The whole aim of accounting is to keep systematic records of financial transactions so they can be communicated to the various stakeholders. And the main way this information is communicated to the relevant parties is through financial statements. So let us take a look at the features and the utmost importance of a financial statement.
A financial statement is an organized and systematic representation of a collection of financial data. These statements represent the financial performance of the entity and its current fiscal position as well. A financial statement is prepared by following certain logical and consistent accounting principles, assumptions and methodologies.
So the term financial statements generally refer to three important statements. They are
- The Balance Sheet (position statement)
- The Profit and Loss Account (income statement)
- Cash Flow Statement
Financial statements are prepared for a period of time which is arbitrarily one year. We call this the accounting year/period. So these statements will reflect the monetary transactions for the said period. The data contained in them is a combination of four aspects. Let us take a look.
- Recorded Facts: This is the information gathered from the accounting records. These accounts (cash account, debtors, creditors, fixed asset account, etc) are maintained at the original cost or historical cost. The marketable value is not recorded. So since such accounts are taken as a part of the statements, they do show the current fiscal condition of the entity.
- Accounting Principles: Again when preparing these statements certain accounting principles, standards, methods have been followed. These get reflected in a financial statement. Incorporation of such accounting principles makes the financial statement uniform, more reliable and comparable as well.
- Assumptions: When recording financial transactions an enterprise will make certain postulates or assumptions. The three common ones are going concern, accrual, and consistency.
- Personal Judgement: While the accounting principles, conventions and assumptions have to be followed, there are certain things which are left to the judgment of the accountant. Like whether to defer expenses, provision for debts, a method of inventory calculation (FIFO, LIFO, etc.). These personal judgment decisions of the accountant will be reflected in the financial statements.
Qualitative Characteristics of Financial Statement
Financial statements are quantitative statements, based on numbers. However, the information they provide to the users have some important qualitative characteristics. let us take a look.
One of the most important features of a financial statement is that it should be easily understood by the user. We assume that the user has a basic understanding of finance and accounting. So the information should be presented in such a manner that he understands and comprehends it.
But no information about materiality or relevance should be left out of the statement because it is deemed too complex. Even if the information is difficult to understand it must be included if it is of importance.
The financial statements must contain relevant information for them to be useful to the users. For such users, any information that helps their decision making about investing is useful information. Such information should help them evaluate past, present or even future events.
The information can be predictive or confirmatory and usually both. Say for example information about the dividend paid in the last year is valuable information for a potential investor. Similarly, information about the asset structure of the company can help a user evaluate the future of a company.
The information communicated to the users will be worthless if it is not reliable and trustworthy. For the information to be reliable it must be error-free and free of any form of material bias.
Say if the information is important but a reliable estimate cannot be made. In such a case the information can be included in the notes to accounts. So if litigation is ongoing and the company predicts they will have to pay a fine. However, the amount of the fine is not predictable. This is important information, so it should be disclosed.
Firstly the users should be able to compare the financial statements of an enterprise over a period of time (a few years). This will enable them to do trend analysis and better understand the finances of the company. This is important for their investment decision.
Another important qualitative characteristic is that the users should be made aware of the accounting policies being followed. They should be informed if any major accounting policy change has taken place that has a material effect on these statements. One way to ensure that the accounts are comparable over time is stringently following the accounting standards.
But the need for comparability should not tamper with the company’s ability to represent their accounts in the best manner possible. The qualitative characteristics of relevance and reliability dictate that if it is inappropriate to continue with the same policies, they should be changed.
Solved Example for You
Q: A company prepared a balance sheet for the first six months of the calendar year. Is this a valid balance sheet?
Ans: Yes it is a valid balance sheet. There are no rules regarding the time period of financial statements. Generally, they are prepared for the whole year. And this year can be a calendar year or a financial year. But they can be prepared for any time frame as needed by the company.