Financial Statements
This paper is all about financial statements. An introduction to financial statements is presented to give a background to the reader. In the introductory part, the fundamental accounting concepts used in the preparation of financial statements are included together with the explanation of their basis. Examples are also given as an illustration of its application. This consist the first part. On the other hand, the second part is about the evaluation of the role of financial accounting in aiding the decision-making processes of the four different non-management stakeholder groups. An explanation of the nature of these decisions is also included. The paper ends with the issue on the conflicts arising from the diverse interest of the said entities to the financial statements.
Introduction to Financial Statements
One of the steps included in the accounting cycle is the preparation of the principal financial statements. They are the Income Statement and the Balance Sheet. These financial statements are a means by which the information accumulated and processed in financial accounting is periodically communicated to the users. Once the worksheet is completed, it is easy to prepare the financial statements as the necessary data have already been summarized. A third financial statement, which is the Statement of Cash Flows, provides information about cash receipts and cash payments into operating, investing, and financing activities.
A Balance Sheet is a formal statement that shows the financial condition of the business as of a given date. It reports the resources of the business (assets), its obligations (liabilities), and the residual ownership (capital or owner’s equity). The Income statement, on the other hand, shows the results of the operations during a given time period. It summarizes business activities for a given period and reports the net income or loss resulting from operations. It contains the nominal accounts or the revenue and expense accounts.
Fundamental Accounting Concepts
All financial statements should be created, preserved and presented according to the concepts and conventions that follow. Accounting concepts and conventions are the rules and guidelines by which the accountant lives. There are four general accounting concepts, although for some there are even more as each concept is interrelated with the other concepts. The four basic concepts are the going concern concept, accruals or matching concept, consistency concept, and the prudence concept.
The going concern concept is the underlying assumption that any accountant makes in preparing the set of accounts. It means that the business under consideration will remain in existence for the foreseeable future. Hence, it is assumed that the enterprise has neither the intention nor the need to liquidate or curtail materially the scale of its operations. However, if such intention or need exists, a different basis is needed in the preparation of the said statements, therefore disclosing the former basis used.
Second is the accrual concept, or otherwise known as the matching principle. The purpose of this concept is to be sure that all revenues and costs are recorded exactly on the time they happened, on the financial statements of the period to which they relate. Thus, when a profit statement is compiled, the cost of goods sold related to those sales should be recorded accurately and completely in that statement. Costs pertaining to a future period must be carried forward as an advance payment for that period and should not be charged in the current profit statement. For example, payments made in advance such as prepaid rent would be treated this way. Expenses paid in arrears (paid after the period to which they relate) must also appear in the current period’s profit statement. This is done with an accruals adjustment. Through this concept, users of the said statement are not only informed of the past transactions involving the payment and receipt of cash, but also of obligations to pay cash in the future and of resources that represent cash to be received in the future. Hence, they provide the type of information about past transactions and other events that is important in the decision-making process of its users.
Due to the variability of methods employed in the treatment of certain items within the accounting records from time to time, the application of the consistency concept arises. For example, due to the fact that no single rate of depreciation is applicable to all fixed assets, every business has the full preference over its choice of a particular rate. However, he can also do necessary adjustments on it as he wishes, as long as he can explain the necessity of the said change as well as its effects, to be placed on the notes to the accounts being presented.
The last concept is about prudence or otherwise known as conservatism. It is the inclusion of a degree of caution in the exercise of the judgments needed in making the estimates required under conditions of uncertainty. Its purpose is to avoid the instances of overstatement of assets or income and understatement of liabilities or expenses. Although the said practice does not allow the creation of hidden reserves or the exercise of provisions, the deliberate understatement of assets or income, nor the deliberate overstatement of liabilities or expenses. Otherwise, it lacks the quality of reliability due to the lack of neutrality of the financial statements. The preparers of financial statements need to assume the presence of inevitable uncertainties that surround many events and circumstances. Examples of which are the collectivity of doubtful receivables, the probable useful life of plant and equipment, as well as the number of warranty claims that may occur. Such uncertainties are recognized by the disclosure of their nature and extent, as well as through the exercise of prudence in the preparation of financial statements.
Other Important Concepts
Another essential quality of the information provided in the financial statements is that it is readily understandable by users. For this purpose, it is assumed that the users already have a reasonable knowledge of business and economic activities, as well as of accounting. In addition, it is also assumed that the users are willing to study the information with reasonable diligence. However, information about complex matters should not be excluded merely because it is difficult for certain users to understand. This information may be relevant to the economic decision-making needs of the users that need to be included in the financial statements.
For the statement to be useful, the information contained here should be reliable. Information has the quality of reliability when it is free from material error and bias. It either can also be depended upon by users to represent faithfully that which it intends to represent or could reasonably be expected to represent. However, information may be relevant but lacks the quality of reliability, resulting to a misleading recognition. For example, if the validity and amount of a claim for damages under a legal action are uncertain, it may be improper for the enterprise to recognize the full amount of the claim in the balance sheet, although it may be right to disclose the amount together with the circumstances of the claim.
Information also needs to be relevant in order for them to be useful to its users. Information is said to be relevant when it influences the economic decisions of the users. This is through the assistance in the evaluation of either past, present or future events of confirming or correcting their past evaluations. Information about financial position and past performance is commonly used as the basis of predictions on future financial position and performance, as well as other matters within the direct interest of the user. It may include dividend wage payments, security price movements and the enterprise’s capacity to pay its liabilities as they fall due. To have predictive value, information need not be in the form of an explicit forecast. However, the ability to make predictions out of the financial statement is improved by the way the information on past transactions and events are being displayed. For example, the predictive value of the income statement is enhanced if there is the separate disclosure of unusual, abnormal and rare items of income or expense.
Users must be able to compare the financial statements of an enterprise through time in order to identify trends in its financial position and performance. In addition, they must also be able to compare the financial statements of different enterprises for them to evaluate their relative financial position, performance and change in financial position. Hence, the measurement and display of the financial effect of similar transactions and other events must be carried out in a consistent way throughout an enterprise, over time for that enterprise, and in a consistent way for different enterprises. An important implication of the qualitative characteristic of comparability is that users be informed of the accounting policies employed in the preparation of the financial statements, as well as any changes in those policies and the effects of such changes. Users need to be able to identify the differences between the accounting policies for similar transactions and other events used by the same enterprise from period to period and by different enterprises. Compliance with the Statements of Financial Accounting Standards, including the disclosure of the accounting policies used by the enterprise helps to achieve comparability.
The Role of Financial Accounting in the Decision-Making Process of the Non-Management Stakeholder Groups
The four different non-management stakeholder groups interested in the financial statements of an enterprise are the institutional shareholders (investors or owners), the debt holders (also known as bondholders), the government, and the employees.
The shareholders/debt holders are among the major recipients of the financial statements of corporations. They range from individuals with relatively limited resources to large, well-endowed institutions such as insurance companies and mutual funds. The decision made by these parties includes shares to buy, retain, or sell, and the timing of the purchase or sale of those shares. Typically, their decisions have a focus either on investment or on stewardship, although in some cases, it is both. If the emphasis is on the choice of a portfolio of securities that is consistent with the preferences of the investor for risk, return, dividend yield, liquidity and so on, it is said to be investment focus. Otherwise, it is stewardship focus. The required information for this choice varies significantly.
Consider approaches that intend to detect the improper pricing of securities by a fundamental analysis approach compared to a technical analysis approach. The former approach examines firm, industry and economy related information, where financial statements play a major role. An important aspect is the prediction of the timing, amounts, and uncertainties of the firm’s future cash flows. In contrast, it is through the examination of the movement in security prices, security trading volume, and other related variables that the technical analysis is able to detect the improper pricing of securities. Typically, financial statement information is not examined in this approach.
When predicting the timing, amounts, and uncertainties of the firm’s future cash flows, the past record of management in relation to the resources under its control can be an important variable. The analysis undertaken for decisions by shareholders and investors can be done by those parties themselves or by intermediaries such as security analysts and investment advisors.
Employees, on the other hand, are motivated by numerous factors. They might have a vested interest in the continued profitability of their firm’s operations. Therefore, financial statements for them serve as an important source of information regarding the possible profitability and solvency of their company at present, as well as in the future. They may also need them in monitoring the viability of their pension plans.
The demand of the government or regulatory agencies can arise in a diverse set of areas. These include revenue raising (for income tax, sales tax, or value-added tax collection), government contracting (for reimbursing suppliers paid on a cost-plus basis or for monitoring whether the companies engaged in government business are earning excess profits), rate determination (deciding the allowable rate of return that an electric utility can earn), and regulatory intervention (determining whether to provide a government-backed loan agreement to a financially distressed firm.
However, due to the diverse interest of the said individuals to the information contained in the financial statements, conflicts may arise. For the shareholders/debt holders, the interest of these parties lies in the fact that the money invested in the firm is their own money. They would like to ensure that they are getting a good return on their investment. This is measured by looking at how much profit the firm is making and whether their investment is increasing in value. For shareholders in companies, this means they will get good dividends and the market value of their shares will increase. They can also make capital gains, in case these shares will be sold.
For the employees, they are part of the organization. As a part of the organization, they also feel that their efforts contributed to the profitability of the firm. They would therefore be delighted if they will be given incentives to their participation to the company’s achievement. They might prefer to be given bonuses, salary increases, and other form of monetary benefits. They might also prefer given stock options or promotions, depending on the discretion of both parties. However, for the firm’s part, it means increases in the expenses of the firm.
For the government, various ministries and departments have different interest in the firm’s ability to pay taxes. They also see and review the enactment of laws for the industry and the provision of social services to the public. The government may also want to ensure that the firm complies with laws on, for example, wage payments and employee benefits. These are for their benefit, as well as the benefit of the society as a whole.
References
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