The Main Purpose of Financial Statements - Essay Example

?Company’s Annual Reports and Accounts Final reports and account of a business enterprise reflect its financial condition and stability in a given financial year. Each and every financial transaction made during the year for the purpose of running the business is first recorded in Journals and then transferred to Ledgers for the purpose of balancing.1 The primary objective of maintaining final accounts is to inform the owner or owners about the profit earned or loss incurred during the year. It is necessary for a businessman to be satisfied that the accounts are written up correctly and with mathematical accuracy since they are scrutinized by external auditors for the assessment of government taxes. From the final reports and accounts, a businessman can get a picture of the profit or loss position of his entity and can make decisions on further investments for the purpose of progress and development of the business. Other than the owners, there are other internal and external parties who need to study final reports and accounts of a business like the management body, investors, creditors, government agencies, labour unions and tax authorities. This paper discusses the usefulness of annual reports in understanding a company’s market, production and financial performances. Rules of accounts The final reports and accounts of a business enterprise are prepared by the directors whose primary responsibility is to provide a “true and fair view of the state of the company’s financial position and results”2 at the end of a financial year. In every country there is the Companies Act that provides directions, rules and regulations regarding the format and content of the final accounts that need to be strictly followed. The final reports and accounts are comprised of profit and loss account, balance sheet, cash flow statement, statement of total recognised profit and loss, note on historical cost profit and losses, activities done with funds of the shareholders, notes to the accounts.3 Together these form the financial statements of a business enterprise and they reflect the strength of market relationship, productivity and financial position of the business, and whether it has the ability to sustain and develop in the competitive market in the long run. The profit and loss account which is also known as the income statement provides a summary of the activities of a business and the financial achievements in a particular financial year. It provides information about the “sales or turnover, operating expenses, exceptional items, interest payments, taxation charges and dividends paid and proposed.”4 Although the profit and loss is prepared in a prescribed format, it is designed in a manner that meets the information needs of the management.5 An example of a published profit and loss account of Pickers PLC is shown in Fig.1. Fig.1: Profit and loss account for the year ended 31 March 2003 ?000s ?000s Turnover 20,300 Cost of sales (13,850) Gross profit (or loss) 6,450 Distribution costs (2,314) Administration expenses (1,424) (3,738) Operating profit 2,712 Income from other fixed asset assessment investments 125 2,837 Interest payable and similar charges (813) Profit (or loss) on ordinary activities before taxation 2,024 Users of accounts The main purpose of financial statements is to “reveal the results and financial position of the business.” For this purpose in every business organization final accounts are prepared at the end of every financial year.6 In a business enterprise, it is not only the owners, shareholders or the management body who need to study the final reports and accounts but there are other internal and external parties who have equal rights to know about the financial condition and stability of the company for variable reasons. These parties are investors, employees, lenders, suppliers and other creditors, customers, government and their agencies, and the public. Investors are those people or organizations that take risks by investing their monies to buy shares of a company. In return they expect dividends or a raised value of their shares in the future market or combination of both. For this purpose the investors and potential investors need to know the financial strength of the company so as to determine whether it will be able to justify their risk taking and accordingly they can make their decisions whether or not to buy shares of the company. The employees and trade unions need to be aware of the financial stability of the company for which they work to be certain that they will be continued to be employed at appropriate levels of remuneration. Then there are lenders like banks and individuals who lend money by buying bonds or loan stock; they need to know the financial position of the company to ascertain whether it will be able to repay their loans along with interest at the right time. Similarly there are suppliers of goods and other creditors who need to know whether they will receive their payments promptly. The customers who buy goods and services from the company need to be assured that they will be getting their supplies as and when required. For this purpose they too need to get the picture of financial stability of the company. The need of the government and their agencies lies in the statistical data for the purpose of assessment of taxes. Final reports and accounts of a company are particularly important to the government for the assessment of corporation tax and certain indirect taxes. The financial activities of a company can also affect the public as inward investment can cause extra employment and also opportunities for local suppliers.7 Management purpose A business enterprise cannot succeed if its activities and interests are not aligned with a complex set of economic, political and social factors. All decisions and policies in relation to the business are designed and implemented by the senior management body. The position of the management becomes elevated because the owners delegate controlling power to the management personnel. Management uses information from final reports and accounts to make decisions on dynamic rearrangement of resources so that the resources can be utilized more efficiently and strategically for the purpose of sustaining the business in the competitive corporate world. Often, the goals set by an organization’s management are not at maximum level but at a satisfied level. This is because it is not always possible to determine the maximum outcome nor it is possible to encourage people involved to achieve the maximum results. The separation of ownership and management ensures that making the maximum profit cannot always be the sole objective as there are other factors that will influence the business policy and behaviour. To understand the level of maximized profit, it is necessary that all organizations “identify marginal cost, marginal revenues and production output up to a point where marginal cost of the last unit produced just equates to the marginal revenue received from its sale.”8 In practice, final reports and accounts that are created in accordance with accounting rules, regulations and standards are used by the management to determine the production cost and the sales price for every unit. By studying the final accounts of preceding years it is possible to understand whether the performance of a company has improved or deteriorated over the years. The profit and loss account, balance sheet and cash flow statement derived from the final reports and accounts “reflect a complex relation between market conditions, the productive organization of resources and forms of capitalization of a business.”9 This means that the financial outcomes like value added, production of cash and earning of profit are dependant on a complex and different set of relations between the market, amalgamation of resources and sources of capital of the business. The profit that is reflected in the final accounts is the total revenue of a year over the total costs of the same year. Total revenue means the cost recovered by sale of products in the market. The efforts of the management to improve the financial performance of an organization are often constrained by several structural and institutional factors that can either elevate or deflate the financial performance. Costs per unit, recovery of costs and revenue earned depend on a complex interaction of various factors. For instance, market positions like demand and supply can differ over time, total sale volumes may get stagnated, prices per unit may decline and export markets may expand.10 Therefore, management should carefully analyze the final reports and accounts before making any marketing, production or financial decisions. It should also compare the activities of the company with those of previous years to decide the course of action in the current year. Conclusion The final reports and accounts are prepared for the primary purpose of revealing the financial position and performance of an organization in a specific year, and also for comparison of the same over several preceding years. This is useful for a wide range of internal and external users for making financial decisions. For the successful running of a business, it is important that the management and owners remain aware of every financial transaction, market relation and productivity of the organization. Final reports and accounts are systematic ways of maintaining detailed records of every performance during a certain year. They are a useful source of information regarding the financial stability of a business for potential investors and lenders. The balance sheet which is the final statement in the annual reports reflects the total value of assets and liabilities of a business thereby informing the user about the loan repayment capacity of the business organization. References Dransfield, R. Business for foundation degrees and higher awards. Heinemann Publishers, UK, 2004 Haslam, C., Neale, A.D. & S. Johal Economic in Business Context, ed.3. Thomson Learning, Corwall, 2000 Laidler, J. & P. Donaghy Understanding UK Annual Reports and Accounts: A case study approach. Thomas Press, London, 1998 Pendlebury, M. & R. Groves Company accounts: analysis, interpretation and understanding, ed 6. Thomas Learning, Croatia, 2004 Rao, M.E.T. Advanced Accountancy. New Age International, New Delhi, 2005 Read More