What are the three financial statements?

The three financial statements are:

(1) The Income Statement,
(2) The Balance Sheet, and
(3) The Cash Flow Statement.
Overview of the three financial statements:
#1 Income statement
Often, the first place an investor or analyst will look is the income statement.
The income statement shows the performance of the business throughout each
period, displaying sales revenue at the very top. The statement then deducts the
cost of goods sold (COGS) to find gross profit. From there, the gross profit is
affected by other operating expenses and income, depending on the nature of the
business, to reach net income at the bottom – “the bottom line” for the business.
Key features:
 Shows the revenues and expenses of a business
 Expressed over a period of time (i.e., 1 year, 1 quarter, Year-to-Date, etc.)
 Uses accounting principles such as matching and accruals to represent figures
(not presented on a cash basis)
 Used to assess profitability

#2 Balance sheet

The balance sheet displays the company’s assets, liabilities, and shareholders’
equity. As commonly known, assets must equal liabilities plus equity. Net income
from the income statement flows into the balance sheet as a change in retained
earnings (adjusted for payment of dividends).
Key features:
 Shows the financial position of a business
 Expressed as a “snapshot” or financial picture of the company at a specified
point in time (e.g. as on 31st March, 2020)
 Has three sections: assets, liabilities, and shareholders’ equity
 Assets = Liabilities + Shareholders Equity
#3 Cash flow statement
The cash flow statement then takes net income and adjusts it for any non-cash
expenses. Then, using changes in the balance sheet, usage and receipt of cash is
found. The cash flow statement displays the change in cash per period, as well as
the beginning balance and ending balance of cash.
Key features:
 Shows the increases and decreases in cash
 Expressed over a period of time, an accounting period (i.e., 1 year, 1 quarter,
Year-to-Date, etc.)
 Undoes all accounting principles to show pure cash movements
 Has three sections: cash from operations, cash used in investing, and cash
from financing
 Shows the net change in the cash balance from start to end of the period
Objective and Importance:
(i) Knowing Profitability of Business:
Financial statements are required to ascertain whether the enterprise is earning
adequate profit and to know whether the profits have increased or decreased as
compared to the previous year(s), so that corrective steps can be taken well in
advance.
(ii) Knowing the Solvency of the Business:
Financial statements help to analyse the position of the business as regards to the
capacity of the entity to repay its short as well as long term liabilities.
(iii) Judging the Growth of the Business:
Through comparison of data of two or more years of business entity, we can draw
a meaningful conclusion as regard to growth of the business. For example, increase
in sales with simultaneous increase in the profits of the business, indicates a healthy
sign for the growth of the business.
(iv) Judging Financial Strength of Business:
Financial statements help the entity in determining solvency of the business and
help to answer various aspects viz., whether it is capable to purchase assets from its
own resources and/or whether the entity can repay its outside liabilities as and when
they become due.
(v) Making Comparison and Selection of Appropriate Policy:
To make a comparative study of the profitability of the entity with other entities
engaged in the same trade, financial statements help the management to adopt
sound business policy by making intra firm comparison.
(vi) Forecasting and Preparing Budgets:
Financial statement provides information regarding the weak-spots of the business
so that the management can take corrective measures to remove these short
comings. Financial statements help the management to make forecast and prepare
budgets.
(vii) Communicating with Different Parties:
Financial statements are prepared by the entities to communicate with different
parties about their financial position. Hence, it can be concluded that understanding
the basic financial statements is a necessary step towards the successful
management of a commercial enterprise.
Limitations of Financial Statements:
(i) Manipulation or Window Dressing:
Some business enterprises resort to manipulate the information contained in the
financial statements so as to cover up their bad or weak financial position. Thus, the
analysis based on such financial statements may be misleading due to window
dressing.
(ii) Use of Diverse Policies:
There may be more than one way of treating a particular item and when two
different business enterprises adopt different accounting policies, it becomes very
difficult to make a comparison between such enterprises. For example, depreciation
can be charged under straight line method or written down value method. However,
results provided by comparing the financial statements of such business enterprises
would be misleading.
(iii) Non-monetary Aspects Ignored:
The financial statements incorporate the information which can be expressed in
monetary terms. Thus, they fail to assimilate the transactions which cannot be
converted into monetary terms. For example, a conflict between the marketing
manager and sales manager cannot be recorded in the books of accounts due to
its non-monetary nature, but it will certainly affect the functioning of the activities
adversely and consequently, the profits may suffer.
 (iv) Historical:
Financial statements are historical in nature as they record past events and facts.
Due to continuous changes in the demand of the product, policies of the firm or
government etc., analysis based on past information does not serve any useful
purpose and gives only postmortem report.
(v) Price Level Changes:
Figures contained in financial statements do not show the effects of changes in the
price level, i.e. price index in one year may differ from price index in other years. As
a result, misleading picture may be obtained by making a comparison of figures of
past year with current year figures.
Users of Financial Statements
There are many users of the financial statements produced by an organization.
The following list identifies the more common users and the reasons why they
need this information:
 Company management. The management team needs to understand the
profitability, liquidity, and cash flows of the organization every month, so that it
can make operational and financing decisions about the business.
 Competitors. Entities competing against a business will attempt to gain access
to its financial statements, in order to evaluate its financial condition. The
knowledge they gain could alter their competitive strategies.
 Customers. When a customer is considering which supplier to select for a major
contract, it wants to review their financial statements first, in order to judge the
financial ability of a supplier to remain in business long enough to provide the
goods or services mandated in the contract.
 Employees. A company may elect to provide its financial statements to
employees, along with a detailed explanation of what the documents contain.
 This can be used to increase the level of employee involvement in and
understanding of the business.
 Governments. A government in whose jurisdiction a company is located will
request financial statements in order to determine whether the business paid
the appropriate amount of taxes.
 Investment analysts. Outside analysts want to see financial statements in order
to decide whether they should recommend the company's securities to their
clients.
 Investors. Investors will likely require financial statements to be provided, since
they are the owners of the business and want to understand the performance of
their investment.
 Lenders. An entity loaning money to an organization will require financial
statements in order to estimate the ability of the borrower to pay back all loaned
funds and related interest charges.
 Rating agencies. A credit rating agency will need to review the financial
statements in order to give a credit rating to the company as a whole or to its
securities.
 Suppliers. Suppliers will require financial statements in order to decide whether
it is safe to extend credit to a company.
 Unions. A union needs the financial statements in order to evaluate the ability of
a business to pay compensation and benefits to the union members that it
represents.
In short, there are many possible users of financial statements, all having
different reasons for wanting access to this information.
AS 1 – Disclosure of Accounting Policies
Introduction
The information presented in the financial statements of an organisation is of its
financial position. The profit or loss can be affected to a large degree by the
accounting policies followed. The accounting policies followed vary from
organisation to organisation. It is important to disclose significant accounting
policies followed to make the financial statements understandable. The disclosure
is required by law in certain cases.

In recent years, organisations in India have adopted the practice of including a

separate statement of accounting policies followed in their annual reports to
shareholders.

Many organisations list the accounting policies followed by them in the notes to
their financial statements, but there is no consistency in the disclosures among
organisations. In other words, the disclosure forms part of accounts in some cases,
while in others it is given as supplementary information.

The purpose of this standard is to promote better understanding of financial

statements by establishing the practice of disclosure of significant accounting
policies followed and the manner in which they are disclosed in the financial
statements. Such disclosure would also facilitate a more meaningful comparison
between financial statements of different organisations.
Fundamental Accounting Assumptions
Certain assumptions are used in the preparation of financial statements. They are
usually not specifically stated because they are assumed to be followed. Disclosure
is necessary only if they are not followed.
The following have been generally accepted as fundamental accounting
assumptions:
Going Concern
The organisation is normally viewed as a going concern, that is to say, it will be in
continuing operations for the foreseeable future. It is assumed that the
organisation has neither the intention, nor the necessity of shutting down or
reducing the scale of operations.
Consistency
It is assumed that accounting policies are consistently followed from one period
to another. No frequent changes are expected.
Accrual
Revenues and costs are recorded when they are earned or incurred (and not as
money is received or paid) in the periods to which they relate.
Nature of Accounting Policies
Accounting policies refer to accounting principles and the methods of applying
these principles adopted by the organisation in the preparation of their financial
statements.
There is no single list of accounting policies which are applicable in all
circumstances. The different circumstances in which organisations operate make
alternative accounting principles acceptable. The choice of the appropriate
accounting principles calls for a large degree of judgment by the management of
the organisation.

The various standards of the Institute of Chartered Accountants of India,

combined with the efforts of the Government and other regulatory agencies have
reduced the number of acceptable alternatives in recent years, particularly in case
of corporates. While continuing efforts in this regard in the future are likely to
reduce the number still further, the availability of alternative accounting principles
is not likely to be eliminated altogether keeping in mind the different
circumstances faced by the organisations.
Areas in which differing Accounting Policies are possible
The following are examples of areas in which different accounting policies may be
adopted by organisations.
1. Methods of depreciation, depletion and amortisation
2. Treatment of expenditure during construction
3. Conversion or translation of foreign currency items
4. Valuation of inventories
5. Treatment of goodwill & its impairment
6. Valuation of investments
7. Treatment of retirement benefits
8. Recognition of profit on long-term contracts
9. Valuation of fixed assets
10. Treatment of contingent liabilities
The above list of examples is not exhaustive.
Considerations in the Selection of Accounting Policies
The primary consideration in the selection of accounting policies by an
organisation is that the financial statements should represent a true and fair
picture of the financial position for the period.
For this purpose, the major considerations governing the selection and application
of accounting policies are:
Conservatism or Prudence
In view of the uncertainty of future events, profits are not anticipated but recognised
only when earned, though not necessarily in cash. However, provision is made for
all known liabilities and losses even though the amount cannot be determined with
certainty and represents only an estimate.
Substance over Form
The accounting treatment and presentation of transactions and events in financial
statements should be governed by their substance and not merely by the legal
form.
Materiality
Financial statements should disclose all “material” items, i.e. items, the knowledge
of which might influence the decisions of the user of the financial statements.
Disclosure of Accounting Policies
To ensure proper understanding of financial statements, it is necessary that all
significant accounting policies adopted in the preparation and presentation of
financial statements must be disclosed.
Such disclosure should form part of the financial statements.
It would be helpful to the reader of financial statements if they are all disclosed in
one place instead of being scattered over several statements, schedules and notes.
Any change in an accounting policy which has a significant effect should be
disclosed. The amount by which any item in the financial statements is affected by
such change should also be disclosed to the extent it can be calculated. Where
such amount is not ascertainable, wholly or in part, the fact should be disclosed. If
a change is made in the accounting policies which has no material effect on the
financial statements for the current period but is expected to have a material
effect in later periods, the fact of such change should be appropriately disclosed
in the period in which the change is adopted.
Disclosure of accounting policies or of the changes is not a remedy for any wrong
or inappropriate treatment of items in the accounts.
Points to remember
 All significant accounting policies used in the preparation and presentation of
financial statements should be disclosed.
 The disclosure should form part of the financial statements, normally in one
place.
 Any change in the accounting policies which has a material effect in the
current period or is expected to have a material effect in later periods
should be disclosed.
 In case of a change in accounting policies which has a material effect in the
current period, the amount by which any item in the financial statements is
affected should also be disclosed to the extent it can be calculated. Where
such amount is not ascertainable, wholly or in part, the fact should be
indicated.
 If the fundamental accounting assumptions of Going Concern, Consistency
and Accrual are followed in financial statements, specific disclosure is not
required. If a fundamental accounting assumption is not followed, the fact
should be disclosed.
Format of Balance Sheet as per the Companies Act
Format of Income Statement as per the Companies Act
Name of the Company……………………..
Profit and Loss statement for the year ended………….

Particulars Note Rs.

No.

Revenue from operations (gross)

Other income

Total revenue (1+2)

Expenses
(a) Cost of materials consumed
(b) Purchases of stock-in-trade
(c) Changes in inventories
(d) Employee benefits expense
(e) Finance costs
(f) Depreciation and amortisation expense
(g) Other expenses

Total expenses

Profit before exceptional and extraordinary

items and tax

Extraordinary items

Profit before tax

Tax expense:
(I) Current tax expense for current year
(II) Deferred tax

Profit / (Loss) from continuing operations

Earnings per equity share:

(1) Basic
(2) Diluted