Nature and Types of financial statements
The financial statements are the statements which are prepared from the data taken from a published annual report of a company. These statements are prepared and presented in a concise form so that the users of the financial statements can understand their meaning and purpose.
Financial Statements present the financial information relating to financial affairs of a firm. The financial statements supply the necessary financial information to the users of financial statements viz. shareholders, creditors, investors, social investigators, government and other organisations for their own interest.
We have already stated above that the financial statements are prepared from the data taken from a published annual report of a company. The annual report includes the Income Statement (i.e. Profit and Loss Account), Balance Sheet, Auditor’s Report, Schedules, and statistical data of last few years for the purpose of comparison.
We know that the financial statements, in their conventional form, are of two types—Income Statement (also known as Profit and Loss Account), and Position Statement (also known as Balance Sheet) and, sometimes, schedules of income and expenses, assets and liabilities forming part of the Income Statement or Balance Sheet—which usually help the analyst to analyse the real financial position of an enterprise. Since the financial statements show even the common purposes of the users (external) of accounting information, they are considered as useful tools in their hands.
External users include:
(i) Trade Creditors;
(ii) Potential Investors;
(vi) Lenders, and;
(vii) Society or the public at large from the standpoint of liquidity, solvency and adequacy of working capital.
Thus, the financial statement consists of:
(a) The Income Statement or Profit and Loss Account, and
(b) The Position Statement or Balance Sheet.
Two other financial statements may also be prepared by the firms:
(c) Statements of Appropriation of Profit or Retained Earnings, and
(d) Statement of Changes in Financial Position. (Funds flow statement, cash flow statement)
In short, when we consider financial statement, it conveys an Income Statement, a Balance Sheet or any supporting statement or other presentations of financial data derived from accounting records. In a broad sense of the term, it includes Income statement, Balance Sheet and additional information, auditor’s report attesting the account, cash flow statement, funds flow statement (sources and application of funds), statement of changes in financial position, etc.
Nature of Financial Statement:
It has been stated in an earlier paragraph that financial statements supply financial information relating to financial position (i.e., revenues and expense, we get from Income Statement and Balance Sheet presents the assets and liabilities positions at a particular date).
No doubt, these sources of information are very important to the analyst for evaluating the financial performance of a firm in the form of liquidity analysis, profitability analysis, and efficiency of management, etc. In the light of the above, the American Institute of Certified Public Accountants stated: “they (financial statements) reflect a combination of recorded facts, accounting conventions and personal judgment, and the judgments and conventions applied affect them materially.”
Thus, the nature of financial statements can be summarised in the following forms:
(a) Recorded facts,
(d) Legal implications, and
(e) Personal judgment.
(a) Recorded Facts:
In accounting, only financial transactions are recorded chronologically day-to-day transactions that are expressed and measured in terms of money or money’s worth. So, financial statements which are prepared from the data contained in the financial transactions contain such recorded data.
Since these data are the result of past activities, these are called historical document/evidence. On the basis of such documents, financial statements are prepared and presented to the users of accounting information.
Convention refers to the general agreement on the usage and practices in social or economic life, i.e., it is a customary practice or rule, method, a usage. In other words, it is an accounting procedure followed for the accounting community on the basis of long-standing customs.
Accounting convention can be expressed as:
(i) Convention of Disclosure:
The doctrine of disclosure suggests that all financial statement should be honest and to that end, full disclosure of all significant information must be made. It involves proper classification, summarisation, aggregation and explanation of accounting data in unpublished financial statements which are of material interest to the users i.e., proprietors, investors, creditors etc. This doctrine actually gives emphasis on the actuality, materiality, objectivity and consistency of accounting data in order to disclose fully the true and fair view of the economic activities of a firm for a particular period.
(ii) Convention of Materiality:
Materiality means ‘relative importance’. In other words, whether a matter should be disclosed or not in the financial statements depends on its materiality, i.e. whether it is material or not (immaterial).
It deals with two importance matters viz:
(a) Materiality of Information, and
(b) Materiality of Amounts.
Materiality depends on the amounts involved and the amount so affected. So, the material item should be disclosed separately whereas immaterial items may not be discussed separately but may be combined in a consolidated form in the published financial statement.
(iii) Convention of Consistency:
This doctrine implies that accounting rules, practice and conventions should be continuously observed and applied. In other words, these should not be changed from year to year or one year to another. Comparison of results of different years is meaningful and significant only when its accounting rules, procedures and practices are continuously adhered from year to year.
Consistency can be analysed into the three following ways, viz:
(a) Vertical consistency,
(b) Horizontal consistency, and
(c) Third Dimensional consistency.
(iv) Convention of Conservatism:
Conservatism refers to the principles and practices which are established by way of tradition— reluctance of change from such established principle and practice, and an inclination to play safe. In short, it is a policy of caution or playing safe and habits origin as a safeguard against possible losses in the world of uncertainty.
It is a principle which is taken to be self-evident or axiomatic (i.e. something which does not require to be proved). In other words, it may be said to be an assumption or axiom constituting the supposed basis of a system of thought or an organised field of endeavour. Its validity is accepted.
In short, a postulate is said to be (i) An Axiom (ii) An assumption (hypothesis) which has already been proved to be true. It is considered to be a more fundamental character and universally acceptable which may be applied in all possible cases. The same will be true and workable in many possible situations since it will have greater general applicability.
Fundamental postulates not only try to explain and support the existing system but also try to formulate rules and procedures for a system, which has wide and varied dimensions. These postulates are either descriptive (explanatory) or suggestive (normative).
Accounting Concept is generally used to mean a ‘Notion’ only or mental idea about something. For example, Cost, Income and Capital, Debit and Credit, Assets and Liabilities, etc. are concepts, i.e. basic assumptions or conditions upon which are science of accounting is based.
There is no authoritative list of these concepts. In other words, concept means such ideas which are coupled with different accounting procedures, e.g. Appropriation and Charge, Reserve and Provisions, Depletion and Amortization, etc.
The following are some of the important generally acceptable concepts:
(i) Business Entity Concept,
(ii) Going Concern Concept,
(iii) Money Measurement (Monetary Expression) Concept,
(iv) Cost Concept,
(v) Accounting Period Concept,
(vi) Dual Aspect Concept,
(vii) Matching Concept,
(viii) Realisation Concept,
(ix) Balance Sheet Equation Concept,
(x) Verifiable and Objective Evidence Concept.
(d) Legal Implications:
While preparing the financial statements, legal formalities of the country must be observed or followed, i.e. law of the land, for example Indian companies must prepare their financial statement as per the requirements of Indian Companies Act, 1956. In short, the Profit & Loss Account and Balance Sheet must be prepared as per the Schedule VI of the Companies (Amendment) Act, 1999.
(e) Personal Judgment:
It has been stated above that financial statements must be prepared as per the accounting principles and the legal framework along with the consultation of Accounting Standard. Under the circumstances, personal judgment plays a very significant role while applying the accounting principles.
For example, while valuing the unsold stock someone prefer to apply FIFO method among other various methods (viz., LIFO, Weighted Average, Simple Average etc.) for valuing unsold stock.
Objectives of Financial Statements:
The primary objectives of financial statements are to present the true and fair value of the state of affairs of the firm with the help of its various statements viz. Income statement, Balance sheet, Cash flow statement, Funds flow statements, i.e. to supply necessary information to the users and analysts for taking decisions which will be formulated in future.
In short, the objectives of financial statement is to provide information about the financial position, performance and change in financial position of an enterprise that is useful to a wide range of users in making economic decisions.
The significant objectives of financial statements are:
(i) They provides necessary information about the financial activities to the interested parties.
(ii) They provides necessary information about the efficiency or otherwise of the management, regarding the proper utilisation of the scarce resources.
(iii) They provide necessary information for predictions (financial forecasting).
(iv) They help to evaluate the earning capacity of the firm by supplying a statement of financial position, a statement of periodical earnings together with a statement of financial activities to the various interested persons.
(v) They facilitate decisions regarding the changes in the manner of acquisition, utilisation, preservation and distribution of the scarce resources.
(vi) They facilitate decisions regarding replacement of fixed assets and expansion of the firm.
(vii) They provide necessary data to the government for taking proper decisions relating to duties, taxes and price control, etc. and for some legal and control purposes.
(viii) They device remedial measures for the deviations between the actual and budgeted performances.
(ix) They also provide necessary data and information to the managers for internal reporting and formulation of overall policies.
(x) They also help to safeguard the interest of shareholders who are not allowed to go through the day-to-day affairs of the firm.
(xi) They help to settle disputes arising from High Court, Supreme Court, Arbitrators etc.
(xii) They help the credit rating agencies to determine the rating of the Company.