Question

What are financial statements? What information do they provide?

Answer 1

Every business firm wants to know its financial position at the end of an accounting period. In order to assess its financial position, profit earned or loss incurred during an accounting period, the book value of its assets and liabilities is to be ascertained. In order to serve this purpose, financial statements are prepared. Financial statements are the statements showing profitability and financial position of a business at the end of the year. It includes:

1. Income statements, viz., Trading and Profit and Loss Account, which represents direct and indirect expenses incurred to generate revenues. On one hand, trading account discloses either gross profit or gross loss, on the other hand, profit and loss account discloses either net profit or net loss.

2. Statement of financial position, viz., Balance Sheet, which enlists the book value of all the assets and liabilities of the firm. Balance Sheet discloses the true financial position, solvency and credit worthiness of the business.

The information provided by the financial statements is in the form of gross profit or gross loss, net profit or net loss and book value of the assets and their liabilities. The value and relevance of the information provided by the financial statements varies from one user of accounting information to another. Various users of accounting information can be explained graphically as below.

1. Internal: Internal users are those persons who are directly related to the business. For example, owners, management, employees, workers, etc.

a. Owners: The information required by owners about profit earned or loss incurred during an accounting period. This information is provided by the financial statements in form of gross (net) profit or gross (net) loss.

b. Management: Financial statements provide vital information to the management for decision making, designing policies and future plans. There are various parameters such as ratio of direct (indirect) expenses to gross (net) profit, by the help of which management can check the adequacy, control and relevance of various expenses incurred and plans and policies implemented.

c. Employees and workers: They expect bonus at the year end, which is directly related to the profit of that particular period. The net profit as disclosed by the profit and loss account forms the basis of this expectation.

2. External: External users are those persons and institutions that are indirectly related to the business. For example, government, tax authorities, investors, etc.

a. Government: Government needs information in order to ascertain various macroeconomic variables, such as national income, GDP, employment opportunities generated, etc.

b. Tax authorities: Tax department is interested in knowing the actual sales, production, turnovers and exports and imports by the business. Tax department levies various taxes, such as income tax, VAT, excise tax, etc. The information disclosed by the financial statements form the basis of estimation of the tax dues of the business.

c. Investors: Financial statements help to know about the earning capacity, scope and potential to grow and to assess financial position of the business. It also helps in knowing various investments made by the business and also investments made by the organisations and individuals in the business. This information helps the investors to assess and determine whether investments by them will be fruitful or not.

d. Bank and other financial institutions: Financial statements provide information to banks and other financial institutions, such as LIC, GIC, etc., about the credit worthiness, solvency and repaying capacity of the business.

e. Creditors: Financial statements provide information to the creditors about the goodwill of the business and its credit worthiness and repaying capacity.