Financial Statements

Introduction

Financial Statements are the summary reports of a company’s financial transactions to a particular period. They report the end results of accounts activities during a given period of time . They provide the operating results and financial position of a company. Income statement, statement of retained earnings, statement of changes in shareholder’s equity and cash flow statement are the financial statements of a company.

Features of financial Statements

1. Expressed in monetary terms: Financial statements are always expressed in monetary terms . They ignore the qualitative aspects. In other words, the non -monetary events do not come under the scope of financial statements.

2. Historical in nature: They are historical in nature as they always present the past performance. Hence , they do no carry futuristic approach.

3. Based on recorded facts: The transactions affecting the business are recorded in the books and shown in the financial statements at the same value . Facts which cannot be recorded in the books are not disclosed by the financial statements.

4. Accounting conventions : The financial statements are prepared by the following accounting conventions and principle. Accounting itself is a dynamic science and accounting have developed from time to time , a number of conventions on the basis of experience .For example, in Nepal , guidelines provided by the Nepal Financial Reporting Standard (NFRS) must be used to present financial statements.

5. Postulates: Account always take some facts as accepted or postulates. In other words business transactions are recorded on the certain assumptions such as going concern, profit accrual , etc. These postulates or assumptions are reflected in the financial statements.

6. Personal judgement: Even though a number of conventions and assumptions have been propounded in accountancy, their use is affected by personal judgement of accountants. Personal judgement of accountants affect the amount kept as reserve for doubtful debts , amount of depreciation on fixed assets ,etc.

7. Time period: Financial statements are prepared for a certain time period. They are usually prepared for a year.

8. Summarized form: Financial statements are prepared on the summary form . They provide summary of revenue, expenses, profit or loss , assets and liabilities. However details of individual items are not shown in financial statements.

Objectives / Purpose of financial statements

The primary objectives

1. Reflect true and fair view of the organisation: The first primary objective of financial statements is to reflect true and fair view of the business conditions of the organisation. As these statements are used by different areas of the society/regulators ,these financial statements should reflect true and fair view of the financial affairs of the business organizations.

2. Provide information for decision making: The primary objective of financial reporting is to provide economic information to permit users of the information to make informed decisions. User include both the management of a company and others not involved in the daily operation of the business. External users make their decisions based on financial statements.

Secondary objective

1.Reflect prospective cash receipts to the investors and creditors: Present stockholders must decide whether to hold their stock in a company or sell it .For potential stockholders, the decision is whether to buy the stock in the first place. Bankers , suppliers and other types of the creditors must decide whether to lend money to a company. In making such decisions, all these groups rely on the information provided in financial statements.

2.Reflect prospective cash flow to the enterprise: Financial statements predict the cash flow in future. The investors and creditors make the relevant decisions by analysing the prospective cash flow in future.

3.Reflect the enterprise’s resources and claim it’s resources: Financial statements should reflect what resources (assets) the company has , what claims to these resources (liabilities and stockholder’s equity) there are and the effects of transactions and the events that change these resources and claims.

Importance of Financial statements

a.Financial statements are the summary of information relating to profitability and resources owned by a firm .

b.It provides the information which can be compared with those of other firms.

c.Employee them to demand for increment in salary and other benefits.

d. Bankers and other financial institutions can use them to make lending decisions.

e.Government bases on financial statements of the companies for the calculation of tax revenue from the firms .

f .It can be used as the basis for management decision - making purpose like planning, promotion , research and development decisions,etc.

g. Financial statement reveals the history of a company.

Limitations of Financial statements

a. Provide qualitative information only : They include only the quantitative information express in monetary units. They do not provide any qualitative information which may have greater impact upon the decision makers.

b. Historical on nature: They record and reveal only the historical data in nature . For example, the value of assets may change over the time . However, they are recorded in their purchase price.

c. Summarized information: Financial statements are just the summary reports of a business transactions. All the detailed information regarding to such transactions cannot be disclosed in the financial statements.

d. No adjustment of price level : Financial statements show the information on cost basis i.e. price paid on the transaction’s date . The effect of price lovely changes (inflation) is not shown in the financial statements. In another words , the information are not given in the current value .

d. Personal judgement: Even though a number of conventions and assumptions have been propounded in accountancy, their use is affected by the personal judgement of the accountants. That is why financial statements prepared by two different personal judgement of accountants . It reduces the reliability of financial statements.

Types and Components of financial statements

The major components of financial statements are income statement of retained earnings, balance sheet, statement of changes in stockholder’s equity and statement of cash flow.

Income statement

A statement that summaries revenue and expenses is called income statement. Income statement reports the results of the company operation during a period of time . It depicts failure or success of a company’s operation. It consists of incomes with expenses occurring during a period.

As income statement provide useful information for predicting future income . It is useful for current as well as prospective investors.

Components of an Income statement

Operating section

The operating section of the income statement is used to report the revenues and expenses associated with the primary business operations. The revenues and expenses appearing in the section provide the Investor with an indication of how well the operations of the business performed.

1.Net sales or Service Revenue: Sales or services revenues are the first items normally reported in the income statement. Revenues are all on cash and credit sales; and a business usually recognizes the revenues at the point their goods and services are delivered to the customer. If a business is reporting net sales , then that business is simply taking the total revenues received in a time period and subtracting it from any sales discounts , allowances or returns.

2.Cost of sales / cost of goods sold : The cost of goods sold or cost of sales represent the cost of goods sold during the accounting periods. For distribution business, the cost of goods sold is the acquisition price of the items sold from inventory plus direct cost related to these items . On manufacturing firm , the cost of goods sold involves various cost incurred in the process of transforming raw materials to a finished products such as labor cost and manufacturing costs. Purchase discount and purchase return reduce the amount of cost of goods sold .

3.Gross profit/margin: Gross profit is the result of buying and selling of goods and services. It is the difference between the firm’s net sales and it’s cost of goods sold .

4.Operating expenses: Operating expenses are all the costs associated with the Operating business. It includes costs related to selling of goods or services, administrative and general expenses.

5.Administrative and General expenses: These expenses appearing in the income statement are the cost associated with the administrations of the company’s operations. It includes salaries of company employees, office workers salaries, legal services, insurance ,etc.

4.Selling expenses: These are the expenses that are linked to the selling of the company’s products or services. It includes salesman salaries and commission, travel and entertainment, freight or transportation,etc

5.Operating profit: Operating profit is a measure of the company’s profit form continuing operations that takes into account of the firm’s recorded expenses related to it’s operating activities. It is the difference between company’s gross profit and the sum of general , selling and administrative expenses and depreciation expenses.

Non operating section

Companies can also realize revenues, gains and expenses that are not directly related to their principal business. So these items are reported on the income statement outside of the operating section. . These are either usual items Apr they occur infrequently. The non -operating section usually broke down into two subsections – other revenues or gains and other expenses or losses.

1.Other revenues and gains : This category includes revenues and /or gains and these items are generally reported net of any related expenses. It includes dividend revenues, rental income or gain of sale of investment .

2.Other expenses and gains :This category includes revenues and gains and these items are generally reported net of any associated income and non operating transactions.

3.Earnings before interest and tax (EBIT): Earnings before interest and tax (EBIT) , is the company’s operating profit less than any extra earnings, capital gains, or losses from business that were sold during the accounting period.

4.Earning before tax (EBT): EBT are the difference between the company’s earning before interest and tax (EBIT)and it’s interest expenses. It measures income before taxation.

5.Income expense: The income tax expense account is a tax provision computed in accordance with the company’s accounting rules of government.

6.Net income / Earning after tax (EAT): Earning after Tax is obtained after deducting the firm’s income tax expenses before it’s reported pretax income, or earning before tax (EBT).

Other adjustments to net income

Some companies need to report very unusual items. These are changes that don’t happen very frequently and are often “discontinued” by the market analysis because they are so unusual that they wouldn’t normally be considered when looking at a company’s long term outlook. Adjustments Falling into this category includes:

1.Gain or loss from discontinuing operations: Gains or losses on the sales of a portion of the business’s operations.

2. Extraordinary items : These items are the expenses and incomes with infrequent in nature unusual like interest received, interest paid ,etc.

3. Changes is accounting principles: Any time a company their accounting approach such as inventory pricing or depreciation rates- that the company needs to explain or disclose the cumulative effect of that change on their income statement.

The heading of Income statement must show following three facts :

a. The entity to which it is related (Name of the company)

b. The name of the statement ( Income statement).

c. The time period cover(For the year ended…)

Types of Income statement

In general, there are two methods of preparing income statement; one is single step income statement and another is multi step income statement.

Single step Income statement

Under single step income statement, all the revenues are accumulated and total revenues is ascertained. Similarly, all the expenses are reported together to come up with the total expenses. Finally, net income is ascertained through the difference between the revenue and expenses.

Format

                           Company Name

                          Income Statement

                     For the Year Ended XXX

Multi- step income statement

Under multi step income statement, the revenues and expenses are separated as operating and non- operating revenues and expenses.

Format

Statement of retained earnings

The statement of retained earnings is summation of opening retail earning and net income less dividends to arrive at closing retained earnings.

The net income components is the output of the income statement while closing retained earnings component is transferred to balance sheet . It shows retained earnings with cause

It is the position of income which is not distributed as dividend.

Format

Statement of financial position or balance sheet

Concept of Balance sheet

Balance sheet is a statement of assets and liabilities of business enterprise at given date .It is a statement summarizing the financial position of the company.

It is a statement that reports the assets and claim to the assets on a specific point of time.The claim can be categorized into claim of creditors and claim of owners. The claim of creditors are called liabilities whereas the claim of owners are called stockholder’s equity. The relationship among the different components of a balance sheet ( also called accounting equations) is presented below:

Assets=Liabilities + stockholder’s equity

Purpose of Balance sheet

1.To present actual and real financial position of the organization.

2. To provide information about the nature and value of operating and non- operating assets.

3. To identify the funding situation of the assets.

4. To provide information about the actual and real owner’s equity.

5. To reveal liquidity position of the organization

6. To help the organization for making provision against possible future losses.

7. To provide relevant information regarding sources of funds of business and their applications.

Components of Balance sheet

Assets

Assets are the economic resources legally owned by the organization, and includes such items as cash , account receivable, inventories, land , buildings and even intangible assets like patent and other legal rights and claim.

Liabilities

Liabilities are amount owned to other relating to loans, extension of credit, and other legal obligation arising in the course of business.

Owner’s / Shareholder’s Equity

Owner’s equity is the owner ‘interest’ on the business. The total owner’s equity of a corporation usually consists of several amounts, generally corresponding to the owner investment in the capital stock and additional amount generated through earnings that have not been paid our ro shareholders as dividend.

The analysis of balance sheet is useful

a. To know the nature of company’s assets and liabilities.

b. To establish relationships between debt and stockholder’s equity.

Preparation of classified statement of financial position

A. Assets side of balance sheet

An asset is a resources legally owned by the enterprise as a result of last event and from which future economic benefits are expected to flow to the enterprise.

Assets may be classified as current assets, investment, fixed assets and other assets

1. Current assets: Current assets are those resources of the firm which are either held in the form of cash or expected to be converted into cash within the accounting period. It is also known as gross working capital.

A . Cash and bank balance: includes actual money in hand and cash deposits in bank account. It’s is current purchasing power in hand of company.

B . Market securities: are the temporary or short term investment in stocks, bonds, debenture bonds and other securities. These securities are readily marketable and can be converted into cash within the accounting period.

C.Accounts receivable: are the amount dues from debtors (customers) to whom goods or services have been sold on open account. These amounts are collected within an accounting year.

D .Notes or bills receivable: represent the promises made in writing by debtors to pay definite sum of money after some specific period of time.

E. Inventories: includes raw materials, work-in-progress and finished goods.

F. Prepaid expenses and accrued revenues: Prepaid expenses are the expenses of future period paid in advance. Example prepaid insurance expenses, prepaid rent expenses. Accrued incomes are the benefits which the company has earned but they have not received in cash yet. Eg: accured dividends,accured commission ,etc.

Investment

It represents an expenditure on assets invested outside the business to earn interest, dividends or other benefits. The intention is to hold the securities for the long run , at least longer than an accounting year. Stocks, bonds, debenture are some of the example of investment.

Plant, property and equipment/ fixed assets

They are infrastructure assets and are not intended for resale in the normal course of business. These assets provide benefits over a long period to the organization. Examples of such fixed assets are land and building, plant and equipment , vehicles,etc.

Intangibles

All other assets which cannot be included in any of the above-mentioned categories or groups as other assets usually represent deferred charges. These are long term assets having the estimated useful life more than one accounting period, which have no physical existence, it cannot be seen or touched. Example : goodwill , copyright, patent, etc.

B. Liability and stockholder’s equity side of balance sheet

1.Current liabilities

Liabilities which are to be paid within a year of date of balance sheet are taken as current liabilities. It represents the obligations of the firm in the ordinary course of operating business. Example accounts payable, bills payable, bank overdrafts, accrued expenses, unearned revenues, etc.

2.Long term debt:

Long term debt is debt less current maturities and includes obligation that are not expected to be paid within one year. Bonds and mortgages are common long term liabilities.

3.Deferred income tax:

Deferred income taxes results from difference between taxable Income and accounting income. Common items giving rise to deferred income taxes includes depreciation methods that are allowed by tax law but do not match the estimated useful of the assets, deferred compensation that is not deductible until paid gives rise to currently reported expenses.

4.Equity and preference share: Equity and preference share ,if any , represent the ownership interests in a company. The preference share will have preferential rights as to dividends or in the event of liquidation of the business.

5.Share premium: It is the difference between the amount obtained by a corporation on the issuance of its own share and the par value of the share.

6.Retained earnings: are the portions of all the company’s past earnings that were not distributed to the stockholder’s .

 7. Treasury share: Treasury share is a share that was once issues by the corporation but later was repurchased for the employee bonus plan. Treasury share receives no dividends and has no vote while held by the company. It is also known as buy back share.

Total liabilities and shareholder’s equity is always equal to total assets.

Statement of changes in owner’s /shareholder’s equity

Concept of statement of changes in owner’s equity

The statement of changes in shareholder’s equity shows the changes in equity over reporting period. The owner’s equity changes by two factor as investment by the owner and net income.

Components of statement of changes in owner’s equity

1. Opening balance of owner’s / shareholder’s equity : It begins with opening balance of equity which is the total of capital, share premium , reserve and net income or loss of previous year.

2. Change in capital during the year: If there are some changes in share capital and premium during the accounting period i.e. issued is added while redemption is deducted.

3. Payment of dividend: When dividend is paid during the year that should be deducted.

4. Income or loss during the period: Retained income as per retained earnings account is added . But if there is loss that should be deducted.

5. Change in reserve: Any change in reserve during the year should be considered while preparing this statement.

Besides, effect of change in accounting policies, effect of correcting prior year error ,etc. should also be considered while preparing the statement.

Statement of cash flow

A statement that shows cash receipts and payments during a particular period of time is called cash flow statement. It shows effect on the position of cash under operating, investing and financing activities.

Relationship of the financial statements

It has been already said that financial statements of a company organization mainly comprises income statement, statement of retained earnings, balance sheet, statement of changes in shareholder’s equity and cash flow statement. These components are interrelated to each other .

The output of a component of financial statements becomes the input of another component of financial statements. The retained earnings account is dependent to the income statement as net income from the income statement is transferred to it . Similarly, balance from the retained earnings account is transferred to the balance sheet. Hence ,they are also related to each other.

Disclosure required for financial statements as per Nepal company act and NFRS

A disclosure is additional information accompanied in the financial statements of the company. So, it is simply the explanation for activities which have significantly influenced it’s financial results. Accountants of the company include important notes on assets , liabilities and equity of the company in financial statements. Financial notes regarding discussion can appear on Income statement, balance sheet and the adjusted general ledger.

Financial Statements as per Nepal Company act 2063

As per section 109 of company act , 2073 ( amended 2074), a public company is required to prepare the following statement before thirty day prior to the holding of its annual general meeting. Similarly, a private company is required to prepare such financial statements within six months of expiry of its financial year. It contains:

a. Balance sheet (statement of financial position) as on last year of financial year.

b. Profit and loss account ( profit or loss statement) for the financial year.

c. Description of cash flow/ statement of cash flow for the financial year.

The financial statements as per Nepal financial reporting standards

Accounting standard board (ASB) is an authorized body to develop common rules and principles to prepare financial statements in Nepal. The ASB earlier issues Nepal Accounting Standard (NAS) and later on it issues Nepal financial Reporting standards (NFRS) under the framework of International Financial Reporting standard (IFRS) as a set of common rules and principle to present financial statement in Nepal.

NFRS are designed as a common global language for business affairs so that company accounts are understandable and comparable within Nepal.

From 15 July 2014, NFRS has set common rules so that financial statements could be constant, transparent and comparable internationally. The company has to present five statements as per NFRS:

1. Statement of profit or loss

2. Statement of other comprehensive income

3. Statement of financial position

4. Statement of change is Equity

5. Statement of change in cash flow

1. Profit or loss statement

As per NFRS, profit or loss statement of the business is prepared to ascertain operating results of the business.

A. On the basis of function of expenses

B. On the basis of nature of expenses

Terminology used in statement of profit or loss

a. Revenue from operations: It is the major source of income depending upon the nature of business.

b. Cost of sales : It is the coat incurred for generating revenue form operation.

Cost of sales = Opening stock+ Purchase+ Carriage Inward + Custom duty – closing stock

c. Other income : It includes income other revenues from operation, e.g. interest income, dividend income ,etc.

d. Selling and distribution expenses: The expenses incurred for selling and distribution of goods and services is called selling and distribution expenses.

e. Administrative expenses: The expenses incurred for operating and handling business administration is called administrative expenses

f. Other expenses: Other various expenses not included in the have heading are fall under this category like sundry expenses, discount allowed,etc.

g. Finance cost: It includes the cost of borrowing such as interest on bank loan , debentures.

h. Income tax expenses: It is the compulsory payment on net income to the government under Income Tax Act .

I. Profit for continuing operations: It is the net income generated from the currently running business or present businesses.

j. Profit or loss on discontinuing operations: It is the net profit or loss from the discontinuing of business or segment after deducting tax.

Statement of financial statements or balance sheet

As per NFRS, statement of financial position is prepared which is the balance sheet of the company. This statement shows various assets and liabilities using vertical format.

Terminology used in statement of financial position

1. Non current assets: The assets which renders economic benefits for more than one year period is called non- current assets. It includes plant, property and equipment, investment,etc.

a. Property, plant and equipment: It includes the fixed assets like land , building, computer, vehicles, etc.

b. Intangible assets: It includes the invisible assets like goodwill, patent right , copyright, etc.

c. Biological assets: It includes plant and animals , for example, animal : goats, cows, buffaloes, etc. and plants : vegetables, crops, trees, etc.

d. Investment property: An investment property is real estate property purchased with the intention of earning a return on the investment either through rental income , the future resale of the property or both.

e. Investment in associates: It refers to the investment in an equity ( share capital) in which the Investor has significant influence but does not have full control like a parent and a subsidiary relationship.

f. Other investment: Investment in other share and securities with expectation of getting fixed amount of return or benefit in the future.

g. Deferred tax assets: It is created due to the overpaid income tax to the tax authorities as compared to the income tax recorded in the financial statements.

h. Other non- current receivable: It refers to the non- trade receivable that is not expected to be collected within one year of the balance sheet date , i.e. notes receivable.

2. Current assets: Current assets refers to those assets or economic resources which renders economic benefits to the business within one accounting period and they can be converted into cash within one year . It includes inventories, debtors or receivable, accursed income, etc.

a. Inventories: It refers to the unsold stock of goods at the end of an accounting period.

b. Investment: It includes short term investment having maturity date less than one accounting period.

c. Biological assets: It includes the short term biological assets which can be converted into cash within one accounting period.

d. Income tax receivable: It includes short – term income tax receivable, which is paid in advance and can be clear in short period after the balance sheet date.

e. Trade and other receivable: It refers to those receivable which were created because of trading of goods and rendering of services on credit. It includes accounts receivable or debtors, short term notes or bills receivable, rent receivable, etc.

f. Cash and cash equivalents: It includes cash and bank balance , cheque received but not deposited, short term investment securities that have maturity period of 90 days or less.

g. Assets classified as held for sale : It includes fixes assets , which the company plan to dispose or sale instead of at lower of carrying value or fair value.

3. Share capital: It is the amount contributed by the owners to an entity. It also includes additional paid in capital ( share premium) and net profit less dividend and drawings.

4. Non current liabilities: Liabilities are those amounts payable to outsiders by the company or entity. Non- current liabilities are those liabilities which have maturity period more than one year. It includes long term bank loan , debentures, bond payable,etc.

a. Loans and borrowings : It includes long term bank loan ,loan received from other parties, debentures, bond payable,etc.

b. Deferred tax liabilities: Deferred tax liabilities results from differences between taxable income and accounting income . Common items giving rise to deferred tax liability includes from depreciation methods.

Statement of changes in equity

As per NFRS, statement of changes in owner's equity is prepared to identify and determine the change in shareholder's equity of the company during a year. Investment made by the shareholders and profit appropriation are the major factor that change the shareholder's equity. The ending balance of this statement is transferred to balance sheet.