Financial Statements — Meaning, Nature and Objectives

At the end of every accounting period a business must answer two plain questions: how much did we earn or lose during the period, and what do we own and owe at the end of it? The formal statements a firm prepares to answer these questions are its financial statements. They are the end-products of the whole accounting process — the point at which the day-to-day recording in journals and ledgers is finally summarised into a small set of reports that management, owners, lenders and the tax authorities can actually read and act upon.

A financial statement is therefore a summarised, periodic report of the financial position and financial performance of a business, prepared from the books of account at the close of an accounting period (usually a financial year). For a typical business the set includes at least the Statement of Profit and Loss, the Balance Sheet and, increasingly, the Cash Flow Statement, together with the notes and schedules that explain the figures in them.

Nature (characteristics) of financial statements

• They are the end-product of the accounting process. They are not prepared from scratch; they are drawn up by classifying and summarising the balances already recorded in the ledger, so their reliability depends entirely on the accuracy of the underlying books.
• They are historical in character. They record what has already happened during a past period; they are a report on the past, not a forecast of the future.
• They rest on recorded facts, accounting conventions and personal judgement together. The figures come partly from recorded transactions (recorded facts), partly from accepted conventions and assumptions (going concern, money measurement, cost basis), and partly from the accountant's estimates and judgement (the useful life of an asset for depreciation, the amount of a doubtful-debt provision).
• They are expressed in monetary terms. Only items capable of being measured in money find a place in them; valuable but non-monetary factors such as the skill of the workforce or the loyalty of customers do not appear.
• They are prepared periodically, for a defined accounting period, so that performance and position can be compared from one period to the next.

Objectives of preparing financial statements

1. To present a true and fair view of the financial performance of the business — the profit earned or loss incurred during the period (through the Statement of Profit and Loss).
2. To present a true and fair view of the financial position of the business — the assets it owns and the liabilities it owes as at the close of the period (through the Balance Sheet).
3. To provide information about the earning capacity and the operating results, so that owners and managers can judge how profitably the resources of the business have been used.
4. To provide information useful for decision-making to a wide range of users — owners deciding whether to reinvest, lenders deciding whether to lend, and management deciding how to run the business.
5. To disclose the changes in the firm's resources and obligations and, through the Cash Flow Statement, how cash was generated and used during the period.
6. To serve as a basis for taxation and statutory compliance, since tax liabilities and many legal filings are computed from the figures reported in these statements.

In short, financial statements convert a year's worth of individual transactions into a compact, comparable picture of how the business performed and where it stands — which is exactly the raw material that the analysis techniques studied later in this chapter work upon.