Why do we Need to Prepare Financial Statements?

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Financial Reporting Standards:

Having discussed various stakeholders group of an entity, let us now turn to financial reporting system which facilitates the preparation and presentation of general purpose financial statements.

International Financial Reporting Standards (IFRSs) have recently emerged as global financial reporting standards which various countries have adopted or are preparing to adopt. Many countries have developed their financial reporting standards in alignment with the IFRSs which is called IFRSs convergence.

Presently, Indian companies follows Indian Accounting Standards for the preparation and presentation of financial statements but India has also declared to converge to IFRSs on and from 1-4-2011.

What are IFRSs?

A set of financial reporting standards issued by the International Account­ing Standards Board is recognised under the brand name IFRSs. ‘IFRSs’ is a trade mark of the International Accounting Standards Committee Foundation.

IFRSs comprise of:

a. International Financial Reporting Standards

b. International Accounting Standards

c. Interpretations originated by the International Financial Reporting Inter­pretations Committee (IFRIC) and

d. Interpretations issued by the former Standing Interpretations Committee (SIC).

Presently there are eight International Financial Reporting Standards, twenty nine International Accounting Standards, seventeen IFRIC interpretations and eleven SIC interpretations. The list of IFRSs and to know about International Accounting Standards Board and its standard setting pro­cess.

Indian Accounting Standards:

Institute of Chartered Accountants of India (ICAI) develops and issues accounting standards in the line of the IFRSs. Of course, the Indian Standards have difference with IFRSs on many counts to suit the local economic and business requirements.

These accounting standards are applicable to companies as well as non-corporate entities like co-operative societies, partnerships, trusts, etc. As regards application to companies, these standards are analysed and recommended by the National Advisory Committee on Accounting Standards (NACAS) to the Ministry of Corporate Affairs and the Ministry in turn notified for application by the companies in the preparation and presentation of financial statements.

Financial Reporting:

“Financial Reporting is a practical exercise in communication not a theoretical or academic construct. We should not lose sight of the importance of financial statements as a tool for communication; currently we are losing the audience as they are becoming too complex.” – The Hundred Group of Finance Directors, UK, 2006.

A company being a large body of shareholders is managed by a Board compris­ing of executive and non-executive directors. The Board of Directors acts as a trustee of the investors who have provided capital to the company, lenders and other stakeholders.

The Board of Directors provide financial reports in discharge of its stewardship role and keep the various stakeholders informed about the past and expected performance of the company, its financial position, cash flows etc. Financial reporting is a channel to communicate financial information of an entity to its various stakeholders.

These reports may be general purpose reports which contain general information without any targeted stakeholders group, whereas special purpose financial reports are directed to satisfy special informa­tion need of a user-group. For example, a major lender of the company may seek confidential financial report about the budget of the company.

Financial statements are general purpose financial report. They are structured form of financial report designed to provide general financial information to aid decision making of all user-groups.

Financial statements are presented normally on an annual basis. Of course, some companies present interim financial statements (on half-yearly or quarterly basis). The listed companies release quarterly financial information in accor­dance with the listing agreements.

Components of Financial Statements:

A complete set of Financial Statements comprise of:

a. A Statement of Financial Position as at the end of the year;

b. A Statement of Comprehensive Income for the period;

c. A Statement of Changes in Equity for the period;

d. A Statement of Cash Flows for the period;

e. Notes comprising of a summary of significant accounting policies and other explanatory information;

f. A statement of financial position as at the beginning of the earliest comparative period when an entity applies an accounting policy retrospec­tively or makes a retrospective restatement of items in its financial statements, or when it reclassifies items in its financial statements.

An entity may use any other suitable titles for these statements. However, all components of financial statements should be given equal prominence in presentation.

In India, Statement of Financial Position is termed as Balance Sheet and Statement of Comprehensive Income is termed as Profit and Loss Account. Indian companies are not required to prepare a Statement of Changes in Equity. Schedule VI to the Companies Act, 1956 provides requirement for the prepara­tion and presentation of financial statements by the companies.

A company issues prospectus for the purpose of issuing shares or debentures which contains financial information. The company may also release financial highlights from time to time.

It may provide special purpose financial report customised to the needs of Government or governmental agencies, lenders, customers (mostly in the tendering process), suppliers and other stakeholders. Thus the term financial reporting is much broader than financial statements, but in the accounting parlance financial reporting has become synonymous to the preparation and presentation of financial statements.

Users of Financial Statements and their Information Needs:

In Table 1.5 seven different user-groups and their information needs are described:

Management of the entity creates financial as well as non-financial information for the purpose of decision making. In fact, the financial statements are the outcome in financial terms of all the managerial decisions taken during the accounting period.

However, the management might use the published financial information prepared by it with a view to evaluate performance, financial position and cash flow of the entity. However, management use of financial statements is of very low degree.

Objectives of Financial Statements:

A set of general purpose financial statements provide information about the financial position, performance and cash flows of an entity which could be used by any of the user groups to assess investment decision, employment stability or growth, debt servicing, business continuity and ability to make societal contribu­tion.

General purpose financial statements are those which intend to meet the financial information needs of users who are not in a position to require an entity to prepare financial reports tailored to their particular information needs. They are useful to a wide range of users in making economic decisions. They are not intended for satisfying special information requirement of a particular user-group.

Accounting Information Provided by Financial Statements:

The objective of accounting is to provide information relevant for decision making of the various user-groups. Preparation of financial statements and communicating to the user-groups is not an end in itself. They are just means to an end. Users need to process it further for the purpose of decision making. Financial Statement Analysis would explain the methodologies for analysing the financial statements information.

Accounting measures various aspects of business activities – costs, price, sales volume, profit, assets, liabilities, equity, cash flows. Every constituent of the stakeholders speak using accounting terms. In other words, accounting terms have become commonly used terminologies. That is why accounting is often referred to as language of business.

Financial Accounting provides information about the assets, liabilities, equity, income, expense and cash flows. They are description of the past activities of the entity. The stakeholders use this information for analysing past performance and financial position, and projecting for the future.

In contrast, Management Accounting generates accounting information that provides the managers with the basis to make informed business decisions and makes them better equipped in their management and control functions.

In contrast to financial accounting information, management accounting infor­mation is:

i. Usually confidential and used by management, instead of publicly reported;

ii. Forward-looking, instead of historical;

iii. Pragmatically computed using extensive management information system and internal controls, instead of complying with accounting stan­dards.