Chapter 3 Financial Statements of a Company

Meaning of Financial Statements

Financial statements are the basic and formal annual reports through which the corporate management communicates financial information to its owners and various other external parties, including investors, tax authorities, government, and employees. These statements refer to the balance sheet (position statement) as at the end of the accounting period, the statement of profit and loss of a company, and the cash flow statement.

Nature of Financial Statements

Financial statements are prepared to present a periodical review of the progress by management and deal with the status of investment in the business and the results achieved during the period under review. They reflect a combination of recorded facts, accounting principles, and personal judgments. The main points explaining the nature of financial statements are:

• Recorded Facts: Based on historical cost data recorded in accounting books.
• Accounting Conventions: Follow conventions like valuing inventory at cost or market price, whichever is lower.
• Postulates: Prepared based on basic assumptions like going concern postulate and money measurement postulate.
• Personal Judgements: Include estimates and judgments, such as depreciation and provisions for doubtful debts.

Objectives of Financial Statements

The primary objective of financial statements is to assist users in their decision-making. The specific objectives include:

• Providing information about economic resources and obligations of a business.
• Providing information about the earning capacity of the business.
• Providing information about cash flows.
• Judging the effectiveness of management.
• Reporting activities of the business affecting society.
• Disclosing significant accounting policies and changes.

Types of Financial Statements

The financial statements generally include two primary statements: the balance sheet and the statement of profit and loss. These are required for external reporting and internal management needs such as planning, decision-making, and control. Additionally, a cash flow statement is prepared to track the movements of funds and changes in the financial position of the company.

Every company registered under The Companies Act 2013 must prepare its balance sheet, statement of profit and loss, and notes to account according to the revised Schedule III to the Companies Act, 2013, to harmonize disclosure requirements with accounting standards and converge with new reforms.

Questions for Practice

Short Answer Questions

1. State the meaning of financial statements?

   Financial statements are the end products of accounting process, which reveal the financial results of a specified period and financial position as on a particular date. They include the Statement of Profit and Loss and the Balance Sheet, prepared for the benefit of various stakeholders.

2. What are the limitations of financial statements?

   Limitations include:

   • Aggregate information but not detailed information.
   • Do not disclose information relating to loss of markets and cessation of agreements.
   • Contain only monetary information, not qualitative information like industrial relations.
   • They are interim reports, not showing the future potential of the business.
3. List any three objectives of financial statements?
   • Provide information about economic resources and obligations.
   • Provide information about the earning capacity of the business.
   • Provide information about cash flows.
4. State the importance of financial statements to:
   1. Shareholders

   They provide information about the profitability and financial health of the company.

   2. Creditors

   They help in assessing the creditworthiness and the ability of the company to meet its obligations.

   3. Government

   They provide data required for taxation and regulatory purposes.

   4. Investors

   They assist in making informed investment decisions.

5. How will you disclose the following items in the Balance Sheet of a company:
   1. Current assets, inventory

   Disclosed under the head 'Current Assets' as part of the balance sheet.

   2. Contingent liabilities in notes to accounts

   Disclosed as a note to accounts, not in the main balance sheet.

   3. Shareholders Funds, Reserve and Surplus

   Disclosed under the head 'Equity and Liabilities' in the balance sheet.

   4. Fixed Assets, Intangible Assets

   Disclosed under the head 'Non-current Assets' in the balance sheet.

Long Answer Questions

1. Explain the nature of the financial statements.

   Financial statements are a summarized form of financial data, prepared in accordance with accounting principles, conventions, and standards. They reflect the financial performance and position of a business at a specific point in time.

   Financial statements are formal records of the financial activities and position of a business, person, or other entity. They are intended to provide an overview of the financial performance and financial position of the entity for a specific period. The primary financial statements include the balance sheet, income statement, statement of retained earnings, and statement of cash flows.

   These statements are prepared based on standardized guidelines, such as Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS). The balance sheet provides a snapshot of the entity's assets, liabilities, and equity at a specific point in time, illustrating the accounting equation: Assets = Liabilities + Equity. The income statement shows the entity's revenues and expenses over a period, culminating in net profit or loss. The statement of retained earnings explains changes in retained earnings over a period, while the statement of cash flows details the cash inflows and outflows from operating, investing, and financing activities.

   Financial statements are crucial for stakeholders, including investors, creditors, management, and regulators, as they offer a transparent and standardized way to assess the financial health and performance of an entity. They serve as a foundation for decision-making, financial analysis, and regulatory compliance.

2. Explain in detail about the significance of the financial statements.

   They provide essential information for decision-making to various stakeholders including shareholders, creditors, investors, and the government. They help in assessing the profitability, liquidity, and financial stability of the business.

   Significance of Financial Statements

   Financial statements are vital tools for assessing the financial health, performance, and cash flows of an entity. They provide critical information to various stakeholders, enabling informed decision-making. Investors use financial statements to evaluate the profitability, stability, and growth prospects of a business, guiding their investment decisions. Creditors assess the creditworthiness and financial stability of a business, determining the risk of lending.

   Management relies on financial statements to make strategic decisions, plan budgets, and monitor operational performance. By analyzing financial data, management can identify trends, strengths, weaknesses, and opportunities for improvement. Regulators and tax authorities use financial statements to ensure compliance with laws and regulations, maintaining transparency and accountability within the financial system.

   Financial statements also facilitate comparability between different entities and over different periods. Standardized reporting ensures consistency, making it easier for stakeholders to compare financial performance and position. Moreover, financial statements provide a historical record of financial activities, aiding in trend analysis and forecasting future performance.

3. Explain the limitations of financial statements.

   Limitations include lack of detailed information, exclusion of non-monetary qualitative data, being interim in nature, and potential for personal biases and estimates affecting the reported data.

   Limitations of Financial Statements

   While financial statements are essential for assessing a company's financial health, they have several limitations. One significant limitation is their historical nature; they report past performance and may not reflect current or future conditions. Consequently, stakeholders must consider additional information and forecasts to make informed decisions.

   Financial statements rely on estimates and judgments, such as depreciation rates and provisions for bad debts, which can introduce subjectivity and affect accuracy. Different accounting policies and standards can also lead to inconsistencies, making it difficult to compare financial statements across companies or over time.

   Non-financial factors, such as market conditions, competition, and management quality, are not captured in financial statements. These factors can significantly impact a company's performance and should be considered alongside financial data. Financial statements also do not account for inflation, which can distort the real value of assets, liabilities, and profits.

4. Prepare the format of the statement of profit and loss and explain its items up to the ascertainment of profit before tax.

   The statement includes items like revenue from operations, other income, total revenue, expenses (such as cost of materials consumed, employee benefits, depreciation), and finally, the profit before tax.

   Format of Statement of Profit and Loss

   The statement of profit and loss, also known as the income statement, outlines a company's revenues and expenses over a specific period, leading to the net profit or loss. Below is a simplified format:

   Particulars	Amount (Rs.)
   Revenue from Operations	XXX
   Other Income	XXX
   Total Revenue (I)	XXX
   Expenses:
   Cost of Materials Consumed	XXX
   Purchases of Stock-in-Trade	XXX
   Changes in Inventories of Finished Goods, Work-in-Progress, and Stock-in-Trade	XXX
   Employee Benefits Expense	XXX
   Finance Costs	XXX
   Depreciation and Amortization Expense	XXX
   Other Expenses	XXX
   Total Expenses (II)	XXX
   Profit Before Tax (I-II)	XXX

   Explanation of Items:
   - Revenue from Operations: The primary income from core business activities, such as sales of goods or services.
   - Other Income: Income from non-core activities, like interest, dividends, or rent.
   - Cost of Materials Consumed: The cost of raw materials used in production.
   - Purchases of Stock-in-Trade: Cost of goods bought for resale.
   - Changes in Inventories: The increase or decrease in stock levels.
   - Employee Benefits Expense: Salaries, wages, and other benefits paid to employees.
   - Finance Costs: Interest and other costs incurred in borrowing funds.
   - Depreciation and Amortization: Allocation of the cost of tangible and intangible assets over their useful lives.
   - Other Expenses: Miscellaneous expenses related to business operations.

5. Prepare the format of the balance sheet and explain the various elements of the balance sheet.

   The balance sheet includes elements like equity and liabilities (shareholders' funds, non-current liabilities, current liabilities) and assets (non-current assets, current assets).

   Format of Balance Sheet

   The balance sheet provides a snapshot of a company's financial position at a specific point in time. It consists of three main sections: assets, liabilities, and equity. Below is a simplified format:

   Particulars	Amount (Rs.)
   Equity and Liabilities
   Shareholders' Funds:
   Equity Share Capital	XXX
   Reserves and Surplus	XXX
   Non-Current Liabilities:
   Long-Term Borrowings	XXX
   Current Liabilities:
   Short-Term Borrowings	XXX
   Trade Payables	XXX
   Total Equity and Liabilities	XXX
   Assets
   Non-Current Assets:
   Property, Plant, and Equipment	XXX
   Intangible Assets	XXX
   Current Assets:
   Inventories	XXX
   Trade Receivables	XXX
   Cash and Cash Equivalents	XXX
   Total Assets	XXX

   Explanation of Elements:
   - Equity Share Capital: Funds raised from shareholders in exchange for ownership.
   - Reserves and Surplus: Retained earnings and other reserves set aside from profits.
   - Long-Term Borrowings: Loans and debts payable after one year.
   - Short-Term Borrowings: Loans and debts payable within one year.
   - Trade Payables: Amounts owed to suppliers for goods and services.
   - Property, Plant, and Equipment: Tangible long-term assets used in operations.
   - Intangible Assets: Non-physical assets like patents and trademarks.
   - Inventories: Goods available for sale.
   - Trade Receivables: Amounts owed by customers.
   - Cash and Cash Equivalents: Liquid assets like cash and short-term investments.

6. Explain how financial statements are useful to the various parties who are interested in the affairs of an undertaking?

   Financial statements provide a comprehensive view of the financial performance and position, helping stakeholders like shareholders, creditors, investors, and regulatory authorities make informed decisions.

   Usefulness of Financial Statements to Various Parties

   Financial statements are invaluable tools for a wide range of stakeholders interested in the affairs of an undertaking. These stakeholders include investors, creditors, management, employees, customers, suppliers, regulators, and the public.

   Investors: Use financial statements to assess the profitability, stability, and growth prospects of a business. This information helps them make informed investment decisions and evaluate the return on their investments.
   Creditors: Analyze financial statements to determine the creditworthiness and financial stability of a business, assessing the risk of lending money or extending credit.
   Management: Relies on financial statements to make strategic decisions, plan budgets, and monitor operational performance. By analyzing financial data, management can identify trends, strengths, weaknesses, and opportunities for improvement.
   

7. ‘Financial statements reflect a combination of recorded facts, accounting conventions, and personal judgments’. Discuss.

   They are based on recorded transactions, follow certain conventions (like conservatism, materiality), and involve personal judgments and estimates (like depreciation, provisions).

8. Explain the process of preparing income statement and balance sheet.

   The process involves recording transactions, classifying them into various accounts, summarizing the data in ledger accounts, and finally preparing the trial balance, from which the financial statements are drafted.

Numerical Questions

1. Show the following items in the balance sheet as per the provisions of the Companies Act, 2013 in Schedule III:
   • Preliminary Expenses Rs. 2,40,000
   • Goodwill Rs. 30,000
   • Discount on issue of shares Rs. 20,000
   • Loose tools Rs. 12,000
   • 10% Debentures Rs. 2,00,000
   • Motor Vehicles Rs. 4,75,000
   • Stock in trade Rs. 1,40,000
   • Provision for tax Rs. 16,000
   • Cash at bank Rs. 1,35,000
   • Bills receivable Rs. 1,20,000
2. On April 1, 2017, Jumbo Ltd. issued 10,000; 12% debentures of Rs. 100 each at a discount of 20%, redeemable after 5 years. The company decided to write-off the discount on issue of such debentures on March 31, 2018. Show the items in the balance sheet of the company immediately after the issue of these debentures.

   The balance sheet will include debentures at their issue price minus the discount, under non-current liabilities, and the discount to be written off as a deduction from the debentures in the notes to accounts.

3. From the following information prepare the balance sheet of Gitanjali Ltd.
   • Inventories Rs. 14,00,000
   • Equity Share Capital Rs. 20,00,000
   • Plant and Machinery Rs. 10,00,000
   • Preference Share Capital Rs. 12,00,000
   • Debenture Redemption Reserve Rs. 6,00,000
   • Outstanding Expenses Rs. 3,00,000
   • Proposed Dividend Rs. 5,00,000
   • Land and Building Rs. 20,00,000
   • Current Investments Rs. 8,00,000
   • Cash Equivalent Rs. 10,00,000
   • Short term loan from Zaveri Ltd. Rs. 4,00,000
   • Public Deposits Rs. 12,00,000

Balance Sheet of Jam Ltd. as at March 31, 2017