Financial statements of an entity
If a company prepares its financial statements under the International Financial Reporting Standards, it will include the following sections:
In this section, we shall look at the contents of three of these, the Statement of Financial Position, the Statement of Profit or Loss and Other Comprehensive Income and the Statement of Changes in Equity and how they are prepared from a trial balance. The Statement of Cash Flows will be examined in section 4 of this course.
Purpose of a set of financial statements
International Accounting Standard 1 (“IAS 1”) tells us that the purpose of a set of financial statements is to provide useful information in four areas:
- The financial position of the entity,
- The financial performance of the entity,
- The cash flows of the entity; and
- The distributions from the entity to its owners and contributions from its owners to the entity
The contents of the financial statements are designed to try and meet this purpose.
The Statement of Financial Position
The Statement of Financial Position, unsurprisingly, provides information about the entity’s financial position. It presents the entity’s ASSETS, LIABILITIES and EQUITY at the end of a financial period.
The Statement of Profit or Loss and Other Comprehensive Income
The Statement of Profit or Loss and Other Comprehensive Income provides information about the entity’s performance. It presents the entity’s INCOME and EXPENSES and enables the entity’s profits and/or losses to be calculated for a financial period.
The Statement of Cash Flows
The Statement of Cash Flows provides information about the entity’s cash flows. It presents how an entity GENERATED CASH and how it USED CASH and how its CASH CHANGED over a financial period.
The Statement of Changes in Equity
The Statement of Changes in Equity provides information about how each section of the entity’s equity has changed in a financial period. This includes information about its dealings with its owners, such as investments in the entity and amounts paid or distributed by the entity to its owners.
A company’s equity will include sections such as:
- Share capital and Share premium
- Affected by share issues in the financial period
- Retained earnings
- Affected by profits made by the entity in the financial period and by dividends declared in the period
- Revaluation reserve
- Affected by any revaluations of non-current assets occurring in the financial period
The Notes to the Financial Statements
The Notes to the Financial Statements provide additional information about:
- The accounting policies that have been used in preparing the financial statements
- The figures contained within the Financial Statements (for example, a set of financial statements will provide a breakdown of the share capital shown in the statement of financial position)
- The entity and its business environment where this is required in order for users to better understand the entity.
Which of the four main financial statements would you use to obtain the following information?
a) The amount raised from an issue of shares
b) The value of amounts owed to debenture holders
c) The amount of cash raised from the disposal of property, plant and equipment
d) The amount of sales generated in the financial period
Click here to reveal the answers
a) The statement of changes in equity, b) The statement of financial position, c) The statement of cash flows, d) The statement of profit or loss and other comprehensive income
Basis of preparation of financial statements
Financial statements are prepared in accordance with financial reporting standards. These provide guidance on:
- The definitions of different types of financial transactions
- When and how different types of financial elements should be recognized in the financial statements (i.e. whether and when assets, liabilities, equity, income and expenses should be recorded)
- The way that different types of financial elements should be measured (i.e. how they should be valued)
- What disclosures are required (i.e. what information must be included in the financial statements and how that information should be presented)
There are a number of different versions of financial reporting standards but this course shall only look at International Financial Reporting Standards (often abbreviated to IFRS). Any set of financial statements prepared using IFRS must include a note stating that they have been used in their preparation.
IAS 1 Presentation of Financial Statements
One of the standards making up IFRS is IAS 1 Presentation of Financial Statements which tells us what should be included in each of the financial statements and how the information should be presented. It also includes the assumptions that should be used when preparing financial statements which we shall look at below.
A going concern is a business that will continue operating for the foreseeable future. Financial statements should be prepared on the assumption that the business is a going concern unless management intend to liquidate the company or there is no realistic alternative to a liquidation.
If the business is not a going concern, its financial statements shall specify that it is not a going concern and shall also specify on what basis the financial statements have been prepared (i.e. how assets, liabilities and equity have been measured/valued).
The Accruals Basis
Financial Statements should be prepared using the accruals basis. This means that transactions are recorded when they occur rather than when the associated money is received or paid. The accruals basis affects the financial statements in various ways including:
- Sales and purchases include transactions made on credit terms
- Cost of sales include adjustments for movements in inventories
- Property, plant and equipment are capitalized (i.e. treated as non-current assets) and then depreciated over their useful lives
The only exception to the use of the accruals basis is found in the Statement of Cash Flows, as this statement deliberately uses the cash basis.
Consistency means that the way assets, liabilities, equity, income and expenses are classified and presented in an entity’s financial statements shall be the same from year to year. So for example, if a company’s new accountant believes that irrecoverable debts are best recorded in the Statement of Profit or Loss as a Selling Cost but the company has previously recorded it as an Administration Cost, the accountant should simply continue with the company’s current treatment.
This does not mean however, that the way financial statements are prepared will never change. Accounting treatments can be changed if an accountant believes that the current treatment is misleading or if there is a change in the financial reporting standards used.
A set of financial statements should be fair in the way it provides information on an entity’s financial position, performance and cash flows.
The information therefore should be accurate and free from error. It should also be complete and not omit, or seek to obscure information, that could affect the decisions taken by users of the financial statements. In addition, the information should be neutral and unbiased.
Financial statements don’t however, have to be perfect. They can include errors and omissions so long as these are not “material”.
Information is material if omitting, misstating or obscuring it could reasonably be expected to influence the decisions that the users of the financial statements make on the basis of those financial statements.
Materiality will therefore be affected by the size of the entity under consideration. An error of, say £10,000 in recording a company’s Sales Revenue is unlikely to be material for a company whose sales are in the tens of millions of pounds but it would be material for a company whose sales are, say £100,000.
An entity shall not offset assets and liabilities or income and expenses unless this is required or permitted by the financial reporting standards used; e.g.
- A company would not net-off the value of a company’s building society savings account against the value of its bank overdraft. Instead the period-end balance for the building society account would be recorded as an asset whilst the bank overdraft would be recorded as a liability
- A company would not net-off its Costs of Goods Sold against the value of its Sales. Instead Sales would be recorded as income and Costs of Goods Sold would be recorded as expenses
Which accounting concepts are being described below?
a) A company decides to treat all leases of low value by recording rights-of-use assets and lease liabilities
b) A company spreads the cost of its plant and equipment over their useful lives rather than charge their cost as an expense in the financial period in which they were acquired
c) A company has decided not to correct a minor error made in calculating the value of the company’s travel costs
a) The answer is Consistency, b) The answer is Accruals, c) The answer is Materiality
Information to be provided in a set of Financial Statements
- The financials statements and notes to the financial statements as mentioned above
- The name of the company and, in the UK, the company’s registered number
- Whether the financial statements are being prepared for a single company or for a group of companies
- The period that is covered by the financial statements (the start and end dates)
- The currency used in the financial statements
- The level of rounding used in the financial statements (most will show figures to the nearest pound but larger companies might show figures to the nearest thousand pounds or even the nearest million pounds)
- Comparative information will be provided for all statements, that is, information for both the current financial period and the previous financial period
Frequency of reporting
Companies should complete financial statements at least every year. Where financial statements are prepared for a period other than a year, the company should disclose the reason why and the fact that the current period’s figures are not entirely comparable with the previous period(s).