Let’s recall the definition of accounting from chapter “Introduction to accounting”.
Accounting is the process of recording business transactions in an organized manner in order to retrieve this financial information and present it in a useful manner in the form of various reports representing the financial performance and financial position of the business.
We have discussed the first part of the definition related to business transactions in previous chapter. Let’s focus on the second part now. Accounting is not merely concerned with recording business transactions. These business transactions should be recorded in an organized manner so that they can be presented efficiently in the form of various reports. The most common and useful reports or outputs of accounting are the financial statements.
Financial statements are summarized reports representing the financial position of a business at any particular date and representing the financial performance (profitability) of the business for a particular period. Usually, a complete set of financial statements has the following statements or components:
- Balance sheet
- Income statement
- Statement of cash flows
- Statement of changes in equity
- Notes to the financial statements giving necessary disclosures
The balance sheet and income statements are the most important components of the financial statements, so we’ll explain both of these in the next two chapters.
Users of financial statements
So far, we have understood that the financial statements contain useful information about the financial position and financial performance of a business, which is critical for the management of the business to make well informed decisions. However, these financial statements are not only for the management and the owners of the business. These are issued for some external stakeholders as well. Let’s take a look at some of the key users of the financial statements.
- Management of the business
Although the financial statements are prepared by the management, however, it is an extremely useful report for the management. It’s a kind of test report representing how the management has performed. The management refers the financial statements to review the performance and profitability of the business, and to get useful information such as liquidity position, assets and liabilities etc. to make informed decision about the business operations.
In small businesses, often the owners are managing the business as well. However, in larger corporations, there is a separate management running the business for the owners. In this case, the owners review the performance of the business by referring to the financial statements.
- Government agencies
All over the world, the governments have set up certain regulatory departments to oversee the business environment. These regulatory departments demand submission of the financial statements, often audited by external auditors to make it more reliable. In addition, in most of the countries, there are income tax, sales tax and certain other types of taxes and levies in place. The revenue authorities dealing with these taxes also require the financial statements of the businesses.
- Banks and other lenders
Before giving any loan to a business, banks, other financial institutions and lenders often review the financial statements to evaluate whether the business would be able to repay the loan and interest. They keep track of the business by reviewing the financial statements periodically to check the recoverability of their loans.
Suppliers who are dealing with the business on credit terms are interested in the liquidity position of the business and they get this information from reviewing the financial statements. Liquidity position means whether the business would be able to pay its liabilities when they fall due or not.
Large customers often use the financial statements of suppliers. For example, ABC Company which manufactures cars, purchases all the electrical equipment from XYZ Company. It keeps an eye on the performance of XYZ Company by reviewing the financial statements, reason being that, if XYZ Company is not doing good and ceases its operations suddenly, they would have to arrange electrical equipment from some other reliable supplier which will be difficult and may result in delays and losses.