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Financial Statements | Definition, Objectives, Nature, Importance & Limitations

What is Financial Statements ?

Financial Statement (also referred to as the "Financial Report") is a formal and structured record of the financial activities of a business entity. It reveals the financial health of an entity with regard to the profits earned during a specific period (Accounting Period), and position of assets and liabilities as on a specific date (Last date of the Accounting Period). It also gives an indication in respect of future prospects of the entity. Thus, the process of classifying the financial information assists in proper and regular presentation of financial health of the business entity.

Definition of Financial Statements 

According to John N. Myer :
"The financial statements provide a summary of the accounts of a business enterprise, the balance sheet reflecting the assets, liabilities and capital as on a certain date and the income statement showing the results of operations during a certain period."
As per this definition financial accounts are the end products of the accounting process.

According to Robert N. Anthony :
"Financial statements, essentially, are interim reports, presented annually and reflect a division of the life of an enterprise into more or less arbitrary accounting period - more frequently a year." 

According to this definition, financial statements are a form of reports which helps management in decision making process. Such reports are prepared after a fixed time period to enable management to carry out its day to-day functions.

Financial Statement

Objectives of Financial Statements

Objectives of financial statements are enumerated in a nutshell as follows :

1) Assessment of Past Performance : 
Trend revealed through the various financial data, like 'Sales", "Cost of Goods Sold", "Operating Expenses", "Net Income', 'Cash-flow etc., of an organisation's past performance may be a good pointer to its future performance. Prospective investors and current creditors rely on such past data to predict the future prospects of an organisation.

2) Assessment of Current Position : 
Through the exercise of financial statement analysis, the current status of 1 organisation with regard to the type of assets held by it and the nature of its liabilities, etc. can be ascertained.

3) Prediction of Profitability and Growth Prospects : 
The assessment and forecasting of the Earning Prospects of a business organisation can be made through the exercise of 'Financial Statement Analysis'. It helps the prospective investors in comparing and choosing an investment out of the many investment opportunities available before them. It is also used by other stakeholders for various other purposes.

4) Prediction of Bankruptcy and Failure : 
"Financial Statement Analysis' is a vital technique, through which the possibilities of an organisation going bankrupt in future or the chances of failure of a business can be predicted.

5) Assessment of the Operational Efficiency : 
Financial Statement Analysis' facilitates the assessment of the Operational Efficiency' of an organisation's management. It can be done through setting standards of performance on the basis of certain parameters and comparing them with the actual performance of the organisation. Any deviation between the 'Set Standards of Performance and the 'Actual Performance may be used as an indicator of "Management Efficiency.

Nature of Financial Statements

The nature / features of financial statements is reflected through the following trails : 

1) Recorded Facts : 
Various transactions recorded in the books of accounts relating to 'Cash in Hand". "Bills Receivable', 'Bills Payable', 'Debtors', 'Creditors'. Fixed Assets'. 'Sales', 'Purchases', "Wages', 'Salaries', 'Capital', etc. are termed as the 'Recorded Facts'. They are also referred to as 'Historical Data', as their recording is done on historical basis. Financial Statements of a business organisation contain only historical data. Facts and events other than historical data are not reflected in the Financial Statements, in-spite of their importance in the affairs of the business organisation.

2) Accounting Conventions : 
Accounting Conventions relate to those accounting principles that have been in practice for long, some of which may be very conservative in nature, e.g. the conventions applied for the Valuation of Inventory', 'Allocation of Expenses between Capital and Revenue', Valuation of Assets', etc. Due to application of such conservative 'Accounting Conventions', the 'Financial Statements may not reflect the true picture of an organisation's affairs. For example, as per the accounting convention, a provision is required to be made for "Anticipated Losses', whereas the 'Anticipated Profit is not taken into consideration.

3) Postulates : 
'Postulates' are the presumptions made by a book-keeper or accountant at the time of following "Accounting Conventions. Some of the postulates are discussed in the following paragraphs : 

i) Going Concern of the Business : 
This postulate depicts valuation of assets at their cost value less depreciation. In the absence of such presumption, the value of assets would have been different, viz. at realizable value.

ii) Stability in the Value of Money Over a Period of Time : 
This assumption results in not valuing the assets on the basis of change in the value of money by some of the accountants. 

iii) Realization Postulate : 
As per of this assumption, there exists a time-gap between the production of goods and their sale and the revenue is realized only after the sale of goods. 

4) Personal Opinion : 
Personal opinion of an accountant is of paramount importance as it is the deciding factor at the time of the application of various conventions or postulates. Some of the examples, where the personal opinion of an accountant plays a significant role in such decisions related to the Method of Depreciating an Asset, Method of Valuation of Inventory, Making Provision for Doubtful Debts, Method of Amortization of Fixed Assets, etc. Thus, the principle of helps to judge the personal view of an accountant. 

5) Accounting Standards and Principles : 
Accounting Standards and Principles' are of immense help while preparing the Financial Statements, as they ensure transparency and disclosure of vital information. Some of the Accounting Standards are mandatory for the business entity, e.g. Disclosure of Accounting Policies, Revenue Recognition, Accounting for Fixed Assets, etc. 

Importance of Financial Statements

The advantages of financial statements are as follows : 

1) Measurement of Short-Term Solvency : 
An organisation's ability to pay its short term liabilities is referred to as its 'Short Term Solvency', assessment of which can be made through the 'Financial Statement Analysis'. If an organisation has a positive 'Short Term Solvency', its creditors would not hesitate in lending funds to it. On the other hand, if an organisation suffers from the lack of 'Short Term Solvency", the creditors would refrain from lending funds to it.

2) Measurement of Long-Term Solvency : 
An organisation's ability to repay its Long Term Liabilities, i.e. bonds and debentures issued by it and other secured liabilities, is referred to as its Long Term Solvency'. A company having such capability is said to be 'Solvent'. Thus, status of an organisation in terms of long term solvency is revealed through the analysis of financial statements.

3) Measurement of Operating Efficiency : 
Through the analysis of Statements of an organisation the position with regard to its profitability can easily be ascertained. If a business organisation is incurring losses, the reasons thereof may also be found out through such analysis, and necessary corrective actions may be taken to curb losses and turn the loss incurring organisation into a profit earning organisation.

4) Measurement of Profitability : 
The existing earning capacity of an organisation as well as forecasting in respect of its future earnings can be gathered through the caring ratio analysis, inputs for which are provided by the Financial Statements. "Measurement of Profitability" is an important indicator, which helps in taking decision by the Investors and 'Leaders'.

5) Comparison of Inter-Firm Position : 
The comparison of the financial position of one organisation with that of another organisation is an exercise undertaken through the 'Financial Analysis'. Such a comparative study is useful in deciding the course of action to be taken by 'Investors and other 'Stakeholders'. 

6) Forecasting, Budgeting and Deciding Future Course of Action : 
Through the Financial Statement Analysis", vital indicators of an organisation's financial health, e.g. 'Capital Base', 'Reserves and Provisions', Profitability", "Working Capital Gap', "Trend in Sales', etc. can be found out. Such indicators make a solid ground, on the basis of which the exercise of 'Forecasting' and 'Budgeting' may be undertaken. Future course of action to be taken for the betterment of the organisation may also be decided on this basis.

Limitations of Financial Statements

Although a lot f vital information may be gathered from the financial statements of a business organisation, it is characterized by certain inherent limitations, which are as follows : 

1) Interim Reports : 
Financial Statements of an organisation are basically considered 'Interim' in nature. The 'Profitability' during an 'Accounting Period' and 'Financial Position as on a particular date, when compared to another period, can indicate the status at certain frequency during the lifetime of a business. However, the final outcome of conducting a business (in the form of strength, weaknesses, future prospects, etc.) is possible with accuracy only at the time of winding-up of the business.

2) Discloses Only Quantitative Information : 
The data revealed through the Financial Statements' is quantitative in nature, which can be measured in terms of money. Many other factors of a business, which are qualitative in nature, cannot be expressed in terms of money, and as such remain out of the purview of the 'Financial Statements.

3) Based on Historical Data : 
Preparation of financial statements is done on the basis of past data, i.e. events that have already taken place. It does not give a foresight of the future events likely to take place and their impact on the profitability, financial health, etc. of a business organisation. Therefore, the financial statements are not of much help as far as the decision-making process is concerned.

4) Based on Accounting Concepts and Conventions : 
Preparation of financial statements is carried out on the basis of certain underlying presumptions as stated under 'Accounting Concepts/Conventions. Some of such Concepts/Conventions may be very conservative and unrealistic, rendering financial statements also unrealistic.

5) Personal Opinion : 
Personal opinion of an accountant is capable of influencing certain decisions taken during the preparation of financial statements. Such decisions generally relate to "Choice of Depreciation Method","Mode of Amortization of Fixed Assets", 'Treatment of Deferred Revenue Expenditures","Inventory Valuation" etc. At times, the personal opinion of an accountant may reflect a distorted picture of an organisation's performance.

6) Window Dressing : 
Resorting to the phenomena of 'Window Dressing, with a view to presenting a rosy picture of an organisation's affairs, is a common practice adopted by the management. Such an exercise creates a better, but false, image of the organisation's financial health, capabilities, etc. and the prospective investors and other stakeholders are misled.

Types of financial Statements

The Financial Statement Analysis is a tool through which various components of "Profitability" during a specific period and Financial Status' as on a specific date, of an organisation are subjected to a detailed scrutiny, analysis and interpretation. This enables one to draw further meaning and conclusions from the data. already provided through the 'Financial Statements'. Various tools and techniques used for making financial decisions on the basis of financial statements are as under :

1) Ratio Analysis : 
'Ratio Analysis' is a technique of quantitative analysis by establishing relationship between two or combination of more than two items of Financial Statements'., viz. 'Balance Sheet', "Income Statement and/or 'Cash Flow Statement. It is used to evaluate various aspects of a company's operating and financial performance such as its efficiency, liquidity, profitability and solvency, which is helpful for the management in making certain decisions.

2) Common-Size Statements : 
A company's "Financial Statements, which displays all items as percentage of a common base figure, (e.g. Total Assets, Total Liabilities' and 'Total Sales') is known as 'Common-Size Statement'. It facilitates comparative analysis between two or more companies, or between two or more time-periods of a company.

3) Comparative Statements : 
The Financial Statements of an organisation for different time-periods are referred to as 'Comparative Financial Statements. Various items of 'Financial Statements are presented in a 'Comparative Form', which may be in the form of a table. This enables one to have a comparative view of various parameters for two or more time-periods at a glance.

4) Trend Analysis : 
"Trend analysis' is a technique based on the underlying premise that what has happened in the past gives an indication as to what will happen in the future. It may be defined a mathematical technique that uses historical data to forecast future outcome. "Trend Analysis" may be undertaken in respect of two organisations for the same time-period or an organisation for different time-period (two or more years). A trend is a series of information from the Financial Statements, analysed to arrive at some meaningful conclusion.

5) Funds Flow Analysis/Statement : 
'Funds Flow Statement is a statement, which depicts the sources and applications of funds for a specific time-period. Through the 'Fund Flow Statement' an analysis with regard to the changes in the financial position of an organisation from the beginning of a time-period to its end, is undertaken. 

6) Cash Flow Analysis/Statement : 
A 'Cash Flow Statement' is a financial statement, which shows how 'Cash' and 'Cash Equivalents' in a business are affected by the changes in various components of Balance Sheet' and 'Profit and Loss Accounts'. It summarizes the reasons behind the changes in cash position of a business entity between the dates of two balance sheets.

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