Chapter 3 Financial Statements of a Company

Financial statements analysis includes gaining an idea of an entitys financial situation by analysing the financial statements of the company. You will use three main financial statements—statement of income, balance sheet and cash flow statement. Analysis of these financial statements is also submitted to the board of directors and senior management committees. They use the information in their decision- making process as input. This research is also used by third stakeholders, such as regulatory authorities and investors, to gain insight into the organisation.

Limitations of financial statement analysis:

1. Not a Substitute of Judgement An analysis of financial statement cannot take place of sound judgement. It is only a means to reach conclusions. Ultimately, the judgements are taken by an interested party or analyst on his/ her intelligence and skill.

2. Based on Past Data Only past data of accounting information is included in the financial statements, which are analyzed. The future cannot be just like past. Hence, the analysis of financial statements cannot provide a basis for future estimation, forecasting, budgeting and planning.

3. Problem in Comparability The size of business concern is varying according to the volume of transactions. Hence, the figures of different financial statements lose the characteristic of comparability.

4. Reliability of Figures Sometimes, the contents of the financial statements are manipulated by window dressing. If so, the analysis of financial statements results in misleading or meaningless.

1. Assessment of Past Performance and Current Position
2. Prediction of Net Income and Growth Prospects
3. Prediction of Bankruptcy and Failure

(i)Shareholders- They are interested in assessing the profitability and viability of the capital invested by them in the business. The financial statements prepared by the business concerns enable them to have sufficient information to assess the financial performance and financial health of the business.

(ii) Creditors- Creditors are interested in the financial statements of businesses to learn about the status of their going concern, profitability, financing, liquidity, and cash flow. An entity is a going concern if it is likely to remain in business for the foreseeable future without going into bankruptcy.

(iii) Government- As a business owner, your financial statements offer valuable
information about your companys overall financial position, such as areas of
financial strength or weakness. Financial statements are important to tax authorities to ensure the accuracy of taxes and additional duties declared and
paid by your company.

(iv) investors- Financial statements are important to investors because they can
provide enormous information about a companys revenue, expenses,
profitability, debt load, and the ability to meet its short-term and long-term
financial obligations.

Disclosure of various items in the Balance Sheet of a company is given below. 

Financial statements are the summarised reports of recorded-facts and are
prepared following the accounting concepts, conventions and requirements of
Law. The American Institute of Certified Public Accountants states the nature of financial statements as, “the statements 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. The following points explain the nature of financial statements.

(i) Recorded Facts :Financial statements are prepared on the basis of facts in the form of cost data recorded in accounting books. The original cost or historical cost is the basis of recording transactions. The figures of various accounts such as cash in hand, cash at bank, bills receivable, sundry debtors, fixed assets, etc are taken as per the figures recorded in the accounting books. The assets purchased at different times and at different prices are put together and shown at costs. As these are not based on market prices, the financial statements do not show current financial condition of the concern.

(ii) Accounting Conventions: Certain accounting conventions are followed while
preparing financial statements. The convention of valuing inventory at cost or
market price, whichever is lower, is followed. The valuing of assets at cost less
depreciation principle for balance sheet purposes is followed. • The convention of materiality is followed in dealing with small items like penci’s, pens, postage
stamps, etc. In this way the use of accounting conventions makes financial statements comparable, simple and realistic.

(iii) Based on Concepts: Financial statements are prepared on certain basic
assumptions (prerequisites) known as Concepts such as going concern concept,
money measurement concept, realisation concept, etc. Going concern concept
assumes that the enterprise is treated as a going concern and exists for a longer
period of time. So the assets are shown on historical cost basis. Money measurement concept assumes that the value of money will remain the same in
different periods. While, preparing profit and loss account the revenue is included in the sales of the year in which the sale was undertaken even though the sale price may be received over a number of years. The assumption is known as realisation concept.

(iv) Personal Judgements: Under more than one circumstance, facts and figures
presented through financial statements are based on personal opinion, estimates and judgements. The depreciation is provided taking into consideration the useful economic life of fixed assets. Provisions for doubtful debts are made on estimates and personal judgments. In valuing inventory, cost or market value, whichever is less is being followed.

The importance of financial statements is mentioned below:

1. Provides Information: Financial statements provide information to various
accounting users both internal as well as external users. It acts as a basic platform for different accounting users to derive information according to varying needs. For example, the financial statements on one hand help the shareholders and investors in assessing the viability and return on their investments, while on the other hand, the financial statements help the tax authorities in calculating the
amount of tax liability of the company.

2. Cash Flow: Financial statements provide information about the cash flows of
the company. The financial statements help the creditors and other investors.in
determining solvency of company.

3. Effectiveness of Management: The comparability feature of the financial
statements enables management to undertake comparisons like inter-firm and
intra-firm comparisons. This not only helps in assessing the viability and
performance of the business but also helps in’ designing policies and drafting
policies. The financial statements enhance the effectiveness and efficacy of the
management.

4. Disclosure of Accounting Policies: Financial statements provide information
about the various policies, important changes in the methods, practices and
process of accounting by the company. The disclosure of the accounting policies
makes financial statements simple, true and enables different accounting users to understand without any ambiguity.

5. Policy Formation by Government: It needs information to determine national
income, GDP, industrial growth, etc. The accounting information assist the
government in the formulation of various policy measures and to address various economic problems like employment, poverty etc.

6. Attracts Investors and Potential Investors: They invest or plan to invest in the
business. Hence, in order to assess the’viability and prospectus of their investment, creditors need information about profitability and solvency of the business.

Limitations of financial statements:

1)Historical Costs Financial reports depend on historical costs. All the transactions record at historical costs; The value of the assets purchased by the Company and the liabilities it owes changes with time and depends on market factors; The financial statements do not provide the current value of such assets and liabilities. Thus, if a large number of items available in the financial statements based on historical costs and the Company has not revalued them, the statements can be misleading.

2) Inflation Adjustments The assets and liabilities of the Company are not inflation-adjusted. If the inflation is very high, the items in the reports will be recorded at lower costs and hence, not giving much information to the readers.

3)Personal Judgments The financial statements are based on personal judgments. The value of assets\ and liabilities depends on the accounting standard used by the person or group of persons preparing them. The depreciation methods, amortization of assets, etc. are prone to the personal judgment of the person using those assets. All such methods cannot be stated in the financial reports and are, therefore, a limitation.

4) Specific Time Period Reporting The financial statements based on a specific time period; they can have an effect of seasonality or sudden spike/dull in the sales of the Company. One period cannot be compared to other periods very easily as many parameters affect the performance of the Company, and that reported in the financial reports. A reader of the reports can make mistakes while analyzing based on only one period of reporting. Looking at reports from various periods and analyzing them prudently can give a better view of the performance of the Company.

5) Intangible Assets The intangible assets of the Company are not recorded on the balance sheet. Intangible assets include brand value, the reputation of the Company earned over a while, which helps it generate more sales, is not included in the balance sheet. However, if the Company has done any expense  on intangible assets, it is recorded on the financial statements. It is, in general, a problem for start-ups which, based on the domain knowledge, creates a huge intellectual property, but since they have not been in business for long could not generate enough sales. Hence, their intangible assets are not recorded on the financial statements and neither reflected in the sales.

6) Comparability While it is a common practice for analysts and investors to compare the performance of the Company with other companies in the same sector, but they are not usually comparable. Due to various factors like the accounting practices used, valuation, personal judgments made by the different people in different Companies, comparability can be a difficult task.

7) Fraudulent Practices The financial statements are subject to fraud. There are many motives behind having fraudulent practices and thereby skewing the financial results of the Company. If the management is to receive a bonus or the promoters would like to raise the price of the share, they tend to show good results of the Company’s performance by using fraudulent accounting practices, creating fraud sales, etc. The analysts can catch these if the Company’s performance exceeds the industry norms.

8) No Discussion on Non-Financial Issues Financial statements do not discuss non-financial issues like the environment, social and governance concerns, and the steps taken by the Company to improve the same. These issues are becoming more relevant in the current generation, and there is an increased awareness amongst the Companies and the government. However, the financial reports do not provide such information/discussion.

9) It May Not be Verified An auditor should audit the financial statements; however, if they are not, they are of minimal use to the readers. If no one has verified the accounting practices of the Company, operations, and general controls of the Company, there will be no audit opinion. An audit opinion that accompanies the financial statements highlights various financial issues (if any)  in the reports.

10) Future Prediction Although many financial statements have a comment that these contain the forward-looking statement, however, no prediction about the business could be made using these statements. The financial statements provide the historical performance of the Company; many analysts use this information and predict the sales and profit of the Company in future quarters. However, it is prone to many assumptions. Thus, financial statements as a standalone cannot provide any prediction on the future performance of the Company.

Only the revenue or expenses related to the current year are debited or credited to profit and loss account. The profit and loss account starts with gross profit at the credit side and if there is a gross loss, it is shown on the debit side.

For a business, the balance sheet is one of the main financial reports prepared by either the bookkeeper or the accountant. Its a snapshot view of your
businesss overall financial situation for a particular period of time. The balancesheet consists of three major elements: assets, liabilities and owners equity. The object of the statement is to prove true the accounting equation, "

Asset = Liabilities + Owners Equity." The statement places a business

assets on the left side of the equation and the liabilities and equity on the right and the amounts on each side of the equation should be equal. Overall Use of the Balance Sheet Your balance sheets show the position of the company on a given day, including its total assets, liabilities and equity, which equals its net worth. Lenders commonly use financial statements to assess your companys creditworthiness. A high debt-to-assets or debt-to-equity ratio is a concern.

The various parties interested in financial statements directly or indirectly
can be categorised in two broad categories

(i) Internal Parties: The following are the internal parties directly related to the company and interested in financial statements.

(a) Owner :The owner/s is/are interested in the profit earned or loss incurred
during an accounting period. They are interested in assessing the profitability and viability of the capital invested by them in the business.

(b) Management: Management interested in financial statements for drafting
various policies measures, facilitating planning and decision making process.

(c) Employees and Workers: The employee and workers are interested in
financial statement for knowing about the timely payment of wages and salaries,
bonus and appropriate increment in their wages and salaries. Financial statement enables them to know about the figure of profit earned during the year.

(ii) External Parties :There are various external parties who are interested in
financial statements for a number of reasons. The following are the various
external parties.

(a) Creditors: Creditors are always interested in financial statement to gather
information about credit worthiness of the business.

(b) Investors and Potential Investors: Persons who are willing to invest in any
organisation always wish to know about the profitability and solvency of the
business concern. Hence, in order to assess the viability and prospectus of their
investment, creditors need information about profitability and solvency of the
business.

(c) Consumers: The survival and growth of any organisation largely depends upon the Goodwill earned in the heart of the customers. In this regards if the Business has transparent financial records it help in assisting the customers to know the correct cost of production and accordingly assess the degree of reasonability of the price charged by the business.

(d) Banks/Financial Institutions: Banks and financial institutions provide finance
in the form of loans and advances to various businesses. Thus, they need
information regarding liquidity, creditworthiness, solvency and profitability to
advance loans.

(e) Tax Authorities: They need information about sales, revenues, profit and
taxable income in order to determine and levy various types of tax on the
business.

(f) Government : It needs information to determine national income, GDP,
industrial growth, etc. The accounting information assist the government in the
formulation of various policies measures and to address various economic
problems like employment, poverty etc.

(g) Researchers :Various research institutes like NGOs and other independent
research institutions undertake various research projects and the accounting
information facilitates their research work.

The financial statements not only help in presenting the true and real financial position of the company but they also help in taking managerial decisions. The nature of the financial statements depends upon the following aspects like recorded facts, conventions, concepts and personal judgement.

(i) Recorded Facts: The items recorded in the financial statements reflect their
original cost i.e., the cost at which they were acquired. Consequently, financial
statements do not reveal the current market price of the items. Further, financial
statements fail to capture the inflation effects.

(ii) Accounting Conventions: The preparation of financial statements is based on
some accounting conventions like, Prudence Convention, Materiality Convention, Matching Concept, etc. The adherence to such accounting conventions makes financial statements easy to understand, comparable and reflects the true and fair financial position of the company. Besides the above while preparing financial statements, certain concepts are adhered to. The nature of these concepts is reflected in the nature of the financial statements.

(iii) Personal Judgements: The nature of financial statement largely depends
upon the personal value judgements. Personal judgements are attached to
different practices of recording transactions in the financial statements, e.g.,
recording stock either at market value or at the cost requires value judgement
depending upon the personal judgement. Thus, personal judgements help in
determining the nature of the financial statements.

The process of preparing income statement is explained below

(i) First of all a Trial Balance is prepared on the basis of the balances of various
accounts in the ledger.

(ii) After that trading account is prepared by recording Opening Stock, Purchases, Manufacturing Expenses and other direct expenses on the debit side.

(iii) On the other hand sales and closing stock is recorded on the credit side of the trading account.

(iv) After that the balancing figure of trading account is determined by totalling
both the sides, if the credit side exceeds the debit side, then the balancing figure
is termed as gross profit, but if the debit side exceeds the credit side, then the
balancing figure is termed as gross loss.

(v) Carry forward the Gross Profit (Gross Loss) to the credit (debit) side of the
Profit and Loss Account.

(vi) After that all the operating and non-operating revenue expenditures with
their relevant adjustments are recorded on the debit side of the profit and loss
account. Record all current year’s operating and non operating revenue incomes
with their relevant adjustments on the credit side of the profit and loss account.

(vii) Ascertain the balancing figure by totalling both the sides of the profit and
loss* account. If the credit exceeds the debit side, then the balancing figure is
termed as net profit, but if the debit side exceeds the credit side, then the
balancing figure is termed as net loss. The process of preparing Balance Sheet is given below

(i) First of all match the total of both the side of trail balance. If there is any
difference in the debit side of trail balance it will be posted in assets side of
balance sheet and if there is any difference in credit side of balance sheet it will
be posted in the liabilities side of the balance sheet.

(ii) Record all the debit balances of real and personal accounts on the left hand
side (i.e., Assets side) of the balance sheet after making all adjustments for
provision and other related items.

(iii) Record all the credit balances of real and personal accounts on the right hand side (i.e., Liabilities side) of the balance sheet after making all adjustments for interest and outstanding items.

(iv) Add Net Profit to the opening capital and deduct Net Loss, if any from the opening capital.

(v) Acertain the total of two sides, which must be equal.