Financial Statements – A Comprehensive Introduction

In this article on financial statements, we explore the regulatory framework, users of financial statements, purposes of financial statements, qualitative characteristics of financial statements, components of financial statements and the balance sheet.

Regulatory Framework

The International Accounting standard Board ( IASB) issues financial reporting standards on how Financial Statements need be prepared ( IFRS). Prior to harmonization of financial reporting standards each country accounting Boards issued guidelines and standards on how financial statements were to be prepared. The move to harmonize accounting standards have caused changes in the classifications of items to be included in the Financial Statements.

USERS OF FINANCIAL STATEMENTS

There are different groups of users of financial statements who use financial statements in order to satisfy some of their different needs for information. The users and their information needs are as follows:

1. Investors – these are providers of risk capital. They are concerned with the return provided by their investments. They need information that will help them determine whether they should buy, hold or sell.

2. Shareholders – these are concerned with whether the company is able to pay dividends or not.

3. Employees – they are interested about the stability and profitability of their employers and the ability of the entity to pay salaries, retirement benefits.

4. Lenders – these are interested in information that enables them to determine whether their loans and interest attached to them will be paid when due.

5.Governments and their agencies – these are interested in the allocation of resources and in the activities of the firm, regulation of the firm and to determine taxation.

6. Suppliers and other trade creditors – they are interested in information that enables them to determine whether amounts owing to them will be paid when due.

7. Customers – these are interested in information about the continuance of an entity, especially when they have long –term involvement with, or are dependent on, the entity.

Purposes of Financial Statements

1. Financial Position – Assets = Liabilities + Equity
2. Performance Measurement – Profit= Income – Expenses
3. Measure of Financial Change – The changes are derived from the change in the Financial position as well as on the performance side.

4. Provide information about the financial position, financial performance and cash flows of an entity that is useful to a wide range of users in making economic decisions.
5. Financial Statements show the results of management’s stewardship of the resources entrusted to it.
6. Financial Statements provide information about an entity’s: Assets, Liabilities, Equity ( Capital), Income and Expenditure including gains and Losses, Other Changes in Equity and Cash flows.

Qualitative characteristics of Financial Statements

Attributes that make the information provided in the financial statements useful to users. These attributes include understandability, relevance, materiality, reliability and comparability.

Components of Financial Statements

These include the Balance Sheet, Income Statement, Cash flow Statement, Statement of Changes of Equity and Notes, comprising a summary of significant accounting policies and other explanatory Notes.

Balance Sheet

The Financial Report which shows the Financial position of the Business entity at a given time. Balance sheet Equation is given as ASSETS= CAPITAL + LIABILITIES or Assets = Liabilities + Equity. Where the funds are invested = Where the funds came from.

A balance sheet is a statement of the total assets and liabilities of an organization at a particular date – usually the last date of an accounting period. The balance sheet is split into two parts: (1) A statement of fixed assets, current assets and the liabilities (sometimes referred to as “Net Assets“) and (2) A statement showing how the Net Assets have been financed, for example through share capital and retained profits.

A balance sheet is a summary of the financial position at a specific point in time. It presents the economic resources of an organization and the claims against those resources. Assets are items in which an organization has invested its funds for the purpose of  generating revenue. Liabilities represent what is owed by the organization to others. Represent what is owned by the organization or owed to it by others. Equity represents the capital or worth of the organization. Includes capital contributions of members, investors or donors, retained earnings, and the current year’s surplus.

ASSETS AND LIABILITIES

Definition of Assets
An asset is any right or thing that is owned by a business. Assets include land, buildings, equipment and anything else a business owns that can be given a value in money terms for the purpose of financial reporting.

Definition of Liabilities
To acquire its assets, a business may have to obtain money from various sources in addition to its owners (shareholders) or from retained profits. The various amounts of money owed by a business are called its liabilities.

Long-term and Current Liabilities
To provide additional information to the user, assets and liabilities are usually classified in the balance sheet as:
Current Liabilities – those due to be repaid or converted into cash within 12 months of the balance sheet date and,
Long-term Liabilities – those due to be repaid or converted into cash more than 12 months after the balance sheet date.

Fixed Assets
1. Fixed asset is an asset which is intended to be of a permanent nature and which is used by the business to provide the capability to conduct its trade. Examples of “tangible fixed assets” include plant & machinery, land & buildings and motor vehicles.
2. Intangible fixed assets may include goodwill, patents, trademarks and brands – although they may only be included if they have been “acquired“.
3. Investments in other companies which are intended to be held for the long-term can also be shown under the fixed asset heading.

Definition of Capital

As well as borrowing from banks and other sources, all companies receive finance from their owners. This money is generally available for the life of the business and is normally only repaid when the company is “wound up”. To distinguish between the liabilities owed to third parties and to the business owners, the latter is referred to as the “capital” or “equity capital” of the company.

In addition, undistributed profits are re-invested in company assets (such as stocks, equipment and the bank balance). Although these “retained profits” may be available for distribution to shareholders – and may be paid out as dividends as a future date – they are added to the equity capital of the business in arriving at the total “equity shareholders’ funds”.

INCOME STATEMENT

Reports on Results of operation of an entire accounting period in Question with respect to selected accounting entity. Income statement shows all revenues and expenditure over the period and the profitability Specific information in the income statement include, Revenue, Cost of Sales, Gross Profit, Operating Expenditures, finance costs, Depreciation. An income statement reports the organization’s financial performance over a specified period of time. It summarizes all revenue earned and expenses incurred during a specified accounting period. An institution prepares an income statement so that it can determine its net profit or loss (the difference between revenue and expenses).

Resources

See this link on adjusting financial statements. If you’re preparing for ACCA F3 (Financial Accounting), here are 58 essential questions and answers to help you prepare.

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Amar Al Habsy

Entrepreneur, blogger and digital marketer who enjoys writing awesome and original content on a variety of topics based on experience. Connect: Twitter.

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