Question

Financial statements and their relationship. Discuss the basic financial statements and how they are interrelated. Include a discussion about the eight concepts underlying financial reporting.

Answer 1

Q: Discuss the basic financial statements and how they are interrelated. Include a discussion about the eight concepts underlying financial reporting.

Answer: Basic Financial Statements:

There are four basic financial statements:

1. Income statement

2. Balance sheet

3. Statement of Cash flows

4. Statement of Retained Earnings

1. Income statement - The objective of income statement is to display the details of items of income & expenditure which have contributed in making the profit or loss. Profit or loss arrived is disclosed in the income statement which is prepared at the close of the accounting period. The income statement discloses the net profit of the business entity for the accounting period after adjusting the income earned & matching expenses incurred during the accounting period. It is basically sub divided into two parts for a Non Manufacturing companies namely (i). Trading account (ii). Profit and Loss account. For Manufacturing companies a separate Manufacturing account which is also a part of income statement is also prepared in addition to the above stated Trading account and Profit and Loss account.

2. Balance Sheet - Balance sheet is a statement which reflects the assets and liabilities of the business enterprise as at a certain date. Generally the balances of all the personal accounts, real accounts & some nominal accounts which are deferred to transfer to Profit and Loss account are shown on a sheet known as Balance Sheet. It is divided into two parts (i). Liabilities are shown on the left hand side of the of the balance sheet & (ii). Assets on the right hand side of the balance sheet.   

3. Statement of Cash flows - A cash flow statement is a statement which shows inflows & outflows of cash and cash equivalents during the accounting period. It generally shows the sources of receipt of cash & cash equivalents and the purpose for which their payments are made. Its is classified in three categories (i). Operating Activities - It depicts the cash inflows and outflows which are related to main revenue earning activities of the business entity. (ii). Investing activities - It is related to cash investment in and sale of the fixed assets & investment in shares & securities of the business entity. (iii). Financing Activities - It relates to cash funds obtained from raising capital or short term or long term borrowings and repayments of capital & borrowings by the business entity.

4. Statement of Retained Earnings - It depicts the changes in the owners equity during the accounting period. It generally includes changes in the share capital, accumulated reserves & retained earnings which belong to the owners.

Each of the above items are interrelated in the sense that Income statement is linked to Balance sheet, statement of Cash flows and retained earnings. Income earned during the accounting period is added with retained earnings in the balance sheet. Cash at the end of the accounting period is shown in the balance sheet under the heading Current Assets. The connection of financial statements can also be explained with the help of accounting equation -

Capital + Net Profit (Income/Profits - Expenses/Losses) + Long term liabilities + Short term liabilities = Fixed Assets + Current Assets

Eight Accounting concepts underlying the financial reporting are as follows -

1. Business Entity Concept - Entity concept states that business enterprise is a separate entity and must treat a business as distinct from the owner. Only business transaction are recorded in business books of accounts & owner's personal and domestic transactions are recorded in his personal books of accounts.

2. Money Measurement Concept - As per this concept only those transactions which can be measured in terms of money are recorded in the books of accounts. Any transaction which cannot be measured in monetary terms are not required to be recorded in books of accounts even if they affect the financial position or financial result of the business.

3. Accrual Concept - As per accrual concept, the effects of transactions are recognized on mercantile basis i.e. as and when they occur (and not when cash or cash equivalents are received /paid). It means each and every transaction is recorded in books of accounts on the date of their occurance and reported in the financial statements related to that accounting period.

4. Matching Concept - As per this concept all expenses is matched with the revenues earned during the accounting period should be considered while ascertaining the profit/Loss for that accounting period. It means that if any revenue is recognized than expenses related to earn that revenue should also be recognized.

5. Going Concern Concept - As per this concept business operations of the entity will continue to exist for the foreseeable future i.e. for a long period in the future. It means transactions were recorded in the books of accounts of the business entity on the assumption that it is a continuing enterprise.

6. Cost Concept - As per this concept an asset is ordinarily recorded in the books of accounts at the price at which it was acquired/purchased/manufactured/constructed. The acquisition cost is of asset is called historical cost of the asset i.e. cost of the acquisition/manufacture/construction.

7. Realization Concept - This concept is related to recognition of reasonable certainty about the receipt of revenue, appreciation in the value of any asset, decrease in the liability. It means when right is established to demand advantage than it is termed as realization of revenue, appreciation in value of asset & decrease in liability.

8. Dual Aspect Concept - This concept is the backbone of entire accounting process. It states that every business transaction affects two or more accounts in such a way that total of debit side is equal to total amount of credit side while recording a transaction in the books of accounts of a business enterprise. Every debit must have a corresponding credit and vice versa.