Financial Statements of a Company

Financial statements are the basic and formal annual reports through which a company communicates its financial information to its owners and other external parties such as investors, tax authorities, government and employees. They mainly include the balance sheet, statement of profit and loss, and cash flow statement.

The limitations of financial statements are:

1. Do not reflect current situation: They are prepared on the basis of historical cost, so they do not show current market values.
2. Assets may not realise: In case of liquidation, some assets may not realise their stated values.
3. Bias: Personal judgement, accounting concepts and conventions may affect the results.
4. Aggregate information: They show only summary information, not detailed information.
5. Vital information missing: Important facts like loss of markets or termination of agreements are not shown.
6. No qualitative information: They contain only monetary data, not qualitative factors like labour relations.
7. Only interim reports: They show results for a specific period and do not predict future performance exactly.

Any three objectives are:

1. To provide information about economic resources and obligations of a business.
2. To provide information about the earning capacity of the business.
3. To provide information about cash flows.

Other objectives mentioned in the chapter include judging management effectiveness and disclosing accounting policies.

The importance of financial statements to different users is:

- Shareholders: They help shareholders know the status, safety and return on their investment and decide whether to continue or discontinue it.
- Creditors: They help creditors judge the company’s ability to repay debts and decide whether to grant credit.
- Government: They provide basic input for fiscal, taxation and other economic policies.
- Investors: They help investors assess profitability, security, liquidity and solvency before investing.

The items are disclosed in the balance sheet as follows:

(i) Current assets, inventory → shown under Current Assets as Inventories.

(ii) Contingent liabilities → disclosed in the Notes to Accounts, not on the face of the balance sheet.

(iii) Shareholders’ Funds, Reserve and Surplus → shown under Equity and Liabilities → Shareholders’ Funds → Reserve and Surplus.

(iv) Fixed Assets, Intangible Assets → shown under Non-current Assets → Fixed assets → Intangible assets.

(v) Proposed Dividend for the current year → shown in Notes to Accounts as it is contingent until approved.

(vi) Non-current Liabilities → shown under Equity and Liabilities as a separate major head.

(vii) Arrears of Dividend on Cumulative Preference Shares → shown under Notes to Accounts / as a liability-related disclosure, depending on the company’s presentation.

Proposed dividend for the current year is shown in the Notes to Accounts as a contingent liability until approved by shareholders. So if the question asks where it is disclosed, it is not treated as a current liability on the face of the balance sheet.

Non-current liabilities are presented under the major head Equity and Liabilities in the balance sheet, as a separate category.

Arrears of dividend on cumulative preference shares are disclosed in the Notes to Accounts.

Financial statements are the end products of the accounting process. They are prepared on the basis of recorded facts, accounting concepts, conventions, policies, standards and legal requirements.

Their nature is explained by the following points:

1. Recorded facts: They are prepared from figures recorded in accounting books at historical cost, not market value.
2. Accounting conventions: Conventions such as valuing inventory at cost or market price, whichever is lower, and valuing assets at cost less depreciation are followed.
3. Postulates: They are prepared on assumptions like going concern, money measurement and realisation.
4. Personal judgements: Items like depreciation, doubtful debts and inventory valuation involve estimates and judgement.

Thus, financial statements are summarised reports of recorded facts prepared according to accounting principles and legal requirements.

The significance of financial statements is that they provide useful information to various users for decision-making.

1. Report on stewardship function: They show how effectively management has used the company’s resources.
2. Basis for fiscal policies: They help the government frame taxation and other economic policies.
3. Basis for granting credit: Banks and financial institutions use them to decide whether to lend.
4. Basis for prospective investors: They help investors judge profitability, liquidity and solvency.
5. Guide to value of investment already made: Shareholders use them to decide whether to continue their investment.
6. Aid trade associations: Associations may analyse them for standards and support to members.
7. Help stock exchanges: They help stock exchanges and brokers judge financial position and transparency.

So, financial statements are important because they provide the key information needed by management, investors, creditors, government and others.

The limitations of financial statements are:

1. Do not reflect current situation because they are based on historical cost.
2. Assets may not realise their stated values if the company is liquidated.
3. Bias may arise because of accounting conventions and personal judgement.
4. They give only aggregate information, not detailed information.
5. Some vital information is missing, such as loss of markets or cessation of agreements.
6. They contain only quantitative/monetary information, not qualitative information.
7. They are only interim reports and do not show future changes.

Hence, financial statements should be analysed carefully before using them for decisions.

The Statement of Profit and Loss is prepared for a specific period to find the company’s operating result.

### Format
It contains the following major items:

- Revenue from operations
- Other income
- Total revenue
- Expenses:
- Cost of materials consumed
- Purchases of stock-in-trade
- Changes in inventories
- Employee benefits expense
- Finance costs
- Depreciation and amortisation expense
- Other expenses
- Profit before extraordinary items and tax
- Exceptional items
- Profit before extraordinary items and tax
- Extraordinary items
- Profit before tax
- Tax expense
- Profit/(Loss) for the period
- Earnings per share

### Explanation of items up to profit before tax
- Revenue from operations includes sale of products, sale of services and other operating revenues.
- Other income includes interest income, dividend income, gain/loss on sale of investments and other non-operating income.
- Expenses include the costs incurred to earn income, such as materials consumed, employee expenses, finance cost, depreciation and other expenses.
- Profit before tax is obtained by subtracting total expenses from total revenue, after considering exceptional and extraordinary items.

In formula form:

Profit before tax = Total Revenue − Total Expenses

where total revenue = revenue from operations + other income.