Explanation of Financial Statements: Objectives, Importance, and Limitations

Financial statements are the product of a process in which a large volume of data about aspects of the economic activities of an enterprise are accumulated, analyzed and reported. Explanation of Financial Statements: Objectives, Importance, and Limitations – Keep study and learn. This process should carry out in conformity with generally accepted accounting principles. These principles represent the most current consensus about how accounting information should record, what information should be disclosed, how it should be disclosed, and which financial statement should prepare.

Financial Statements explanation of each, Meaning of Financial Statements, Objectives of Financial Statements, Importance, and Limitations of Financial Statements.

Thus, generally accepted principles and standards provide a common financial language to enable informed users to read and interpret financial statements. Financial statements are prepared primarily for decision-making. They play a dominant role in setting the framework of managerial decisions. But the information provided in the financial statements is not an end in itself as no meaningful conclusions can draw from these statements alone.

However, the information provided in the financial statements is of immense use in making decisions through analysis and interpretation of financial statements. Financial analysis is the process of identifying the financial strengths and weaknesses of the firm by properly establishing the relationship between the items of the balance sheet and the profit and loss account. There are various methods or techniques used in analyzing financial statements, such as comparative statements, common-size statements, trend analysis, schedule of changes in working capital, funds flow, cash flow analysis, and ratio analysis. Related learn Financial Accounting: Meaning, Nature, and Scope!

Meaning of Financial Statements:

Financial Statements are the collective name given to Income Statement and Positional Statement of an enterprise which shows the financial position of a 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.

The 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 the credit column. To find out the profit earned or loss sustained by the firm during a given period and its financial position at a given point in time is one of the purposes of accounting. For achieving this objective, financial statements are prepared by the business enterprise, which includes the income statement and positional statement.

A firm communicates to the users through financial statements and reports.  The financial statements contain summarized information on the firm’s financial affairs, organized systematically. Preparation of the financial statements is the responsibility of top management.  They should prepare very carefully and contain as much information as possible.

Two basis financial statements prepared for external reporting to owners, investors, and creditors are:

1. Statement of financial position (or Balance sheet): Balance sheet contains information about the resources and obligations of a business entity and about its owners’ interests in the business at a particular point in time. In accounting’s terminology, balance sheet communicates information about assets, liabilities and owner’s equity for a business firm as on a specific date.  It provides a snapshot of the financial position of the firm at the close of the firm’s accounting period.
2. Income statement (or Profit and loss account): The profit and loss account presents the summary of revenues, expenses and net income (or net loss) of a firm for some time. Net income is the amount by which the revenues earned during a period exceed the expenses incurred during that period.

More information is required for planning and controlling and therefore the financial accounting information is presented in different statements and reports in such a way as to serve the internal needs of management.  Financial statements are prepared from the accounting records maintained by the firm.

These two basic financial statements viz:

(i) Income Statement,  or Trading, and Profit & Loss Account and (ii) Positional Statement, or Balance Sheet portrays the operational efficiency and solvency of any business enterprise.

The following formula summarizes what a balance sheet shows:

ASSETS = LIABILITIES + SHAREHOLDER’S EQUITY

A company’s assets have to equal, or “balance,” the sum of its liabilities and shareholder’s equity.

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.

The 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. In the 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. The positional statement is another term used for the Balance Sheet. The position of assets and liabilities of the business at a particular time is determined by the Balance Sheet.

Objectives of financial statements are:

• To provide reliable financial information about economic resources and obligations of a business enterprise.
• Reliable information about changes in the resources (resources minus obligations) of an enterprise that result from the profit-directed activities.
• Financial information that assists in estimating the earning potential of the enterprise.
• Other needed information about changes in economic resources and obligations.
• To disclose, to the extent possible, other information related to the financial statement that is relevant to statement users

Objective and Importance:

The profitability of Business:

Financial statements are required to ascertain whether the enterprise is earning the adequate profit and to know whether the profits have increased or decreased as compared to the previous years so that corrective steps can be taken well in advance.

The Solvency of the Business:

Financial statements help to analyze the position of the business as regards to the capacity of the entity to repay its short as well as long-term liabilities.

The Growth of the Business:

Through comparison of data of two or more years of business entity, we can draw a meaningful conclusion about the growth of the business. For example, an increase in sales with a simultaneous increase in the profits of the business indicates a healthy sign for the growth of the business.

Financial Strength of Business:

Financial statements help the entity in determining the solvency of the business and help to answer various aspects viz., whether it is capable to purchase assets from its resources and/or whether the entity can repay its outside liabilities as and when they become due.

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 the sound business policy by making Intra firm comparison.

Forecasting and Preparing Budgets:

The financial statement provides information regarding the weak-spots of the business so that the management can take corrective measures to remove these shortcomings. Financial statements help the management to make the forecast and prepare budgets.

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:

Manipulation or Window Dressing:

Some business enterprises resort to manipulating the information contained in the financial statements to cover up their bad or weak financial position. Thus, the analysis based on such financial statements may be misleading due to window dressing.

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 the straight-line method or written down value method. However, the results provided by comparing the financial statements of such business enterprises would be misleading.

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.

Historical:

Financial statements are historical 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 the only post­mortem report.

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 the price index in other years. As a result, the misleading picture may be obtained by making a comparison of figures of the past year with current year figures.

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.

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.

Financial statements are the means of conveying to management, owners and interested outsiders a concise picture of profitability and financial position of the business. The preparation of the final accounts is not the first step in the accounting process but they are the end products of the accounting process which give concise accounting information of the accounting period after the accounting period is over. To know the profit or loss earned by a firm, Trading, and Profit and Loss Account is prepared. Balance Sheet will portray the financial condition of the firm on a particular date.