Financial Statements and Concepts of Capital Maintenance - Essay Example

Financial ments Introduction Financial ments are formal records of financial activities of businesses, people or organizations. Financial statements provide information about the reporting entity that is useful to existing and potential stakeholders. Information in a financial statement is presented in a simple structured form easy to understand, either as a balance sheet,income statement or a statement of cash flows. A balance sheet reports on an organisation’s liabilities, ownership equity and assets at a given time. A balance sheet is a statement of financial position of an organisation. An income statement reports on the organisations profits, expenses and income over a period of time. An income statement is also known as the profit and loss report, it provides information on the processes of the business enterprise. A statement of cash flows reports on an organisation’s cash flow activities,which include its processing, financing and investing activities. Financial statements for large companies are complex compared to the small companies because they include a wide range of notes added to the financial statements, management discussions, and analysis (Bragg, 2013). The notes added to the financial statements are considered as an essential part of the statements because they normally explain each item on the balance sheet, cash flow statement and income statement in further details. Concepts of capital maintenance Albrecht an Stice (2011) defined capital maintenance as an accounting concept based on the principle that income is only recognized after capital has been maintained or there has been a full recovery of costs. When the amount of a company’s capital at the end of a period is unchanged from that at the beginning of the period,with any excess amount treated as profit (Albrecht an Stice ,2011). According to the writings of Taparia (2003), the concept of capital maintenance is significant as only income earned in excess amounts is needed to maintain capital may be considered as profit. There two concepts of capital maintenance are the financial capital maintenance and the physical capital maintenance. Under the concept of financial capital maintenance, profit is earned only if the financial amount of the net assets at the end of the fixed period exceeds the financial amount of net assets at the beginning of the period, after excluding any distributions to and contributions from owners during the period (Antle and Garstka,2004). Antle and Garstka, (2004) also stated that financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power. Physical capital maintenance is the concept where profit is earned only if the physical productive capacity of the entity at the end of the period exceeds the physical productive capacity at the beginning of the period, after excluding any distributions to, and contributions from owners during the period (Antle and Garstka, 2004). In consideration to the concepts of capital maintenance, internal and external stakeholders, use financial statements for various purposes. Stakeholders invest their monies into entities that are not organized by them, which is a risky step. Stakeholders use financial statements to check where a company stands as compared to their competitors. External stakeholders who are composed of suppliers, investors, lenders, customers, competitors, government agencies and labour unions use financial statements to make decisions on whether the organisation is making profit or loss. The information from the financial statements helps to support the actions and decisions of the organization. The best way for stakeholders to find out where the company stands in the market profitability is by looking at the companies’ financial reports, financial statements, and financial ratios (Fridson and Alvarez, 2011). Gibson (2010) stated that financial statement analysis is done to examine past and current financial data with the aim of evaluating performance and estimating future risks and potential of the enterprise. This financial statement analysis is used by the external stakeholders who rely on the financial data for making economic decisions about the company. Creditors and investors use the financial statements in finding the type of information they require for making decisions relating to their interests in various companies. Gilbert and Lehman (2009) stated that past performance is a good indicator of future performance. Investors look at the financial statements of the past sales, expenses and cash flow to determine whether the organisation will perform better in the future. A company with profits from the past encourages stakeholders to invest in it without fear since they have good financial statements. This means that future potential risks are reduced when the current financial statements are promising. Gilbert and Lehman (2009) stated that the riskiness of an investment depends on how easy it is to predict future profitability. Key components and purposes of financial statements The purpose of financial statements is to provide information about the financial position and financial performance of a company to its stakeholders. It provides the changes in the financial position of an organisation that is useful to internal and external stakeholders in making economic decisions (Kwok, 2005). Financial statements should be understandable to the business people who are willing to study the information in the statements completely. Managers and business owners use financial statements to make important business decisions that affect the enterprise operations. The managers use the financial statement analysis to report to the stockholders the performance of the company. This helps the managers and owners to know their position in the market and know how to challenge their competitors. Prospective investors use financial statements to assess the possibility of investing in a business. When the business is making profits, many investors are attracted to invest in the business. Financial analysis provide investors with a basis of making investment decisions; depending with the company, they are interested in working with. Banks and other lending institutions use financial statements to decide whether to grant a company with loans or fresh working capital to finance their expenditures (Kwok, 2005). When the company has poor financial statements, the lending companies will find it difficult to offer them loans to expand their businesses since they are not performing well. Employees in the organizations need financial statements to make collective agreements with the managements, especially for employees in discussing their rankings, promotion, and compensation. According to the writings of Kolitz and Mcallister, (2009), the key components of financial statements comprise of the income statement and the balance sheet. An income statement is a representation of the group’s financial performance. An income statement is a finance statement measures an enterprises performance over a specific accounting period (Gibson, 2010). The income statement is divided into two parts, the operating and non-operating sections. The operating section discloses information about revenues and expenses that are a direct result of the regular business operations. The non-operating items section discloses revenue and expense information about activities that are not tied directly to a company’s regular operations (Kolitz and Mcallister, 2009). The purpose of the income statement is to show stockholders how the business makes its money. It shows how the enterprise is spending their money and whether there are profits made in a particular period. A balance sheet is representation of a company’s financial position. Investors use the balance sheet to determine whether a company is making profits or losses because it lists what a company owns and what it owes (Kwok, 2005). The stockholders equity is found by subtracting the company’s liabilities from the assets. The purpose of the balance sheet is to summarise the flows of economic resources to and from the company inform of revenue and expenses over a period of time (Needles and Crosson, 2008). Needles and Crosson (2008) stated that the balance sheet summarises the company’s economic resources in the form of non-current assets, working capital, and owner’s equity; in the form of debts, and liabilities at a particular period. Noncurrent assets are assets, which are considered long- term to be used for investment such as fixed assets and investments in jointly controlled entities (Needles and Crosson, 2008). These are things like vehicles and buildings, which are not expected to be sold within the normal business operations. The working capital comprises of current assets and current liabilities, which are continuously circulating in the organisation, they include bank balances and payables (Needles and Crosson, 2008). Debts and non-current liabilities are funds borrowed from banks and lender institutions, which the company is supposed, to repay and other liabilities like tax. The company is normally supposed to settle these debts after the next twelve months. Needles and Crosson (2008) defined equity as the funds contributed by external shareholders either as capital or profits retained in the company. Equity is the interest that remains in the company after all the liabilities have been paid off. Kolitz and Mcallister (2009) stated that the balance sheet and income statement are essential documents in the company and their purpose is to allow owners of the enterprise to make key decisions to evaluate the company’s operations and make changes when need arises. Kolitz and Mcallister (2009) also stated that these statements allow the creditors to make decisions on loans they make to the company and investors use the statements to determine whether the company represents good investments by checking if they are making profits. Antle and Garstka (2004) stated in their writing the relationship between the income statements and balance sheet. They stated that a company earns revenue from customers through the deployments of non-current assets and working capital and on the other hand pays operating expenses to suppliers of goods and services for their supplies. The net balance of revenue and operating expenses is the profit available for payment to lenders and for distribution to shareholders in return for their contribution of funds to the company (Antle and Garstka, 2004). A cash flow statement is another component of financial statements that shows changes in the balance sheet accounts and income statements (Gibson, 2010). It shows how the company has used its monies in its operations, financial activities and investing. The cash flow statement also shows the amount of money the company has generated and used over certain period. The purpose of a cash flow statement in a company is to provide information on a firm’s liquidity and change in cash flows (Gibson, 2010). When the firm has enough money, employees and employees will be paid on time hence successful running of the business, on the other hand when the company does not have enough money and resources; it becomes insolvent hence leading to losses. The cash flow statement assists the organization in providing more information on the evaluation of changes in equity, liabilities, and assets in the company. Conclusion Financial statements are essential in the business operations as they provide information about performance of the organization. Managers require the financial statements to assess the financial performance of their enterprises. Internal and external shareholders require the statements to assess the risks involved with investment in a company. Suppliers need financial statements to assess whether they have steady supplies in the future for the survival of their businesses. Competitors need the financial statements to develop strategies to improve their businesses and the general public also needs the financial statements in order gauge the effects of a business on the people in the society. References Albrecht, W. S., Stice, E. K., and Stice, J. D. (2011). Financial accounting. Mason, OH, South-Western/Cengage Learning. Antle, R., and Garstka, S. J. (2004). Financial accounting. Mason, Ohio, Thomson/South-Western. Bragg, S. M. (2013). Financial analysis a controllers guide. Hoboken, N.J., Wiley. Fridson, M. S., and Alvarez, F. (2011). Financial statement analysis a practitioners guide. Hoboken, N.J., Wiley. Gibson, C. H. (2010). Financial Reporting and Analysis: Using Financial Accounting Information (Book Only). [S.l.], South Western Educational Pub. Gilbert, C. B., and Lehman, M. W. (2009). Fundamentals of accounting. Mason, Ohio, South-Western/Cengage Learning. Kolitz, D. L., Quinn, A. B., & Mcallister, G. (2009). A concepts-based introduction to financial accounting. Lansdowne, Juta. Kwok, B. (2005). Accounting irregularities in financial statements: a definitive guide for litigators, auditors, and fraud investigators. Aldershot, Hants, England, Ashgate. Needles, B. E., Powers, M., & Crosson, S. V. (2008). Financial and Managerial Accounting. Boston, Mass, Houghton Mifflin. Taparia, J. (2003). Understanding financial statements: a journalists guide. Oak Park, IL, Marion Street Press. Read More