01 · Explore
Meaning and Nature of Financial Statements
Financial statements are the formal annual reports through which a company's management communicates financial information to stakeholders.
Financial statements are the end products of the accounting process. They provide a summarized view of a company's profitability and financial position at the end of an accounting period. These reports primarily include the Balance Sheet (Position Statement), the Statement of Profit and Loss, and the Cash Flow Statement.
The nature of these statements is a combination of recorded facts, accounting conventions, and personal judgments. Recorded facts refer to historical cost data from accounting books. Accounting conventions, such as valuing inventory at the lower of cost or market price, ensure comparability and realism.
Postulates or basic assumptions like the 'Going Concern' concept and 'Money Measurement' also underpin these statements. Finally, personal judgments are required for estimates, such as determining the useful life of a fixed asset or making provisions for doubtful debts.
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What are the three main components of a company's financial statements?
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Why are financial statements said to reflect 'recorded facts'?
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02 · Explore
Objectives and Users of Financial Statements
The primary objective of financial statements is to assist various users in making informed economic decisions.
Financial statements aim to provide reliable information about a business's economic resources (assets) and obligations (liabilities). They help users evaluate the earning capacity of the business and predict potential cash flows. Furthermore, they serve as a tool to judge the effectiveness of management in utilizing resources.
The users of these statements are diverse. Internal users like management use them for planning and control. External users include shareholders (to assess investment safety), creditors (to evaluate creditworthiness), and the government (for fiscal and taxation policies).
Other stakeholders include employees, who are interested in the company's stability for job security, and prospective investors, who analyze the statements to determine the risk and return on potential investments.
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How do financial statements help the government?
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03 · Explore
The Balance Sheet: Equity and Liabilities
As per Schedule III of the Companies Act, 2013, the Balance Sheet must follow a vertical format, categorizing items into Equity and Liabilities and Assets.
The first part of the vertical Balance Sheet is 'Equity and Liabilities'. This is divided into four major heads: Shareholders' Funds, Share Application Money Pending Allotment, Non-current Liabilities, and Current Liabilities.
Shareholders' Funds include Share Capital, Reserves and Surplus, and Money received against share warrants. Share Capital disclosures in the 'Notes to Accounts' must specify authorized, issued, and subscribed capital, along with a reconciliation of shares outstanding.
Non-current Liabilities are those not expected to be settled within the operating cycle or 12 months, such as long-term borrowings and deferred tax liabilities. Current Liabilities include short-term borrowings, trade payables, and short-term provisions.
| Major Head | Sub-Head Examples |
|---|---|
| Shareholders' Funds | Share Capital, Reserves and Surplus |
| Non-current Liabilities | Long-term borrowings, Long-term provisions |
| Current Liabilities | Trade payables, Short-term provisions |
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Where is a 'Debit' balance in the Statement of Profit and Loss shown in the Balance Sheet?
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04 · Explore
The Balance Sheet: Assets
Assets are classified into Non-current and Current categories based on the company's operating cycle.
Non-current Assets are those held for the long term. These include Fixed Assets (Tangible and Intangible), Non-current Investments, and Long-term loans and advances. Tangible assets are physical items like machinery, while intangible assets include goodwill and patents.
Current Assets are expected to be realized within 12 months or the operating cycle. This category includes Current Investments, Inventories, Trade Receivables, and Cash and Cash Equivalents. All inventories are always treated as current assets.
Trade receivables realized beyond twelve months from the reporting date or operating cycle are classified as 'Other non-current assets' under the head Non-current assets in the Notes to Accounts.
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What is the criteria for an asset to be classified as 'Current'?
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05 · Explore
Worked Example: Share Capital Presentation
This example demonstrates how to present share capital and arrears in the Balance Sheet and Notes to Accounts.
When a company has unpaid calls or forfeited shares, these must be adjusted in the Notes to Accounts to arrive at the final Share Capital figure shown on the face of the Balance Sheet.
Consider a company with an authorized capital of 50,000 shares of 100 each. It invites applications for 40,000 shares, and 36,000 are received. If 35,500 are fully paid and 500 have a 20 call unpaid, but 200 of those 500 are forfeited, the calculation must account for the remaining 300 shares in arrears and the forfeited amount.
Calculation of Subscribed Capital
Total Share Capital = (Fully Paid Shares * Par) + [(Remaining Arrears Shares * Par) - (Remaining Arrears Shares * Unpaid Call)] + (Forfeited Shares * Amount Paid)
Based on the Dinkar Ltd. example: 1. Subscribed and fully paid: 35,500 * 100 = 35,50,000. 2. Subscribed but not fully paid (300 shares remaining after 200 forfeited): (300 * 100) - (300 * 20) = 30,000 - 6,000 = 24,000. 3. Add Share Forfeiture A/c (200 shares * 80 paid): 16,000. Total = 35,50,000 + 24,000 + 16,000 = 35,90,000.
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How are forfeited shares treated in the Balance Sheet?
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06 · Explore
Statement of Profit and Loss
The Statement of Profit and Loss measures the operational results of a company over a specific period.
The statement begins with 'Revenue from Operations'. For a general company, this includes sales of products and services. However, in respect to a finance company, revenue from operations shall include revenue from interest, dividend, and income from other financial services.
Expenses are categorized into specific heads: Cost of Materials Consumed, Purchase of Stock-in-Trade, Changes in Inventories, Employee Benefit Expenses (salaries/wages), Finance Costs (interest on borrowings), and Depreciation/Amortization.
The final result is calculated by subtracting total expenses from total revenue to find 'Profit before Tax'. After accounting for exceptional and extraordinary items and deducting tax expenses (current and deferred), the 'Profit for the Period' is determined.
Profit Calculation Sequence
- 1
Total Revenue
Sum of Revenue from Operations and Other Income.
- 2
Total Expenses
Sum of all operating and non-operating costs like materials, employee benefits, and finance costs.
- 3
Profit Before Tax
Total Revenue minus Total Expenses.
- 4
Net Profit
Profit Before Tax minus Tax Expenses (Current and Deferred).
The sequential process of determining a company's net profit for the reporting period.
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What is included in 'Finance Costs'?
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07 · Explore
Limitations of Financial Statements
While essential, financial statements have inherent limitations that users must consider.
One major limitation is that they do not reflect the current market situation because they are prepared based on historical costs. As the purchasing power of money changes, the recorded values may become outdated.
Financial statements also lack qualitative information. They record only monetary transactions, ignoring vital factors like industrial relations, management quality, or employee satisfaction. Furthermore, they are aggregate reports that may hide specific details needed for deep analysis.
Because they involve personal judgments (like depreciation methods) and accounting conventions, the results can be biased. They are also 'interim' in nature, meaning they show the position at a specific point in time but cannot perfectly predict future earning capacity.
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Why are financial statements considered 'biased'?
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What is meant by 'qualitative information' in this context?
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08 · Explore
Treatment of Special Items
Certain items require specific disclosure rules under Schedule III and Accounting Standards.
Proposed Dividend: According to AS-4, the dividend proposed by directors is a contingent liability until approved by shareholders. It is disclosed in the 'Notes to Accounts' rather than as a liability on the Balance Sheet face.
Preliminary Expenses: These must be written off completely in the year they are incurred. They should be written off first from the Securities Premium Account, and the balance, if any, is taken from the Statement of Profit and Loss.
Rounding Off: This is mandatory based on turnover. If turnover is less than 100 crore, figures are rounded to the nearest hundreds, thousands, lakhs, or millions. If turnover exceeds 100 crore, rounding is to the nearest lakhs or millions.
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How is Proposed Dividend treated in the current year's Balance Sheet?
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