Importance of Financial Statements - Essay Example

Finance and accounting Financial ments Financial ment can be defined as a vital tool for analysing financial position of a company. It actually aims at depicting the financial health of the company. It does not only provide a wide view into the financials of a company but it also identifies whether it can sustain in the long run or not as it has the ability to forecast the future. It is important for the investors to understand the components of the financial statements and its uses so that they are not misguided by the company accounts. The layman in investment has to check the financial statements in order to know whether it is making profit or loss (Will, Subramanyam and Robert, 2001). Interpretation of these statements is vital for a successful investment. The relation between the different elements of the financial statements is important to understand as it reflects the performance of the company and the management can take proper decision pertaining to any strategic change. The external and internal financial statements are prepared in order to fulfil a set of objectives. The external statements highlight the external reporting only and it is mostly used by the tax authorities, investors, suppliers, creditors and public. These statements are usually prepared at an interval of one year and the period is defined by the individual company or the accounting standards they follow. Internal financial statements are flexible in nature and have excellent analytical components. These reports are prepared for the internal use i.e. for the management and its employees. These statements are prepared weekly or even quarterly (Will, Subramanyam and Robert, 2001). Importance of financial statements For a layman financial statement of an organisation or financial institution is the only source of information pertaining to its financials. This financials are essential for the layman investors who try to decide whether the company is worth investing or not. The liquidity, profitability and solvency are checked by the investors however, for a layman it is difficult to analyze so he/she actually concentrates on the net profit and sales revenue of the company to assess its financial position. Thus, this investor has the opinion that these financial statements are accurate enough to analysis and take any investment decision. The financial statements have a number of components which are very important for a number of individuals. These individuals include company, shareholders, creditors, stakeholders and general public (Stickney, 1993). The components of the financial statement are described below. Components of Financial statement The components of financial statements are highlighted below: Balance sheet It is the most important parts of the financial statement as it highlights the assets and liabilities of the company. It elaborately describes the assets as fixed, liquid and current, which is helpful for the users of financial statement for taking any investment decision. The assets and liabilities are divided into a number of elements such as current and fixed asset and current liability. The difference between assets and are referred as the equity interest. It is observed that all the assets, liabilities and equity should be equal in order to make a proper balance sheet. If the balance is not maintained and one side (asset or liability) is unequal then it is referred as the accounting error. Accounting error should be avoided by the accountant during the preparation of the balance sheet so as to maintain a sound financial statement. If this error exists then it is highlighted when the balance sheet or the financial statement is reviewed or scrutinized. In order to scrutinize the balance and avoid the mistake or error, double-entry book-keeping system is introduced. This system keeps record of all the transactions considering both the sides of the equation. The fixed assets are those which are kept and used for long term such as machineries and plants. However, current assets are easily convertible into cash and it is used for short term payments and lasts for a year. The elements in liability sides are current liability and long term liability. Current liabilities are defined as the amounts that are owed to the creditors or suppliers at the end of the year. The long-term liabilities are defined as those obligations which exist for more than a year. The ratios that can be calculated after considering financial data from the balance sheet are current, quick and inventory ratio. The current ratio lays emphasis on the ability of the company to pay off its short term liability. The quick ratio also highlights the capability of the company to pay off its current obligations without harming the inventory. This ratio indicates whether the company has the liquidity position to sustain in the long run (Narayananswamy, 2008; Milad, 2009). Profit and Loss statement or income statement The profit and loss statements highlight one of the most important elements of the financial statement i.e. the profit of the company. This it indicates the performance of the company for a certain period of time. It gives emphasis on the calculation of profit by highlighting on the income and expense of the company. The revenue is the amount which is earned by the company in the course of the business by selling any product or service (Grant, 2001). The expenses are the costs that are sacrificed in order to earn the revenue. When the company dispose the assets, it experience either loss or gain. The difference between the expense and income is referred as net profit of the company. Hence, an income statement helps an investor to determine whether the company is performing well or not. The different ratios that can be calculated by considering the financial data from income statement are net profit, gross profit and operating profit margin. This ratios indicates the profitability of the company to the investors and suppliers and thus they can get its profit accurately (Banerjee, 2010). Cash flow statement Cash flow statement highlights the net inflow and outflow of cash in the company. There are three activities related to the cash flow i.e. operating, investing and financing. The statement highlights the cash inflow and outflow that is categorized under these three activities. The cash flow of the company changes as the business operates and changes takes place. The cash flow from operating activity includes the cash inflow and outflow from the sales and cost of sales, payment from customers and payment to the suppliers. The investing activities include cash received and paid for the investing in shares of the company (Harrison, 2008; Jennings, 2006). The financing activity includes the cash inflows and outflows owing to the financial securities of the company. The cash outflow in this activity includes purchase of assets like plants, machineries and buildings, depreciation of fixed assets and loan payments. The cash flow statements indicates the cash balance of the company at the end of the year, which helps the users of the financial statement to compare it with that of the previous years; the users also evaluate whether the company has performed well with respect to its previous year’s performance. Process undertaken by large companies to complete the financial statements The financial reports are prepared in accordance with the preferred accounting standards International Financial Reporting Standard (IFRS) (Francis, 2010; Edwards, 2008.). It explains the selection of accounting methods to be followed for preparing the financial statements. The mandatory policies and exceptional rules are also considered while preparing the financial statements. The exceptions to the IFRS code are applied by the companies when they merge or acquire any other company in the same industry. In such a situation, the past records are obtained for determining the fair values and the amounts as per the IFRS (Pwc, 2013; Hoofman, 2009). The consolidated financial statements do not include all the disclosures and does not also require the use of few logical and critical accounting techniques and assumptions. The process of completing a financial statement can be elaborated into various steps which are clubbed together. Firstly the transactions are recorded in the general journal by the accountants of the company with the help Golden rules of accounting. The Golden rules of accounting are very important in this case as it directs the placement of the transaction on the debt or credit column of the journal (Henry and Piekarski, 2005). Secondly, the transactions are posted to the general ledger in from of worksheet; this is also done by accountants of the company. Then the general ledger is summarised and trial balance is developed. Thirdly, the post adjusting entries are inserted in the primary trial balance. The adjustment include deferred/ prepaid and accrued item. The estimated items are also included in this step. Fourthly, the financial statement is prepared using the adjusted and pre-closing value of the trail balance. Fifthly, the post closing entries are adjusted in the primary trial balance and as a result the same is reflected in the financial statements. After the financial statements are prepared, they are reviewed very minutely so that there is no error (Hung and Subramanyam, 2007; Elmaleh, 2005; Harrison, 2008). A Financial Statement should include a Balance Sheet as at the end of the current year and a comparative Balance Sheet as at the end of the preceding year. It should also include a comparative Profit and Loss Statement or separate Profit and Loss Statements of both years, current and preceding, for comparison. A Statement of Shareholder’s Equity is also included in the Financial Statements, showing changes in equity in the current financial year as compared to the preceding year. Lastly, it includes the comparative Cash Flow Statement which reflects the differences in cash flows between the current year and the preceding year. IFRS states that the presentation of Profit and Loss Statement, either single or consolidated or comparative, should appear after the presentation of the Balance Sheet Statement. It also mentions that the Financial Statements must include the fair value which must abide by the disclosures, such as quoted prices of identical assets or liabilities in active market, inputs that directly or indirectly support the quoted prices of assets or liabilities and unobservable inputs for the assets or liabilities. The exceptions to the IFRS apply mostly when a company merges with or acquires another company. It is when the past records of both the companies are required to determine the fair values and amounts as per IFRS. It also states that the consolidated Financial Statements do not include all disclosures; rather it requires the use of some critical and logical accounting techniques and assumptions. It also requires the company to adopt the accounting policies which are exclusively used by the company. Areas where subjectivity is required The rules governing the preparation of financial statements are very stringent and well managed. The companies and financial institutes or any business entity has to abide by the industry norms as well as the specific norms pertaining to accounting policies. These accounting policies are specified by the International Financial Reporting Standards (IFRS). The purpose of such rules and principles is to ensure that the interests of the shareholders, investors and other individuals or groups are not hampered. Cost Principle: It refers to the amount spent for an item. In some cases the cost should not be adjusted for changes in inflation rate. For instance, if the cost of a car in 1990 was $50,000, which is the cost to be recorded in the books, even if a comparable car would cost $100,000 in present values concern (AICPA, 2013; Grant, 2001). Full-Disclosure Principle: The principle mentions that it is required to disclose all relevant information in a Financial Statement. Any unfair value or undisclosed information would make the Financial Statement an invalid one. For instance, a company has high earnings, but at the same time they are due to pay huge amounts to creditors, it should be disclosed in the Financial Statements. Any other extra information related to the same has to be disclosed in the footnote of the report concern (AICPA, 2013; Bebbigton, 2001). Matching and Revenue Recognition Principle: It refers to the accounting technique used for the purpose of financial reporting, i.e. Accrual accounting (Kimuda, 2008). In Accrual accounting, the revenues and expenses are recorded when they accrue, not when they are received. For instance, when a purchase is made, the payment is considered to be made even if the money is not delivered. Again, payment for goods and services are assumed to be received even if the money for the same has not arrived yet. The matching principle is associated with expense accrual element. On the other hand, the revenue recognition principle is associated with the revenue generation accrual element concern (AICPA, 2013; Ingram, 2007; Kimuda, 2008; Porter, 2011). Going Concern Principle: It refers to the assumption that the company will not abort its business operations in future. It states that it will not go out of business and default on its liabilities. It also mentions that the company will remain in business and continue to be a going concern (AICPA, 2013). Use of IFRS for comparing the financial statements The financial statements of different companies are prepared in accordance with the rules and regulations that are set by either IFRS or GAAP. Both the regimes are stringent have specific way of preparing the financial statements. The financial statements are prepared in such a manner that it highlights the basic difference between the different elements. The different elements are balance sheet, income statement and cash flow statements. The components in balance sheet and income statement have specific way of incorporating the financial data. This financial data helps the investor and other stakeholders to take investing decisions. A comparison between IFRS and GAAP can be carried out in order to prepare financial statements. The main difference is seen during the preparation of balance sheet. In case of inventory management, two methods are followed LIFO and FIFO. IFRS does not take into consideration LIFO and GAAP uses LIFO for the calculation of the inventory and mange it efficiently. GAAP authorities have decided to change its inventory calculation method to FIFO. GAAP does not take into account ant upward adjustments related to the equipment and property. Nevertheless, IFRS takes into account the depreciation and any upward adjustments that are required for the valuation of equipment and property (Hoofman, 2009). Downward revaluation of goodwill is calculated in case of IFRs however, GAAP does not allow revaluation of goodwill. The difference that is highlighted in the income statement is depicted henceforth. The revenue recognition under the two policies is different in many ways. Both the philosophies are similar but GAAP provides more industry specific assistance than IFRS. The determination of cost of goods sold, operating expenses and construction contracts are different in both the cases. There is huge impact of the both the policies on the financial ratios. When the financial ratios under IFRS converge to GAAP or vice versa there is huge change in the way of determining the value (AICPA, 2013; Ingram, 2007; Kimuda, 2008; Porter, 2011). This comparability confuses the investors and stakeholders to a great extent as they are not quite aware of the accounting policies. They often make a mistake of comparing two companies’ financial which follow different accounting policies. This will result in wrong evaluation of the data and the investors can mislead themselves in investing decisions. The difference in the accounting policies should be understood by the stakeholders and shareholders so that they do not encounter any problem in taking any wrong investment decision. The investment decisions are solely dependent on the understanding of the investors pertaining to the investment objectives. The investment objectives are dependent on companies’ financial as well as the operation of the company. If the financial strength of the company is not supportive enough to provide good return to the investors. Moreover, if the investor is convenient enough to understand the accounting policies it becomes impossible for them to make a right investment decision. The investment decisions are dependent on the type of accounting policies that are followed by the companies (Henry and Piekarski, 2005). Reason pertaining to the difference between net assets and net worth The reason pertaining to the difference between values of net assets and net worth of company recorded in financial statements, lies in the fact that they are depicted differently in the financial statements. The difference is due to the accounting policies, which are different for separate companies. As a result the values differ in both the cases and this also takes into consideration the initial the presentation guidelines and polices for depicting the same values (Francis, 2010). Reference List AICPA, 2013. The Importance of Internal Controls in Financial Reporting and Safeguarding Plan Assets. [pdf] AICPA. Available at: < http://www.aicpa.org/InterestAreas/EmployeeBenefitPlanAuditQuality/Resources/PlanAdvisories/DownloadableDocuments/Plan_AdvisoryInternalControls-lowres.pdf > [Accessed 22 August 2014]. Banerjee, B., 2010. Financial accounting. Delhi: PHI Learning Private Limited. Bebbigton, J., 2001. Financial accounting. Singapore: British Library Cataloguing-in- Publication Data. Edwards, J., 2008. Financial accounting. New York : Routledge Elmaleh, M., 2005. Financial accounting. Union Bridge: Eplphany Communication. Francis, J., 2010. Financial accounting. New York: South-Western Cengage Learning. Grant, E., 2001. Depreciation. New Jersey: Ronald Press Company. Harrison, W., 2008. Financial accounting. London: Pearson Prentice Hall. Henry, C. and Piekarski, J., 2005. Techniques for capital expenditure analysis. New York: M Dekker. Hoofman, G., 2009. Financial accounting. Boston: Houghton Mifflin Company. Hung, M. and Subramanyam, K. R., 2007. Financial statement effects of adopting international accounting standards: the case of Germany. Review of Accounting Studies, 12(4), pp. 623-657. Ingram, R., 2007. Financial accounting. New York: South-Western Cengage Learning. Jennings, R., 2006. Financial accounting. Singapore: British Library Cataloguing-in- Publication Data. Kimuda, D., 2008. Financial accounting. Kampala : East African Publishers ltd. Milad, A., 2009. Financial accounting. Bloomington: AuthorHouse. Narayananswamy, R., 2008. Financial accounting. Delhi: PHI Learning Private Limited. Porter, G., 2011. Financial accounting. New York: South-Western Cengage Learning. Pwc, 2013. Understanding A Financial Statement Audit. [pdf] Pwc. Available at: < http://www.pwc.com/en_GX/gx/audit-services/publications/assets/pwc-understanding-financial-statement-audit.pdf > [Accessed 22 August 2014]. Stickney, C. P., 1993. Financial statement analysis. New York: Dryden. Will, I., Subramanyam, K. R. and Robert, F. H., 2001. Financial statement analysis. New York: McGraw-Hill. Read More