The Primary Objective of Financial Statements - Essay Example

? Finance Finance The primary objective of financial ments is to shed light on the financial position and performance of an enterprise so as to assist the users of financial information in making informed economic decisions. In order to achieve this purpose, it is imperative that these statements possess certain qualities which can ensure their usefulness for the various users of financial information (Epstein et al, 2010). In this paper, I have made an attempt to first briefly discuss what constitutes financial statements and what implications these statements possess for their users, and then analyze some of the essential characteristics of financial information in detail along with the problems that affect the qualitative characteristics of materiality, prudence, neutrality, relevance and reliability In addition to that, this paper also focuses on the various ways in which these qualities may come into conflict with each other and how the reporters of financial information struggle to strike a balance among these attributes to ensure the usefulness of information for the user. According to the U.S. GAAP Codification of Accounting Standards, financial statements of an enterprise comprise of profit/loss statements, balance sheets, statement of cash flows and an account of stockholders' equity. These statements, combined with additional financial analysis tools and formulae constitute the financial information which in turn serves the needs of the wide range of users of financial information. These users may be the owners and managers of the business itself who need the information to successfully conduct managerial and commercial activities; employees of the organization who may wish to assess the performance of the business they work for; actual and prospective investors who need the financial information to evaluate the feasibility of investing in the business; government entities which need the information for tax collections; financial institutions such as banks so that they can decide whether to extend working capital or loans to the business keeping into consideration the liquidity position of the organization; financial analysts and surveyors who research and study the financial performance of organizations or the general public which might be interested in gathering information for various reasons (Gibson, 2011). In order to satisfy the needs and requirements of the users of financial information, the accountant's job is essentially to maximize the usefulness of the information to facilitate the users and to fulfil the expectations of the users with regard to the accuracy of the information. Along with the reporting being simply and evidently comprehensible, analogous and unswerving, it should also be relevant, reliable, material, neutral and definitely prudent (Rich et al. 2010). In the following paragraphs, I shall proceed to discuss the latter five characteristics mentioned in an orderly fashion along with highlighting the challenges faced in ensuring the effective implementation of these qualities. Relevant financial information is that which has the ability to influence decision-making of the users and is meaningful. It assists them to make informed judgments on the basis of past events, accurate decisions in relation to the present scenarios and wise forecasts about future events along with facilitation in correct evaluation of situations. Data that fails in influencing the decisions in the appropriate manner is futile for the users regardless of whether it represents external phenomena or whether it conforms to the other user-oriented criteria (Rosenfield, 2006). For example, a supplier who is planning to sell goods to a company on credit will find the total cash balance in the cash flow statement of that company relevant since it will enable him to assess the liquidity position of the company. Likewise, a prospective shareholder of a company would surely desire to discern the profitability state of the company so that he could decide whether an investment will be worthwhile or not. Reliability of financial information refers to the accuracy of the data and information. Users possess the right of being provided with information which is not only accurate and acceptable but also that can be relied upon to make decisions. When users can depend on the accounting information to perfectly demonstrate the economic conditions which it claims to represent, then such information is considered to be reliable (Financial Accounting and Standards Board, n.d.). One of the basic characteristics of reliable information is Verifiability, that is, when the user can be certain that the information is trustworthy and does not carry any error (Porter et al, 2009). Verifiability of a sales figure, for example, can be ensured by referring to the actual sales invoice document that accompanied the sales. Reliability should be such that the information faithfully represents the actual transaction or event that lies behind the information. If information is incorrect or carries any kind of biases, then it cannot be trusted upon to help the user in arriving at an informed and acceptable decision. Relevance and reliability are thus the fundamental qualities of sound financial information. However, a trade-off is sometimes made between the two when certain users desire greater reliability whereas other users emphasize more on the relevance side. For example, auditors while carrying out audit of financial data often place much greater stress on reliability of the figures whereas an investor may focus more on the relevance of the information to his decision regarding venture in the company. None of these two characteristics can be dispensed with wholly since both are essential conditions for usefulness of the information (International Accounting Standard Board, 2005). Another significant attribute of high-quality financial information is Materiality, which is not much different to the notion of relevance. It is principally the extent of misstatement and/or amount of exclusion of some accounting data to the level that it affects the decision-making capacity of the user relying on the information (Juma’h, 2009). The error may be too insignificant such that it has no consequences on the quality of the information, or may be large enough so as to result in misjudgement on the part of the user. Consequently, Materiality is dependent on the size of the error judged in case of its omission or misstatement and hence provides a threshold. These and other similar definitions provided do not yield any clear guidelines to accountants as to how to apply the materiality threshold, which in turn makes the issue a con-founding one, there by, requiring them to apply their judgment and logic in discovering a solution. The threshold for materiality depends on the size and nature of the company as well and varies accordingly. For example, a purchase under a certain dollar amount may be classified by a company as expenditure and hence expensed away, whereas a purchase above that amount be counted as an asset and depreciated accordingly. However, predicament occurs with reference to who makes a decision, what threshold to set and at what amount and whether it affects the financial information in a noteworthy manner. For a large company, the threshold might be set as high as $1000 whereas for a small stationery store it may be set at $20. Furthermore, a transaction or economic event might be regarded as trivial in the eyes of the company but at the same time be of significant importance to the users. Materiality may be determined in accordance to the likelihood of the happening of an economic affair (Price et al, 2002). For instance, probable liabilities can be shown on the financial statements, possible liabilities in the notes to statements and remote liabilities neither reported nor disclosed. Qualitative aspects such as industry tendencies, interior and exterior control measures, alongside experiences and perceptions of the accountants may be used to determine materiality in addition to the application of quantitative factors such as historical data analysis and financial ratios (Carpenter et al 1994). In order to shrivel deceptive information; reporters and auditors recognize the aspects prone to materiality hitches, and seek reference to any available help from the accounting regulations. However, in absence of such type of assistance, they employ judgment and experiences of their own and evaluate the inferences of materiality decisions on the stakeholders. Subsequently follows the concept of Prudence, also known as Conservatism, which requires that the accountant should neither overestimate the revenues nor underestimate the expenses while recording them in the books. Also, the accountant ought to be conservative when recording assets and ought not to underestimate liabilities. The purpose is to present a true and fair snapshot of the organizational performance to the users by minimizing uncertainty and exercising caution while preparing statements such that profits may not depict an inflated figure (Kwok, 2005). A few instances of prudent financial information include provision for doubtful accounts and allocation of value to the inventory on the basis of either lower of cost or net attainable worth. The major shortcoming that evolves from this mechanism is the relatively pessimistic view adopted by accountants while recording profits, since they are expected to anticipate no revenues and account for all possible losses. The prudence concept is also said to be in conflict with the Accruals method, which on the whole states that revenues should be matched against expenses. Moreover, the prudence concept clashes with reality in several cases. For example, when investors understate the true value of the assets of the company they have invested into, it may misguide them in selling off their securities rather than keeping them. Also, if profits of a company are understated, it may dissuade potential investors from investing in the company, yet again a misguided action. In fact, the FASB Concept Statements have issued a word of warning that understated assets under the prudence method more often than not lead to overstated income in afterward periods (Porter et al, 2009). The last qualitative characteristic is based on the concept of Neutrality. Information is said to be neutral when it presents a factual and just position of the organization, neither exhibiting it in an extremely bright situation nor in a gloomy one. Neutrality of financial information is necessary so that the company does not deviate much from the truthfulness. Conversely, this concept comes into conflict with the earlier illustrated prudence concept which is more inclined towards a pessimistic view of the company as compared to optimistic. One may argue here that prudence concept only ensures that a business is providing a margin of safety for itself by allowing for any unfavourable circumstances in the near future. As a result, the accountant must strive to hit the precise balance between being neutral in the reporting whereas at the same time complying with prudence. For instance, though the provision for doubtful debt complies with prudence method, yet it is also common that ultimately, a few customers do not make their payments, hence creating bad debts for the business. For that reason, a careful estimate of percentage of doubtful debt account can in fact present a fair picture of the actual situation prevalent in the company. In this manner, neutrality holds its own importance in the development of financial statements. Companies are required by GAAP (Generally Accepted Accounting Principles)-set of authoritative standards set by policy boards, to report their financial data and information as accurately and reasonably as possible keeping into consideration the above discussed factors and their implications. In order to counter the financial and accounting frauds which were rising considerably during the early 2000’s; Sarbanes-Oxley (SOX) Act of 2002 was passed which established enhanced accounting standards for all types of firms operating in the United States. This was certainly an exceptional step taken by the United States government which not only reduced the intensity of financial crimes and accounting deceit, but also raised the quality of financial information across the country by setting tougher principles. The inability to adapt to the SOX resulted in severe penalties for the management and auditors of the company. In this manner, the overall standards of financial information in all aspects: materiality, neutrality, reliability, relevance and prudence improved by a fair margin. There is an urgent need to come up with more such laws in other parts of the world as well so that the overall credibility and accuracy of the financial information gets better internationally (De vay, 2006). Bibliography Carpenter, BW., Dirsmith, MW and Gupta, PP. (1994). ‘Materiality judgments and audit firm culture: social-behavioural and political perspectives’. ScienceDirect [online]. Available from: http://www.sciencedirect.com/science/article/pii/0361368294900027[Accessed 10 February 2012) DE VAY, D. L. (2006). The Effectiveness of the Sarbanes-Oxley Act of 2002 in preventing and detecting fraud in financial statements: a dissertation. Boca Raton, Florida, Dissertation.com. EPSTEIN, B. J., NACH, R., & BRAGG, S. M. (2010). Wiley GAAP 2010: interpretation and application of generally accepted accounting principles. 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(2006). Contemporary issues in financial reporting: a user-orientated approach. London, Routledge. Read More