances from subsidiary companies, loans and advances from subsidiary companies from other sources. Short term loans include those which are due for not not more than one year on the date of the balance sheet. As regards loans from directors, managers, etc. these should be shown separately under different sub-headings

Current liabilities and provisions: current liabilities include acceptances, sundry creditors, subsidiary companies, advance payments and unexpired discounts, unclaimed dividends and other liabilities etc. provisions include provision for taxation, proposed dividends, provision for contingencies, provision for provident fund schemes and other provision.

Assets side:

1.      Fixed assets: Fixed assets are those which are purchased for use over a long period. These assets are meant to increase production capacity of the business. They are not acquired for sale but are used for a considerable period of time. The balance sheet is prepared depicts true financial position of the business. Fixed assets are shown distinctly from each other, e.g., goodwill, land buildings, leaseholds, plant and machinery etc.

2.      Investments: Investments are shown by giving their nature and mode of valuation. Investments under various sub-heads such as investments in government or trust securities, in shares, debentures, bonds and in immovable properties are given separately in the inner column of the balance sheet.

4. Current assets: current assets are such assets as in the ordinary and natural course of business move onward through the various processes of production, distribution and payment of goods, until they become cash or its equivalent by which debts may be readily and immediately paid.
5. Miscellaneous expenditure: we show deferred expenditure under this heading. These are the expenses which are not debited fully to the profit and loss account of the year which they have been incurred. These expenses are spread over a number of years and the unwritten balance is shown in the balance sheet.

• (ii) Income statement or profit and loss account: income statement is prepared to determine the operational position of the concern; it is a statement of revenues earned and the expenses incurred for earning that revenue. If there is excess of revenue over expenditure it will show a profit and if the expenditure are more than the income then there will be a loss. The income statement is prepared for the particular period, generally a year. The income statement is prepared for the year ending on 31st December 1999 then all revenues and expenditure falling due in that year will be taken into account irrespective of their receipt or payment.

• The income statement is prepared according to the nature of the business. A trading concern will prepare trading and profit and loss account for finding out gross profit and net profit respectively. In the case of sole proprietorship and partnership concerns there are no prescribed forms for income statement. The preparation of this statement is not compulsory but desirable. In case of Joint Stock Company it is compulsory to make income statement.

• (iii) Statement of changes in owners’ equity (or retained earnings): the owner equity refers to the claims of the owners of the business (shareholders) against the assets of the firm. it consists of two elements (i) paid up share capital i,e. that is initial amount of funds invested by the shareholders and (ii) retained earnings/reserves and surplus representing undistributed profits. The surplus of changes in owner‟s equity simply shows the beginning balance of each owner‟ s equity account, the reasons for increases and decreases in each and its ending balance. A statement of retained earnings is also known as profit and loss appropriation account or income disposal statement. As the name suggests it shows appropriations of earnings.

Profit and loss appropriation account

Joint stock companies prepare profit and loss appropriation account also. This account is known as retained earnings account also. This account is prepared to show the profit of the company have been used of appropriated, the form of this account is given as follows:

• (iv) Statement of changes in financial position: The statement of changes in financial position, refer to as the funds flow statement (either working capital basis or the cash basis), provides information about the flow of fund during a particular period. It also provides information about the financial and investing activities of a firm. Thus, it is a financial statement that explains the cause of change in the financial position from the beginning of the period to the end of the period. The statement of changes in financial

position may take any of the following two forms:

• (a) Funds flow statements: the funds flow statement is desined to analyse the changes in the financial condition of a business enterprise between two periods. The word „fund‟ is used to denote working capital. This statement will show the sources from which the funds are received and the uses to which these have been put. This statement helps the management in policy formulation and performance appraisal.

• (b) Cash flow statement: a statement of changes in the financial position of a firm on cash basis is called cash flow statement. Its summarises the causes of changes in cash position of a business enterprise between dates of two balances sheets. This statement is very much

SUMMARY:

Financial statements are the basis for decision making by the management as well as all other outsides who are interested in the affairs of the firm such as investors, creditors, customers, suppliers, financial institutions, employees, potential investors, government and general public. The analysis and interpretation of financial statements depend upon the nature and type of information available in these statements. The financial statements, by nature, are summaries of the items recorded in the business and these statements are prepared periodically generally for the accounting period. Financial statements primarily comprise two basic statements.(i) the position statements or the balance sheet; and (ii) the income statement or profit and loss account however, generally accepted accounting principles (GAAP) specify that a complete set of financial statements must include: (i) a balance sheet, an income statement, a statement of changes in owner‟s accounts, and a statement of changes in financial position. . Income statement is prepared to determine the operational position of the concern; it is a statement of revenues earned and the expenses incurred for earning that revenue. If there is excess of revenue over expenditure it will show a profit and if the expenditure are more than the income then there will be a loss. A statement of retained earnings is also known as profit and loss appropriation account or income disposal statement. As the name suggests it shows appropriations of earnings. The statement of changes in financial position, refer to as the funds flow statement (either working capital basis or the cash basis), provides information about the flow of fund during a particular period. It also provides information about the financial and investing activities of a firm.

Few suggested reading to learn:

·         Shashi K Gupta,R.K,Sharma(2005), “Management Accounting”, Kalyani Publishers,New Delhi

·         Tulsian . P.C (2014) “Financial Accounting” Pearson Education India.

·         Lal, Jawahar and Seema Srivastava (2004) “Financial Accounting” S.Chand (G/L) & Company Ltd.

·         Goyal, V.K. and Ruchi Goyal (2012) “Financial Accounting” PHI.

·         Maheshwari, S.N., Suneel K Maheshwari and Sharad K Maheshwari(2012) “Financial Accounting” Vikas Publishing House Pvt Ltd.

·         Monga, J.R. “Avanced Financial Accounting” Mayoor Paperbacks.

·      Bhattacharyya Asish K., (2012)” Essentials of Financial Accounting” PHI.

·         A Students Guide to IFRS (2012), Kaplan Publishing.

Points to Ponder

• Accounting is the process of identifying, measuring and communicating economic information to permit informed judgments and decisions by users of the information.
• Financial statements are interim reports and provide a summary of assets.
• The preparation of financial statements is not an end aim
• Financial statements provide reliable information about changes in bet resources and obligations of a business activities.
• A company is required to publish its accounts every year
• Certain assumptions are necessary to prepare financial statements
• The owner equity refers to the claims of the owners of the business (shareholders) against the assets of the firm