In this article we will discuss about the components of financial statements.
The Balance Sheet shows the financial position or condition of the firm at a given point of time. It provides a snapshot and may be regarded as a static picture. The Income Statement or Profit and Loss Account reflects the performance of the firm over a period of time.
Financial Statements are prepared for the purpose of presenting a periodical review or report on the progress by the management and deal with:
(a) the status of investments in the business and
(b) the results achieved during a period under review.
The statement disclosing status of investments is known as Balance Sheet and the statement showing the result is known as Profit and Loss Account.
A firm communicates financial information to the users through financial statements and reports. The financial statements contain summarised information of the firm’s financial affairs, organised systematically. They are means to present the firm’s financial situation to users. The preparation of the financial statements is the responsibility of top management.
The two basic financial statements prepared for the purpose are the Balance Sheet and Profit and Loss Account. As these statements are used by investors and financial analysts to examine the firm’s performance in order to make investment decisions, they should be prepared very carefully and contain as much information as possible.
Recently a number of schedules are also being used to supplement the data and information contained in the above statements. Thus, Schedule of Fixed Assets, Schedule of Debtors, Schedule of Creditors, Schedule of Reserves etc. are some of the schedules which are generally attached to the statements.
The schedules are considered as part of the statements for the purpose of analysis and, in fact, they constitute the first step towards the analysis of certain data in financial statements. The financial statements are prepared from the accounting records maintained by the firm. The generally accepted accounting principles and procedures are followed to prepare these statements. It seems quite desirable to discuss the nature of each of the financial statements.
The Balance Sheet comprises of a list of assets, liabilities and capital at a given date. It is static in character because it tells about the financial position of a business as on a certain date. At the same time, business is dynamic while Balance Sheet is static. It records only periodic changes rather than continuous ones.
More specifically, Balance Sheet contains information about resources and obligations of a business entity and about owners’ interests in the business at a particular point of time. Thus, the Balance Sheet of a firm prepared on 31st December reveals the firm’s financial position on this specific date.
In simple language or in a layman’s language, a Balance Sheet may be called as a statement of equality in which equality is established by representing assets values on one side and the values of liabilities and owners’ fund on the other side of it.
The Balances Sheet is a statement which reports the property’s value-owned by the enterprise and the claims of the creditors and owners against these properties. The amount of value is obtained by posting and balancing the individual accounts of each item.
A Balance Sheet is called by different names. Generally the following titles are used in respect of a Balance Sheet:
1. Balance Sheet or General Balance Sheet
2. Statement of financial position or condition
3. Statement of Assets and Liabilities
4. Statement of Resources and Liabilities
5. Statement of Assets, Liabilities and Owners’ Fund, etc.
However, the title “Balance Sheet” is mostly used. Let us look at a few definitions: “Balance Sheet is a classified summary of the ledger balances remaining after closing all revenue items into the Profit and Loss Account.” —Cropper
“The Balance Sheet is a statement which reports the values owned by the enterprise and the claims of the creditors and owners against these properties.” —Howard
“Balance Sheet is a screen picture of the financial position of a going business at certain moment.” —Francis
A clear and correct understanding of the basic divisions of the Balance Sheet and the meanings which they signify and the amount which they represent is very essential for the proper interpretation of financial statements.
The various items of the Balance Sheet for the purpose of analysis may be grouped into the following categories:
1. Current Assets
2. Fixed Assets
3. Intangible Assets
4. Other Assets
5. Deferred Expenditure
1. Current Liabilities
2. Non-current Liabilities
3. Net Worth
The important functions served by a Balance Sheet are:
(1) It gives a concise summary of the firm’s resources and liabilities and owners equity.
(2) It is a measure of the firm’s liquidity.
(3) It is a measure of the firm’s solvency.
A brief discussion regarding the meaning, nature and contents of various groups of Balance Sheet is given below:
1. Current Assets:
“The goods of the merchant yield him no revenue profit till he sells them for money and the money yields him as little till it is again exchanged for goods.” His capital is continuously going from him in one shape and returning to him in another and it is only by means of such circulation or successive exchanges that it can yield him any profit. Such a capital can be properly called circulating capital.
The term Current Assets, in the words of Alexander Wall, “are such assets as in the ordinary and natural course of business move onward, through the various processes of production, distribution and payment for goods, until they become cash or its equivalent, by which debts may be rapidly and immediately paid.” Current Assets are the assets acquired through cash and easily convertible into cash during the normal course of business.
The normal course takes a period of one year. The accounting period is of one year duration. In other words, Current Assets are those resources of the firm which are either held in the form of cash or are expected to be converted into cash within the accounting period or the operating cycle of the business. The operating cycle is the time period which is taken to convert raw materials into finished goods, sell finished goods, and convert receivables into cash.
All assets which are acquired for reselling during the course of business are to be treated as Current Assets. For instance, furniture purchased by a furniture dealer will be treated as Current Asset: whereas furniture purchased by a hotel owner will be treated as non-current asset.
Thus, it is clear that the nature i.e., current asset or non- current asset is to be decided with reference to its objective of acquisition and not to its name by which it has been termed in the accounting system. Generally, the operating cycle is equal to or less than the accounting period.
The following are generally included in Current Assets:
1. Cash in Hand and at Bank
2. Book debts (or Debtors or Accounts Receivables)
3. Bills Receivables (or Notes Receivables)
4. Stocks—Raw Materials, Work-In-Progress, Finished Goods
5. Government and Other Marketable Securities
6. Advance Payments
2. Fixed Assets:
Fixed assets are those assets which are acquired for the purpose of using them in the conduct of business operations and not for reselling to earn profit. They are of such a nature that they will be used over a considerable period of time, and are not meant for resale. Since these are not for reselling, these assets are not readily convertible into cash in the normal course of business operations.
Some examples of assets coming into the fixed assets categories are:
3. Plant, Machineries, Equipment etc.
4. Furniture and Fixtures
5. Leasehold Improvements etc.
The above list is not exhaustive one. A number of other assets may be included in the list, if they are acquired primarily for the purpose of continuous use in the business operations.
3. Intangible Assets:
Fixed Assets may be either tangible or intangible. The tangible assets have a definite physical existence. They can be seen and can, if necessary, be sold separately. The intangible assets cannot be seen though their existence has some effect, often very material, on the profit-earning capacity of the business. While the tangible assets often have a value as things apart from their profit-earning capacity, the intangible assets usually have no physical value whatever. They are not available for the payment of the debts of a going concern.
They depreciate greatly in case of liquidation. Intangible assets represent the firm’s rights and include the following:
1. Patents and Trademarks
2. Copyright, Formula, Licence.
3. Goodwill etc.
Patents are the exclusive rights granted by the Government enabling the holder to control the use of an invention. Copyrights are the exclusive rights to reproduce and sell literary, musical and artistic works. Franchises are the contracts giving exclusive rights to perform certain functions or to sell certain services or products. Goodwill represents the excessive earning power of a firm due to special advantages that it possesses. Costs of intangible fixed assets are amortised over their useful lives.
4. Other Assets:
All other assets which cannot be included in any of the above categories are grouped as Other Assets. These assets possess a tangible form but these are not directly used in the operations of business.
Such assets may be:
1. Investments excluding marketable securities
2. Non-trade Debtors
3. Fund earmarked for assets.
5. Deferred Expenditures:
There are certain expenditures which are not incurred repeatedly or which are not of recurring nature and which do not arise from the present operations. These expenditures contribute income or benefit in the future years also. These expenditures are written off gradually over several years of operations, treating each year’s share in such expenditure as a charge on operational profit for that year.
The amount of such expenditure not written off at a point of time is shown as an asset in the Balance Sheet at that point of time. Prepayments for services or benefits for period longer than the accounting period are referred to as deferred charges and include advertising expenditure, preliminary expenses etc.
6. Current Liabilities:
Current liabilities includes such debts and obligations or charges which are payable either at demand or within one year from the date of Balance Sheet. All short-term obligations generally due and payable within one year are described as Current Liabilities. All long-term loans and borrowings may take the character of current liabilities as and when they become due for payment.
Typical examples of current liabilities are:
1. Trade Creditors or Accounts Payables
2. Bills Payables or Notes Payables
3. Short-term Public Deposits
4. Outstanding or accruals
5. Short-term Loans
6. Bank overdraft but not bank loan
7. Provision for Taxes
8. Unclaimed Dividends
9. Current maturity of long-term debt due payable within the Period of the current year.
7. Non-Current Liabilities:
These are also called Long-Term liability or debt. All such liabilities payable over a longer period of time, say after one year, are known as Non-current liabilities.
Some examples of such liabilities are:
1. Loan on Mortgage
2. Debentures or Bonds
3. Bank Loan
4. Loans from Financial Institution etc.
8. Net Worth:
The financial interests of owners are called owners’ equity. The owners’ interest is residual in nature, reflecting the excess of the firm’s assets over its liabilities. It has several names, such as Net Assets, Shareholders’ Fund, Owners’ Equity, and Net Capital Employed etc.
What remains after deducting all liabilities (both current and long-term) from total assets is called Net Worth or Shareholders’ Fund. As liabilities are the claims of outside parties, owners’ equity represents owners’ claim against the business entity as of the Balance Sheet date. The nature of the owners’ claim is not same as the claims of creditors. Creditors’ claim are defined and have to be met within a specified period.
The claim of owners changes and the amount payable to them can be determined only when the firm is liquidated. In the beginning stage, owners’ equity arises on account of the funds invested by them. But it changes due to the earnings of the firm and their distribution.
The firm’s earnings (or losses) do not affect creditors’ claims. Owners’ equity will increase when the firm makes earnings and retains whole or a part of it. If the losses are incurred by the firm, owners’ claim will be reduced.
Shareholders’ equity or capital has two parts:
(i) Paid Up Share Capital, and
(ii) Reserves and Surplus (retained earnings), i.e., representing undistributed profits:
1. Preference Share Capital
2. Equity Share Capital
3. General Reserve
4. Capital Reserve
5. Other Reserves and Undistributed Profits
A Balance Sheet reflects the financial position of a firm. Balance Sheet can be prepared in the Account Form or the Report Form. The Account form of Balance Sheet has two sides. The right hand side lists the various assets and left hand side shows the liabilities and owners’ equity.
The total of the two sides are equal i.e., Total Assets = Total Liabilities + Owners’ Equity. The Balance Sheet does not convey anything very special, as the two sides must always balance.
In the Report Form of Balance Sheet, the figures should be arranged properly. Usually instead of two-columns (T Form) statement as ordinarily prepared, the statement is prepared in single-vertical column form.
A specimen is given below:
Balance Sheet Equation:
Both sides of the Balance Sheet should be equal. That is, the assets must be equal to liabilities plus owners’ capital. We can express this equality of the Balance Sheet in an equation form. The equation is known as Balance Sheet Equation, also known as Accounting Equation.
The relationship can be expressed in the following equation:
Total Assets = Total Liabilities + Owners’ Equity
We have noted earlier that Owners’ Equity is a residue i.e., it is the difference between assets and liabilities.
Total Assets – Total Liabilities = Owners’ Equity
We can obtain more equations if we elaborate the above equation. For instance,
Liquid Assets = Current Assets – Stock of all types
Working Capital = Current Assets – Current Liabilities
Capital Employed = Total Assets – Current Liabilities
The equation can be technically stated as “for every debit there is an equivalent credit.” As a matter of fact the entire system of double entry book-keeping is based on this concept.
Profit and Loss Account:
The Balance Sheet, as we know it, is a pictorial presentation of the financial health of a business on a certain date. “It fails to indicate whether a concern is making or losing money.” This financial statement merely indicates the resources and liabilities of a business enterprise at a particular date.
In short, the Balance Sheet is nothing but a snapshot of the financial condition of a business at a given moment. But every transaction has immediate and direct impact on the items of the Balance Sheet and items do change due to this impact.
The earning capacity and potential of the firm are reflected by the Income Statement i.e., Profit and Loss Account. The Profit and Loss Account is the “Score-board” of the firm’s performance during a particular period of time.
The Profit and Loss Account may also be called by various names, such as:
1. Statement of Income and Earned Surplus
2. Income Statement
3. Statement of Revenue and Expenses
4. Profit and Loss Account
5. Operating Statement etc.
The Profit and Loss Account presents the summary of revenues, expenses and net income or net loss of a firm for a period of time. It serves as a measure of the firm’s profitability. Net income which is an indicator of the firm’s profitable operations, is the amount by which the revenues earned during a period exceed the expenses incurred during that period.
If the firm’s operations prove to be unprofitable, total expenses will exceed total revenues and the difference is referred to as net loss. Revenues are the amounts which the customers pay to the firm for providing them the goods and services. Profit and Loss Account is an explanation of the impact of profit-seeking operations on shareholders’ equity.
The statement of Profit or Loss is the condensed and classified record of the gains or losses causing changes in the owners’ interest in the business for a period of time. A comparison of earnings and expenses incurred in the earning of those incomes is made in this statement and the difference between the two is known as net profit or loss.
The Indian Companies Act 1956 fails to prescribe any legal porforma for Profit and Loss Account, as it has prescribed for Balance Sheet. As a result, the Profit and Loss Account is being prepared in varying form due to diversity in the nature of industry and also in business interest. Again Profit and Loss Account in the statement form can be prepared in two ways for the purpose of analysis.
(a) Single Step Form:
In Single Step Form records all revenues (Operating or non-operating) and all expenses (operating or non-operating) in one stroke. The items of revenues and expenses are not grouped into distinct heads or sub-heads.
A specimen is given below:
(b) Multi Step Method:
Multi-step income statement gives more useful information. Each item of revenue and expenses are considered step by step. It makes a distinction between operating revenue and non- operating revenue. This method of preparing the statement of incomes and expenses is much useful for the purposes of analysis and interpretation.
A specimen is given below:
1. Items of operating revenue (sales minus returns) and cost of goods sold are considered first, which gives gross profit or gross margin. That is, Gross Profit = Sales minus Cost of goods sold.
2. Secondly, all operating expenses are deducted from Gross Profit and the difference is known as operating profit (Operating expenses consisting of general, administrative, selling and depreciation).
3. Thirdly, non-operating incomes as addition and non-operating expenses as deduction are taken up to the operating profit. This gives net profit before tax.
4. Fourthly, provision for tax and interest are deducted from the Net Profit and the balance is known as Net Profit after tax and interest.
The Profit and Loss Account up to net operating profit may be expressed in equation form, thus:
Gross Profit = Sales – Cost of Goods Sold
Net Operating profit = Gross Profit – Operating Expenses
Net Operating profit = Sales – (Cost of Sales + Operating Expenses)
Sales – Net Operating Profit = Cost of Sales + Operating Expenses
Sales = Cost of Sales + Operating Expenses + Net Operating Expenses
Financial statements are the result of accounting process involving recording, classifying and summarizing business transactions.
Financial statements are organised, collection of data according to logical and consistent accounting procedures. Its purpose is to convey an understanding of some financial aspect of a business firm.