Financial Statements: Definition, Component, Importance (Explained)

Financial Statements: Definition, Component, ImportanceRecords of various business activities are maintained to ascertain the financial position and profit earning capacity of a business concern.

Statements prepared from the accounting records of an organization are called financial statements.

That is, the statements that are prepared at the end of a particular accounting period to measure the overall result of business activities and exhibit the financial position of a business concern are generally called financial statements.

In the modem business world, two statements are generally termed as financial statements.

These 2 statements are –

  1. Income statement and
  2. Balance sheet.

Besides, some other statements are also included in financial statements. These statements are also very much important for many reasons, particularly in making financial decisions.

Of these statements, statement of retained earnings, cash flow statements, and fund flow statement is mentionable.

The net income or net loss of business concerns for a particular accounting period can be known from the income statement.

The summary of the financial position of a business concern reflected by the records relating to accounts at the end day of the accounting period can be known through the balance sheet. This statement also shows how net income is distributed into different heads.

Changes in the working capital of a particular period can be known from the fund flow statement. This statement provides necessary information regarding sources of working capital and their uses.

The cash flow statement provides the sources of cash receipts and payments under different heads for a particular period.

Financial statements represent a brief picture of the financial activities of a company.

Regarding financial statements Donald E. Kieso, Jerry J. Weygandt, and Terry D. Warfield have stated in their Intermediate Accounting (10th edition): “Financial statements are the principal means through which financial information is communicated to those outside an enterprise. These statements provide the firm’s history quantified in money terms.

The financial statements most frequently provided are;

  1. the balance sheet,
  2. the income statement,
  3. the statement of cash flow, and
  4. the statement of owner’s or stockholder’s equity. Also, note disclosures are an integral part of each financial statement.”

The American Institute of Certified Public Accounts states that financial statements are integrated information of recorded events, accounting conventions, and individual judgment capacity.

Judgment capacity that is used to influence the statement materially.

Presentation of financial data including Balance Sheet, Income Statement, and statement of cash flow or any supporting statement that is intended to communicate an entity’s financial position at a point in time and its results of operations for a period then ended.

Importance of Financial Statements

Accounting is an information communication system.

Through financial statements, necessary information is communicated to various interested parties. Financial statements play a role in providing information.

Financial statements are considered as the mirror of a business concern because they reflect the working capacity or weakness of a business concern. Financial statements come to the use of various parties.

For example, management, investors, banks, creditors, officials, government, business organizations, consumers, and general masses are benefited by financial statements.

George May has classified the financial statements from which parties are benefited into ten;

  1. Reports of financial supervisor,
  2. The basis of revenue principles,
  3. Dividend determining principles,
  4. Dividend payment basis,
  5. The basis for granting a loan,
  6. Information to potential investors,
  7. Investment value determining,
  8. Government supervisory control,
  9. The basis of cost control,
  10. The basis of tax principles.

7 Components of Financial Statements

Financial statements are mainly four statements and generally prepared by most of the business concerns. These are;

  1. Income statement
  2. Owner’s equity statement
  3. Balance sheet.
  4. Statement of cash flow. These are the most important other statements are;
  5. Retained earnings statement.
  6. Statement of fund flow
  7. Notes to accounts and disclosure.

Income statement

The statement which is prepared at the end of a particular accounting period with the help of periodic income and expenditure to know the operating result i.e., profit or loss of a company, is called an income statement.

The main source of income of a business concern is sales, and for the profiteering service-oriented organization is the income received from service rendered.

Besides these, other incomes are interest received on investment, profit or sale of assets, etc.

Expenditures mean merchandise purchase of a particular period and operating expenses of a particular period such as administrative expenses, selling and distribution expenses, and other expenses.

Owner’s equity statement

The statement which is prepared to show changes of owner’s equity for a particular period is called the owner’s equity statement.

In this statement, the profit of a particular period is added with the beginning capital of that period and loss, if any, drawings are deducted for ascertaining the ending capital of that particular period.

Balance sheet

A balance sheet is prepared at a particular date to know the financial position of a company of that particular date. The ledger account balances that remain after the preparation of income statements are assets, liabilities, and capital.

The statement which is prepared on the end day of an accounting period with assets, liabilities, and owner’s equity is called a balance sheet. The balance sheet is called the statement of financial position.

Cash flow statement

In the present day, the cash flow statement is considered as an important part of financial statements.

Incorporate business organizations, preparation of cash flow statement is mandatory.

The statement, which is prepared to show cash inflow and cash outflow for a particular period, is called the cash flow statement.

Elements of Financial Statements

  1. Asset: Assets are the resource owned by a business; for example, cash, land, furniture, and equipment.
  2. Drawing: Drawing is the withdrawal of cash or other assets from a business for the personal use of the owner. For example- Cash drawing. Goods drawing.
  3. Liability: Liability is the creditorship claim on total assets. For Example- Accounts payable, Salary payable, and Rent payable.
  4. Owner’s equity: owner’s equity is the ownership claim on total assets. For example- Capital, Additional Investment.
  5. Owner’s Equity Statement: Owner’s Equity Statement summarizes the changes in owner’s equity for a specific period.
  6. Shareholder’s Equity: The owners’ interest in a corporation is called shareholder’s equity.
  7. Accounts Receivable: Account Receivables are amounts due from customers for goods or services solid on credit services already provided, Accounts Receivables are oral promises of the purchases to pay for goods and services sold.
  8. Accounts Payable: Amounts owed to customers for goods or services purchased on credit.
  9. Cash Flows Statement: A Cash flows statement provides information about the cash inflows and outflows for a specific period.
  10. Income (Earning) statement: Financial statement that shows the revenues and expenses and reports the profitability of a business organization for a stated time.
  11. Revenues: Revenues are the inflows of assets resulting from the sale of products or the rendering of services to customers.
  12. Retained Earnings: Retained earning equal to the accumulated net income fewer dividend distributions to shareholders.
  13. Expenses: Expenses are the cost incurred to produce revenues measured by the assets surrendered or consumed in serving customers.

Discussion of the importance of financial statements to various parties


The owner or management can know the results and true financial position of a business from financial statements. With the help of the statements, it becomes easier to decide on the expansion or contraction of business as per necessity.

For example, if the ratio of return on investment is comparatively high, the management is inspired to invest more. On the other hand, if the business incurs a loss, management may decide to contract the business or to close it down.

That is, management can make proper and timely decisions determining the success or failure of a business with the help of financial statements. Total assets of the business, total outstanding credits, and debts are available in financial statements.


Investment is of both long term and short term.

A conscious investor invests in business after proper consideration of its debts, assets, profit-earning capacity, etc. The investor takes into consideration the paying capacity of interest and the security of his investment.

An investor can analyze long, term financial capacity of concern from financial statements.

Besides current analysis and interpretation, the investor analyses the future financial position with the help of financial statements.


A business is to repay the creditors within the short-term. This debt is paid out of current assets. Therefore, the creditors are interested to know the position of current assets.

Financial solvency of a business concern can be ascertained with the help of the current ratio and acid test ratio prepared with current assets and current liabilities mentioned in the balance sheet.


The bank always considers the security of the loan given to the business concern.

It also studies the financial capacity of the business concern regarding regular payment of interest on the loan.

Bank interprets the balance sheet of a business concern to know the financial solvency and debt-paying capacity of a business. It also studies the revenue earning capacity of the business.


Financial statements are important to the government for various purposes. The government can be aware of income tax, VAT, sale tax, duties, etc. payable to the government by business concerns from financial statements.

Besides, in formulating trade policy, taxation rules, industrial policy, etc. of a country, financial statements of business concerns play an important role.

Government analyses the financial position of the country from financial statements of business concerns. These financial statements are the proofs of compliance with the government rules in running the business.

Trade Association

Trade associations render necessary services to their members to protect the interest. They can fix up the benefits to be provided to their members by interpreting and analyzing financial statements of the business concern.


Employees’ interests are directly related to financial progress and regress of the business concern. Employees always remain eager to know the true financial position of a business concern, and this can be known from financial statements.

Stock Exchange

Shares and debentures of various companies are traded through a stock exchange.

Financial statements help share brokers know the financial position of a business concern. The values of securities of a business concern are fixed upon the basis of its financial statements.


The consumers remain interested in a controlled accounting system, which minimizes the cost of production, resulting in the availability of goods at a lower price.

Research scholars

Financial statements are important to research scholars engaged in the financial research work of a country.

Because they can have necessary data from financial statements of business concerns.


Mass people are also benefited from the financial statements of business concerns.

Flourishment of business leads a country to the path of development by increasing investment.

As a result, employment opportunities increase, regular supply of good at reasonable rates is ensured. This helps social development increase the standard of living of the mass people.

From the above discussion, it can be said that the financial statements of concern mean a consolidated position of some matters.

For example;

a statement of asset and liabilities prepared at the end day of the year, an income statement determining results of business activities of a particular period, cash flow and fund flow statements showing the reasons of changes of cash and funds, statement of owner’s or stockholder’s equity and notes to accounts and disclosure.

Effects of Price Changes on Financial Statements

The effect of price level changes on an entity’s financial statements depends on both the rate of price level changes and the composition of assets, liabilities, and equities. The composition of assets, liabilities, and equities is an important determinant of the effect of price-level changes on an entity and its financial statements.

The following are some useful generalizations regarding such effects in times of significant inflation.

  • The larger the proportion of depreciable assets and the higher their age, the more understated income tends to be. Thus, the income of capital-intensive companies tends to affect more than that of others by price-level restatements. Accelerated depreciation reduces this effect.
  • The rate of inventory turnover has a bearing on price-level effects. The slower the inventory turnover, the more operating income tends to be overstated unless the LIFO method is used.
  • The mix of assets and liabilities between monetary and nonmonetary is important. Net investment in monetary assets will, in times of rising price levels, lead to purchasing power losses, and, conversely, purchasing power gains will result from a net monetary liability position.’
  • The methods of financing also have an important bearing on results. The larger the amount of debt, at fixed and favorable rates relative to the inflation rate, and the longer its maturities, the better is the protection against purchasing power losses, or the better is the exposure to purchasing power gains.

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