What are Financial Statements?
Financial Statements are statements that serve as a means of communication between the organization and different users of financial statements regarding the financial position and profitability of the business at the end of a financial year. The financial statements of an organization also help them in different analyses, such as Credit Analysis, Debt Analysis, Security Analysis, and General Business Analysis. To ensure the reliability and accuracy of the financial statements, firms, accountants, government agencies, etc., audits the statements.
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Objectives of Financial Statements
- The first objective of preparing financial statements is to present an organization’s true and fair picture of its financial performance.
- The second objective of preparing financial statements is to present an organization’s true and fair picture of its financial position.
- The third objective is to provide detailed information to different users of the financial statements about the resources of the company.
- The last objective of preparing financial statements is to help the owners and management of an organization in the decision-making process.
Need for Financial Statements
An organization needs financial statements to communicate its performance, profits/losses, and financial position to the different internal and external users. The organization can indicate its performance and profits/losses through the Trading and Profit and Loss Account. However, it can indicate its financial position through the Balance Sheet.
Types or Components of Financial Statements
1. Trading and Profit and Loss Account
It is a financial statement of an organization that helps in determining the loss incurred or profit earned by the business during a financial or accounting year. In simple terms, the Trading and Profit and Loss Account is a summary of an organization’s expenses and revenues and ultimately calculates the net figure of the business in terms of profit or loss. If the revenues of an organization are more than its expenses, it is known as profit. However, if the revenues of an organization are less than its expenses, it is known as loss. The figures of expenses and revenues are transferred to the Trading and Profit and Loss Account from the organization’s Trial Balance. The expenses and losses of the firm are recorded on the debit side of the account, whereas the revenues and profits are recorded on the credit side of the account. Some of the essential items included on the debit side are opening stock, wages, purchases less return, salaries, rent paid, interest paid, commission paid, etc. The items included on the credit side are sales less returns, and other incomes.
2. Balance Sheet
It is a financial statement of an organization that shows its financial position, liabilities, assets, and stockholder’s equity as on the date mentioned in the report. It means that the balance sheet does not show the figures of an organization for an accounting period; instead, it shows the figures on a specific date. There are two sides to a balance sheet, namely, the asset side (on the right side) and the liabilities side (on the left side). The asset side of the balance sheet shows the debit balance of the organization. However, the liabilities side of the balance sheet shows the credit balances. The total of the asset side must always be equal to the total of the liabilities side. The balance sheet of an organization is prepared after the preparation of the Trading and Profit and Loss Account. The balance sheet includes the balances of all those ledger accounts, which have not been transferred to the Trading P&L A/c and are yet to be carried forward to the next financial year of the organization. The relevant items included in the balance sheet of an organization are current liabilities, current assets, capital, fixed assets, investments, drawings, long-term liabilities, etc.
Format of the Financial Statements
Trading and Profit and Loss Account
Note: * or ** represents that the firm will either have gross profit or gross loss, i.e., when credit side is greater than the debit side, the difference is denoted as Gross Profit, and when debit side is more than the credit side, the difference is denoted as Gross Loss. The same will be applied in the case of Net profit and Net loss in Profit and Loss Account.
Balance Sheet:
Users of Financial Statements:
- Competitors: Companies competing against each other require financial statements of its competitors so that they can evaluate its performance and financial conditions. It helps them gain knowledge about the firm’s competitive strategies and make decisions accordingly.
- Company Management: The management of an organization uses its financial statements to have a better understanding of its liquidity, profitability, and cash flows. It helps the management in making financing and operational decisions accordingly.
- Employees: An organization can also provide its employees with financial statements, with detailed explanations regarding the elements of the documents. Organizations do so to increase the involvement of employees and help them better understand the business.
- Investment Analysts: Individuals or a group of individuals hires investment analysts to know about the securities of different companies. Therefore, the investment analysts use financial statements and decide whether or not they should recommend them to their clients.
- Rating Agencies: Different rating agencies or credit rating agencies use financial statements so that they can review them and give a credit rating to the organization or its securities.
- Lenders: The lenders use financial statements of the borrower companies to estimate their ability to pay back the loan along with the interest charges.
- Suppliers: Suppliers to an organization often provide them with the supplies on credit. These suppliers use the financial statements to decide whether or not they should extend the credit to the organization.
- Investors: As the investors of an organization are its owners, they require the financial statements to understand their investment’s performance and results.
- Governments: The organizations under the jurisdiction of a government have to provide them with their financial statements at their request. The government uses the statements to evaluate the taxability and tax paid by the organization.