Accountancy Chapter 2.3 – Financial Statements of a Company

by

Chapter 2.3 – Financial Statements of a Company

Accountancy Chapter 2.3 – Financial Statements of a Company

1. Introduction to Financial Statements

  • Definition:
    Financial statements are formal records of a company’s financial activities, prepared annually to communicate financial health to stakeholders. They include:
    • Balance Sheet: Snapshot of assets, liabilities, and equity at a specific date.
    • Statement of Profit and Loss: Summary of revenues, expenses, and profits/losses over a period.
    • Cash Flow Statement: Details cash inflows/outflows from operating, investing, and financing activities.
  • Purpose:
    • To provide stakeholders (investors, creditors, government) with transparent information for decision-making.
    • To comply with legal requirements under the Companies Act, 2013 and Accounting Standards (AS).

2. Nature of Financial Statements

Financial statements are derived from recorded facts, accounting conventions, postulates, and personal judgments:

  1. Recorded Facts:
    • Based on historical cost (e.g., fixed assets recorded at purchase price).
    • Example: A machine bought for Rs. 10 lakh in 2015 appears at Rs. 10 lakh in the balance sheet, ignoring market value changes.
  2. Accounting Conventions:
    • Conservatism: Inventory valued at lower of cost or market price.
    • Materiality: Small items (e.g., stationery) expensed immediately.
  3. Postulates (Assumptions):
    • Going Concern: Assumes the company will continue operations indefinitely.
    • Money Measurement: Transactions recorded in monetary terms.
    • Realization: Revenue recognized when earned, not when cash is received.
  4. Personal Judgments:
    • Depreciation methods (e.g., straight-line vs. reducing balance).
    • Provisions for doubtful debts (based on management estimates).

3. Objectives of Financial Statements

  1. Inform about Economic Resources and Obligations:
    • Disclose assets (e.g., machinery, inventory) and liabilities (e.g., loans).
  2. Assess Earning Capacity:
    • Help investors predict future profitability (e.g., via profit trends).
  3. Track Cash Flows:
    • Essential for creditors to evaluate liquidity (e.g., cash from operations).
  4. Evaluate Management Effectiveness:
    • Compare budget vs. actual performance.
  5. Social Impact Reporting:
    • Disclose CSR activities or environmental costs.
  6. Transparency in Accounting Policies:
    • Example: Disclosure of depreciation methods or inventory valuation policies.

4. Types of Financial Statements

  1. Balance Sheet:
    • Structure (as per Schedule III):
      • Equity & Liabilities: Shareholders’ funds, non-current/current liabilities.
      • Assets: Non-current/current assets.
    • Key Features:
      • Vertical format.
      • Mandatory bifurcation of current/non-current items.
      • Rounding-off rules based on turnover (e.g., <Rs. 100 crore: nearest lakh).
  2. Statement of Profit and Loss:
    • Components:
      • Revenue from Operations: Sales, service income.
      • Other Income: Interest, dividends.
      • Expenses: Cost of materials, employee benefits, depreciation.
    • Format:
      • Profit before tax → Tax expense → Net profit.
  3. Cash Flow Statement:
    • Not covered in detail but mentioned as part of financial reporting.

5. Balance Sheet: Form and Content (Schedule III)

  • Key Disclosures:
    • Share Capital:
      • Authorized, issued, subscribed, paid-up capital.
      • Details of shares held by holding companies or shareholders with >5% stake.
    • Reserves and Surplus:
      • Capital reserve, securities premium, revaluation reserve.
      • Surplus: Balance in Statement of Profit and Loss (debit balance shown as negative).
    • Borrowings:
      • Long-term: Debentures, bank loans.
      • Short-term: Trade payables, overdrafts.
  • Classification of Assets/Liabilities:
    • Current: Expected to be realized/settled within 12 months (e.g., inventory).
    • Non-current: Long-term assets/liabilities (e.g., machinery, long-term loans).

6. Statement of Profit and Loss

  • Key Components:
    1. Revenue from Operations:
      • Sale of goods/services.
    2. Other Income:
      • Interest, dividends, gains on asset sales.
    3. Expenses:
      • Cost of Materials: Raw materials consumed.
      • Employee Benefits: Salaries, wages, PF contributions.
      • Finance Costs: Interest on loans.
      • Depreciation: Charged on tangible/intangible assets.

7. Uses and Importance of Financial Statements

  1. For Shareholders:
    • Assess dividend potential and management efficiency.
  2. For Creditors:
    • Evaluate liquidity (e.g., current ratio).
  3. For Government:
    • Basis for taxation and economic policies.
  4. For Investors:
    • Analyze profitability (ROI) and solvency (debt-equity ratio).

8. Limitations of Financial Statements

  1. Historical Cost Basis:
    • Assets not revalued to reflect current market prices.
  2. Bias in Estimates:
    • Example: Overstatement of inventory value.
  3. Lack of Qualitative Data:
    • No disclosure of employee morale or brand value.
  4. Interim Nature:
    • Balance sheet reflects position only on a specific date.

9. Practical Applications

  • Balance Sheet Preparation:
    • Step 1: Classify assets/liabilities as current/non-current.
    • Step 2: Disclose share capital, reserves, and borrowings as per Schedule III.
    • Step 3: Include notes for detailed disclosures (e.g., contingent liabilities).

10. Summary Table: Balance Sheet vs. Statement of Profit and Loss

AspectBalance SheetStatement of Profit and Loss
PurposeShows financial position at a point in time.Shows financial performance over a period.
ComponentsAssets, Liabilities, Equity.Revenues, Expenses, Profits/Losses.
Key DisclosuresShare capital, reserves, borrowings.Cost of materials, employee benefits, taxes.
ComplianceSchedule III of Companies Act, 2013.Accounting Standards (AS-1 to AS-5).

Leave a Comment