Financial statements and accounting - Essay Example

Financial ments and accounting Table of Contents Importance of financial ments 3 Rules followed 3 Objectives of financial ments 4Past performance 4 Current position 4 Operational efficiency 5 Profitability and growth 5 Financial accounting principles 5 Important financial statements 7 Income statement 7 Balance sheet 7 Cash flow statement 8 Users of financial information 8 External users 8 Internal users 8 Reference List 10 Importance of financial statements Financial statements can be described as the formal financial records which are maintained by a firm. The records are maintained in respect of the financial transactions of the company since its inception. The reports and statements portray the financial strength, position, liquidity and the performance of the company. The statements provide all the necessary details regarding the financial structure and position of a given entity. The financial statements of an entity usually include an income statement, balance sheet, cash flow statement and statement of ratio calculations. Firms may also prepare other types of statements such as the statement of retained earnings (Francis, 2004). Financial statements are required to be audited by authorized government agencies so as to ensure the accuracy maintained in the statements for tax purposes. Auditing helps to estimate whether the table revenue has been correctly been identified by the firms. Audited financial statements are also referred by different other firms, banks and individuals for taking decisions regarding investments. It is important that organizations follow all existing norms are regulations established by the regulatory authorities while preparing such statements. The financial statements are prepared by referring the detailed records maintained in the journal, ledger, trail balance and other books and statements of primary and secondary entry. These records are then presented in the financial statements in a summarized manner. Entries which have earlier not been passed in the primary and secondary books of accounts are recorded in the final statements by preparing an adjusted journal proper. Such entries have their impact upon both in the income statements as well as the balance sheet (Francis, 2011). Rules followed Accounting statements are generally prepared using the U.S. Generally Accepted Accounting Principles (GAAP) in most nations across the world. Many nations are also seen to follow the IFRS principles. More and more nations across the worlds are adopting the IFRS principles. At present, approximately 110 nations of the world adhere to the IFRS principles. The IFRS principles were mainly established so that a common ground can be established for comparing the financial statements and developing a global language of business interaction. The rules followed under both the sytems of accounting have certain fundamental differences. In case of GAAP, inventory costs and records are required to be maintained following the principles of LIFO, FIFO or weighted average costs. IFRS regulations states that the inventory record are to be maintained following the FIFO or the weighted average cost of inventory. Under the U.S. GAAP written down value of inventory cannot be reversed, whereas under IFRS the reversal is permitted if certain criteria’s are met. Intangible assets under the U.S. GAAP are estimated at its fair values. Under the IFRS principles, intangible assets are only recognized if they possess future economic benefits and are measurable (Patel and Psaros, 2000). Objectives of financial statements Past performance One of the primary objectives of financial statements is to assess the past performance of a firm. It is considered that the past performance of a firm can act as a good indicator of the future performance of a firm. Investors, shareholders and creditors are interested in knowing the past trend in sales, net income earned and cash flows (Antle, 1984). Current position Financial statements reveal the current financial positions of the firm. The financial position is mainly estimated by comparing the assets and liabilities of the firm. Investors are seen to particularly interested in knowing the current financial position before they provide funds. Operational efficiency Financial statements play a crucial role in depicting the operational efficiency of a firm. Efficiency is mainly achieved by minimizing the costs of operations, minimizing wastage and optimizing the use of resources. An organization is also seen to be having high operational efficiency if it can increase its revenue from sales by a considerable margin year after year. The amounts of retained and excess earnings also are considered to be indicators of operational efficiency (O’sullivan, 2000). Profitability and growth Users of financial statements mainly verify the profitability of the firm. Profitability is mainly analyzed by calculating different ratios from the figures available from the income statement and the balance sheet. Net profit ration, return on assets, return on equity and investments are some of the common methods of estimating the profits earned b the firm. High profitability ratios indicate that an organization have sufficient capacity to convert resources into revenues and incur minimum costs in the process. Firms having adequate profitability, present high growth prospects and are therefore considered to be suitable for making investments (Fearnley and Beattie, 2004). Financial accounting principles Financial statements are prepared based on certain principles. These principles are known as accounting conventions and concepts. The principles ensure that the interest groups which are associated with the business are provided with accurate information. Some of these concepts and principles are discussed as follows. Accrual principle- Accounting entries are required to be made for the period in which they occur, instead of recording them in the period in which the cash flows occur. The accrual systems of accounting reveal the transactions which have actually occurred during the financial period. The accrual system prevents artificial delays in the receiving or providing of services. Conservatism principle- The principle of conservatism states that provisions for expenses which may arise in the future should be maintained whereas revenues should only be recorded when they actually occur. The principle encourages recording losses and expenses as soon as possible (Fearnley and Beattie, 2004). Cost principle- The cost principle states that equity, assets and liabilities must be recorded at their original purchase prices. However many assets are identified at their fair values. Going concern principles- The going concern principle states that organizations will continue to operate for a long term in the future. The principle justifies calculating expenses such as depreciation over a number of years. Reliability concept- The transactions entered in the books of accounts must be supported with adequate evidences. For instance a supplier’s invoice acts as a strong proof that purchase has occurred. Full disclosure concept- The concept of full disclosure states that all revenues and expenses pertaining to a given financial period must be recorded in the books. Monetary unit principle- This principle states that transactions which are measurable in terms of money should only be recorded in the books of accounts. Time period principle- Financial statements are prepared taking into consideration a definite period of time. The financial year begins from April of a particular year and ends in the month of March in the next year (Palepu and Healy, 2007). Important financial statements Income statement The income statement is also known as the profit and loss account. The income statement reveals all the revenues and expenses pertaining to a given financial year. The income statements help in estimating the net operating income of a firm by deducting all the expenses from the revenues. Investors give adequate importance towards analyzing the income statement of a firm as they represent the expenses incurred by firms during the course of business. The income statements are also indicators of the management efficiency and the amount of investments and the manner in which an organization manages its funds (Hung, 2000). Balance sheet Balance sheet is a summarized statement of assets and liabilities of a firm. It also reveals the capital structure of an organization. The balance sheet informs the investors about the credit and debit situations of a firm. The balance sheet is also an indicator of the liquidity position of the firm. The statement is named as balance sheet as it is essential that both the asset and liability sides of the statement should match. The asset section of the balance sheet records both fixed and current assets. Property, intangible assets and equipments are some of the important types of long term fixed assets. Current assets are those assets which can be converted into cash within a short period of time. The assets in general represent the items in which the finance of the firm is trapped (Will, Subramanyam, and Robert, 2001). Cash flow statement The cash flow statement reveals the inflow and outflow of fund in respect of operational activities, investing activities and financing activities. The cash flow statement estimates the net cash balance at the end of given period. The cash flow statement is a useful tool for estimating the financial position of a firm. The statement only records the recipes and payments of the firm under different head. Non-cash activities are not revealed by the cash flow statement (Day and Woodward, 2004). Users of financial information External users Investors- Investors mainly analyze the financial statements to estimate profitability and future revenue earning capacities of the firm. Government- Government officials analyze the financial statements to check whether firms have made timely and accurate tax payments. Vendors- Vendors assess the credit worthiness of a firm by analyzing the financial statements. They mainly check the financial statements for estimating the liquidity position and the cash balances over a number of years (Hung, 2000). Internal users Shareholders- Shareholders are the most important verifiers of the financial statements of an organization. Shareholders check the revenues which are earned. Shareholders wealth can only be increased if the firm can generate high revenues. Shareholders are required to provide their consent upon the important strategic decisions taken by the organization. As a result it is important to analyze the financial statements so as to check the firm’s ability to grow in the future. Employees- Employees analyze the financial statements of a firm in order to determine whether firm is likely to continue its operations in the long run. Employees also use the financial statements for negotiating pay related aspects with the managers (Hung, 2000). Reference List Antle, R. (1984). Auditor independence. Journal of Accounting Research, 22(1): 1-20. Day, R. and T. Woodward (2004). Disclosure of information about employees in the Directors’ report of UK published financial statements: substantive or symbolic? Accounting Forum, 28(1): 43-59. Fearnley, S. and V. Beattie (2004). The Reform of the UKs Auditor Independence Framework after the Enron Collapse: An Example of Evidence‐based Policy Making. International Journal of Auditing, 8(2): 117-138. Francis, J. R. (2004). What do we know about audit quality? The British accounting review, 36(4): 345-368. Francis, J. R. (2011). A framework for understanding and researching audit quality. Auditing: A journal of practice & theory, 30(2): 125-152. Hung, M. (2000). Accounting standards and value relevance of financial statements: An international analysis. Journal of accounting and economics, 30(3): 401-420. O’sullivan, N. (2000). The impact of board composition and ownership on audit quality: evidence from large UK companies. The British Accounting Review, 32(4): 397-414. Palepu, K. and Healy, P. (2007). Business analysis and valuation: Using financial statements. Boston: Cengage Learning. Patel, C. and J. Psaros (2000). Perceptions of external auditors ‘independence: some cross-cultural evidence. The British Accounting Review, 32(3): 311-338. Will, I., Subramanyam, K. R., and Robert, F. H. (2001). Financial statement analysis. New York: McGraw-Hill Internation. Read More