Financial Statement

Definition: Financial Statement are systematically maintained, written

summary of all the ledger account heads, exhibited in a way that it provides a
clear view of the financial position, profitability and performance of the
enterprise.

These are prepared at the end of the accounting period, which is usually one
year, after that it is audited by the auditor, to check their accuracy,
transparency and fairness, for taxation and investment purposes.

Objectives of preparing financial statement

The objectives of the financial statement are as under:

 To ascertain the financial position, profitability and performance.

 To determine the cash inflows and outflows.
 To know the results of business operations.
 To provide information related to financial resources and obligations of
the concern.
 To disclose the accounting policies.
 To check the efficiency and effectiveness of the company’s
management.

Components of Financial Statement

A financial statement is a combination of five major statements, as shown in
the figure below:
Income Statement or Trading and Profit & Loss Account
The profit earned or loss sustained by the enterprise during an accounting
period can be ascertained by the preparation of the income statement. The
profit/loss is calculated at two levels, i.e. gross profit and net profit. The
gross profit is nothing but the variance in the selling price and cost of goods
sold, which is measured by preparing a trading account.

On the other hand, net profit can be calculated by preparing a profit and loss
account. The profit and loss account is a summary of the company’s
revenues and expenses and reflects the outcome of the company’s operations
for the specified period.

Position Statement or Balance Sheet

A Balance Sheet can be understood as a snapshot indicating the company’s
obligations and resources, i.e. liabilities and assets, at a specified date.

Although a single transaction, can make a huge difference in the overall

picture of the company’s position, the balance sheet is correct at a specific
point of time. And only because of this very reason, we use the word ‘as
at’ along with the date. That is why it is called a position statement.

Cash Flow statement

Cash flow statement is a summary of company cash sources and
applications. It ascertains the firm’s effectiveness in generating cash to pay
off its obligations, funding the operations and investment activities.

The cash flow statement reflects the changes in the company’s cash and cash
equivalents, i.e. commercial paper, certificate of deposit, treasury bills,
marketable securities, short term government bonds, etc. between two
accounting period.

Statement of changes in equity (if applicable)

It is a statement that indicates the changes in the company’s share capital,
retained earnings and reserves over the accounting period, i.e. it reconciles
the equity balances at the beginning with the balances at the end.

Explanatory notes
Otherwise called as notes to accounts, these are supporting notes annexed
to any of the above statements. It provides additional information about the
company’s operations and finance.
Simply put, the financial statement is nothing but a basic formal annual report
that helps the company to conveys the financial information to the interested
parties such as owners. investors, employees, government, tax authorities
and so forth.

Characteristics of Ideal Financial

Statements | Accounting
The following points highlight the nine characteristics of financial
statements, i.e, 1. Depict True Financial Position 2. Effective
Presentation 3. Relevance 4. Attractive 5. Easiness 6. Comparability 7.
Analytical Representation 8. Brief 9. Promptness.

Ideal Financial Statement Characteristic # 1. Depict True Financial

Position:
The information contained in the financial statements should be such
that a true and correct idea is taken about the financial position of the
concern. No material information should be withheld while preparing
these statements.

Ideal Financial Statement Characteristic # 2. Effective Presentation:

The financial statements should be presented in a simple and lucid
way so as to make them easily understandable. A person who is not
well versed with accounting terminology should also be able to
understand the statements without much difficulty. This characteristic
will enhance the utility of these statements.

Ideal Financial Statement Characteristic # 3. Relevance:

ADVERTISEMENTS:

Financial statements should be relevant to the objectives of the

enterprise. This will possible when the person preparing these
statements is able to properly utilize the accounting information. The
information which is not relevant to the statements should be avoided,
otherwise it will be difficult to make a distinction between relevant
and irrelevant data.

Ideal Financial Statement Characteristic # 4. Attractive:

The financial statements should be prepared in such a way that
important information is underlined so that it attracts the eye of the
reader.

Ideal Financial Statement Characteristic # 5. Easiness:

Financial statements should be easily prepared. The balances of
different ledger accounts should be easily taken to these statements.
The calculation work should be minimum possible while preparing
these statements. The size of the statements should not be very large.
The columns to be used for giving the information should also be less.
This will enable the saving of time in preparing the statements.

Ideal Financial Statement Characteristic # 6. Comparability:

The results of financial analysis should be in a way that can be
compared to the previous years statements. The statement can also be
compered with the figures of other concerns of the same nature.
Sometimes budgeted figures are given along with the present figures.

Ideal Financial Statement # 7. Analytical Representation:

The information should be analyzed in such a way that similar data is
presented at the same place. A relationship can be established in
similar type of information. This will be helpful in analysis and
interpretation of data.

Ideal Financial Statement # 8. Brief:

If possible, the financial statements should be presented in brief. The
reader will be able to form an idea about the figures. On the other
hand, if figures are given in details then it will become difficult to
judge the working of the business.
Ideal Financial Statement # 9. Promptness:
The financial statements should be prepared and presented at the
earliest possible. Immediately at the close of the financial year,
statements should be ready.

What is GAAP?
Generally accepted accounting principles (GAAP) refer to a common set of
accounting principles, standards, and procedures.
The Core GAAP Principles

GAAP is set forth in 10 primary principles, as follows:

1. Principle of consistency: This principle ensures that consistent

standards are followed in financial reporting from period to period.
2. Principle of permanent methods: Closely related to the previous
principle is that of consistent procedures and practices being applied in
accounting and financial reporting to allow comparison.
3. Principle of non-compensation: This principle states that all aspects of
an organization’s performance, whether positive or negative, are to be
reported. In other words, it should not compensate (offset) a debt with
an asset.
4. Principle of prudence: All reporting of financial data is to be factual,
reasonable, and not speculative.
5. Principle of regularity: This principle means that all accountants are to
consistently abide by the GAAP.
6. Principle of sincerity: Accountants should perform and report with
basic honesty and accuracy.
7. Principle of good faith: Similar to the previous principle, this principle
asserts that anyone involved in financial reporting is expected to be
acting honestly and in good faith.
8. Principle of materiality: All financial reporting should clearly disclose
the organization’s genuine financial position.
9. Principle of continuity: This principle states that all asset valuations in
financial reporting are based on the assumption that the business or
other entity will continue to operate going forward.
10.Principle of periodicity: This principle refers to entities abiding by
commonly accepted financial reporting periods, such as quarterly or
annually.
 4 Accounting Assumptions are;

1. Business Entity Assumption.

2. Money Measurement Assumption.
3. Going Concern Assumption.
4. Accounting Period Assumption.

And 4 basic accounting assumptions are part of GAAP, accounting principles,

and the double-entry system.

The basic accounting assumptions are like the pillars on which the structure of
accounting is based.

Business Entity Assumption

According to this assumption, the business is treated as a unit or entity apart

from its owners, creditors, managers, and others.

In other words, the proprietor of an enterprise is always considered to be

separate and distinct from the business which he controls.

All the transactions of the business are recorded in the books of the

business from the business. Even the proprietor is treated as a creditor to the
extent of his capital.

Upon investment of money in the business by the proprietor, it is deemed that

the proprietor has given money, and the business has received the money.

The assumption of the separate entity applies to all forms of business

organizations.

For example, from a legal point of view, a body corporate is a separate entity,
and the sole trader and his business are regarded as the same thing.

But for accounting purposes, they are regarded as different entities. For
recording the transactions, it is the business that is the entity and with which
we are concerned.

The assumption of the business as a separate legal entity as distinct from its
owners has been well accepted about companies all over the world since the
legal decision in the case of Salmon vs. Salmon & Co. (1897).
 Though this legal assumption has not been extended to the sole trader and
partnership business firms, for purposes of accounting, all transactions should
specifically relate to the business operations of the entity itself.

In a partnership business, the firm is quite separate from the individual

partners who are its members and who have agreed to come together in a
formal way to attain an agreed objective.

Still, each partner has his own separate life and may have many interests –
financial and otherwise, outside the partnership.

It is most desirable that the dealings and transactions of the partnership

business should be recorded in a firm’s books.

If any partner enters into private financial dealings, e.g., to purchase or sell
equity shares in a limited company, it has no relevance to the partnership
business, and so it should not be recorded in a firm’s books.

Similarly, a sole proprietor may have many interests apart from or in addition
to his business.

But these should not be included in the firm’s books if they are not connected
with it.

In brief;

1. Only the business transactions and not the personal transactions of the
proprietor are recorded and reported.
2. The personal assets of the owners or shareholders are not considered
while recording and reporting the assets of the business entity.
3. Income is the property of the business assets distributed to owners.

The economic entity assumption means that economic activity can be

identified with a particular unit of accountability.

In other words, a company keeps its activity separate and distinct from its
owners and any other business unit.

An individual, department, division, or an entire industry could be considered

a separate entity if we choose to define it in this manner.

Thus, the entity concept does not necessarily refer to a legal entity.
A parent and its subsidiaries are separate legal entities, but merging their
activities for accounting and reporting purposes does not violate the
economic entity assumption.

Money Measurement Assumption

The monetary unit assumption means that money is the common

denominator of economic activity and provides an appropriate basis for
accounting measurement and analysis.

That is, the monetary unit is the most effective means of expressing to
interested parties changes in capital and exchanges of goods and services.

The monetary unit is relevant, simple, universally available, understandable,

and useful.’

The application of this assumption depends on the even more basic

assumption that quantitative data are useful in communicating economic
information and in making rational economic decisions.

The money measurement assumption underlines the fact that in accounting

every worth-recording event, happening or transaction is recorded in terms of
money.

In other words, a factor an event which cannot be expressed in terms of

money is not recorded in the account books.

The general health condition of the chairman of the company, working

conditions in which a worker has to work, sales policy pursued by the
enterprise, quality of products introduced by the enterprise, etc., cannot be
expressed in terms of money and thus are not recorded in the books.

Because of the above conditions, this concept puts a serious handicap on the
usefulness of accounting records for management decisions.

In spite of the above limitations of the money measurement assumption, it

remains indispensable.

This assumption increases the understanding of the state of affairs of the

business.

For example, if a business has a cash balance of $7,000, a building containing

20 rooms, a piece of land of 2,000 square meters, 40 tables, 20 fans, 2
machines, one tone of raw material and so on then in the absence of money
measurement assumption the value of different types of assets cannot be
measured by the simple method if addition.

But if they are expressed in monetary terms – $7,000 cash, $50,000 for
building, $2,00,000 for land, $8,000 for tables, $6,000 for fans, $1,60,000 for
machines, $80,000 for raw material.

It is possible to add them and use them for comparison or any other purpose.

This assumption has another serious limitation and is currently attracting the
attention of the accountants the entire world over.

As per this assumption, a transaction is recorded at its money value on the

date of occurrence, and the subsequent changes in the money value are
conveniently ignored.

For example, a building purchased for $50,000 in 1960 and another purchased
for the same amount in 1992 are recorded at, the same price, although the
one purchased in 1960 may be worth four times more than the value recorded
in the books, due to rising in land value and construction costs (conversely,
because of the fall in the money value).

Inflation accounting seeks to deal with this type of problem.

Going Concern Assumption

It is also known as continuity assumption.

Most accounting methods rely on the going concern assumption—that the

company will have a long life. Despite numerous business failures, most
companies have a fairly high continuance rate.

As a rule, we expect companies to last long enough to fulfill their objectives

and commitments.

This assumption has significant implications. The historical cost principle will
be of limited usefulness if we assume eventual liquidation.

Under a liquidation approach, for example, a company would better state

asset values at net realizable value (sales price fewer costs of disposal) than at
acquisition cost.

Depreciation and amortization policies are justifiable and appropriate only if

we assume some permanence to the company.
 If a company adopts the liquidation approach, the current/non-current
classification of assets and liabilities loses much of its significance.

Labeling anything a fixed or long-term asset would be difficult to justify.

Indeed, listing liabilities on the basis of priority in liquidation would be more
reasonable.

The going concern assumption applies in most business situations.

Only where liquidation appears imminent is the assumption inapplicable.

In these cases, a total revaluation of assets and liabilities can provide

information that closely approximates the company’s net realizable value.

According to the going concern assumption, the enterprise is normally viewed

as a going concern, i.e., continuing in operation for the foreseeable future.

It is assumed that the enterprise has neither the intention nor the necessity of
liquidation or of curtailing the scale of its operations materially. It is because
of the going concern assumption:

1. That the assets are classified as current assets and fixed assets.
2. The liabilities are classified as short-term liabilities and long-term
liabilities.
3. The unused resources are shown as unutilized costs (or unexpired costs)
as against the break-up values, as in the case of a liquidating enterprise.
Accordingly, the earning power and not the break-up value evaluates the
continuing enterprise.

According to accounting standards, if this concept is followed, this fact needs

not to be disclosed in the financial statements since its acceptance and use
are assumed.

In case this concept is not followed, the fact should be disclosed in the
financial statements together with reasons.

Why is the going concern assumption important in the preparation of

financial statements?

Going concern assumption is one of the fundamental assumptions in

accounting on the basis of which financial statements are prepared.

Financial statements are prepared to assume that a business entity will

continue to operate in the foreseeable future without the need or intention on
the part of management to liquidate the entity or to significantly curtail its
operational activities.

Therefore, it is assumed that the entity will realize its assets and settle its
obligations in the normal course of the business.

It is the responsibility of the management of a company to determine whether

going a concern assumption is appropriate in the preparation of financial
statements.

If the going concern assumption is considered by the management to be

invalid, the financial statements of the entity would need to be prepared on a
break-up basis.

This means that assets will be recognized at an amount that is expected to be

realized from its sale (net of selling costs) rather than from its continuing use
in the ordinary course of the business.

Assets are valued for their individual worth rather than their value as a
combined unit. Liabilities shall be recognized at amounts that are likely to be
settled.

Periodic Assumption

It is also known as the periodicity assumption or period assumption.

To measure the results of a company’s activity accurately, we would need to

wait until it liquidates. Decision-makers, however, cannot wait that long for
such information.

Users need to know a company’s performance and economic status on a

timely basis so that they can evaluate and compare firms and take appropriate
actions.

Therefore, companies must report information periodically.

The periodicity (or time period) assumption implies that a company can divide
its economic activities into artificial time periods. These time periods vary, but
the most common are monthly, quarterly, and yearly.

The shorter the time period, the more difficult it is to determine the proper net
income for the period.
A month’s results usually prove less reliable than a quarter’s results, and a
quarter’s results are likely to be less reliable than a year’s results.

Investors desire and demand that a company quickly process and disseminate
information.

Yet the quicker a company releases the information, the more likely the
information will include errors.

This phenomenon provides an interesting example of the trade-off between

relevance and reliability in preparing financial data.

The problem of defining the time period becomes more serious as product
cycles shorten, and products become obsolete more quickly. Many believe
that, given technology.

According to this assumption, the economic life of an enterprise is artificially

split into periodic intervals which are known as accounting periods, at the end
of which an income statement and financial position statement are prepared
to show the performance and financial position, the use of this assumption
further requires the allocation of expenses between capital and revenue.

That portion of capital expenditure, which is consumed during the current

period, is charged as an expense to the income statement, and the
unconsumed portion is shown in the balance sheet as an asset for future
consumption.

Truly speaking, measuring the income following the concept of the accounting
period is more an estimate than factual since actual income can be
determined only on the liquidation of the enterprise.

The Purpose of Accounting Standards

The purpose of accounting standards can be answered by first looking at the purpose
of accounting. The accounting profession is looked upon to provide analysis of assets,
financial stability, financial performance, record-keeping and more. To provide
accurate and reliable information, the accounting profession requires rules and
guidelines on how to report information. That is the purpose of accounting standards –
to provide guidance to the accounting profession.
What is Financial Analysis?

Financial analysis is the examination of financial information to reach business decisions. This
analysis typically involves an examination of both historical and projected profitability , cash
flows, and risk. It may result in the reallocation of resources to or from a business or a specific
internal operation.