The Importance of Financial Statements - Literature review Example

Financial Accounting Table of Contents Introduction 3 A Brief Overview of Financial ments 4 The Objective of Financial ments 5 The Usefulness of Financial Statements for the General User Groups 7 Conclusion 8 Reference 9 Introduction Financial activities of business organisations have increasingly become complex in recent years. Finance in the context of business implies the credit or the amount of money that has been employed for business purposes. Financial activities of business include acquiring and utilising available funds that have been acquired from different sources so that the operational activity of a business organisation can be carried out efficiently and effectively. Business finance is therefore indispensable to any type of profit-making and non-profit making organisations. The degree and value of finance varies according to the size and nature of business. Financial statements are the reflection of these financial activities. Companies are mandated to provide it to their stakeholders so as to keep their operations transparent and measurable. Government authorities responsible for maintaining business ethics and compliances, has framed strict guide lines regarding its execution. Listed companies of most of the countries are found to follow either GAAP (Generally Accepted Accounting Principal) or IFRS (International Financial Reporting Standard) for their accounting activities. These two accounting standards help to develop proper and appropriate policies for disclosing the financial reports. These reports are very helpful for internal and external users. The primary objective of this paper is to critically examine the importance of financial statements and its utility to general user groups. To meet this objective, at first, a clear explanation of financial statements will be given, followed by a discussion on the importance of financial statements. The next sections will deal with the utility of financial statements for the external users. Finally, the paper will be concluded by summing up the overall discussions. A Brief Overview of Financial Statements Financial reports are the recorded statements of financial activities of an organisation. These recorded reports quantitatively explain the financial health of a company. For a public holding or a listed company, it is mandatory to disclose its financial statement through quarterly and annually reports. Financial statements constitute of cash flow, income statements, balance sheet and other necessary statements like that of shareholders’ equity. These financial statements are very helpful in evaluating the performance of business activities. The income statement reveals the net earnings of a company and the balance sheet provides a clear insight of company’s assets and liabilities at a specific point of time. Every company is liable to maintain a proper and legal method of disclosing the financial statements. These guidelines are known as the standard accounting policy. GAAP accounting policy offers a method for compiling the financial statement of a company. GAAP strives to provide the investors and other users of financial statements a minimum level of transparency and consistency. ‘Financial Accounting Standards Board’ (FASB) is a US non-profit making organisation and is responsible for “establishing standards of financial accounting that govern the preparation of financial reports by nongovernmental entities” (Financial Accounting Standards Board, “Facts about FASB”). This organisation has developed the GAAP accounting policy to facilitate the financial reporting activities. IFRS on the other hand is a more advanced international accounting standard. It is more consistent, transparent and comparable than GAAP. “International Financial Reporting Standards (IFRS) are a set of accounting standards developed by the International Accounting Standards Board (IASB) that is becoming the global standard for the preparation of public company financial statements” (The American Institute of Certified Public Accountants, “International Financial Reporting Standards”). The Objective of Financial Statements ‘Financial Accounting Standards Board’ and the ‘American Institute of Certified Public Accountants’ are the two organisation responsible for developing GAAP and IFRS respectively. Both these organisations follow similar objectives i.e. to develop globally accepted standard accounting policy that guarantees reliability, consistency and transparency of the financial statements. The primary objective of financial statements is to disclose information related to the financial condition of a company. Financial statements are also very useful in evaluating the performances and changes in financial position of an organisation. These statements also assist in making financial and managerial decisions. Both internal and external stakeholders use these statements for multiple purposes. Internal parties include the management team and external party constitute of a number of people like investors and financial analysts. One of the most essential objectives of financial statements is to detect and prevent the financial fraud and scam. “Fraud is commonly referred to as an intentional act committed to harm or injure other securing an unfair or unlawful gain” (Rezaee and Riley, “Financial Reporting and Financial Statement Fraud”). In the corporate sector, increasing number of frauds and scams are making the market instable. For example, during late 1990s, due to misleading financial accounts of Enron Corporation, investors along with the entire market had to suffer. There are certain qualitative features of financial statements that help to meet the primary objectives of financial statement. These quantitative features help to make the financial information relevant. There are four prime features of financial statements and these are relevancy, reliability, understandability and comparable. These four features can be interpreted as the basic objectives of financial reporting. Each of these features has been discussed below. Relevancy: The information disclosed by the companies through financial statement must be useful and relevant for the users of financial statements for decision making process. Financial statement contains the past records, and is therefore not the foolproof way of determining the company’s future financial position. Nonetheless, the past performance indicates relevant information for predicting the future of the company. Understandability: It is an essential quality of financial statements. The financial reports prepared by the company must be clear and comprehendible by the common people. The general users of financial statement may not have sufficient expertise to understand complex accounting entries. Therefore, the financial reports must be understandable. Reliability: The financial statements should be free from any intentional or unintentional errors. Many unethical companies often mislead the market in order to secure unlawful gain. Biased and inaccurate reports misguide the users of financial reports while making very crucial decisions. Reliable financial reports are consistent and transparent and portray the true picture of the company’s financial position. Comparability: The financial reports should be comparable in terms of financial positions. Comparability by virtue of its quality helps to compare the past years’ financial positions. This also helps the investors to compare different firms of the same industry for investments purposes (Rolfe, p.142). The Usefulness of Financial Statements for the General User Groups Accounting information is very useful for different entities like stakeholders, investors and other users. Different people have different uses of financial reports. Internal management teams use these financial statements to make future decisions for business operational activities. They also use these statements to measure the effectiveness and efficiency of business performances. The investors use the published financial reports for making investments decisions. Many individuals or institutional investors invest their money in different profit making companies by buying the shares. The stock price of a company with strong financial position and performance tends to increase in future, thereby increasing the wealth of investors. In this respect, the rational investors evaluate and analyze the financial performance of companies. The external users of financial reports include financial institutions, governments, vendors, financial analysts and mass media. Financial institutions like banks or lending institutions keep evaluating the position of a company as they lend money in the market. They must understand and know the requirement of money in the company. Government authorities like tax departments also investigate these statements to ensure that the company pays the accurate tax. Vendors and suppliers also need these financial statements to measure the creditworthiness of business because they often supply materials in credit to the companies. They are willing to extend the credit limits to companies having strong financial position. The financial analysis and mass media analyse the financial statements to report the financial health of company which is very helpful for the common people and investors. However, financial statement also suffers from certain limitations and disadvantages. Firstly, due to inflations and other macro-economic factors, the value of currency fluctuates. The existing accounting standards do not consider these factors and therefore, historical financial statements are unable to predict accurate future of a company’s financial health. Secondly, the financial reports do not provide concrete or absolute data as it does not consider many small but vital adjustments. Thirdly, the financial reports present only quantitative data and it justifies a company on the basis of monetary units. For example, a loss-making company may possess sufficient skills and efficiency which will yield long term return Conclusion The reporting of financial statements by listed companies has now been made mandatory. These statements are very useful for insiders as well as outsiders of a company. It is essential for every public holding company to publish its annual and quarter financial reports. This paper has dealt with three main sections. The first section has explained the concept of financial statements and its methods. GAAP and IFRS are two major accounting policies for reporting the financial statements. The second section has clearly described the objectives of financial reports. Understandability, reliability, relevancy and comparability are the four prime characteristics of financial statements that help it to meet its objectives. The last section has pointed out the utility of financial statements for general users and its limitations. Investors, governments, financial institutions, financial analysts and mass media are the chief external users of financial reports. Reference Financial Accounting Standards Board. “Facts about FASB”. No date. About FASB. October 27, 2010. . Rezaee, Z. and Riley, R. “Financial Reporting and Financial Statement Fruad”. Financial Statement Fraud: Prevention and Detection. 2nd Edition. John Wiley and Sons. 2009. Rolfe, T. Financial Accounting and Tax Principles. 5th Edition. Elsevier. 2008. The American Institute of Certified Public Accountants. “International Financial Reporting Standards”. 2010. IFRS FAQs. October 27, 2010. . Read More