--By Paramananda Adhikari, FCA

 

An entity’s financial statement (FS) is used to show its performance over a certain period of time, normally end of the financial period. Financial statements must ‘present fairly’ the financial position, financial performance and cash flows of an entity. They should be prepared on a going concern basis, unless the management either intends to dissolve the entity or to cease trading. An entity should prepare its financial statements except the cash-flow statement following the accrual basis of accounting. Financial statements are intended to be understandable by readers who have a reasonable knowledge on business and economic activities and who are willing to know the financial information. Different users may use them for different purposes. Highlighting the overview of the components of financial statements and understanding the entity’s performance by the public will be the main objective of this article.

 

Components of Financial Statements

Financial statement comprises five different components namely: balance sheets/statement of financial position, income statement, cash flow statement, changes in equity and notes to the financial statements.

 

 

(i) Balance Sheets/Financial Position

Balance sheet is the statement that shows the financial position of an entity on a specified date, generally the last day of the financial year. It is also called the statement of financial position.

Among other items of information, a balance sheet shows:

• the assets the entity possesses

• amount paid/payable to creditors

• the entity’s liabilities and 

• amount available after discharging liabilities

 

Balance sheet figures are based on the fundamental accounting equation i.e. assets = equity + liability. The major items of a balance sheet are further classified under sub-items such as current assets, non-current assets, current liabilities, non-current liabilities, etc. An audited balance sheet is often required by investors, lenders, suppliers, tax authorities and is also mandated by different laws. To be considered valid, a balance sheet must give a true and fair view of an entity’s state of affairs and be prepared following the provisions of applicable accounting standards. 

 

(ii) Income Statement

Income statement shows the revenue generated by the entity over a specified period of time and the amount expended to generate the revenue. It shows the entity’s net earnings or losses on the bottom line and indicates its earning capability and performance. It is based on a fundamental accounting equation i.e. income = revenue-expenses and shows the rate at which the owners’ equity is changing for better or worse. It is also called operating statement or performance statement or profit or loss account.

 

(iii) Cash Flow Statement

Statement of cash flows represents the inflow and outflow of the entity’s cash over the specified period of time. The cash flow statement is presented and reported into three different activities namely operating activities, investment activities and financing activities. Results of these three activities show the change in cash and cash equivalent position of the entity during the period. This statement shows the liquidity position and cash generation by the entity during the period.

 

(iv) Statement of Changes in Equity

Statement of Changes in Equity (SCE), often referred to as the statement of retained earnings, details the changes in owners' equity over a specified period of time. This statement represents the movement in reserves and surplus comprising the shareholders' equity. Movement in shareholders' equity over the period comprises, but is not limited, to the following elements:

• Net profit or loss during the period attributable to shareholders

• Increase or decrease in share capital and reserves

• Dividend payments to shareholders

• Gains and losses recognized directly in equity 

• Effect of changes in accounting policies

• Effect of correction of prior period error 

 

(v) Notes to the Financial Statement

Notes comprise the principles, estimation/judgments and procedures selected and consistently followed by the management of an entity in preparing and reporting the financial statements. Accounting policies deal specifically with matters such as inventory valuation, depreciation methods, treatment of goodwill and research and development expenses. The detailed text including facts, clarification on unusual items, prior year items provided in the notes are the supplements to the balance sheet, income statement, and statement of changes in equity in the entity’s annual financial statements. These notes also provide important information to the shareholders. Such information includes the accounting methods used in preparing the financial statements and details of employee benefits and contractual liability, which affects the shareholders' investment in the entity. Disclosure of accounting policies of the reporting entity must identify and describe inter alia the following: 

• the accounting principles followed by the entity

• methods of application of these principles by the entity

• how such methods affect determination of the financial position, and 

• the accounting principles in recognition of revenue and allocation of costs.

 

Going Concern Convention

An entity will continue to operate in the foreseeable future is the fundamental principle in accounting that is considered while preparing the financial statements. The significance of this principle becomes apparent when the value of the running business is compared with the value of the one being liquidated. The moment a business is declared liquidated, all debts become immediately due in full; tangible assets are worth only what they will be realizable; and all the intangible assets, if any, become worthless. Going concern is that type of business where banks and financial institutions lend money and suppliers extend the credit period. Further, the management of listed entities must explicitly state in their financial statements that they have taken all reasonable steps to ensure the continuing viability of the entity as a going concern. This is the prime responsibility of the operator of the entity and the main indicator to judge the sustainability of the business.

 

Conclusion

The above mentioned components of financial statements are the important tools for analysing the financial strength of an entity along with the sustainability of the entity in the foreseeable future. By being able to read and analyse the financial statement, we can determine where an entity has made or lost money, where the money is invested and whether the entity stands financially sound and is doing business sustainably. The financial statement gives the shareholders an account of how their investment is performing and provides opportunity to potential investors to invest in the entity. Knowing how to read a financial statement gives an investor or analyst a clear picture of the financial position of an entity. Nevertheless, past performance does not normally guarantee future results. Keep this motto in mind before investing in any entity.

 

The writer is Technical Director of the Institute of Chartered Accountants of Nepal.