Financial Reporting and Analysis - Literature review Example

Financial reporting and analysis Contents Contents 2 Introduction 3 Discussion 3 Answer 3 Users of the Financial Reports 6 Owners 6 Employees 6 Lenders 6 Suppliers 6 Customers 6 Government 7 Public 7 Answer 2 7 Conclusion 10 References 10 Introduction Conceptual framework is a new concept. Many companies have used existing accounting standards without using conceptual framework in place. This made accounting standards often being in haphazard state and it changed largely due to frequent scams or scandals occurred in the company. Basically it was a result of reactive action as compared to proactive campaign. This lack of unified conceptual framework increased the risk of such standards being inconsistent with each other, which resulted in no single objective for preparing financial statements. Conceptual framework for financial statements increased the robustness of the statements, while ensuring consistency in future development of the standards. It can help the users of the financial information in correctly interpreting them since it is provides an understanding of the principles on which the statements are prepared. Hence it is of the view of many leading experts that maintaining consistency should be the priority of many nations. Conceptual framework should be the key driver for development of many accounting standards. In real life economic, political and social factors play an important role in influencing the guidance needed by the standards. Situations like credit crunch and accounting scandals will continue to influence the standard setting procedure. This report takes a look at the importance of financial statements to its several users and the key components of the financial statements and its relevance to the intended users. Discussion Answer 1 In today’s world all accounting system uses the capital maintenance concept. It forms the basis of unit of measurement and value of assets. Capital maintenance is a key concept in measurement of total profit calculated. Accounting profit is defined as the difference between the capital of the company at the start of a period and at the end. Profit can only occur when a company’s capital base increases over and above the necessary initial capital needed to start the business. Hence total accounting profit can be calculated once the definition of capital is established. There are two concepts of capital maintenance. One is financial capital maintenance and other is physical or operating capital maintenance (Accounting Standards Board, 2010, p. 211). Operating capital maintenance though can be measured in many ways it ensures that the operating capacity of the business is preserved. Financial capital maintenance aims to conserve the funds which the shareholders have invested in the firm. Financial capital maintained can either be in monetary value of the capital which is attributed to the shareholders or a value which is adjusted by the purchasing power index so as to maintain capital as a fund of real purchasing power. The main difference between them is the way the change in the price of assets and liabilities are treated. Generally an entity can maintain the capital on condition that it has much capital is the end of a period as it has at the begging. Any excess amount over it is called as accounting profit (Maynard, 2013, p. 162). Financial capital maintenance is a concept where the capital is defined in nominal monetary units. Here profits represent an increase in nominal money capital over a period of time. Hence any increase in asset prices over a period of time is known as holding gains or profits. In case the concept of financial capital maintenance is defined in terms of constant purchasing power units, then any increase in the invested purchasing power will represent the profit (Weygandt, Kieso and Kimmel, 2010, p. 73). Hence any part of increase in the prices of assets which exceeds the general increase in level of prices is known as profit. The rest of the increase is known as capital maintenance adjustment which forms part of equity. When capital is defined in terms of physical productive capacity, profit under operating capital maintenance represents the increase of the capital in a period. Hence all forms of price change which has an impact on the assets and liabilities of an entity is considered in the measurement of physical productive capacity of the entity (Godfrey and Chalmers, 2007, p. 84). Hence clearly the selection of the concept of capital maintenance and measurement bases determines the accounting model used while preparing the financial statements. Different accounting model will give different degree of reliability and relevance and the work of management is to balance out them. Financial reporting is not an end. The objective of providing general purpose financial reports is to give useful information to the users of it. Hence the objective of a financial reporting is determined by the users of the financial statements. The aim of financial reporting is meeting the information needs of users who are primary to the group. The primary users are those individual who have a claim or may have a potential claim. These user groups are interested in financial information because it is needed to make the decision of providing capital to the company. Hence users like lenders, creditors, equity investors look up to this source of information. The decision of these individuals include whether to allocate and how much to allocate the resources to an entity (Walton, 2011, p. 176). It will provide them with information needed to realise key decisions like whether their investment will increase or not. While making these decisions, the capital providers are keen on assessing the ability of an entity to generate cash inflow and the level of management’s efficiency. They basically look at the information of an entity’s resources, claims they have on their resources, any changes which may affect the resource or claims on it. They include all these things as input into the decision making process. According to IASB Framework, there are many users of financial report. These include investors both present and potential, lenders, employees, customers, trade creditors, governments etc (Mirza, Holt and Knorr, 2011, p. 121). Users of the Financial Reports Owners They need information to make decisions regarding their capital investment and the efficiency of the management in running the business. They also make judgements about the level of risk and return they might have to take in the future. Hence they need financial information to assess the repayment ability of the entity in terms of dividend (Morini, 2011, p. 129). Employees They are also interested to know the profitability and stability of the company. Hence they also need information to assess the ability of the company to pay remuneration, employment opportunities and retirement benefits (Fridson and Alvarez, 2011, p. 192). Lenders They want to assess the ability of a company to pay their obligation which comprises of the loan amount together with the interest. Suppliers They need information to assess whether the company will be able to repay the amounts owed to them. They are interested over a short period of time as compared to lenders. Customers They are interested about the continuation of the entity in case they have a long term relationship with the entity. Government They need information to regulate the activities of the entity. They want to see if the entity has complied with the agreed pricing policies, tax policy, source of financing etc. It helps them in assessing how much of income tax they have to pay this year as well as in the coming year (Wild, Subramanyam and Halsey, 2006, p. 75). Public In case any entity has a substantial contribution to the local economy then it impacts a large section of people by providing them employment. Hence such information may give these people a sense of recent development and trends of the entity. Answer 2 Financial statements indicate the financial effects of events and transaction by grouping them into broad classes. The elements are divided into two broad groups The first group is related with the measurement of the financial position of the entity. It is indicated by liabilities, equity and assets (Drake and Fabozzi, 2012, p. 131). The second group is concerned with the measurement of performance which includes expenses and incomes. Within these groups there can be many sub-classifications. Assets Asset is resource which is owned by an entity. It has future expected benefits which is very important for a firm. There are many assets which exist in physical form, like plant, property, equipment etc. Others exist in non-physical form like copyrights, patent whose future benefits are expected to flow throughout their lifetime (Sinha, 2009, p. 61). Liabilities Liability represents an obligation of an entity to another individual. It results in outflow of resources for the entity. Some liabilities are legally enforceable because of statutory requirement or contract. If an entity possess large amount of liability, it becomes a burden to the entity (Wahlen, Baginski and Bradshaw, 2010, p. 69). Equity Equity is the residual amount left after liabilities have been subtracted from the assets of the entity. Within the entity, it can be sub-classified into various types of reserves and capital like statutory reserves, retained earnings, tax reserves, general reserves etc. Such kind of classification the equity helps the users to take decision regarding investment. It may also signify that parties with ownership interests will have different rights with respect to receipt of dividends (Walton, 2000, p. 132). Performance Performance of an entity can also be measured in terms of assets and liabilities. Any increase in assets or decrease in liability indicates Income. Conversely expenses are measured by decrease in assets and increase in liabilities. The incomes and expenses are presented in ways so that it helps in the decision, making process. In the income statement, the expenses and incomes are grouped into groups so as to identify which elements have direct impact on the operation of the entity. For example income statement may reveal the gross profit margin, net profit margin, operating activities and non-operating activities. All the above elements are useful to evaluate the decision making process of a stakeholder. It enables the users to identify their resources and the claims to the resources at that time period. It provides information like the extent to which management is carrying out its responsibilities of managing the resources and safekeeping it. It also indicates the resources which are available to the entity for supporting future delivery activities and changes during the time period. It also indicates the timing and amount of future cash flow which are important for repaying existing claims. The information about the cash flow helps in assessing the solvency and liquidity of the company. It shows how funds are raised and cash used during the time period, whether funds are borrowed or it is achieved from sale of property. It also indicates the source of cash received like from government, international organisation etc. It also indicates all the areas where the cash are spent and whether it is in according to spending mandate decided in annual general meeting. Financial statements assist the users in understanding, interpreting the information. Financial reports also provide financial and non-financial data which is helps the users to check whether the entity is performing under the approved budgets. Resource providers also need information to assess matters which it important to them. These include achieving objectives which are promised. The users want justification of the resources which are raised during the reporting period. The fund raised from current operations during the time period of is looked after (Robinson, Munter and Grant, 2004, p. 92). Whether the entity needs additional resource in the future and what can be the likely sources of those resources. Creditors and Lenders will need financial information to assess the liquidity of the entity and whether the time of repayment will remain the same as was agreed. Donors will need information to look at whether the resources acquired are effectively, economically and efficiently used. They also require information about the future service delivery of the entity and the amount of resources needed fort that purpose. This helps the stakeholder in understanding the entity in which they are interested and whether they will maintain long term relationship with them. Conclusion Financial reporting is compulsory and is done in all the companies. It helps the stakeholders of a company in generating useful information which are needed by them in maintaining a long tern relationship with the entity. Financial report consists of many items which hold significance to the users. Users need to analyse the information out of the report so that they can extract out things which are needed for them. Conceptual framework is the key driver for development of many accounting standards. In real life economic, political and social factors play an important role in influencing the guidance needed by the standards. References Accounting Standards Board. 2010. The Future of Financial Reporting in the United Kingdom and Republic of Ireland. London: ASB. Drake, P.P. and Fabozzi, F.J. 2012. Analysis of Financial Statements. New Jersey: John Wiley & Sons. Fridson, M.S. and Alvarez, F. 2011. Financial Statement Analysis: A Practitioners Guide. New Jersey: John Wiley & Sons. Godfrey, J.M. and Chalmers, K. 2007. Globalisation of Accounting Standards. Massachusetts: Edward Elgar Publishing. Maynard, J. 2013. Financial Accounting, Reporting, and Analysis. Oxford: Oxford University Press.\ Mirza, A.A., Holt, G. and Knorr, L. 2011. Wiley IFRS: Practical Implementation Guide and Workbook. New Jersey: John Wiley & Sons. Morini, M. 2011. Understanding and Managing Model Risk: A Practical Guide for Quants, Traders and Validators. New Jersey: John Wiley & Sons. Robinson, T.R., Munter, P. and Grant, J. 2004. Financial Statement Analysis: A Global Perspective. New York: Pearson/Prentice Hall Sinha, G. 2009. Financial Statement Analysis. New Delhi: PHI Learning Pvt. Ltd. Wahlen, J., Baginski, S. and Bradshaw, M. 2010. Financial Reporting, Financial Statement Analysis and Valuation: A Strategic Perspective. Mason: Cengage Learning. Walton, P. 2000. Financial Statement Analysis: An International Perspective. Mason: Cengage Learning. Walton, P. 2011. An Executive Guide to IFRS: Content, Costs and Benefits to Business. New Jersey: Wiley Weygandt, J.J., Kieso, D.E. and Kimmel, P.D. 2010. Financial Accounting: IFRS Edition. New Jersey: John Wiley & Sons. Wild, J.J., Subramanyam, K.R. and Halsey, R.F. 2006. Financial Statement Analysis. New Delhi: Tata McGraw-Hill Education Read More