Principles of Financial Statements

Financial statements are official summaries that companies use to communicate their financial information to their owners and other stakeholders like investors and employees, as well as tax authorities, the government, and other regulators and market participants. These comprise the balance sheet at the end of the estimation period, the profit and loss declaration, and the cash flow statement. The main principles of financial statements are disclosing accounting policies and to judge the effectiveness of management.

Parts of financial statements

The businesses use income statements, balance sheets, and cash flow statements to regulate their policies and give the stakeholders the transparency that is required. The three documents produce a diverse perspective of a company’s operations when linked together.

• Balance sheet

The balance sheet shows a company’s financial worth in terms of its valuation. A company’s assets, liabilities, and investors’ equity are separated into three categories. Short-term assets like cash and accounts receivable reveal a lot about a company’s operational efficiency; liabilities reveal the company’s expenditure arrangements and debt capital it is repaying, and shareholder’s equity tells details on equity investments and retained earnings from periodic net income.

• Income statement

To arrive at a bottom line, or net profit or loss, the income statement compares a company’s top line or revenues to its expenses. The statement assists in the calculation of business efficiency at three different points. Revenues and the direct costs associated with them are the starting point for calculating gross profit. The company then continues to run profit after deducting indirect costs such as sales, general, and depreciation. After subtracting interest and taxes, the net income is calculated.

• Cash flow statement

The cash flow statement displays how the company’s cash flows from operations, investments, and financing are distributed. Net income, which is taken to the cash flow statement, is the top-line number for operational strategies.

Principles of financial statements

• To judge the effectiveness of management

The term “effectiveness” refers to whether the target is met or not. As a result, owners might consider if their decision to appoint the management was reasonable or if it requires revision.

It also reveals whether the company’s internal policies are effective. Since the shareholders do not have time to attend to the day-to-day operations of the firm, they select management to oversee the entity. Strong financials are a reflection of the management’s effectiveness and efficiency in making judgments. If the goal is met in a fair amount of time, it is said to be efficient.

The owners might consider their options by looking at the gross profit and net profit ratios from recent years. The financial statement’s principle is to illustrate the past and present practices of the company with future strategies, so that the effectiveness of the management could be judged accordingly.

• Provide information about activities of the business

Financial statements provide information about activities of business affecting society. They tell about the activities and resources of management that are typically of interest to many people in the society.

Although some of these people can command the preparation of special purpose financial reports to obtain the information they need, the rest—usually the vast majority—rely on general purpose financial reports, such as financial statements and other financial information. Many people are, therefore, potentially interested in a business’s financial statements.

It does not follow that financial statements are prepared specifically for all those interested persons. However, although there continues to be debate about for whom precisely they are prepared, there is no doubt that they are prepared for a range of persons that extends far beyond existing investors. These persons in the society are referred to in the statement as the “users”.

• Disclosing accounting policies

An organisation’s financial status is represented by the information contained in its financial statements. The accounting policies used can have a significant impact on profit or loss. The accounting policies that are followed differ from one company to the next.

To make the financial statements understandable, it is necessary to disclose significant accounting policies. In some circumstances, the disclosure is forced by law. In recent years, Indian companies have begun to include a prepared statement of accounting policies in their annual shareholder reports.

Many companies include their accounting policies in the notes to their financial statements, but the disclosures are inconsistent.

Another principle of financial statements is to disclose the accounting policies applied to them more transparently to the readers. This helps in a better understanding of statements.

Conclusion

The financial statement’s main purpose is to provide information about an organisation’s operating results, financial status, and cash flows. The information is utilised by users to make judgments about resource allocation.  Financial statements have the purpose of providing information about a reporting entity’s financial activities and economic condition that is relevant to a wide variety of users for evaluating the entity’s management and making economic decisions. This goal is frequently achieved by concentrating solely on the information needs of current and potential investors, the defining user class. Present and future investors require information about the reporting entity’s financial activities and financial position that will help them assess the entity’s ability to create cash and its financial flexibility.