Wednesday, October 12, 2011

Financial Statements

Financial statements are the summarized statements of accounting data produced at the end of accounting process by an enterprise through which accounting information are communicated to the internal and external users.
A set of financial statements includes (Types):
a)      Balance sheet
b)      Profit and loss account
c)       Schedules and notes to accounts.

In the words of Myer,” The financial statements provide a summary of accounts of a business enterprise, the balance sheet reflecting the assets, liabilities and capital as on a certain date and income statement showing the result of operations during a certain period”.

Characteristics of financial Statements are:
a)      Financial statements relate to past period and thus, are historic documents.
b)      The statements are expressed in monetary terms.
c)       Financial statements show financial position through balance sheet and profitability through profit and loss account.

Nature of Financial Statements:
The Statements are prepared for the purpose of presenting a periodical review of reports on progress by the management and deal with the status of investment in the business and the results achieved during the period under review. They reflect the following:
(i)      Recording facts of a business transactions;
(ii)    Accounting Conventions;
(iii)   Accounting Concepts;
(iv)  Personal judgments used in the application of conventions and postulates.

                (i) Recorded Facts: The Financial statements are statements prepared on the basis of recorded facts, they do not depict the unrecorded facts. Recorded facts means recording of transactions based on evidence in the accounting books.
(ii) Accounting Conventions: Certain accounting conventions are followed while preparing financial statements such as convention of ‘Conservatism’, convention of ‘Materiality’, convention of ‘Full disclosure’, convention of ‘Consistency’. The use of accounting conventions makes financial statements simple, comparable, and realistic.

                (iii) Accounting Concepts: While preparing financial statements the accountants make a number of assumptions known as accounting concepts such as going concern concept, money measurement concept, realisation concept, etc.

                (iv) Personal Judgment: Personal judgments also have an important bearing on financial statements. For example, selection of one method out of various methods of charging depreciation, inventory valuation etc., depends on the personal judgment of the accountant.

Objectives of Financial Statements:
a)      To provide information about economic resources and obligations of a business.
b)      To provide information about earning capacity of the business.
c)       To provide information about cash Flows.
d)      To judge effectiveness of management.
e)      Information about activities of business affecting the society.
f)       Disclosing accounting policies.

Balance Sheet and Profit and loss account or Income statement:
A balance sheet is a quick picture of the financial condition of a business at a specific period in time. It shows the assets and liabilities of business at the end of Accounting year.
The profit and loss account is the accounting report which summaries the revenues and expenses and ascertains the profit/loss for a specified accounting period. It also represents the changes in the owner’s equity between two successive periods. It is an essential statement for preparation of balances sheet and hence annexed to it.
Income statements may be divided into three components:
a) Trading Account
b) Profit and Loss Account
c) Profit and loss Appropriation Account.

Process to be followed for preparation on income statement in account form:
a)      Recording all the revenue receipts appearing on the credit side of the trial balance on the credit side of income statement after making suitable adjustments for revenues received in advance of revenues realised but not received, etc.
b)      Recording all the revenue expenditure items appeared on the debit side of trial balance on the debit side of income statement after making adjustments for outstanding, prepaid expenses, depreciation, provisions for bad debts, taxes, etc.
c)       Recording non-operating incomes and gains on the credit side of the income statement.
d)      Recording non-operating incomes and gains on the credit side of the income statements.
e)      Ascertaining the difference between totals of credit items and totals of debit items.
f)       If the credit items are more than the debit items, it is known as net profit and if it is the other way around, it will be treated as loss.
g)      In India, the accounting year for preparing financial statements for companies is April 01 to March 31.

Format of balance sheet according to Schedule VI of the companies Act, given in Appendix I.

Horizontal Form of Balance Sheet
Balance Sheet of... (Name of the company) as on...
Share Capital:
Preference share capital
Equity share capital
Reserve and surplus:
Capital Reserve
Capital Redemption Reserve
Securities Premium
Other Reserves
Profit and Loss Account
Secured Loans:
Loans and advance from banks
Loans and advances from subsidiary
Other Loans and Advances
Unsecured Loans:
Fixed Deposits
Loans and Advances
From Subsidiaries
Short Term Loans And Advances
Other Loans and Advances
Current Liabilities and Provisions:
A. Current Liabilities:
Sundry Creditors
Outstanding Expenses
B. provisions:
For Taxation
For Dividends
For Contingences
For Provident Fund Schemes
For Insurance, Pension and other similar benefits
Fixed Assets
Households Premises
Railway Sidings
Plant and Machinery
Patents and Trademark
Live Stock
Government or Trust Securities
Share Debentures, Bonds
Current Assets, Loans and Advances:
A) Current Assets:
Interest Accrued
Stores and Spare parts
Loose Tools
Stock in Trade
Work in Progress
Sundry Debtors
Cash and Bank Balances
(B) Loans and Advances:
Advances and loans to Subsidiary companies
Bills Receivable
Advance Payments
Miscellaneous- Expenditure:
Preliminary expenses
Discount on Issue of Shares and Debentures
Other Deferred Expenses
Profit and Loss Account (debit balance: If any)

Asset side:
a)      Fixed assets: The expenditure incurred on various fixed are to be shown separately for various fixed assets which include goodwill, land, buildings etc. These are shown at cost less depreciation till the date.
b)      Investments: Under this head, various investments made such as investments in government securities or trust securities; investment in share, etc. are to be shown separately in the balance sheet.
c)       Current Assets: Loans and advances: Current assets include interest accrued on investments, inventories, etc.
d)      Miscellaneous Expenditure: The expenditure which has not been written of fully its balance is shown under this heading. These expenses include preliminary expenses, advertisement expenditure, discount on issue of share debentures, share issue expenses, etc.
e)      Profit and Loss Account: When the Profit and Loss account shows a debit balance, i.e., loss which could not be adjusted against general reserves, the same is shown as a last item on the assets side.

Liabilities Side:
a)      Share Capital: It is the first item on the liabilities side of the balance sheet and show details of authorised capital and issued and paid-up capital in terms of the number and amount of each type of share, and so also the amounts if call in arrears and the forfeited shares.
b)      Reserves and Surplus: This item includes various reserves such as capital reserves, capital redemption reserves, balance of securities premium account, General Reserve, credit balance of profit and loss account, and other reserve, specifying the nature of each reserve and the amount in respect thereof including the addition during the current year.
c)       Secured loans: Long-term loans, which are taken against some security, are included under this head. Debentures and secured loans and advances from banks, subsidiary companies, etc., are fall under this category and are shown separately under this head.
d)      Unsecured Loans: Loans and advances for which no security is given are shown under this heading. This item includes public deposits, unsecured loans and advances from subsidiary companies, short-term loans and advances and other loans and advances from banks.
e)      Current Liabilities and Provisions: Current liabilities refer to such liabilities, which mature within a period of one year.

Users of Financial Statements:
Users of accounting information may be categorised into
(1) Internal Users; and
(2) External Users.

(1) Internal Users:
                (i) Owners: Owners contribute capital in the business and they are always exposed to risk. In view of risk involved, the owners are always interested in knowing the profitability and financial strength of the company.
                (ii) Management: Managers has the responsibility to not only safeguard the owner’s investment but also to increase the value of business. Financial statements help the management to find out the overall as well as segment-wise efficiency of the business. It helps them in decision making as well as in controlling and self evaluation.
                (iii) Employees and Workers: Employees and workers are entitled to bonus at the yearend besides the salary and wages which is directly linked with the profits of the enterprise. Therefore, the employees and workers are interested in financial statements.

(2) External Users:
                (i) Banks and Financial Institutions: Banks and Financial Institutions provide loans to the businesses. They watch the performance of the business to ensure the safety and recovery of the loan advanced.
                (ii) Investors and Potential Investors: Investors uses financial statements to assess the earning capacity of the enterprise and ensure the safety of their investment.
                (iii) Creditors: Creditors supply goods and services on credit. Before granting credit, Creditors satisfy themselves about the creditworthiness of the business. The financial statement helps them in making such assessment.
                (iv) Government authorities: The government makes use of financial statements to compile national income accounts and other information. The information so available to it enables them to take policy decisions.
                (v) Consumers: Customers have an interest in information about the continuance of an enterprise, especially when they have a long-term with the enterprise.
Sometime, prices of some products are fixed by the government, so it needs accounting information to fix fair prices so that consumers and producers are not exploited.

Importance of Financial Statements to its various users
a)      Report on performance of the management to the shareholders
b)      Basic for fiscal policies
c)       Basic for granting credit
d)      Basis for prospective investors
e)      Guide to the value of the investment already Made
f)       Aids trade associations in helping their members
g)      Helps stock exchanges.

Limitations of financial statements:
Financial Statements suffers from various limitations which are given below:

                (i) Historical Records: Persons like shareholders, investors etc., are mainly interested in knowing the likely position in future. The financial statements are not of much help as the information given in these statements is historic in nature and does not reflect the future.

                (ii) Ignores Price Level Changes: Price level change and purchasing power of money are inversely related. Different assets are shown at the historical cost in financial statements. It, therefore, ignore the price level change or present value of the assets.

                (iii) Qualitative aspect Ignored: Financial statements considered only those items which can be expressed in terms of money. Financial Statements ignores the qualitative aspect such as quality of management, quality of labour force, Public relations.

                (iv) Suffers from the Limitations of financial statements: Since analysis of financial statements is based on the information given in the financial statements, it suffers from all such limitations from which the financial statements suffer.

                (v) Not free from Bias: Financial statements are largely affected by the personal judgments of the accountant in selecting accounting policies. Therefore, financial are not free from bias.

                (vi) Variation is accounting practices: Different firms follow different accounting practices. For example, depreciation can be provided either on SLM basis or WDV basis. Profits earned or loss suffered will be different when different practices are followed. Therefore, a meaningful comparison of their financial statements is not possible.