Financial Accounting and Reporting

Importance of Financial Statements

Financial statements are the formal, structured records that summarise the financial position, performance and cash flows of an entity. Their importance can be explained as follows:

1. Basis of decision-making: Owners, managers, investors and lenders rely on financial statements to take informed decisions regarding investment, lending, expansion or contraction of business activities.

2. Measurement of profitability and financial position: The income statement reveals the profit earned or loss suffered during a period, while the balance sheet shows assets, liabilities and equity at a point of time. This helps in judging the true financial health of the organisation.

3. Aid to planning and control: Comparison of actual results with budgets and past periods helps management in planning, cost control and performance evaluation.

4. Source of information for stakeholders: Employees, trade unions, creditors, suppliers, customers, the government and the general public use financial statements to assess job security, creditworthiness, tax liability and social contribution of the entity.

5. Statutory and regulatory compliance: In Nepal, the Companies Act, 2063, Income Tax Act, 2058 and other laws require preparation and submission of financial statements. They are also needed for audit, tax assessment and regulatory reporting.

6. Facilitates financing and credit: Banks and financial institutions evaluate financial statements before granting loans, overdrafts and other facilities.

7. Basis of valuation and settlement: Financial statements provide the basis for valuation of shares, settlement of claims, insurance, compensation and distribution of dividends.

8. Inter-firm and inter-period comparison: They enable comparison of performance between firms and between different accounting periods, helping in trend analysis and benchmarking.

Limitations of Financial Statements

Despite their importance, financial statements suffer from the following limitations:

1. Based on historical cost: Assets and liabilities are generally recorded at historical cost, ignoring changes in market value and the effect of inflation. Hence they do not reflect the current worth of the business.

2. Dependent on accounting conventions and policies: Principles such as going concern, consistency, accrual and materiality, and the choice of depreciation method, inventory valuation (FIFO/LIFO/weighted average) etc., affect the figures. Different policies make comparison difficult.

3. Window dressing and manipulation: Management may manipulate figures to show a better picture — overstating revenues, understating expenses or hiding liabilities — reducing reliability.

4. Omission of qualitative factors: Non-financial aspects such as employee skill, customer loyalty, brand value, management quality and market reputation are not reflected, though they greatly affect the business.

5. Affected by personal judgement: Estimates for doubtful debts, depreciation, provision for taxation and inventory obsolescence involve personal judgement, so the statements are not fully objective.

6. Static in nature: A balance sheet shows the position on a particular date only; it does not show the continuous flow of business activities.

7. Ignore price level changes: In inflationary conditions, profits appear inflated because revenues are recorded at current prices while costs (depreciation, inventory) are based on historical cost.

8. Not suitable for future prediction: Financial statements report past events; they cannot reliably predict future performance, as future conditions may differ.

9. Affected by timing and matching problems: Transactions spread over different periods, and the matching of revenue and expense is not always perfect, which distorts profit measurement.

10. Depend on the reliability of underlying records: If the books of account are incomplete, inaccurate or fraudulent, the financial statements derived from them will also be misleading.

Conclusion: Financial statements are indispensable tools for financial reporting and decision-making, but they should be used with caution, supported by other information such as market data, qualitative factors and ratio analysis.

Financial Analysis

Financial analysis is the process of examining a firm's financial statements — the balance sheet, income statement, and cash flow statement — along with other financial data, to assess its profitability, liquidity, solvency, efficiency and overall financial health. It converts raw accounting data into meaningful information that supports decision-making by management, investors, lenders, creditors and regulators. It helps answer questions such as: Is the firm earning enough? Can it pay its short-term dues? Is it over-borrowed? How does it compare with peers and with its own past performance?

Methods (Techniques) of Financial Analysis

1. Comparative Statement Analysis Financial statements of two or more periods are placed side by side and changes in each item are expressed in absolute amount and in percentage. It reveals the direction, trend and magnitude of change in assets, liabilities, revenue and expenses over time.

2. Common-Size Statement Analysis Items of the balance sheet are expressed as a percentage of total assets (or total liabilities and equity), and items of the income statement as a percentage of net sales. It allows meaningful comparison between firms of different sizes and across years, since all figures are reduced to a common base of 100.

3. Trend (Index) Analysis A base year is assigned the value 100 and figures of subsequent years are expressed as percentages of the base year. This shows the relative direction of movement of each item over a long period and helps in forecasting.

4. Ratio Analysis Accounting relationships are expressed as ratios, classified mainly into:

• Liquidity ratios — current ratio, quick ratio (short-term debt-paying ability).
• Leverage/Capital structure ratios — debt-equity ratio, debt to total assets, interest coverage (long-term solvency and risk).
• Activity/Turnover ratios — inventory turnover, debtors turnover, total asset turnover (efficiency in using assets).
• Profitability ratios — gross profit margin, net profit margin, return on assets, return on equity, EPS (earning capacity).

5. Fund Flow and Cash Flow Analysis The fund flow statement shows sources and applications of funds (working capital basis) between two balance sheet dates. The cash flow statement (under NAS 7, based on IAS 7) classifies cash flows into operating, investing and financing activities, showing how cash is generated and used. Both reveal the firm's financing and liquidity position.

6. Break-Even (Cost-Volume-Profit) Analysis Sales volume at which total revenue equals total cost (no profit, no loss) is determined. It measures the margin of safety, contribution margin and operating leverage, and is useful for profit planning and pricing decisions.

7. Du Pont Analysis Return on equity is decomposed into net profit margin × total asset turnover × equity multiplier. It shows how profitability, asset efficiency and financial leverage together determine return to shareholders.

8. Statistical and Other Techniques Correlation, regression, time-series analysis, and in modern practice computer-based financial modelling and cash-flow forecasting are also used.

Conclusion

No single method is complete in itself. In practice, an analyst uses a combination of these techniques — ratio analysis supported by comparative, common-size and cash flow analysis — to reach a reliable judgement about the financial strengths and weaknesses of an organisation.

Responsibility accounting is a system of accounting under which the organisation is divided into separate responsibility centres, and each centre is placed under a manager who is held accountable for the costs, revenues, or profits (and sometimes investment) of that centre. Performance is measured by comparing budgeted figures with actual figures for each centre, so that the performance of each manager can be evaluated on the basis of factors the manager can control. It is also called activity accounting or profitability accounting.

Its main features are:

• The organisation is divided into clearly defined responsibility centres.
• Each centre has a specified manager with defined authority and responsibility.
• Targets (budgets) are set for each centre in advance.
• Actual performance is compared with the target, and variances are reported.
• Only controllable items are charged to a centre; uncontrollable items are excluded from the manager's evaluation.

Types of responsibility centres

Responsibility centres are classified according to the nature of responsibility assigned to the manager:

1. Cost centre A unit whose manager is responsible only for costs incurred, not for revenues or investment. Performance is judged by comparing actual cost with budgeted/standard cost. Examples: production department, maintenance department, accounts department. It may be an engineered cost centre (costs have a clear input–output relation, e.g. direct materials) or a discretionary cost centre (costs are decided by management policy, e.g. advertising, research).

2. Revenue centre A unit whose manager is responsible only for revenue generation, not for the cost of goods sold or investment. Performance is measured by comparing actual sales revenue with the sales budget or quota. Examples: sales branch, marketing division.

3. Profit centre A unit whose manager is responsible for both revenues and costs, and hence for the profit of the unit. Performance is measured by the excess of revenue over cost (divisional profit or contribution). Examples: a product division, a branch of a bank or a departmental store.

4. Investment centre A unit whose manager is responsible for revenues, costs, and investment in assets employed. Performance is measured by return on investment (ROI) or residual income (RI). Examples: a subsidiary company, a large autonomous division.

Thus responsibility centres move from the narrowest responsibility (cost centre) to the widest (investment centre), and the choice of centre depends on the extent of authority delegated to the manager concerned.