Let us make in-depth study of the meaning, objectives and limitations of financial statement.
Financial Statements are the collective name given to Income Statement and Positional Statement of an enterprise which show the financial position of business concern in an organized manner. We know that all business transactions are first recorded in the books of original entries and thereafter posted to relevant ledger accounts. For checking the arithmetical accuracy of books of accounts, a Trial Balance is prepared.
Trial balance is a statement prepared as a first step before preparing financial statements of an enterprise which record all debit balances in the debit column and all credit balances in credit column. To find out the profit earned or loss sustained by the firm during a given period of time and its financial position at a given point of time is one of the purposes of accounting. For achieving this objective, financial statements are prepared by the business enterprise, which include income statement and positional statement.
These two basic financial statements viz:
(i) Income Statement, i.e., Trading and Profit & Loss Account and
(ii) Positional Statement, i.e., Balance Sheet portrays the operational efficiency and solvency of any business enterprise.
The income statement shows the net result of the business operations during an accounting period and positional statement, a statement of assets and liabilities, shows the final position of the business enterprise on a particular date and time. So, we can also say that the last step of the accounting cycle is the preparation of financial statements.
Income statement is another term used for Trading and Profit & Loss Account. It determines the profit earned or loss sustained by the business enterprise during a period of time. In large business organization, usually one account i.e., Trading and Profit & Loss Account is prepared for knowing gross profit, operating profit and net profit.
On the other hand, in small size organizations, this account is divided into two parts i.e. Trading Account and Profit and Loss Account. To know the gross profit, Trading Account is prepared and to find out the operating profit and net profit, Profit and Loss Account is prepared. Positional statement is another term used for Balance Sheet. The position of assets and liabilities of the business at a particular time is determined by Balance Sheet.
Objective and Importance:
(i) Knowing Profitability of Business:
Financial statements are required to ascertain whether the enterprise is earning adequate profit and to know whether the profits have increased or decreased as compared to the previous year(s), so that corrective steps can be taken well in advance.
(ii) Knowing the Solvency of the Business:
Financial statements help to analyse the position of the business as regards to the capacity of the entity to repay its short as well as long term liabilities.
(iii) Judging the Growth of the Business:
Through comparison of data of two or more years of business entity, we can draw a meaningful conclusion as regard to growth of the business. For example, increase in sales with simultaneous increase in the profits of the business, indicates a healthy sign for the growth of the business.
(iv) Judging Financial Strength of Business:
Financial statements help the entity in determining solvency of the business and help to answer various aspects viz., whether it is capable to purchase assets from its own resources and/or whether the entity can repay its outside liabilities as and when they become due.
(v) Making Comparison and Selection of Appropriate Policy:
To make a comparative study of the profitability of the entity with other entities engaged in the same trade, financial statements help the management to adopt sound business policy by making intra firm comparison.
(vi) Forecasting and Preparing Budgets:
Financial statement provides information regarding the weak-spots of the business so that the management can take corrective measures to remove these short comings. Financial statements help the management to make forecast and prepare budgets.
(vii) Communicating with Different Parties:
Financial statements are prepared by the entities to communicate with different parties about their financial position. Hence, it can be concluded that understanding the basic financial statements is a necessary step towards the successful management of a commercial enterprise.
Limitations of Financial Statements:
(i) Manipulation or Window Dressing:
Some business enterprises resort to manipulate the information contained in the financial statements so as to cover up their bad or weak financial position. Thus, the analysis based on such financial statements may be misleading due to window dressing.
(ii) Use of Diverse Procedures:
There may be more than one way of treating a particular item and when two different business enterprises adopt different accounting policies, it becomes very difficult to make a comparison between such enterprises. For example, depreciation can be charged under straight line method or written down value method. However, results provided by comparing the financial statements of such business enterprises would be misleading.
(iii) Qualitative Aspect Ignored:
The financial statements incorporate the information which can be expressed in monetary terms. Thus, they fail to assimilate the transactions which cannot be converted into monetary terms. For example, a conflict between the marketing manager and sales manager cannot be recorded in the books of accounts due to its non-monetary nature, but it will certainly affect the functioning of the activities adversely and consequently, the profits may suffer.
Financial statements are historical in nature as they record past events and facts. Due to continuous changes in the demand of the product, policies of the firm or government etc, analysis based on past information does not serve any useful purpose and gives only postmortem report.
(v) Price Level Changes:
Figures contained in financial statements do not show the effects of changes in the price level, i.e. price index in one year may differ from price index in other years. As a result, misleading picture may be obtained by making a comparison of figures of past year with current year figures.
(vi) Subjectivity & Personal Bias:
Conclusions drawn from the analysis of figures given in financial statements depend upon the personal ability and knowledge of an analyst. For example, the term ‘Net profit’ may be interpreted by an analyst as net profit before tax, while another analyst may take it as net profit after tax.
(vii) Lack of Regular Data/Information:
Analysis of financial statements of a single year has limited uses. The analysis assumes importance only when compared with financial statements, relating to different years or different firm.