What is Financial Statements? Definition, Nature, Objectives, Types, Importance, Limitations

What is Financial Statements?

Financial statements are the basic and formal annual reports through which the corporate management communicates financial information to its owners and various other external parties which include investors, tax authorities, government, employees, etc.

These refer to: the balance sheet (position statement) as at the end of accounting period, the statement of profit and loss of a company and the cash flow statement

Financial statements are the end products of the accounting process, which reveal the financial results of a specified period and financial position of a business as on a particular date. These statements include income statement and balance sheet.

The basic objective of these statements is to provide information required for decision making by the management as well as parties who are interested in the affairs of the undertaking. A cash flow statement when used along with other financial statements provides information that enables users to evaluate changes in net assets of a business, its financial structure (including its liquidity and solvency) and its ability to affect the amounts and timings of cash flows in order to adapt to changing circumstances and opportunities.

The users of financial statements are investors, employees, lenders, suppliers, creditors, customers, government and public. In addition, these statements reveal the business’s source of generating cash and cash outflows. Financial institutions check the overall condition of a business by analysing financial statements before approving loans as they are considered to be an indicator of business performance.

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Financial Statements Definition

According to the American Institute of Certified Public Accountants, Financial Statements are prepared for the purpose of presenting a periodical review of report 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 a combination of recorded facts, accounting principles and personal judgments

Financial statements are prepared by sole proprietorships, partnership firms, not-for-profit organisations and companies.

Here, in this post, we will focus on financial statements of sole proprietorships.

Who is Sole Proprietorship?

A sole proprietorship refers to an unincorporated business that is owned, managed and controlled by a single person who pays personal income tax on the profits earned from the business.

Sole proprietorships can be divided into two categories namely non-manufacturing business entities and manufacturing entities. The financial statements (final accounts) prepared in case of manufacturing and non-manufacturing entities are mentioned below:

• Sole Proprietorship
  • Non-Manufacturing Entities
    • Final Accounts
      • Trading Account
      • Profit and Loss Account
      • Balance Sheet
        
        
  • Manufacturing Entities
    • Final Accounts
      • Manufacturing Account
      • Trading Account
      • Profit and Loss Account
      • Balance Sheet

Apart from the statements mentioned above, another financial statement called cash flow statement is also prepared.

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Characteristics of Financial Statement

We have discussed that various users of financial information need financial statements for making economic decisions. Organisations publish financial statements to fulfil the information needs of the users. Therefore, it can be seen that there is a great dependence of the users on the financial statements. If the financial statements are not accurate, true and fair, users may end up making decisions.

Following are some of the important characteristics of financial statements:

Understandability

Stakeholders cannot use financial information which they are unable to comprehend. Problems in understanding financial information may arise out of two reasons: the users incapability in understanding information and ambiguity in the information itself. An organisation cannot do anything about the understanding level of the users.

However, an organisation can present the financial information in such a way that it helps in understanding the underlying information. There- fore adequate measures need to be taken on behalf of the organisation to follow standard guidelines so that the financial statements are comprehensible. However, it does not mean that complex information should be excluded from the financial statements just because these are creating problems in overall understanding of the statements.

Relevance

A set of information can only be considered relevant when the information adds value to the decision-making process. Through relevant information, users can evaluate whether they are making right eco- nomic decisions or not. Moreover, a set of information can also be considered to be relevant when it has the capability of correcting or confirming the existing thought process and information.

Reliability

Information is reliable when it is dependable and this is possible only when it is:

• Free from errors, especially material errors
• Complete
• Free from bias

Relevance does not suffice for reliability. A set of information must be reliable as well as relevant in order to be useful in decision-making.

Comparability

In simple words, comparability refers to the ability of financial statements to stand useful over time against financial information obtained from other sources. It is not possible for users to evaluate different aspects of an organisation’s financial performance without comparing the financial information of one period with another or the financial information of one entity to another.

In order to attain comparability, organisations prepare financial statements by following a uniform pattern or standards as instructed by the international or local accounting standards board. Once a particular standard is adopted, it remains consistent in application.

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Nature of Financial Statements

Financial statements of a business contain chronologically recorded facts in monetary terms for an accounting year. These facts reveal the financial position of a business and help in reviewing business reports and making judgements based on reports.

The following points explain the nature of financial statements:

• Financial statements contain financial information of a business in the books of accounting. Such information includes cash in hand, bills receivables, fixed assets, etc. and is recorded on the basis of historical cost.
  
  
• Financial statements are not based on the current or market price so these statements do not present the present financial condition of the business.
  
  
• Financial statements are made by keeping in mind accounting conventions such as valuing stock or inventory based on cost or market price and convention of materiality, which says that cost incurred on small items will be treated as expense.
  
  For example, pen and stamp are assets but are considered as expenditure.
  
  
• Financial statements are made by human so they are based on personal judgement, estimates or opinions; for example, provision of doubtful debt is made based on the personal estimates and judgement.

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Scope of Financial Statements

Following are the main scopes of financial statements:

Providing information about the financial position

It refers to the reporting of assets and liabilities of the organisation. It depicts the financial position of the organisation at a particular point in time. This is like a snapshot of the company.

Providing information about the financial performance

It refers to the reporting of the expenses incurred and profits earned by the organisation during an accounting period. It represents the organisation’s ability to use the available economic resources in a profitable manner. This is like a video of the operations of the company.

Providing information about changes in the financial position

It refers to the reporting of the effect of business activities on the stake of the investors in the organisation. It is presented in the form of statement of cash flows and a statement of changes in equity.

Providing notes and supplementary schedules

It refers to information about the risks and uncertainties affecting the organisation. In addition, it notices the item that has not been mentioned in the balance sheet of an organisation.

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Objectives of Financial Statements

The main objective of financial statements is to provide information about the financial position and performance of an organisation based on which various economic decisions are made by different users.

Apart from that, the following are some other objectives of financial statements:

• To find out whether a business is in profit or loss
  
  
• To compare the current year’s performance of the business with that of the previous year
  
  
• To analyse the capacity of the business to repay liabilities
  
  
• To judge whether the company is financially strong and is in a position to purchase assets or pay debts
  
  
• To do intra-firm comparison and help management in adopting appropriate policies
  
  
• To help management in the preparation of budget
  
  
• To communicate necessary information to the interested parties

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Elements of Financial Statements

Following are the important elements of financial statements:

• Asset
• Drawings
• Liabilities
• Owners Equity
• Cash Flow Statement
• Income Statement
• Revenues
• Retained Earnings
• Expenses

Asset

You have already studied that all those resources that are owned by a business are called assets. There are two types of assets, namely current assets and non-current assets.

Current assets are easily convertible into cash within one year, for example, bills receivables and short-term investments. Non-current assets are used for more than 5-10 years, for example, land, furniture, plant and machinery.

Drawings

Cash or other goods for personal use by business owner are called drawing.

Liabilities

These are the dues or debts that a business owes. The liabilities are mainly of two types, i.e., current and non-current liabilities.

Current liabilities are those debts that a business has to pay within one year, for example, bills payable, creditors, bank overdraft, etc.

Non-current liabilities are those liabilities that a business has to pay in long term; for example, long-term loans, debentures, public deposits, etc.

Owners Equity

It is the ownership claim on total assets such as equity and reserve and surplus.

Cash Flow Statement

This statement gives information about the flow of cash in and out of the business for a particular period.

Income Statement

This statement presents revenues and expenes and finds out the profit or loss of the business.

Revenues

These are inflows of cash or assets from the sale of products or services rendered.

Retained Earnings

This is the undistributed profit of the business.

Expenses

The cost incurred by a business for producing and selling goods and serving customers.

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Uses and Importance of Financial Statements

The users of financial statements include management, investors, shareholders, creditors, government, bankers, employees and public at large. Financial statements provide the necessary information about the performance of the management to these parties interested in the organisation and help in taking appropriate economic decisions.

It may be noted that the financial statements constitute an integral part of the annual report of the company in addition to the directors report, auditors report, corporate governance report, and management discussion and analysis.

• Report on stewardship function
• Basis for fiscal policies
• Basis for granting of credit
• Basis for prospective investors
• Guide to the value of the investment already made
• Aids trade associations in helping their members
• Helps stock exchanges

Report on stewardship function

Financial statements report the performance of the management to the shareholders. The gaps between the management performance and ownership expectations can be understood with the help of financial statements.

Basis for fiscal policies

The fiscal policies, particularly taxation policies of the government, are related with the financial performance of corporate undertakings. The financial statements provide basic input for industrial, taxation and other economic policies of the government.

Basis for granting of credit

Corporate undertakings have to borrow funds from banks and other financial institutions for different purposes. Credit granting institutions take decisions based on the financial performance of the undertakings. Thus, financial statements form the basis for granting of credit.

Basis for prospective investors

The investors include both short-term and long-term investors. Their prime considerations in their investment decisions are security and liquidity of their investment with reasonable profitability. Financial statements help the investors to assess longterm and short-term solvency as well as the profitability of the concern.

Guide to the value of the investment already made

Shareholders of companies are interested in knowing the status, safety and return on their investment. They may also need information to take decision about continuation or discontinuation of their investment in the business. Financial statements provide information to the shareholders in taking such important decisions.

Aids trade associations in helping their members

Trade associations may analyse the financial statements for the purpose of providing service and protection to their members. They may develop standard ratios and design uniform system of accounts.

Helps stock exchanges

Financial statements help the stock exchanges to understand the extent of transparency in reporting on financial performance and enables them to call for required information to protect the interest of investors. The financial statements enable the Stock brokers to judge the financial position of different concerns and take decisions about the prices to be quoted.

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Limitations of Financial Statements

Though utmost care is taken in the preparation of the financial statements and provide detailed information to the users, they suffer from limitations.

Following are the disadvantages of financial statements:

• Do not reflect current situation
• Assets may not realise
• Bias
• Aggregate information
• Vital information missing
• No qualitative information
• They are only interim reports

Do not reflect current situation

Financial statements are prepared on the basis of historical cost. Since the purchasing power of money is changing, the values of assets and liabilities shown in financial statement do not reflect current market situation.

Assets may not realise

Accounting is done on the basis of certain conventions. Some of the assets may not realise the stated values, if the liquidation is forced on the company. Assets shown in the balance sheet reflect merely unexpired or unamortised cost.

Bias

Financial statements are the outcome of recorded facts, accounting concepts and conventions used and personal judgements made in different situations by the accountants. Hence, bias may be observed in the results, and the financial position depicted in financial statements may not be realistic.

Aggregate information

Financial statements show aggregate information but not detailed information. Hence, they may not help the users in decision-making much.

Vital information missing

Balance sheet does not disclose information relating to loss of markets, and cessation of agreements, which have vital bearing on the enterprise.

No qualitative information

Financial statements contain only monetary information but not qualitative information like industrial relations, industrial climate, labour relations, quality of work, etc.

They are only interim reports

Statement of Profit and Loss discloses the profit/loss for a specified period. It does not give an idea about the earning capacity over time similarly, the financial position reflected in the balance sheet is true at that point of time, the likely change on a future date is not depicted.

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Adjustments in the Preparation of Financial Statements

At the end of an accounting period, some income and expenses may not be recorded, taken up or updated. Thus, there is a need to update the accounts.

For such situations, adjustments are made in the current year so that the profit and loss account presents the accurate net profit or loss and the balance sheet may depict the true financial position of a business. Entries must be passed for adjusting various accounts of income and expenditure.

Some of the important adjustments are as follows:

Expenses Accrued and Accruing

For example, rent, interest, local taxes, wages, etc.

The adjustment entry will be passed as:

Appropriate Expense Account. ………………………………………………………………………….. Dr.

To Expenses Accrued/outstanding Account

Assume that interest paid is ₹40,000 and outstanding interest is ₹3,000; then, entries will be shown in the P&L account and Balance Sheet as follows:

P&L Account

Particulars	Amount (in ₹)	Particulars	Amount (in ₹)
To Interest Paid 40,000 Add: Outstanding 3,000	4300

Balance Sheet

Liabilities	Amount (in ₹)	Assets	Amount (in ₹)
Interest Paid Outstanding	3000

Income Accrued and Accruing

For example, interest on government loans, discounts on bill, professional fees, rents and premiums on leases, etc. The adjustment entry will be passed as:

Interest/Fees, etc. Accruing Account ………………………………………………………………………….. Dr.

To Appropriate Income Account

Assume that a company receives interest of ₹40,000 and accrued interest is ₹8,000; then, entries will be shown in P&L account and Balance Sheet as follows:

P&L Account

Particulars	Amount (in ₹)	Particulars	Amount (in ₹)
		By Interest 40,000 Add: Accrued Interest 3,000	43,000

Balance Sheet

Liabilities	Amount (in ₹)	Assets	Amount (in ₹)
		Accrued Interest	3,000

Provision for Bad and Doubtful Debts

At times, companies are doubtful whether or not they will be able to collect the amount due from customers. In such a case, it is a good practice to recognise the expected loss by reducing the current year’s profit and crediting the amount to a special account named “Provision for Bad and Doubtful Debts Account”. The adjustment entry will be passed as:

Profit and Loss Account ………………………………………………………………………….. Dr.

To Provision for Bad and doubtful Debts Account

Here, it is important to note that the accounts of customers concerned are not affected until the given amount is written-off. The entry for writing-off of bad debts is as follows:

Bad Debts Account ………………………………………………………………………….. Dr.

To Customer’s A/c