Financial Statements

Managers, shareholders, creditors, and other interested groups seek answers to the following questions about a firm: What is the financial position of a firm at a given point of time? How was the firm performed financially over a given period of time? What have been the sources and uses of cash over a given period? To answer these questions, the accountant prepares two principal statements, the balance sheet and the profit and loss account and an ancillary statement, the cash flow statement.

Liabilities, defined very broadly, represent what the firm owes others. A liability arises when a firm receives benefits or services and, in turn promises to pay cash or provide goods and services in future.

Most liabilities are monetary liabilities meaning that they require payments of specific amounts of cash. If the payment is due within a year or less, the liability is shown at the amount of cash the firm is expected to pay to discharge the obligation. If the payment dates extend beyond one year, the liability is shown at the present value of the future cash outflows. This discount rate used for valuing the future cash flows is the borrower’s interest rate on that liability.

Some liabilities are non-monetary meaning that the firm expects to discharge them by delivering goods or providing services, rather than by paying cash. For example, a magazine publisher may collect cash for subscriptions and promise delivery of, magazines for many months to come. While the firm receives cash currently, it discharges its obligations by delivering the magazines in future. Such non-monetary liabilities are shown at the amount of cash received, rather than the expected cost of publishing the magazines.

The format prescribed in the Companies Act classifies liabilities as follows:

1. Share capital
2. Reserves and surplus
3. Secured loans
4. Unsecured loans
5. Current liabilities and provisions

Share capital includes equity (or ordinary) capital and preference capital. Equity capital represents the contribution of equity shareholders who are the owners of the firm. Equity capital being the risk capital carries no fixed rate of dividend. Preference capital represents the contribution of preference shareholders and the dividend rate payable on it is generally fixed.

While the final figure shown against share capital is the paid up capital to balance sheet also provides information on authorized capital, issued capital, subscribed capital, and paid-up capital. The amount of capital that a company can potentially issue as per its memorandum represents the authorized capital; the amount offered by the company or the investors is called the issued capital; the part of issued capital which has been subscribed to by the investors is called subscribed capital; the actual amount paid up is called the paid up capital. Typically the issued, subscribed and paid up capital are the same.

Reserves and Surplus: Reserves and surplus comprise retained earnings as well as non-earning items, share premium and capital subsidy.

There are two broad kinds of reserves viz., capital reserves and revenue reserves. Capital reserves include items such as share premium account, revaluation reserve, and capital redemption reserve. A capital reserve cannot be distributed as divided to shareholders. Revenue reserves represent accumulated retained earnings from the profits of the business. They are held in accounts like investment allowance reserve, dividend equalization reserve, taxation reserve and general reserves.

It is a common practice for companies to affect transfers from the profit and loss account to various reserve accounts. This process is called appropriation.

Surplus is the balance in the profit and loss account which has not been appropriated to any particular reserve account. Note that reserves and surplus along with paid up capital represent owners’ equity which is also called shareholders funds or net worth.–