Critically review the statement of “the objective of financial statements is to provide information about the financial position, performance and changes in financial position of an enterprise that is useful to a wide range of users in making economic decisions.” (IASB: IAS Framework, 2001)
Introduction
According to the International Accounting Standards Board (2009), the general purpose of financial statements regularly prepared by business firms is to meet the information expectations of a variety of parties outside of the business firm. The wide range of targeted information beneficiaries imply that the underlying framework for financial statements do not only support the organization and reporting of information for purposes of regulatory compliance but also with other non-regulatory interests. However, the usefulness of financial statements is deteriorating or diminishing over the past years. Lev and Zarowin (1999) explained that the importance of financial statements on the part of investors is decreasing relative to other information or sources of information in the market. While the importance of financial statements of purposes of compliance to regulations remains, the importance for other parties have decreased partly because of the relative importance and merit of other sources of company, industry and market information and the concurrent decline in the value of financial statements. The second reason points to the need to assess and improve the framework or standards governing financial statements to increase the confidence of investors and other external parties towards the information value of the contents of financial statements. This re-establishes the importance of financial statements as sources of valuable information to different external parties in support of the dynamism of business firms.
Financial Position and Financial Statements
One of the objectives of financial statements is the provision of information on the current and periodic financial position of business firms in terms of the control of economic resources, financial structure, liquidity and solvency, and adaptability to its business environment. Specifically, the balance sheet contains this information. (International Accounting Standards Board, 2009)
However, there is a strong link between standards and the value of information contained in financial statements. On one hand, effective and sufficient standards likely create high value for information, particularly the financial position, reported in financial statements. On the other hand, ineffective and inefficient standards likely lead to perceptions of the low value of information in financial standards on the part of many external beneficiaries. Hung (2000) explained that in a survey of industrial firms operating in twenty one countries in the early to late 1990s, the use of accrual accounting as against cash accounting in completing financial statements have negative impact on the information value of financial statements. This is mostly occurs in countries implementing standards unable to provide due protection for shareholders. Nevertheless, in countries implementing standards strongly providing strong protection to shareholders, the negative value relationship between methods of accounting and value of information is non-existent.
This implies a number of considerations in the role of financial statements in informing external parties about the financial position of the company. First is dependence of the value of information in financial statements on the accounting method employed. Second is the importance of effective and sufficient reporting standards in supporting the effectiveness of some methods of accounting such as the importance of standards providing due protection for stakeholders in supporting the effectiveness of accrual accounting. Overall, financial statements do not provide automatic or absolute informational value in terms of the financial position of business firms because the value of information depends upon the quality of standards applied.
Moreover, another factor that affects the information value of financial statements in indicating the financial position of companies is the disparity between the intended application of standards and the actual use in informing the public about the financial position of the company. Standards apply as a set of objective guide applicable to all companies for purposes of ensuring the extent of information made public and the use of appropriate methods. Graham, Harvey and Rajgopal (2005) explained the degree of subjectivity involved in the reporting on financial position of the company. A survey of four hundred executives involved in the completion of financial statements that inform the public on the financial position of the company, experience the influence of subjective factors. These motivate their dedication to the reporting of earnings as well as the extent of disclosure. Specifically, managers have the tendency to prefer economic actions even if this means adverse long-term effect on the firm instead of keeping activities within the options for managing earnings provided by GAAP. Seventy-eight percent of respondents admit that they engage in activities sacrificing long-term benefits just to experience smooth earnings in the short-term. With knowledge that these activities would likely reflect during the reporting, many managers experience the sway of the drive to ensure the predictability of information on its financial position, even if the long-term implication may be different. In addition, managers also take concern over disclosure in order to minimize information risk and enhance stock prices but managers also simultaneously exert effort to prevent committing precedents on disclosure expected to be difficult to maintain in the long-term.
The disparity between the expectations of standards for the reporting of financial position through financial statements to be objective shows that even with the existence of sufficient standards, this does not automatically imply compliance and effectiveness in actual practice. The objectivity intended in the development and the subjective interests of managers, that may or may not align with the information interests of different external stakeholders, could overshadow the objective enforcement of standards. Again, reporting standards governing the organization of financial statements do not necessarily lead to the objective information on the financial position of business firms because of the possible intervention of subjective interests.
These areas of weakness of financial statements determines the extent of use of these reporting documents in providing information of value to different external recipients. Perceptions of reporting documents as tinted with subjectivism and ineffective or insufficient reporting standards adversely affect the intended purpose of financial statements in providing information on the financial position of companies of value to different stakeholders.
Performance and Financial Statements
Another objective of financial statements is the provision of information on the performance of business firms, particularly the capability of enterprises to draw profit from the use of resources and investments. Information on profitability is important because this supports expectations of the cash flows of the company in the future relative to existing resources and resource management practices in generating new resources. Information on the performance of business firms is in the income statement. (International Accounting Standards Board, 2009)
Profitability is the basic indicator of performance of business firms pointing to the importance of the income statement as one financial statement. However, there are issues in the information value of income statements to different stakeholders. Kinnunen and Koskela (1999) explained one issues emerging from the informational value of income statements is the disparity between the cash flows reported by the company and the cash flows estimated based on the income statements of companies. A look at cash flow data of different business firms in Finland shows that there is lack of articulation of the implications and meanings of information contained in income statements is common and similar to the situation in the United States. There is also limited articulation of cash flows from investments and other financial activities.
There are two explanations for this disparity. On one hand, a perspective is that the disparities are due to biases in representation but of little importance on the overall value of the information. Income statements could still serve as important sources of information on the performance of the company as long as stakeholders perceive the disparity as inconsequential. On the other hand, another perspective calls for the importance of the disparities since this could affect the interpretation of information and the corresponding actions of stakeholders. Income statements perceived to exhibit strong bias would lack appeal and value to stakeholders likely to experience adverse effects from relying on the information on the performance of the company. This means that the value of information depends on the perspective of stakeholders depending on the expected impact of the disparity between reported and forecasted information on the income statement. It is important for firms to exhibit credibility in income statements to create high informational value for different stakeholders. In addition, standards and guidelines in reporting various items such as cash flows that affect profitability also have important implications on the values and use of information on performance from the income statements of companies to various stakeholders. Although disparities in forecasts and actual reports may vary, it is important for the company to minimize the disparity and thoroughly clarify and explain the disparities.
Black and White (2003) explained another issue pertaining to the value of information in income statements in informing the public about the performance of business firms as the varying relevance accorded to the earnings, which also says something about the standards applied in the jurisdiction. Earnings reports that indicate performance receive greater importance in the United States because of the structure of the accounting system and the stress of the reporting standards. This is different in the case of Germany and Japan, which place greater relevance on book value instead of earnings, because of the greater interest of the market in balance sheet information such as liquidity. The stress on liquidity has something to do with the conservative and credit orientation of the banking system in Germany and Japan.
This implies a number of things. One, the context of use of different kinds of financial statements determines the relative values of these reporting instruments. This means that the value of income statements in informing the public about the performance of business firms depends on the relative importance of the information to different stakeholders depending on the situation in that country. Earnings information found in income statements have greater value in the United States relative to Germany and Japan. Another, the accounting and reporting standards in different countries influence the value accorded to information in income statements. Although, it may be true that income statements provide information on the performance of business firms, the importance of information varies depending on the jurisdiction.
Changes in Financial Positions and Financial Statements
A third objective of financial statements is the provision of changes in the financial position of business enterprises. Information indicating the financial position of companies says something about the investment, financial and operational activities of business enterprises during a given reporting period. The aggregate of this information are able to support assessments of the extent that business firms generate cash and the extent of cash flows. Cash flow statements contain this information. (International Accounting Standards Board, 2009)
However, there are also issues determining the value of information shown in cash flow statements. Bradbury and Newby (2005) discussed one issue as relating to the extent of value of information in cash flow statements on financial analysis. The study derived empirical evidence of the value of information on the changes in financial position of firms to financial analysts. A survey of analysts made to consider cash flow statements of companies showed that information on the change in financial position of companies do not necessarily improve financial analysis. One explanation could be the differences in the standards employed in making cash flow statements. Weak standards likely translate into ineffective cash flow statements or the irregular and voluntary compliance with cash flow statements. Any of these situations adversely affect the value of cash flow statements to different stakeholders. The other is the quality of the statement of changes included by the companies in the cash flow statement. Unclear statements of change in performance carry lesser information value to different stakeholders including financial analysts.
Another issue on the value of cash flow statements in informing stakeholders about changes in the position of the business firms include problems in the creation of cash flow statements. One problem is the clarification of items in the cash flow statements such as on investments and finance activities by placing notes in the relevant spaces for cross-referencing. The reporting of pure numbers carries little value without any notes for stakeholders to understand. Another problem is the due labelling of increases and decreases in current assets and liabilities to ensure informative value. By addressing these problems in the creation of cash flow statements, there emerges greater informative value for different stakeholders.
Overall, changes in the financial position of business firms carry high value different stakeholders, especially investors or shareholders. However, the value depends on the manner of reporting including the provision of notes and clarification of the changes. The manner of communicating or expressing information is as important as the type and methods of presenting information.
Wide Range of Users of Financial Statements
The International Accounting Standards Board (2009) explained that financial statements have various uses to different stakeholders because of the scope of the information required and the objectives identified for different forms of financial statements. Various users of information in financial statements could include creditors, investors, employees, suppliers, customers, and governments. These parties all rely on financial statements to support decision-making. The wide range of information provided by financial statements implied that all information needed by these parties to make sound economic decisions is available from financial statements. The responsibility for creating financial statements lies in the managers of business firms based on information internally collected on its financial activities or operation.
However, this only comprises a general rule and expectation and has exceptions in actual practice. In addition, as general rule, there is need to focus on specific influencing factors such as issues or problems in reporting as previously discussed as well as the relative value of information to different stakeholders. This means that for information in financial statements to be useful, there is need to consider the expectations of stakeholders by following standards as well as best practices. Although, information in financial statements has different uses to different stakeholders, the extent of use differs according to the subjective priorities of the business firm and the operation of standards.
White, Sondhi and Fried (2002) explained that financial statements are important to two general groups of creditors and investors by helping these parties to make sound economic decisions. The use of financial statements to these groups depends on the extent that the information contained represents reality. Accurate representation of reality entails greater use to more stakeholders while inaccurate information has little use of different parties. However, there is also the recognition that financial statements are also merely representations of reality because of two factors. One is the influence of the subjective interests of managers making the report. The other is the influence of the quality of reporting standards existing in a particular jurisdiction. The utility of financial statements also depend on the timeliness of the reporting. Continuous and regular reporting provides information of greater use to different parties as compared to non-continuous and irregular reporting of information. However, there is also common recognition that there is a tendency of firms to delay in reporting depending on expected subjective benefits. This means the concurrent tendency of financial statements to lag behind reality. This affects of use of information statements, especially in situations requiring immediate economic decisions for creditors and investors. Moreover, the use differs for creditors and investors, with creditors focusing more on information on the liquidity of business firms while investors focus on earnings.
Francis and Schipper (1999) explained the utility of financial statements to different parties according to the value expected from the information contained in these reports. One measure of value is the aggregate return potentially earned from having a foreknowledge of information in financial statements. The second measure of value is the extent of explanatory power of different accounting information such as the capability of earnings in income statements to explain yearly market-adjusted returns or the ability of book value or earnings relative to assets and liabilities in explaining the market values of equity. The value of information found in financial statements determines the extent of usefulness to different parties.
Conclusion
It is true that financial statements have different uses to various stakeholders such as in providing information on the financial position, performance, and changes in financial positions of business firms. However, the extent of usefulness depends on various factors occurring in the practical context. One factor is the subjective interest of the business firm that determines the relative value of information to different parties. Another factor is the quality of reporting standards in influencing types of information, methods of reporting, and other rules of reporting that in turn determines the varied utility of information in financial statements to different parties. This has implications on improving the quality of reporting standards since this address both factors.
References
Black, E. L., & White, J. J. (2003). An international comparison of income statement and balance sheet information: Germany, Japan and the US. European Accounting Review, 12(1), 29-46.
Francis, J., & Schipper, K. (1999). Have financial statements lost their relevance?. Journal of Accounting Research, 37(2), 319-352.
Graham, J. R., Harvey, C. R., & Rajgopal, S. (2005). The economic implications of corporate financial reporting. Journal of Accounting and Economics, 40(1-3), 3-73.
Hung, M. (2000). Accounting standards and value relevance of financial statements: An international analysis. Journal of Accounting and Economics, 30(3), 401-420.
International Accounting Standards Board. (2009). The framework for the
preparation and presentation of financial statements. Retrieved January 12, 2009, from http://www.iasplus.com/standard/framewk.htm
Kinnunen, J., & Koskela, M. (1999). Do cash flows reported by firms articulate with their income statements and balance sheets? Descriptive evidence from Finland. Retrieved January 12, 2009, from http://ssrn.com/abstract=193409 or DOI: 10.2139/ssrn.193409
Lev, B., & Zarowin, P. (1999). The boundaries of financial reporting and how to extend them. Journal of Accounting Research, 37(2), 353-387.
White, G. I., Sondhi, A. C., Fried, D. (2002). The analysis and use of financial statements (3rd ed.). New York: Wiley.
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