The Companies Act 2006 and Financial Statements
The Companies Act 2006 requires companies to prepare financial statements (accounts) annually, including the balance sheet and profit and loss account (P&L). These must be provided to both shareholders and Companies House.
Objectives of Financial Statements
The primary objectives of financial statements are:
- To provide information about a company’s financial position and performance, enabling stakeholders to make informed decisions on buying or selling shares or lending to the company.
- To assess whether the company is well managed by analysing its financial success.
Key Qualities of Financial Statements
Financial statements should comply with the following principles:
- Understandability – Information should be presented clearly so that anyone with a basic understanding of finance can interpret it.
- Relevance – Statements should provide useful information that helps users make informed economic decisions.
- Materiality – All relevant information must be included, as omissions (even small ones) can influence decision-making. For example, directors’ remuneration is always considered material.
- Reliability – Financial statements must be accurate, free from material errors, and unbiased.
- Substance over form – Transactions should be recorded based on their economic reality, not just their legal form. For instance, if a company purchases a car on hire purchase, it should be recognised as an asset from the start of the contract, even if legal ownership transfers at the end.
- Prudence (Caution) – When uncertainty exists, companies should avoid overstating income and assets or understating liabilities and expenses.
- Comparability – Users should be able to compare financial statements over time to identify trends, and also compare them with those of other companies in the same industry to assess performance.
- Timeliness – Information should be provided while it is still relevant and useful for decision-making. Delayed financial statements may lose their value.
Financial Position of a Company
A company’s financial position is shown by its assets, liabilities, and equity on a specific date, as presented in the balance sheet.
- Asset – A resource controlled by the company as a result of past events, from which future economic benefits are expected.
- Example 1: A company makes a credit sale (past event) and expects to receive cash from a debtor (future economic benefit). The debtor is considered an asset.
- Example 2: A company purchases a machine (past event) to produce goods for future sales (future economic benefit). The machine is an asset.
- Liability – A present obligation arising from past events, which is expected to result in an outflow of economic benefits.
- Example: A company makes a credit purchase and will need to pay the supplier in the future.
- Equity – The company’s net assets, representing the value of its assets after deducting liabilities.
Performance of a Company
A company’s performance is assessed by analysing the relationship between its income and expenses over a reporting period.
- Income – Transactions or events that increase equity, excluding capital contributions from owners.
- Revenue – Income generated in the ordinary course of business, such as sales and interest receivables.
- Gains – Other income not directly related to revenue, such as profit from selling company investments.
- Revenue and gains are reported separately in the profit and loss account (P&L).
- Expenses – Costs and losses incurred by the business, excluding directors’ drawings and dividends.
Accrual Basis of Accounting
The accrual basis means that income and expenses are recognised when they occur, rather than when cash is received or paid.
- Limited liability companies and partnerships must use the accrual basis.
- Sole traders with annual income below £150,000 can opt for the cash basis instead.
Provisions
A provision is a liability where the timing or amount is uncertain. A provision should be recognised in the balance sheet and recorded as an expense in the profit and loss account when all the following conditions are met:
- The company has a present obligation due to a past event.
- It is probable that a payment will be required in the future.
- A reliable estimate can be made of the obligation amount.
