Nature of Financial Statements

All business firms carry out several financial transactions, such as purchase and sale of goods and services, payment of salaries, wages, interests and other expenses. These transactions need to be properly classified, chronologically recorded and then summarized to know the profit and loss situation of the business firm over a period of time. Similarly, business firms have to raise funds (in the form of capital and liabilities) by issuing securities like shares and debentures or by making loan from banks and financial institutions. They use these funds to acquire several types of assets such as property, plant, equipment, inventories and so on. The business firm also has to maintain records of these assets, capital and liabilities to obtain updated information on financial position of the business firm at a point in time. Business firms use systematic accounting process and apply generally accepted accounting principles (GAAP) to maintain proper records of these financial transactions. Finally, they come up with summarized statements of financial transactions at the end of accounting process (usually at the end of fiscal year or at the end of accounting cycle) These summarized statements of financial transaction are called financial statements Financial statements of a business firm show the true picture of its financial performance over a period of time. They represent financial and accounting information associated with a business firm.


Financial statements of a business firm consist of four basic types of statements. They are balance sheet (the statement of financial position), income statement (the profit or loss statement), the statement of stockholders equity and the statement of cash flows These financial statements are of great interest to several stakeholders. So, the management of business firm uses these financial statements to communicate with stakeholders. These stakeholders include shareholders, investors creditors, tax authorities, regulatory agencies, researchers, and so on Financial statements contain the basic financial information about revenues, expenses, assets, liabilities and cash flows during a specified period. The balance sheet and the income statement are basic financial statements. They are prepared in accordance with generally accepted accounting principles. The income statement summarizes the revenues and expenditures of a firm during an accounting year (fiscal year). The balance sheet summarizes the balance of the firm's assets, liabilities, and shareholders claim as on the date of balance sheet preparation


Financial statements report what happened to the business firm in terms of sales assets, liabilities, dividends and so on over the period. They provide an input to shareholders, creditors and other investors to evaluate risk and return associated with the firm's financial affairs. Based on the information contained in financial statements, these stakeholders can revise their expectations about the magnitude, timing and riskiness of the firm's cash flows. Therefore, understanding financial statements is important for shareholders, creditors, other investors and for the firm's management as well.


Tips:

  • Financial statements are prepared using facts relating to monetary transactions, which are recorded chronologically.
  • Therefore, first we have to maintain the records of monetary transactions, and then we process them using accounting rule and principles Finally, we use these data to generate financial statements such as balance sheet, income statement, and others.


Need for Financial Statements

Financial statements provide information about financial position, financial performance, and changes in financial position of a firm. Such information is useful to a wide range of users in making financial decisions. Collective use of all components of financial statements provides comprehensive information on profitability and risk associated with a firm. In this section, we discuss some of the major needs for which financial statements are useful. They are described below:



Need for Reporting

Financial statements, such as income statement and balance sheet, represent historical records of a firm's financial performance over the period. They are needed for reporting shareholders, creditors, managers and other stakeholders in order to give information about financial situation of the firm


Need for Decision Making

Financial statements contain important information useful for decision making purpose Further, an analysis of financial statements highlights the strength and weakness of the firm Owners and managers use financial statements to make important business decisions. Financial analysis is performed on these statements to provide management with a more detailed understanding of the figures


Need for Forecasting

Financial statements also can be used to provide an estimate of future financial course of action A firm prepares pro-forma financial statements to provide a future forecast of revenues. expenses, investment and financing


Other Uses

Financial statements, such as statement of cash flow, are prepared to know about comparative cash flow position of a firm between two periods. Besides, prospective investors use financial statements to assess the profitability of investing in firm's shares. Financial institutions like banks, finance companies use financial statements to decide whether to grant a loan to the business Government entities, such as tax authorities, use financial statements to ascertain the accuracy of taxes declared and paid by a firm. Suppliers extending credit to a firm use financial statements to assess the creditworthiness of the firm Media and the general public are also interested in financial statements for a variety of reasons


Tips:

  • Managers need financial statements to manage business affairs by assessing financial performance and taking important decisions.
  • Shareholders need financial statements to assess risk and return of their investment.
  • Prospective investors need financial statements to assess the viability of investing in a business firm.


Annual Report and its Major Components

Shareholder wealth maximization is the basic goal of a firm. Therefore, it is the duty of corporate managers to report shareholders about financial affairs that affect their wealth. A corporation prepares various types of reports for the purpose of reporting to shareholders. The annual report is the basic annual document issued publicly by corporations. the chairman of the board presents annual report in annual general meeting. It is a comprehensive report which presents a firm's preceding year's activities in detail.


The purpose of annual report is to provide information on firm's operations and financial performance to shareholders,  potential investors and other stakeholders By studying annual reports, the reader can obtain deep insight into the overall performance of the form during the preceding year. The annual report does not only contain the textual description of firm's performance. Besides, it also incorporates some graphic and tabular presentation of financial information on visually appealing manner to the reader.

The contents of annual report may vary from one firm to other depending on the nature of business and regulatory requirements Annual report basically contains the following types of information.

                            

Chairman's Speech


The first component of annual report appears in the form of chairman's written speech. The chairman of the firm delivers this speech addressing shareholders in annual general meeting. It highlights main achievements of the company during the past year along with the corporate activities, policies and strategies. It also focuses on future goals and prospective growth and development of the firm. Besides, the chairman's speech also presents a generalization and constructive comments on the economic condition of the industry and the economy as a whole.

Performance Highlights and Future Outlook Another section of the annual report presents performance highlights and future outlook of the firm. This section provides a summary of firm's performance in the previous year in textual form. This section explains firm's achievements its performance relative to the industry, special initiatives undertaken, and goals achieved during the year. These information are presented to ensure that shareholders are satisfied with firm's performance. Besides, this section also presents the information on new developments, if any, the firm is going to pursue Such information helps shareholders to be familiar with firm's future goals and performance.


Auditor's Report

As per the provision of Companies Act of the concerned country, every business firm should get audited its books of accounts by qualified auditor after the close of every fiscal year. So, audit is mandatory for all business firms. The auditor is appointed by the shareholders. The auditor should make a report to shareholders after completing the audit of firm's books of account. A copy of this report should be attached to the annual report to bring firm's financial affairs and performance to the knowledge of shareholders

Financial Statements and Schedules

Second section of annual report presents four basic financial statements- the income statement, the balance sheet, the statement of cash flows, and the statement of stockholders' equity. These statements are prepared by auditor in the process of auditing and they are attached to the annual reports. These statements give authorized information about firm's income, expenses, profits, losses, assets, liabilities, cash flow position, and net worth of the company. We shall discuss these components of financial statements in ensuing section in detail. Besides financial statements, an annual report generally also contains some schedules forming part of balance sheet and income statement. These schedules are attached with financial statements for giving detailed information about the contents of balance sheet and income statement.

Also read Introduction to Business Finance