Chapter Notes

Meaning of Financial Statements

Think of Financial Statements as a company's annual report card. They are formal documents that a company's management prepares to communicate its financial performance and position to everyone interested, such as the owners (shareholders), investors, tax authorities, and the government. These are the final products of the entire accounting process for the year.

The main financial statements include:

• The Balance Sheet, which shows the company's financial position on a specific date.
• The Statement of Profit and Loss, which shows the company's financial performance over a period.
• The Cash Flow Statement, which details the movement of cash.

These statements are prepared according to a consistent set of rules, including accounting standards and the legal requirements of the Companies Act. This ensures that anyone reading them can easily understand and use the information to make informed economic decisions.

Nature of Financial Statements

Financial statements aren't just a random collection of numbers; they are built on specific principles. The American Institute of Certified Public Accountants describes them as a mix of recorded facts, accounting principles, and personal judgements. Let's break down what this means.

1. Recorded Facts: Financial statements are based on actual transactions that have been recorded in the company's accounting books. These transactions are recorded at their historical cost—the price at which an asset was originally purchased. [!example] If a company bought a building for ₹50 lakhs ten years ago, it will be shown at ₹50 lakhs in the books, even if its market value today is ₹2 crores. This means the statements show what was paid, not necessarily what things are currently worth.

2. Accounting Conventions: To ensure consistency and simplicity, accountants follow certain established practices, or conventions.

   • Valuing Inventory: Inventory is valued at its cost or market price, whichever is lower.
   • Materiality: Small, insignificant items like pens and pencils are treated as expenses for the year they are bought, even though they are technically assets, because their value is too small to track over time.
   • Following these conventions makes the financial statements of different companies comparable and more realistic.

3. Postulates (Assumptions): Financial statements are prepared based on a few fundamental assumptions.

   • Going Concern Postulate: This assumes the business will continue to operate for a long time. Because of this, assets are shown at their historical cost, not at a sell-off price.
   • Money Measurement Postulate: This assumes that the value of money remains stable over time. This is why assets bought at different times are added together at their original cost, even though inflation may have changed the purchasing power of money.
   • Realisation Postulate: Revenue is recognized when a sale is made, not necessarily when the cash is received.

4. Personal Judgements: Accounting is not always black and white. It often requires accountants to use their professional judgement and make estimates.

   • Depreciation: The useful life of an asset (like a machine or a vehicle) is an estimate used to calculate depreciation.
   • Provision for Doubtful Debts: A company estimates how much of its receivables might not be collected and makes a provision based on that judgement.
   • Valuing Inventory: Deciding the market value of inventory involves judgement.

These judgements are guided by the principle of conservatism, which aims to avoid overstating assets or income.

Objectives of Financial Statements

The main goal of financial statements is to provide useful information to help users make decisions. The specific objectives are:

• To provide information about economic resources and obligations: To show what the business owns (assets) and what it owes (liabilities). This helps investors and creditors understand the company's financial strength.
• To provide information about earning capacity: To show how profitable the business is. This helps users predict, compare, and evaluate the company's ability to generate profit in the future.
• To provide information about cash flows: To show where the company's cash came from and how it was used. This is crucial for assessing the company's ability to pay its debts and dividends.
• To judge the effectiveness of management: To show how well the management has used the company's resources to generate profits.
• To provide information about social impact: To report on activities that affect society, reflecting the company's role in its social environment.
• To disclose accounting policies: To clearly state the accounting policies and concepts followed, so users can better understand how the numbers were calculated.

Types of Financial Statements

For companies registered under the Companies Act 2013, the primary financial statements are the Balance Sheet and the Statement of Profit and Loss. These must be prepared according to the format prescribed in Schedule III of the Act. This standardised format helps in comparing the financial statements of different companies.

Form and Content of Balance Sheet

The Balance Sheet provides a snapshot of a company's financial health on a particular date. As per Schedule III, it must be presented in a vertical format.

Format of a Balance Sheet

I. EQUITY AND LIABILITIES

1. Shareholder's Funds
   • Share Capital
   • Reserves and Surplus
   • Money received against share warrants
2. Share Application money pending allotment
3. Non-current Liabilities
   • Long-term borrowings
   • Deferred tax liabilities (net)
   • Other long-term liabilities
   • Long-term provisions
4. Current Liabilities
   • Short-term borrowings
   • Trade payables
   • Other current liabilities
   • Short-term provisions

II. ASSETS

1. Non-Current Assets
   • Fixed assets (Tangible, Intangible, Capital work-in-progress, Intangible assets under development)
   • Non-current investments
   • Deferred tax assets (net)
   • Long-term loans and advances
   • Other non-current assets
2. Current Assets
   • Current investments
   • Inventories
   • Trade receivables
   • Cash and cash equivalents
   • Short-term loans and advances
   • Other current assets

Key Features of Presentation

• Current and Non-current Classification: Assets and liabilities are split into current (expected to be realised or settled within 12 months or the company's operating cycle) and non-current (everything else).
• Terminology: Old terms like 'Sundry Debtors' and 'Sundry Creditors' are now replaced with Trade Receivables and Trade Payables.
• Rounding Off: Figures must be rounded off based on the company's turnover. For a turnover less than ₹100 crore, rounding is to the nearest hundreds, thousands, lakhs, or millions. For turnover over ₹100 crore, it is to the nearest lakhs or millions.
• Notes to Accounts: The face of the Balance Sheet shows only the main items. Detailed information for each item is provided in the Notes to Accounts, which are a mandatory part of the financial statements.

Understanding Key Balance Sheet Items

Shareholders' Funds

This represents the owners' stake in the company.

• Share Capital: This section requires detailed disclosure in the Notes to Accounts, including the number of authorised, issued, and subscribed shares. It must also show shares held by the holding company or shareholders with more than 5% ownership.
• Reserves and Surplus: This includes profits that have been retained in the business. It is classified into items like Capital Reserve, Securities Premium Reserve, and the balance in the Statement of Profit and Loss (Surplus). A debit balance (loss) in the Statement of Profit and Loss is shown as a negative figure under 'Surplus'. Even if the total of 'Reserves and Surplus' becomes negative after this adjustment, it is still shown under this head.
• Money received against share warrants: This is the amount a company receives for issuing share warrants, which can be converted into shares at a later date.

Current/Non-current Distinction

This classification is crucial for understanding a company's short-term financial health. An item is classified as current if:

• It is part of the entity's operating cycle.
• It is expected to be realised or settled within twelve months.
• It is held mainly for trading.
• It is cash or a cash equivalent.
• For a liability, the company does not have an unconditional right to defer its settlement for at least 12 months.

All other assets and liabilities are classified as non-current.

Important Accounting Treatments

• Preliminary Expenses: These expenses, incurred when a company is formed, must be written off completely in the year they are incurred. They are first adjusted against the Securities Premium and then from the Statement of Profit & Loss.
• Proposed Dividend: A dividend proposed by the Board of Directors is not a liability until it is approved by the shareholders at the Annual General Meeting (which happens in the next financial year). Therefore, as per AS-4, the proposed dividend for the current year is disclosed in the Notes to Accounts as a contingent liability.
• Inventories: All inventories (like raw materials, finished goods) are always treated as current assets.
• Fixed Assets: Assets like buildings and machinery are always non-current, even if their useful life is less than 12 months.

Form and content of Statement of Profit and Loss

The Statement of Profit and Loss shows the company's operational results for a specific period. It matches the revenues earned during a period with the expenses incurred to earn that revenue.

Format of a Statement of Profit and Loss

Key Items in the Statement of Profit and Loss

1. Revenue from operations: This is the income generated from the company's main business activities, such as the sale of products or services. For a finance company, this would include interest and dividend income.
2. Other income: This includes income from non-operating activities. [!example] For a car manufacturing company, selling cars is 'Revenue from operations'. Earning interest on a bank deposit or profit from selling an old investment would be 'Other income'.
3. Expenses: These are the costs incurred to generate revenue.
   • Cost of Materials Consumed: The cost of raw materials used in manufacturing.
   • Purchases of Stock-in-Trade: The cost of goods purchased for resale (for a trading company).
   • Changes in inventories: The difference between the opening and closing stock of finished goods, work-in-progress (WIP), and stock-in-trade.
   • Employee benefit expenses: Salaries, wages, and other staff welfare costs.
   • Finance costs: Interest paid on borrowings like debentures and loans. Bank charges are shown under 'Other Expenses'.
   • Depreciation and amortisation: The expense related to the wear and tear of tangible fixed assets (depreciation) and the writing off of intangible assets (amortisation).
   • Other expenses: Any expenses that do not fit into the above categories.

Uses and Importance of Financial Statements

Financial statements are vital tools for a wide range of users, helping them make important economic decisions.

• For Management: Helps in planning, decision-making, and controlling business operations.
• For Shareholders and Investors: Helps them assess the company's profitability and financial health to decide whether to buy, hold, or sell their shares. They can see how well management is performing (the stewardship function).
• For Creditors and Banks: Helps them evaluate the company's ability to repay its loans (solvency). They use this information to decide whether to grant credit.
• For Government: Provides the basis for formulating fiscal policies, levying taxes, and ensuring companies comply with the law.
• For Employees: Gives them information about the company's stability and profitability, which can affect their job security and future salary negotiations.
• For Stock Exchanges: Helps them ensure transparency in financial reporting and protect the interests of investors.

Limitations of Financial Statements

While extremely useful, financial statements have certain limitations that users must be aware of.

1. Do not reflect current situation: They are based on historical cost, so the values of assets may not reflect their current market prices.
2. Assets may not realise: The value of assets shown in the balance sheet is their unamortised cost, not necessarily the amount they would fetch if sold, especially in a forced liquidation.
3. Bias and Personal Judgements: The use of estimates and personal judgements (e.g., for depreciation or provisions) can introduce bias.
4. Aggregate information: They provide a summary of information, which might not be detailed enough for specific decisions.
5. Vital information missing: They do not disclose non-financial information that could be critical, such as the loss of a major customer or market.
6. No qualitative information: They only report information that can be measured in money. They do not reflect qualitative aspects like customer satisfaction, employee morale, or the quality of management.
7. They are only interim reports: The Statement of Profit and Loss shows performance for one period, which may not indicate long-term earning capacity. The Balance Sheet is true only for a single point in time.