The Objective of Financial Statements
What are financial statements? A financial statement is a document produced yearly which shows the profit or loss that has been made during that period of time. These details are presented in two statements. (Thomas & Ward 2009)
The first statement, which is the income statement, provides details on the profits or losses made by the entity. For example, financial statements are able to show a company's financial position, operating results, and changes in financial position from time to time. It helps investors and creditors look at past financial performances, predict future performances, and ensure sufficient cash flows for daily operations through the report of the income and expenses.
The second statement, which is the statement of financial position (balance sheet), provides information on the financial position of the entity. A balance sheet is often known as a "snapshot of a company's financial condition". (Williams et. al 2008). A standard entity's balance sheet has three parts: assets, liabilities and ownership equity.
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Question 2: Users of Financial Statements
Financial statements are basically prepared to provide useful information for economical decision making. Specifically, the data from the financial statement is helpful in making investments and credit decisions. These data are to provide information to specific users, such as investors, management and lenders.
Investors are known as someone who provides capital to make a profit. Investors require information to help them assess capability of investing in a business. Shareholders on the other hand, require information to enable them to assess the ability of the business to pay dividends. (Thomas & Ward 2009)
Investors look at the performance of the business and its management in terms of profitability and sale figures. The purpose is to see the effectiveness of the business in achieving its goals.
Investors also look at the efficiency of the business. This is to evaluate on how the business is making best use of its resources and to see that it is generating adequate sales from its investment and capital.
Investors require information to assess the stability and vulnerability, including liquidity of the business to see the long-term prospects of the business. The structure of the business' finance also shows if there is a burden to invest on the business; whether there is enough cash flow to pay its debts. Therefore, investors require information to see the future position of the business whether or not it is generating sufficient resources to repay its liabilities.
Investors also look at the area of investment returns. The purpose is to predict future scenarios of the business, including the returns that the investor or lender expects to get out of the business. For example, its capacity to pay dividends. Other than that, investors also require these information to compare with similar investments in other entity's.
One of the duties required of management is to prepare financial statements that give an honest view of the company's affairs and its financial position at the end of the period. This is to ensure that they agree with the terms of the accounting standards and legislation. For the business to run smoothly, managers of the organisation need the financial reports to make business decisions from past performances and to decide their future projections. (Thomas & Ward 2009) For example, financial statements are used to formulate contractual terms between the company and other organisations to provide a clearer view of the financial position of the company.
Lenders are someone who gives loans or credit in business matters with the expectation that the money borrowed will be returned, with interest, in a period of time. Lenders require information from the entity's financial statement to decide if their loans and the interest added to them, will be repaid when due.
Lenders usually want to know the position of cash flow of the business; this will determine whether the company will be able to repay the annual interest and the loan taken when due.
Lenders also want information about the stability and vulnerability of the business as this will proof the possibility of failure to pay the money that was borrowed by the company. Previous business experience or past claims on the company's assets are also some of the information important to the lender; as it proofs liquidation of the company. (Thomas & Ward 2009)
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Question 3: Qualitative Characteristics of Financial Information
Qualitative characteristics are attributes that make the information in financial statements useful to the users. There are four principal characteristics that are found in financial statements. (Thomas & Ward 2009)
Accounting information should be understandable to the users of the information. The information would tend to lean towards less complexity, for users to know its meaning. For the information to be understandable, information contained according to standard disclosure formats must be transparent (clearly disclosed) but without sacrificing relevance or reliability.
The information is relevant when it has the ability to make a difference in the decision making of the users. The information should help users make decisions about the allocation of resources, such as helping them predict outcomes of past and future events, or improve their past evaluation. (Thomas & Ward 2009)
Information given should be relevant to the users, as it affects their decision making. Financial information should be reliable to the users; meaning that the information can be depended on without bias or unnecessary errors, if not it will be useless or misleading. The information is to be represented faithfully on any transaction or event it claims to represent. (Johnson 2005)
For information to be useful, the financial information given must be able to differentiate and evaluate the similarities between aspects of the entity and other companies or industries. It must allow comparisons one time and over time across competing interests. However, to compare, consistency is to be expected. (Qualitative Characteristics of Financial Information 2001)
Question 4: Limitations of Financial Statements
Although financial statements service the needs of the users and also the qualitative characteristics that financial information should have, there are some problems that are associated with the terms of the financial information, as if they achieve the objective of financial statements or not.
i) Emphasis on Future
Planning is an important part for the management; therefore needing a more future orientated financial information. On the contrary, financial statements mainly provide summaries of past financial transactions (historical cost accounting). These summaries may be useful in economic decision making, but only to a certain extend. The future does not only reflect of what has happened in the past. Although we may see profit & loss, the info will not guarantee future profit. Changes are always taking place in economic situations, political, business needs, and etc. Users are interested in what will happen rather than on summaries of what has already happened.
ii) Relevance of Data
Financial accounting data should be objective and provable. By relevant, I mean suitable for the problem at hand. Financial statements lack of non-financial information. For example, it is difficult to verify approximate sales for "Maxis Bhd", but this is exactly the type of information that is most useful to the users in their decision making, as they need to fix the price and quantity of the products they supply. Users need information about performance of the entity in order to assess its ability to provide rewards. The financial information should be flexible to provide any data relevant for economical decision making.
iii) Less Emphasis on Precision
Relevance is often more important than precision to managers. A decision involving millions of dollars does not have to be based on estimates that are precise down to the cents or even a dollar. Estimations accurate to the nearest million dollars may be exact enough to make a good decision. Since precision is costly in terms of both time and resources, financial accounting should place less emphasis on precision. In consequence, they should concentrate on non-financial information, such as, information about customer satisfaction. This also will result in the image of the entity; giving a bad or good image. (Difference between financial and Managerial Accounting)
iv) Segments of an Organization
Financial accounting emphasizes on reporting for the company as a whole. Financial accounting does include revenues and cost by major parts in external reports, however, information of each sector is not given. Therefore, I think that it should also include more parts of the company. For example, product lines, sales divisions, or any other parts that the management find useful for decision making.
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v) Generally Accepted Accounting Principles (GAAP)
Financial statements prepared must be according with the generally accepted accounting principles (GAAP). Users must have guarantee that the reports have been prepared in accordance with a set of regulations; this is to show comparability and help reduce fraud and misrepresentations. However information such as current market value is not included in financial statements thus, ignored under the GAAP; because the GAAP only requires the historical cost. The current market value is vital information as it shows where the entity is standing; which makes it important to the users. (Difference between financial and Managerial Accounting)