Nature of Financial Statements

Financial statements are not just a collection of numbers — they are the final, condensed picture of a business's financial life over a specific period. They show two things: the financial position on a particular date (the Balance Sheet) and the financial results (profit or loss) achieved during that period.

The American Institute of Certified Public Accountants describes them as reports prepared by management to review progress, showing the status of investment in the business and the results achieved. They are a blend of three things: recorded facts, accounting principles, and personal judgements.

Let’s break down each of these four characteristics in detail.

1. Recorded Facts

The foundation of financial statements is the data already recorded in the books of accounts. This data is based on historical cost — the original price paid at the time of the transaction.

• Assets like cash, bank balances, trade receivables, and fixed assets are shown at the figures recorded in the books.
• Assets purchased at different times and at different prices are simply added together and shown at their total cost.
• Because market prices are ignored, financial statements do not reflect the current market value or the true current financial condition of the business. They show what was paid, not what something is worth today.

2. Accounting Conventions

Certain well-established conventions are followed to make the statements comparable, simple, and realistic.

• Valuation of Inventory: The convention of cost or market price, whichever is lower is followed. This prevents overstatement of stock.
• Valuation of Fixed Assets: Assets are shown at cost less depreciation — not at their resale value.
• Convention of Materiality: Small, insignificant items (like pencils, pens, postage stamps) are treated as an expense in the year of purchase, even though they are technically assets (they last more than a year). Stationery is valued at cost, not at cost or market price, whichever is lower, because the difference is immaterial.

3. Postulates (Basic Assumptions)

Financial statements are built on fundamental assumptions called postulates.

• Going Concern Postulate: The business is assumed to continue operating for the foreseeable future. This is why assets are shown at historical cost (not liquidation value) and depreciation is spread over their useful life.
• Money Measurement Postulate: It assumes the value of money remains stable over time. Even though the purchasing power of money changes drastically, assets purchased years apart are still shown at the amount originally paid for them.
• Realisation Postulate: Revenue is recognised in the year the sale is made, even if the cash is received over several years. The profit is recorded when the sale is earned, not when the cash is collected.

4. Personal Judgements

In many areas, the accountant must use personal opinion, estimates, and judgement. This is necessary to avoid overstating assets, liabilities, income, or expenses, following the convention of conservatism (prudence).

• Depreciation: The useful economic life of a fixed asset is an estimate. Different accountants may choose different useful lives, leading to different depreciation amounts. …