What is Financial Statements? Preparation, Limitations, Nature

  • Post last modified:16 April 2022
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What is Financial Statements?

A financial statement is an organised collection of data prepared in accordance with logical and consistent accounting procedures. Its function is to convey an understanding of key financial aspects of a business firm.

What is Financial Statements?
What is Financial Statements?

It may show a position at a moment in time, as in the case of a Balance Sheet or may reveal a series of activities over a given duration, as in the case of an Income Statement.

Thus, the term financial statement includes trading account, profit and loss account, balance sheet and cash flow statement.

Trading account

It is that part of a financial statement, which shows how the gross (operating) profit was generated through the firm’s trading activities. An example of the trading account of a business would look like this: Trading account for XYZ Company for the year ended 31st March 2010.

Category
Sales Rs 1,200,000
Opening StockRs 1,50,000
PurchasesRs 4,00,000
Less Closing StockRs (2,20,000)
Cost of SalesRs 3,30,000(Rs 3,30,000)
Other Costs(Rs 70,000)
Gross ProfitRs 800,000
Trading account for XYZ Company for the year ended 31st March 2010.

Profit and loss account

It is a company’s financial statement that indicates how the revenue (money received from the sale of products and services before expenses are taken out, also known as the “top line”) is transformed into the net income (the result after all revenues and expenses have been accounted for, also known as the “bottom line”).

It displays the revenues recognised for a specific period and the cost and expenses charged against these revenues, including write-offs, (e.g. depreciation and amortisation of various assets) and taxes. The purpose of the income statement is to show managers and investors whether the company made or lost money during the period being reported.

Balance sheet

It is a summary of the financial balances of a sole proprietorship, a business partnership or a company. Assets, liabilities and ownership equity are listed as of a specific date, such as the end of its financial year.

A balance sheet is often described as a “snapshot of a company’s financial condition”. Of the four basic financial statements, the balance sheet is the only statement, which applies to a single point in time of a business’ calendar year. A standard company balance sheet has three parts: assets, liabilities and ownership equity.

Cash flow statement

It is a financial statement that shows how changes in balance sheet accounts and income affect cash and cash equivalents and breaks the analysis down to operating, investing and financing activities. Essentially, the cash flow statement is concerned with the flow of cash in and cash out of the business.

The statement captures both the current operating results and the accompanying changes in the balance sheet. As an analytical tool, the statement of cash flows is useful in determining the short-term viability of a company, particularly its ability to pay bills.


Nature of Financial Statements

Nature of Financial Statements
Nature of Financial Statements

According to the American Institute of Certified Public Accountants, financial statements reflect, “a combination of recorded facts, accounting conventions and personal judgments and the judgments and conventions applied affect them materially”.

This implies that data exhibited in the financial statements is affected by recorded facts, accounting conventions and personal judgments.

Recorded facts

The facts recorded in the books of accounts are known as Recorded Facts. Facts, which have not been recorded in the financial books, are not depicted in the financial statements, however material they might be. For example, fixed assets are shown at cost irrespective of their market or replacement price since such price is not recorded in the books.

Accounting conventions

Accounting conventions imply certain fundamental accounting principles, which have been sanctified by long usage. For example, because of the convention of „Conservatism‟, provision is made for expected losses but expected profits are ignored. This means that the real financial position of the business may be much better than what has been shown by the financial statements.

Personal judgments

Even personal judgments have a fair amount of influence on the financial statements. For example, it is the choice of an accountant to choose the method of depreciation. Similarly, the method of amortisation of fictitious assets also depends on the personal judgment of the accountant.


Limitations of Financial Statements

The objectives of financial statements are subject to certain limitations as given below:

Financial statements are essentially interim reports

The profit exhibited by the Profit and Loss Account and the financial position revealed by the Balance Sheet is not exact. The instances of contingent liabilities, deferred revenue expenditure, etc. make them more imprecise.

Accounting concepts and conventions

The preparation of the financial statements is based on certain accounting concepts and conventions. Owing to this, the financial position, as disclosed by these statements, may not be realistic. Because of convention of conservatism, the income statement may not disclose true income of the business; probable losses are taken into consideration while probable incomes are ignored.

Influence of personal judgment

Many items are left to the personal judgment of the accountant. Examples include the method of depreciation, mode of amortisation of fixed assets, treatment of deferred revenue expenditure, etc. All of these depend upon the personal judgment of the accountant. The competency of this opinion relies on the experience and integrity of the accountant.

Disclose only monetary facts

Financial statements do not portray the facts that cannot be expressed in terms of money. For example, development of a team of loyal and efficient workers, enlightened management, the reputation and prestige of management in the eyes of the public are matters of considerable importance for the business but out of the confines of financial statements. Therefore, financial statements can nowhere reflect such nonmonetary aspects.


Preparation of Financial Statements

Financial statements mainly comprise of two statements, i.e. the Balance Sheet and the income statement or Profit and Loss Account. They are usually prepared at the end of the accounting period; hence, they are also known as financial accounts of the company.

In case of companies, the financial accounts have been termed as annual accounts and Balance Sheet. Section 210 of the Companies Act governs the preparation of the financial accounts of a company.

Some significant provisions vis-à-vis the preparation of the above accounts is as follows:

1. At every Annual General Meeting of the company, the Board of Directors of the Company shall lay before the company:

  • The Balance Sheet as at the end of the accounting period.

  • A Profit and Loss Account for that period.

In the case of a company that does not engage in business for profit, an income and expenditure account shall be laid before the company instead of the Profit and Loss Account at it‟s Annual General Meeting.

2. The Profit and Loss Account (or the income and expenditure account) relate to the period as per the following premises:

  • In case of the first Annual General Meeting of the company: From the date of incorporation of the company to a date not more than 9 months before the meeting.

  • In case of any subsequent Annual General Meeting: From the date immediately after the period for which account was last submitted to not more than 6 months before the meeting.

The tenure for which the account has been prepared is called the financial year. It may be less or more than a calendar year but it shall not exceed 15 months. However, with the permission of the Registrar, it may extend up to 18 months.


Profit and Loss Account

Requirements of Profit and Loss Account.

The requirements of Profit and Loss Account can be categorised into two parts:

  1. General Requirements.

  2. Special Requirements as per Schedule VI, Part II.

Heading

In case of companies, it is not essential to segregate the Profit and Loss Account into three sections, viz. Trading Account, Profit and Loss Account and Profit and Loss Appropriation.

It must also be noted that dividing the account into three sections is not prohibited and should be done to give a better idea regarding the profit earned and distributed by the company during a particular period.

The Profit and Loss Account can be prepared under two headings:

  • Profit and Loss Account giving details regarding the Gross Profit and the Net Profit earned by the company during a particular period.

  • Profit and Loss Appropriation Account giving details regarding the Balance of Profit and Loss Account brought forward from the last year, the Net Profit (or loss) trend (or made) during the year and appropriations made during the year.

Items shown in the Profit and Loss Account are popularly termed as items appearing “above the line” whereas the items shown in the Profit and Loss Appropriation Account are popularly termed as items appearing “below the line”.

Provision for Taxation

Companies are liable to pay income tax at a high rate. Usually the tax rate is about 40% or more of the taxable profit. Though provision for taxation is an appropriation of profits, the common practice is to show it “above the line”, i.e. in the Profit and Loss Section and not in Profit and Loss Appropriation Section.

In other words, profit after tax is taken from “Profit and Loss Account” to “Profit and Loss Appropriation” account. However, tax for a previous period, now provided or refunded for, is charged or credited to the Profit and Loss Account.

Accounting Year

Though the Companies Act permits a company to select any period of 12 months as its accounting year, tax laws have made it almost obligatory for every company to close its books of accounts on 31st March every year.

Special Requirements as per Schedule VI, Part II

The Profit and Loss Account of a company must be prepared in accordance with the requirement of Part II of Schedule VI of the Companies Act, 1956. These requirements are summarised as follows:

The Profit and Loss Account should clearly reveal the result of the working of the company during the period covered by the account. It should reveal separately the incomes and expenses of a non-recurring nature and exceptional transactions.

The Profit and Loss Account should particularly disclose information in respect of the following items:

  1. The turn-over of the company.

  2. Commission paid to sole-selling agents.

  3. Commission paid to other selling agents.

  4. Brokerage and discount on sales other than the usual trade discount.

  5. Opening and closing of goods, purchases made or cost of goods manufactured or value of services rendered during the period covered by the account.

  6. Interest on company‟s debentures and other fixed loans.

  7. Amount charged as income tax.

  8. Remuneration payable to the managerial personnel.Amount paid to auditor for services rendered as auditor and as advisor in any other capacity, viz. taxation matters, company law matters, management services, etc.
    .
  9. The details of licensed, installed and actual capacity utilized.

  10. Value of imports, earnings in foreign exchange and amounts remitted during the year in foreign currencies on account of dividends.

For the sake of convenience of the students, we are giving below the format of Profit and Loss Account of a company:


Balance Sheet

According to Section 210 of the Companies Act, it is mandatory for a company to prepare a Balance Sheet at the end of each trading period. Section 211 requires the Balance Sheet to be set up in the prescribed form.

This provision is not applicable to banking, insurance, electricity and other companies governed by special Acts. The Central Government also holds the power to exempt any class of companies from compliance with the requirements of the prescribed form, in case it appears to be in public interest.

Schedule VI, Part I gives the prescribed form of a company‟s Balance Sheet. Notes and instructions regarding various items are given under any of the items or sub-item. If the prescribed form cannot be conveniently given under any item due to lack of space, it can be given in a separate schedule or schedules. Such schedules will be annexed to and for M part of the Balance Sheet.

Schedule VI, Part I permits the presentation of Balance Sheet both in horizontal as well as vertical forms.


Analysis of Financial Statements and Ratio Analysis

Financial statement analysis is defined as the process of identifying financial strengths and weaknesses of the firm by properly establishing relationship between the items of the balance sheet and the profit and loss account.

There are various methods or techniques that are used in analysing financial statements, such as comparative statements, schedule of changes in working capital, common size percentages, funds analysis, trend analysis and ratios analysis.

Financial statements are prepared to meet external reporting obligations and also for decision-making purposes. They play a dominant role in setting the framework for managerial decisions.

There are various advantages of financial statements analysis. The major benefit is that the investors get a fair idea to decide about the investments of their funds in the specific company. Secondly, regulatory authorities like International Accounting Standards Board can ensure whether the company is following the requiredaccounting standards or not. Thirdly, financial statements analysis can help the government agencies to analyse the taxation due to the company.

Tools and Techniques of Financial Statement Analysis:
Following are the most important tools and techniques of a financial statement analysis:

  1. Horizontal and Vertical Analysis
  2. Ratios Analysis

Horizontal and Vertical Analysis

Horizontal Analysis or Trend Analysis:
Comparison of two or more year’s financial data is known as horizontal analysis or trend analysis. Horizontal analysis is facilitated by showing changes between years in both dollar and percentage form.

Vertical Analysis

Vertical analysis is the procedure of preparing and presenting common size statements. Common size statement is one that shows the items appearing on it in a percentage form as well as in a dollar form. Each item is stated as a percentage of some total of which that item is a part. Key financial changes and trends can be highlighted by the use of common size statement.

Vertical Analysis and Common Size Statements:
Definition and Explanation of Vertical Analysis and Common Size Statements:
Vertical analysis is the procedure of preparing and presenting common size statements. Common size statement is one that shows the items appearing on it in percentage form as well as in dollar form.

Ratio Analysis

The ratio analysis is the most powerful tool of financial statement analysis. Ratio simply means one number expressed in terms of another. Using ratio we can compare and measure relationship between two or more figures and ultimately understand how one number is related to another. The method of calculating a ratio is simple: we have to divide one number by another number to derive the ratio.

Profitability Ratio

Profitability ratio measure the results of business operations or overall performance and effectiveness of the firm. Some of the most popular profitability ratios are as under:

  • Gross profit ratio
  • Net profit ratio
  • Operating ratio
  • Expense ratio
  • Return on shareholders investment or net worth
  • Return on equity capital
  • Return on capital employed(ROCE) Ratio
  • Dividend yield ratio
  • Dividend payout ratio
  • Earnings Per Share Ratio
  • Price earning ratio

Liquidity Ratio

Liquidity ratio helps us to measure the financial position or solvency of the firm in the short runs. In other words, liquidity ratios are calculated to comment upon the short-term paying capacity of concern or the firm’s ability to meet its current obligations. Following are the most important liquidity ratios.

A. current ratio

B. Liquid / Acid test / Quick ratio

Activity Ratio

Activity ratios are calculated to measure the efficiency with which the resources of a firm have been employed. Activity ratio help us derive the time lapsed in converting the assets into sales. Following are the most important activity ratios:

  • Inventory / Stock turnover ratio
  • Debtors / Receivables turnover ratio
  • Average collection period|
  • Creditors / Payable turnover ratio
  • Working capital turnover ratio
  • Fixed assets turnover ratio
  • Over and under trading

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