23 Significance of Financial Statements to different parties and limitations of Financial Statements

Deepika Gautam

LEARNING OBJECTIVES:

Basically, Financial statements are organised summaries of detailed information about the financial position and performance of an enterprise. Traditionally the term Financial Statement ids used to denote only two basic statements. The information contained in these statements is used by the management, present and potential investors, lenders, short-term creditors, employees, customers and their agencies to satisfy some of their different needs for information. Financial statements are prepared primarily for decision-making. They play a dominant role in setting up framework of managerial decisions. These decisions are very important to all parties’ concern weather it is investors, creditors, bankers, government, trade associations and stock exchange. The utility of these statements is dependent upon a number of factors. The financial statement suffers from various limitations.

CHARACTERTICS OF IDEAL FINANCIAL STATEMENTS:

1.      Depicts true financial position: The information contained in the financial statements should be such that a true and correct idea is taken about the financial position of the concern. No material information should be withheld while preparing these statements.

2.      Effective presentation: The financial statements should be presented in a simple and lucid way so to make them easily understandable. A person who is not well versed with accounting terminology should also be able to understand the statements without much difficulty. These characteristics will enhance the utility of these statements.

3.      Relevance: Financial statements should be relevant to the objectives of the enterprise. This will be able when the person preparing these statements is able to properly utilise the accounting information. The information which is not relevant to the statements should be avoided; otherwise it will be difficult to make a distinction between relevant and irrelevant data.

4.      Attractive: Financial statements should be prepared in such a way that important information is underlined so that it attracts the eye of the reader.

   5.      Easiness: financial statements should be easily prepared. The balance of different ledger accounts should be easily taken to these statements. The calculation work should be minimum possible while preparing these statements. The size of the statements should not be very largely the columns to be used for giving the formation should also be less. This will enable the saving of time in preparing the statements.

6.      Comparability: the results of financial analysis should be in a way that can be compared to the various years statements, the statement can also be compared with the figures of other concerns of the same nature. Sometimes budgeted figures are given along with compared either the figures of other concerns of the same future, sometimes budgeted figures are given along with the present figures. The comparable figures will make the statements more useful. The Indian companies’ act 1956 has made it obligatory to give previous year’s figures into the balance sheet. The comparison of figures will enable a proper assessment for the working of the concern.

7.      Brief: if possible, the financial statements should be presented in brief. The reader will be able to form the idea about the figures. On the other hand, if figures are given in details then it will become difficult to judge the working of the business.

8.      Analytical representation: the information should be analysed in such a way that similar data is presented at the same place. A relationship can be established in similar type of information. This will be helpful for analysis and interpretation of data.

9.      Promptness: The financial statements should be prepared and presented at the earlier possible immediately at the close of the financial year, statements should be ready.

Elements of Financial Statements:

The elements directly related to the measurement of financial position are assets, liabilities and equity. The elements directly related to the measurement of profit are income and expenses. The various elements of Financial Statements are discussed as follows:

1.      Asset: It is a resource controlled by the enterprise as a result of past events and from which future economic benefits are expected to flow to the enterprise. An enterprise usually employs its assets to produce goods or services capable of satisfying the wants or needs of customers.

2.      Liability: It is a present obligation of the enterprise arising from past events. The settlement of which is expected to result in an outflow from the enterprise of resources embodying economic benefits. An important characteristic of a liability is that the enterprise has a present obligation. An obligation is a duty to act or perform in a certain way and it may be legally enforceable as a consequence of a binding contract or statutory requirement.

3.      Equity: It is a residual interest in the assets of the enterprise after deducting its liabilities. In a corporate enterprise equity is suitably sub-classified in the balance sheet. Under each head further details are provided.

4.      Income: It is increase in economic benefits during the accounting period in the form of inflows or enhancement of assets or decrease of liabilities that result in increase in equity, other than those relating to contribution from equity participants. It also includes unrealised gains.

5.      Expenses: Expenses are decrease in economic benefits during the accounting period in the form of outlook or depletions of assets or incurrence’s in liabilities that result in decrease in equities other than those relating to distribution to equity participants.

Measurement of the Elements of Financial Statements:

It is the process of determining the monetary amounts at which the elements of the financial statements are to be recognised and carried in the balance sheet and income statements. A number of different measurement bases are employment to different degrees and in varying combinations in financial statements. They include the following:

1.      Historic Cost: Assets are recorded at the amount of cash or cash equivalents paid or the fair value of the consideration given to acquire them at the time of their acquisition and liabilities are recorded at the amount of proceeds received in exchange for the obligation.

2.      Current Cost: Assets are carried at the amount of cash or cash equivalent that would have to be paid if the same or equivalent assets were acquired currently.

3.      Realisable Value: Assets are carried at the amount of cash or cash equivalent that could currently be obtained by selling the assets in an orderly disposal.

  4.      Present value: Assets are carried at the present discounted value of the future net cash inflows that the firm is expected to generate in the normal course of business.

SIGNIFICANCE OF FINANCIAL STATEMENTS TO DIFFERENT PARTIES:

The financial statements are mirror which reflects the financial position and operating strength or weakness of the concern. These statements are useful to management, investors, creditors, bankers, workers, government and public at large.

The utility of financial statements to different parties is discussed in detail as follows:

1.      Management: The financial statements are useful for assessing the efficiency for different cost centres. The management is able to exercise cost control through these statements; the efficient and inefficient spots are brought to the notice of the management. The management is able to decide the course of action to be adopted in future.

2.      Long-term Creditors (For Example, Supplier of long-term loans): The trade creditors are to be paid in a short period. This liability is met out of current assets. The creditors will be interested in current solvency of the concern. The calculation of current ratio and liquid ratio will enable the creditors to assess the current financial position of the concern in relation to their debts.

3.      Bankers: The banker is interested to see that the loan amount is secure and the customer is also able to pay the interest regularly. The banker will analyse the balance sheet to determine financial strength of the concern and profit and loss account will also be studied to find out the earning position. A banker has a large number of customers and it is not possible to supervise their business activities. It is through the financial statements that a banker can keep a watch on the business plans and performances of its customers. These statements also help the banker to determine the amount of securities it will ask from the customers as a cover for the loans.

4.      Present Investors (For Example, equity shareholder): The investors include both short–term and long term investors. They are interested in the security of the principal amount of loan and regular interest payments by the concern. The investors resolve study the long–term solvency of the concern with the help of financial statements. The investors will not merely analyse the present financial position but will also study future prospects and expansion plans of the concern. The possibility of paying back the loan amount in the face of liquidation of the concern is also taken into consideration. In simple words present investors need information to judge prospects for their investment and to determine whether they should buy, hold or sell the shares.

5. Government: The financial statements are used to assess tax liability of business enterprises. The government studies economic situations of the country form these statements. These statements enable the government to find out whether business is following various rules and regulations or not. These statements also become a base for framing and amending various laws for the regulation of business.
6. Trade associations: Trade associations provide service and protection to the members, they may analyse the financial statements for the purpose of providing facilities to these members. They may develop standard ratios and design uniform system of accounts.
7. Stock exchange: The stock exchange deal in purchase and sale of securities of dissimilar companies. The financial statements facilitate the stock brokers to judge the financial position of different concern. The fixation of prices for securities etc. is also based on these statements.
8. Tax Authorities: Tax authorities need information to assess the tax liability of enterprise.
9. Public: Enterprise affects members of the public in a variety of ways. For example, enterprise may make a substantial contribution to the local economy in many ways including the number of people, they employ and their patronage of local suppliers. While all the information needs of these users cannot be made by financial statements, there are some needs of the investors or provider of risk capital will also meet most of the needs of the public.

Quick Revision:

Ø  Financial statements are prepared primarily for decision-making. They play a dominant role in setting up framework of managerial decisions

Ø  The financial statements should be presented in a simple and lucid way so to make them easily understandable.

Ø  Financial statements should be prepared in such a way that important information is underlined so that it attracts the eye of the reader.

Ø  It is the process of determining the monetary amounts at which the elements of the financial statements are to be recognised and carried in the balance sheet and income statements.

Ø  Trade associations provide service and protection to the members, they may analyse the financial statements for the purpose of providing facilities to these members

Ø  The allotment of expenses and incomes will depend on the individual judgement of the accountant

Ø  The financial statements are arranged on the basis of historical costs or original costs.

LIMITATIONS OF FINANCIAL STATEMENTS:

Through financial statements are appropriate and useful for the concern, still they do not present a final picture of the concern. The utility of these statements is dependent leading a number of factors. The analysis and interpretation of these statements should be done very carefully otherwise confusing conclusions may be drawn. The financial statements suffer from the following limitations.

1.      Interim report: These statements do not provide a final picture of the concern. The data give in these statements is only fairly accurate. The actual position can only be determined when the business is sold or liquidated. However, the statements have to be prepared for dissimilar accounting periods, normally one year, during the life time of the concern. The costs and incomes be apportioned to different periods either a view to resolve profits etc. The allotment of expenses and incomes will depend on the individual judgement of the accountant. The subsistence of contingent assets and liabilities also makes the statements imprecise. So financial statements do not give the final picture and they are at the largely interim reports.

2.      Do not provide accurate position: The financial statements are expressed in monetary values, so they appear to give final and accurate position. The value of fixed assets in the balance sheet is prepared on the presumption of a going concern. The concern is expected to continue in the future. So fixed assets are revealed at cost less accumulated depreciation. There are certain assets in the balance sheet such as preliminary expenses, goodwill, discount on issue of share which will realise not anything at the time of bankruptcy through they are exposed in the balance sheet.

3.      Historical information: The financial statements are arranged on the basis of historical costs or original costs. The value of assets decreases with passage of time current price changes are not taken into account. The statements are not prepared keeping in view the present economic conditions. The balance sheet loses the significance of being an index of current economic realities. Similarly, the profitability shown by the income statement may not represent the earning capacity of the concern. The increase in profits may be due to an increase in prices or owing to some abnormal causes and not due to enhance in efficiency. The conclusion drawn from financial statements may not give a fair picture of the concern.

4.      Impact of non Monetary factors ignored: There are certain factors which have a bearing on the financial position and operating results of the business but they do not become a part of these statements because they cannot be measured in monetary terms. Such factors may include the reputation of the management, credit worthiness of the concern, sources and commitments for purchases and sales, corporation of the employees etc. The financial statements only show the position of the financial accounting for business and not the financial position.

5. Lack of accuracy: The accuracy of financial statement data is not possible because the statement deal with matters which cannot be precisely stated the data are recorded by conventional procedures followed by the years. Various conventions, postulates, personnel judgements etc are used for developing the data.
6. Influenced by personal judgement: Financial statements and conclusions are influenced by biasness derived by the accountants themselves. For example, depreciation method, valuation of stock, writing of deferred expenses etc depends upon the personal judgement of the accountant. The rationality of such decision depends upon the experience, ability, honesty and objectivity of the accountant concerned. Thus, the financial statements are biased and the results extracted from them are also biased.
7. Static Statement: financial statements are static in nature i.e. prepared at a point of time. They do not present the process by which the figures are arrived at. Thus, there static nature limits the importance of analysis also.

SUMMARY:

Financial statements are prepared primarily for decision-making. They play a dominant role in setting up framework of managerial decisions. The information contained in the financial statements should be such that a true and correct idea is taken about the financial position of the concern. The trade creditors are to be paid in a short period. This liability is met out of current assets. The creditors will be interested in current solvency of the concern. Through financial statements are appropriate and useful for the concern, still they do not present a final picture of the concern. The utility of these statements is dependent leading a number of factors. The analysis and interpretation of these statements should be done very carefully otherwise confusing conclusions may be drawn.

Few Suggested Readings:

• Ø Tulsian . P.C (2014) “Financial Accounting” Pearson Education India.
• Ø Lal, Jawahar and Seema Srivastava (2004) “Financial Accounting” S.Chand (G/L) & Company Ltd.
• Ø Goyal, V.K. and Ruchi Goyal (2012) “Financial Accounting” PHI.
• Ø Maheshwari, S.N., Suneel K Maheshwari and Sharad K Maheshwari(2012) “Financial Accounting” Vikas Publishing House Pvt Ltd.
• Ø Monga, J.R. “Avanced Financial Accounting” Mayoor Paperbacks.
• Ø Bhattacharyya Asish K., (2012)” Essentials of Financial Accounting” PHI.
• Ø A Students Guide to IFRS (2012), Kaplan Publishing.

Points to Ponder:

1. Financial statements are prepared primarily for decision-making. They play a dominant role in setting up framework of managerial decisions.
2. The information contained in the financial statements should be such that a true and correct idea is taken about the financial position of the concern. The trade creditors are to be paid in a short period.
3. This liability is met out of current assets.
4. The creditors will be interested in current solvency of the concern. Through financial statements are appropriate and useful for the concern, still they do not present a final picture of the concern.
5. The utility of these statements is dependent leading a number of factors.
6. The analysis and interpretation of these statements should be done very carefully otherwise confusing conclusions may be drawn.