Three Main Financial Statements
Three main financial statements of an entity as per GAAP are Balance Sheet, Income Statement (also known as Profit and Loss account), and Cash Flow Statement.
Balance Sheet is “no more and no less than a statement of what a business owns and what it owes at one particular point in time. The difference between what the company owns and what it owes represent equity.” (Karen Berman and others, page 77)1. The balance sheet is divided into two main sections. One section shows the assets of the entity and the other section describe how those assets have been financed. That is to say that the other section shows the investments of the entity in the shape of equities and borrowings, as well current and non-current liabilities. Assets are divide into current assets, non-current assets (Fixed assets), and other assets. Current assets contain those short-term assets that are converted into cash from assets like inventories, receivables, and vice versa over an operational cycle of the entity. Fixed assets are acquired for the long term to be exploited by the entity to generate revenue and profits for maximization of the wealth of shareholders. Other assets include intangibles like patent, goodwill only the extent of purchases and not inbuilt goodwill.
An income statement or profit and loss account is a “report that presents the revenue, expenses, and resulting net income for a period of time.”(Peter J Eisen, page 14)2 There are two approached to prepare an Income statement. Companies that have a primary source of revenues with costs that can easily be identified as related to those revenues will prepare a multiple-step income statement. Under this approach, the income statement is divided into sections, each providing information about a different aspect of the business. When a company is diverse and it is difficult to draw meaningful conclusions about a single aspect of the business based on income statement classifications, then such a company would prepare a single-step statement. Regardless of which of the two formats is used, some certain special transactions or circumstances will be reported separately on the bottom of an income statement. These items are reported net of taxes in the order as discontinued operations, extraordinary items, and the cumulative effect of a change in accounting principle. The difference between a balance sheet and a Profit and loss account is explained by “comparing the balance sheet to a still picture and the profit and loss statement to a moving picture.”(Ronald C Spurga, page 7)3
“The Cash Flow Statement shows where the company’s cash came from and where it was spent during the period covered by the statement.”(Tom Gorman, page 163)4 In the cash flow statement inflows and outflows of cash are reported under three categories, namely, operating activities, investing activities, and financing activities. All business activities are concerned with the flow of cash and that is why balance sheet and income statement have some logical relationship with the cash flow statement. But all business transactions do not immediately and directly hit cash flow, and that is why it becomes important to prepare an income statement to compute the results of transactions over the period, and a balance sheet to understand the financial position at one particular time.
Evaluation of information needs of four non-management users
The selected non- management users of financial statements information are banks, investment bankers, investors, and revenue authorities.
Besides maintaining the regular financial transactions of receipts and payments of their constituents, the bankers provide credit and other related facilities meeting the short-term and long-term needs of the business. Accordingly, banks are directly concerned with the financial statements prepared as per GAAP by the entities. Banks seek not only the yearly financial statements but also the interim statements on a quarterly or another periodic basis that meet their requirements.
The important information that banks draw from audited financial statements mostly relates to detailed aged accounts receivables, accounts payables, and inventories. Various ratios are calculated by the banks on basis of information from financial statements at the time of decision making about sanctioning of loans, credit lines, providing guarantee to business clients of an entity, or other such financing facilities. Ratios that matter is current ratio, debt-equity ratio, inventory turnover, return on assets, profitability ratios, return on equity, and like that. This information is sought to assess the compliance with debt covenants Banks also seek information from financial statements for collateral reports, and quarterly cash flow coverage. Asset-based financing activities need information about the assets at the behest of which financing is done and banks seek such information mainly from the balance sheets of the borrowers.
Investment banking is an “umbrella term for a range of activities: underwriting, selling, and trading securities; providing financial advisory services such as mergers and acquisition advice; and managing assets.”(Wet feet, 2008)5 All these activities need some or other information from the financial statements of their clients. In the case of IPO the company has to provide last three years financial statements to investment bankers so that investors know the performance of the entity. Investment bankers need to evaluate capital structure of the company and balance sheet is the only source to get the details of borrowed and owned funds of the company. Investment bankers have to study financial statements for several years in order to create estimated financial for coming years.
The main activities of investments bankers include helping companies to raise capital, arranging finances for bigger projects, helping in squaring the merger and acquisition deals, and for these deals and activities investment bankers need financial and information in depth. Accordingly investments bankers have to depend a lot upon the information contained in financial statements of their clients.
Before taking decisions about investments the investors require information from financial statements about the strength of the company where they are proposing to invest. The information sought by investors is generally critical like the liquidity position of the company, that is to say ability of the company to meet its short term commitments. They also want to know about rate of returns on assets or equities in order to establish the soundness of the company to meet long term commitments. In a way investors need information about the use and disposal of their investments to analyze their own returns and safety of the amount they have invested. All such information either are readily available in financial statements or the information can be deduced from figures provided in the financial statements.
Taxes are levied on income and the source of computation of income is the income statement of the company. “Revenue collection requires the intensive exchange of financial information on economic transactions, revenue, expenditures, and income with high degree of voluntary compliance.”(Glenn P Jenkins, page 2)6. Taxpayers compute their tax liabilities on basis of financial statements; and whenever revenue authorities are of the opinion that voluntary compliances in tax computations and tax payments lack genuineness, they have legislative powers to assess income calculations by summoning or confiscating financial statements along with other records. Accordingly for revenue authorities the financial statements of taxpayers are the only direct source to establish genuineness of taxable income computed by taxpayers.
Regulations attracting financial statements
Financial statements are prepared as per Generally accepted accounting principles (GAAP). That means basically GAAP regulate the preparation and presentation of financial statements of an entity. The sources of GAAP and other regulations governing financial statements in UK are as under:
- The Companies Act, 2006 and relevant provisions regulating financial statements are contained in Chapter 15: Accounts and Reports. Provisions in some other sections of the act also directly or indirectly regulate and impact the preparation and presentation of the financial statements of the companies.
- UK Accounting Standard Board (ASB) has issued Financial Reporting Standards (FRS) and that is a direct source of GAAP for preparation of financial statements of entities in UK
- UK Accounting Standard board has also issued Statement of Standard Accounting Practices (SSAPs) that also regulate financial accounting of the entities
- Urgent Issue Task Force (UTTF) of the Accounting Standard Board issue UITF Abstracts on matters of extreme importance and urgency concerning accounting issues. The entities have to take care of these abstracts while formulating financial statements.
- The companies that are listed with London Stock Exchange has to follow reporting requirements of LSE as per the agreements between listed companies and LSE, and one those important requirement is that effective from January 2005 all listed companies have to follow International Accounting Standards (now known as International Financial Reporting Standards) in formulating the financial statements. This is a big happening in the international accounting arena as efforts are being made by International Financial Standard Board (IFSB) to converge national standards of member countries with IFRS.
- British Bankers Association (BBA) has also issued the Statement of Recommended Accounting Practice and its regulations are also required to be followed by the entities over and above the established GAAP. Similarly a statement of Recommended Practices (SORP) has been issued by the Association of British Insurers that require the application of FRS, SSAPs, ASB, and ASB(UITF) abstracts to ensure the fair view of financial performance and financial position of the entities.
The regulations of Companies Act, 2006 as stated above seeks a true and fair view of profit or loss for the accounting year and of the state of affairs shown by the balance sheet of the companies. Companies are required to keep individual accounts when in group in order to formulate separate financial statements. Over and above the companies are required to present group financial statements in the annual returns of the company. Companies are also directed to make disclosure of emoluments and other benefits given to directors. The directors are also required to issue a directors’ report relating to certain matters in the financial statements. Over and above the company has to seek an independent auditor’s opinion on financial statements. It is important to note that UK Accounting Standard Board has been recognized under the companies Act to establish and regulate accounting standards for UK entities.
- Karen Berman and others, Financial Intelligence, Harvard Business Press, 2006, page 77
- Peter J Eisen, Accounting the Easy Way, Barron’s Educational Series, 2003, page 14
- Ronald C Spurga, Balance Sheet Basics, published by Ronald C Spurga, 2004, page 7
- Tom Gorman, The Complete Idiot’s Guide to MBA Basics, Alpha Books, 2003, page 163
- Wet feet, Investment Banking.
- Glenn P Jenkins, An Autonomous Revenue Authority for South Africa, 1995, page 2.