UNIT :2 ACCOUNTANCY THEORY

Meaning of financial statements

Financial statements are written records that convey the business activities and the financial
performance of a company. Financial statements are often audited by government agencies,
accountants, firms, etc. to ensure accuracy and for tax, financing, or investing purposes. Financial
statements include:

 Balance sheet
 Income statement
 Cash flow statement

The financial statements are used by investors, market analysts, and creditors to evaluate a
company's financial health and earnings potential. The three major financial statement reports are
the balance sheet, income statement, and statement of cash flows.

 The balance sheet provides an overview of assets, liabilities, and stockholders' equity as a
snapshot in time.
 The income statement primarily focuses on a company’s revenues and expenses during a
particular period. Once expenses are subtracted from revenues, the statement produces a
company's profit figure called net income.
 The cash flow statement (CFS) measures how well a company generates cash to pay its debt
obligations, fund its operating expenses, and fund investments.
Features of Financial Statements

 1. The Financial Statements should be relevant for the purpose for which they are prepared.

Unnecessary and confusing disclosures should be avoided and all those that are relevant and

material should be reported to the public.

 2. They should convey full and accurate information about the performance, position,

progress and prospects of an enterprise. It is also important that those who prepare and

present the financial statements should not allow their personal prejudices to distort the

facts.

 3. They should be easily comparable with previous statements or with those of similar

concerns or industry. Comparability increases the utility of financial statements.

 4. They should be prepared in a classified form so that a better and meaningful analysis

could be made.

 5. The financial statements should be prepared and presented at the right time. Undue delay

in their preparation would reduce the significance and utility of these statements.
  6. The financial statements must have general acceptability and understanding. This can be

achieved only by applying certain “generally accepted accounting principles” in their

preparation.

 7. The financial statements should not be affected by inconsistencies arising out of personal

judgment and procedural choices exercised by the accountant.

 8. Financial Statements should comply with the legal requirements if any, as regards form,

contents, and disclosures and methods. In India, companies are required to present their

financial statements according to the Companies Act, 

Importance of Financial Statements

1. Importance to Management:

Increase in size and complexities of factors affecting the business operations necessitate a scientific

and analytical approach in the management of modern business enterprises. The management team

requires up to date, accurate and systematic financial information for the purposes. Financial

statements help the management to understand the position, progress and prospects of business

vis-a-vis the industry.

By providing the management with the causes of business results, they enable them to formulate

appropriate policies and courses of action for the future.

2.  Importance to the Shareholders:

These statements enable the shareholders to know about the efficiency and effectiveness of the

management and also the earning capacity and financial strength of the company.

By analyzing the financial statements, the prospective shareholders could ascertain the profit

earning capacity, present position and future prospects of the company and decide about making

their investments in this company.

Published financial statements are the main source of information for the prospective investors.
3.  Importance to Lenders/Creditors

It is through a critical examination of the financial statements that these groups can come to know

about the liquidity, profitability and long-term solvency position of a company. This would help them

to decide about their future course of action.

4.  Importance to Labour:

Workers are entitled to bonus depending upon the size of profit as disclosed by audited profit and

loss account. Thus, P & L a/c becomes greatly important to the workers. In wages negotiations also,

the size of profits and profitability achieved are greatly relevant.

5.  Importance to the Public:

Business is a social entity. Various groups of society, though directly not connected with business,

are interested in knowing the position, progress and prospects of a business enterprise.

They are financial analysts, lawyers, trade associations, trade unions, financial press, research

scholars and teachers, etc. It is only through these published financial statements these people can

analyse, judge and comment upon business enterprise.

6.  Importance to National Economy:

The rise and growth of corporate sector, to a great extent, influence the economic progress of a

country. Unscrupulous and fraudulent corporate managements shatter the confidence of the

general public in joint stock companies, which is essential for economic progress and retard the

economic growth of the country.

Financial Statements come to the rescue of general public by providing information by which they

can examine and assess the real worth of the company and avoid being cheated by unscrupulous

persons.

The law endeavours to raise the level of business morality by compelling the companies to prepare

financial statements in a clear and systematic form and disclose material information.

Limitations of Financial Statements:

Most of the limitations are mainly due to the cumulative effect of recorded facts, accounting

conventions and personal judgment on financial statements. Unless they are prepared specially they

fail to reflect the current economic picture of business. As such, financial statements have a number

of limitations.

limitations are as follows:

1.  Information is Incomplete and Inexact:

The financial statements are interim reports usually prepared for an accounting period. Hence, the

financial information as revealed by them is neither complete nor exact.

The true financial position or ultimate gain or loss, can be known only when the business is closed

down.
2.  Qualitative Information is Ignored:

Financial statements depict only those items of quantitative information that are expressed in

monetary terms.

But, a number of qualitative factors, such as the reputation and prestige of the management with

the public, cordial industrial relations and efficiency of workers, customer satisfaction, competitive

strength, etc., which cannot be expressed in monetary terms , are not depicted by the financial

statements.

However, these factors are essential for understanding the real financial condition and the operating

results of the business.

3.  Financial Statements Mainly Show Historical Information:

As the financial statements are compiled on the basis of historical costs, they fail to take into

account such factors as the decrease in money value or increase in the price level changes. Since

these statements deal with past data only, they are of little value in decision-making.

4. Financial Statements are Based on Accounting Concepts and Conventions.

Accounting concepts and conventions used the preparation of financial statements make them

unrealistic.
For example the income statement prepared on the basis of the convention of conservatism fails to

disclose the true income, for it includes probable losses and ignores probable income.

Similarly the value of fixed asset is shown in the balance sheet on the ‘going concern concept’. This

means that the value of the asset rarely represents the amount of cash, which would be realized on

liquidation.
5.  Personal Judgment Influence Financial Statements:

Many items in the financial statements are left to the personal judgment of the accountant. For

example, the method of inventory valuation, the method of depreciation the treatment of deferred

revenue expenditure, etc., depend on the personal judgment of the accountant.

If it goes wrong, the real picture may be distorted. However, such indiscreet personal judgments are

controlled to a certain extent by the convention of conservatism.

TOOLS OF FINANCIAL ANALYSIS

COMPARATIVE STATEMENTS

Also known as ‘horizontal analysis, are financial statements showing financial position & profitability at
different periods of time. These statements give an idea of the enterprise financial position of two or
more periods. Comparison of financial statements is possible only when same accounting principles are
used in preparing these statements.

COMPARATIVE BALANCE SHEET

The progress of the company can be seen by observing the different assets and liabilities of the firm on
different dates to make the comparison of balances from one date to another. To understand the
comparative balance sheet, it must have two columns for the data of original balance sheets. A third
column is used to show increases/decrease in figures. The fourth column gives percentages of increases
or decreases.

By comparing the balance sheets of different dates, one can observe the following aspects

 Current financial position and Liquidity position

 Long-term financial position

 Profitability of the concern

COMPARATIVE INCOME STATEMENT

Traditionally known as trading and profit and loss A/c. Net sales, cost of goods sold, selling expenses,
office expenses etc are important components of an income statement. To compare the profitability,
particulars of profit & loss are compared with the corresponding figures of previous years individually.
To analyze the profitability of the business, the changes in money value and percentage is determined.

By comparing the profits of different dates, one can observe the following aspects:

 The increase/decrease in gross profit.

 The study of operational profits.

 The increase or decrease in net profit

 Study of the overall profitability of the business.

COMMON SIZE STATEMENTS

Common size statements are also known as ‘Vertical analysis’. Financial statements, when read with
absolute figures, can be misleading. Therefore, a vertical analysis of financial information is done by
considering the percentage form. The balance sheet items are compared:

 to the total assets in terms of percentage by taking the total assets as 100.

 to the total liabilities in terms of percentage by taking the total liabilities as 100.
Therefore, the whole Balance Sheet is converted into percentage form. And such converted Balance
Sheet is known as Common-Size Balance Sheet. Similarly profit & loss items are compared:

 to the total incomes in terms of percentage by taking the total incomes as 100.

 to the total expenses in terms of percentage by taking the total expenses as 100.
Therefore, the whole Profit & loss account is converted into percentage form. And such converted profit
& loss account is known as Common-Size Profit & Loss account. As the numbers are brought to a
common base, the percentage can be easily compared with the results of corresponding percentages of
the previous year or of some other firms.

 TREND ANALYSIS
Also known as the Pyramid Method. Studying the operational results and financial position over a series
of years is trend analysis. Calculations of ratios of different items for various periods is done & then
compared under this analysis. Whether the enterprise is trending upward or backward, the analysis of
the ratios over a period of years is done. By observing this analysis, the sign of good or poor
management is detected.
RATIO ANALYSIS

Quantitative analysis of information contained in a company’s financial statements is ratio analysis. It

describes the significant relationship which exists between various items of a balance sheet and a
statement of profit and loss of a firm.

To assess the profitability, solvency, and efficiency of a business, management can go through the
technique of ratio analysis. It is an attempt at developing a meaningful relationship between individual
items (or group of items) in the balance sheet or profit and loss account.

CASH FLOW ANALYSIS

The actual movement of cash into and out of a business is cash flow analysis. The flow of cash into the
business is called the cash inflow. Similarly, the flow of cash out of the firm is called cash outflow. The
difference between the inflow and outflow of cash is the net cash flow.

Cash flow statement is prepared to project the manner in which the cash has been received and has
been utilized during an accounting year. It is an important analytical tool. Analysis of cash flow explains
the reason for a change in cash. It helps in assessing the liquidity of the enterprise and in evaluating the
operating, investment & financing decisions.

ABOUT ACCOUNTING RATIOS

Objectives of Ratio Analysis

Interpreting the financial statements and other financial data is essential for all stakeholders of an
entity. Ratio Analysis hence becomes a vital tool for financial analysis and financial management. Let us
take a look at some objectives that ratio analysis fulfils.

1] Measure of Profitability

Profit is the ultimate aim of every organization. So if I say that ABC firm earned a profit of 5 lakhs last
year, how will you determine if that is a good or bad figure? Context is required to measure profitability,
which is provided by ratio analysis. Gross Profit Ratios, Net Profit Ratio, Expense ratio etc provide a
measure of the profitability of a firm. The management can use such ratios to find out problem areas
and improve upon them.

2] Evaluation of Operational Efficiency

Certain ratios highlight the degree of efficiency of a company in the management of its assets and other
resources. It is important that assets and financial resources be allocated and used efficiently to avoid
unnecessary expenses. Turnover Ratios and Efficiency Ratios will point out any mismanagement of
assets.

3] Ensure Suitable Liquidity

Every firm has to ensure that some of its assets are liquid, in case it requires cash immediately. So
the liquidity of a firm is measured by ratios such as Current ratio and Quick Ratio. These help a firm
maintain the required level of short-term solvency.

4] Overall Financial Strength

There are some ratios that help determine the firm’s long-term solvency. They help determine if there is
a strain on the assets of a firm or if the firm is over-leveraged. The management will need to quickly
rectify the situation to avoid liquidation in the future. Examples of such ratios are Debt-Equity Ratio,
Leverage ratios etc.

5] Comparison

The organizations’ ratios must be compared to the industry standards to get a better understanding of
its financial health and fiscal position. The management can take corrective action if the standards of
the market are not met by the company. The ratios can also be compared to the previous years’ ratio’s
to see the progress of the company. This is known as trend analysis.

ADVANTAGES OF RATIO ANALYSIS

When employed correctly, ratio analysis throws light on many problems of the firm and also highlights
some positives. Ratios are essentially whistleblowers, they draw the managements attention towards
issues needing attention. Let us take a look at some advantages of ratio analysis.

 Ratio analysis will help validate or disprove the financing,  investment  and operating
decisions of the firm. They summarize the financial statement into comparative figures, thus
helping the management to compare and evaluate the financial position of the firm and the
results of their decisions.

 It simplifies complex accounting statements and financial data into simple ratios of operating
efficiency, financial efficiency, solvency, long-term positions etc.

 Ratio analysis help identify problem areas and bring the attention of the management to such
areas. Some of the information is lost in the complex accounting statements, and ratios will
help pinpoint such problems.

 Allows the company to conduct comparisons with other firms, industry standards, intra-firm
comparisons etc. This will help the organization better understand its fiscal position in the
economy.
LIMITATIONS OF RATIO ANALYSIS

While ratios are very important tools of financial analysis, they d have some limitations, such as

 The firm can make some year-end changes to their financial statements, to improve their
ratios. Then the ratios end up being nothing but  window dressing.
  Ratios  ignore the price level changes due to inflation. Many ratios are calculated using
historical costs, and they overlook the changes in price level between the periods. This does not
reflect the correct financial situation.

 Accounting ratios completely ignore the qualitative aspects of the firm. They only take into
consideration the monetary aspects (quantitative)

 There are no standard definitions of the ratios. So firms may be using different formulas for
the ratios. One such example is Current Ratio, where some firms take into consideration all
current liabilities but others ignore bank overdrafts from current liabilities while calculating
current ratio

 And finally, accounting ratios do not resolve any financial problems of the company. They are
a means to the end, not the actual solution.

ABOUT CASH FLOW STATEMENT

Advantages of Cash Flow Statement:

The advantages of Cash Flow Statement are:

(a) Ascertaining Liquidity and Profitability Positions:
Cash Flow Statement helps the management to ascertain the liquidity and profitability position of a
firm.

Liquidity means one’s ability to pay the obligation as soon as it becomes due.

Since Cash Flow Statement presents the cash position of a firm at the time of making payment it
directly helps to ascertain the liquidity position, the same is also applicable in case of profitability.

One can understand from Cash Flow Statement that how efficiently the firm is paying its obligation
in various forms of expense and liability. At the same-time, as the cash earning capacity of a firm can
be ascertained from this statement, profitability position depends also on cash earning capacity.

(b) Ascertaining Optimum Cash Balance:

Cash Flow Statement helps also to ascertain the optimum cash balance of a firm. If optimum cash

balance can be determined, it is possible for a firm to ascertain the idle and/or excess and/or

shortage of cash position. After ascertaining the cash position, the management can invest the

surplus cash, if any, or borrow funds from outside sources accordingly to meet the cash deficit.

(c) Cash Management:

Proper management of cash is possible if cash flow statement is properly prepared. The

management can prepare an estimate about the various inflows of cash and outflows of cash so that

it becomes very helpful for them to make plans for the future.
(d) Capital Budgeting Decisions:

Since capital budgeting relates to the decision of capital expenditure in various forms on a long-term

basis cash flow timing is very important for this purpose.

(e) Superiority over Accrual Basis of Accounting:

No doubt, Cash Flow Statement or cash basis of accounting is more reliable or dependable than

accrual basis of accounting as a number of technical adjustments are made in the latter case. Cash

flow accounting is free from such snags.

(f) Planning and Co-ordination:

Cash Flow Statement is prepared on an estimated basis meant for the successing/next year which

helps the management to know how much funds are required for what purposes, how much cash is

generated from internal sources, how much cash can be procured from outside the business. It helps

also to prepare cash budgets. Thus, the management can prepare plans, coordinate various activities

with the help of this statement.

(g) Movement of Cash:

A Cash Flow Statement presents the management the flows in and flows out of cash for various

purposes on the basis of which future estimates can be prepared.

(h) Performance appraisal:

By comparing the actual Cash Flow Statement with the projected Cash Flow Statements, the

management can evaluate or appraise the performances regarding cash. If any unfavourable

variance is found, the reason for such variation is located and rectified accordingly.

LIMITATIONS OF CASH FLOW STATEMENT:

Cash Flow Statement is, no doubt, an important tool in financial management which exhibits the

movement of funds in various ways of a firm. It assists the management to understand the amount

of capital blocked-up in a specific segment of a firm. Although the cash flow statement performs as

an important tool, it is not free from snags.

(a) Fails to present Net Income:

Cash flow statement actually fails to present the net income of a firm for a period since it does not

consider non-cash items which can easily be ascertained by an Income Statement. It can be used as a

supplement to Income Statement.

(b) Fails to Assess the Liquidity and Solvency Position:

Practically cash flow statement does not help to assess liquidity or solvency position of a firm. Proper

liquidity position cannot be assessed from the cash flow statement which presents only the cash

position at the end of the period. It only helps how much amount of obligation can be met i.e. cash

flow statement does not represent the real liquidity position.

(c) Neither a substitute of Funds Flow Statement nor Income Statement:

Cash flow statement is neither a substitutes of funds flow statement nor a substitute of income

statement. The functions which are performed by a funds flow statement or Income statement

cannot be done by a cash flow statement.

(d) Not to Assess Profitability:

Practically, cash flows from operation does not help to assess profitability of a firm since it neither

considers the costs nor revenues.

(e) Does not Conform with Companies Act:

The provision which are made be the companies’ Act is in conformity with Profit and Loss Account

and Balance Sheet and not in conformity with cash flow statement which is prepared as per AS- 3.

(f) Does not Assess Future Cash Flows:

Since cash flow statement is prepared on the basis of historical cost and, as such, it does not help to

know the future/projected cash flows.

(g) Inter-Industry Comparison not possible:

Since cash flow statement docs not measure the economic efficiency of a firm, in-comparison with

other inter-industry comparison is not possible, e.g., a firm having less capital investment will have

less cash flow than the firm which have more capital investment having a higher cash flow.