Financial Statements, Contents and Importance

Financial statements are formal records of organizational financial activities for a given fiscal period. These records quantify and confirm the “financial position, strength, performance, and liquidity of an organization” (Illinois Small Business Development Center, n.d, p. 2). Financial statements account for the financial impacts of business engagements.

Five major types of financial statements are covered in this research to show the contents and importance of these financial records.

Balance Sheet / Statement of Financial Position

The balance sheet or the statement of financial position shows the financial position of an organization for a selected fiscal period. The balance sheet reflects what an organization owns, what it owes, and what is left over after the balancing (Illinois Small Business Development Center, n.d). There are three major components of the balance sheet. First, assets are contained in the balance sheet to show what an organization owns. For instance, plant, machinery, and cash are some of the assets found in a typical company’s balance sheet. Second, liabilities reflect constituents that an organization owes other entities. They include bank loans and creditors, among others. Finally, equity shows what an entity owes the investors. Equity captures the leftover or amount of capital left after all assets are used to pay off all liabilities. Equity, therefore, reflects the variation between assets and liabilities.

Income Statement / Profit and Loss Statement

The income statement is also referred to as Profit and Loss Statement, and it shows a company’s sales and expenses plus its profit (or loss) (Illinois Small Business Development Center, n.d). Simply, the income statement captures an entity’s financial performance based on net profit or loss for a given fiscal year. There are two major components of the income statement. First, income is considered as what an entity as earned for a specific period. Items such as sales revenues and dividend incomes are elements of income reflected in the income statement. Second, expense reflects the cost incurred by an entity during a specific fiscal year. Constituents of expense may be salaries, fixed charges, asset depreciation, and other operating costs. Thus, the result is reflected as net profit or loss after all expenses have been deducted from the income.

Cash Flow Statement

The statement of cash flow reflects the sources, uses, and the balance of cash left for a specific period, such as a fiscal year or month (Illinois Small Business Development Center, n.d). For ease of understanding, constituents of cash flow statements have been classified as “operating, investing, and financing activities” (Illinois Small Business Development Center, n.d, p. 8). Operating activities show cash flow from major business activities. Investing activities represent cash flow from the sale and purchase of assets apart from inventories. Finally, financing activities contain cash flow realized or spent on raising or repaying share capital and debt alongside interests and dividends.

Statement of Changes in Equity

This statement is also referred to as the statement of retained earnings. It shows changes in owners’ equity for a given fiscal period. The change in owners’ equity is noted from the following elements. First, net profit or loss as indicated in the income statement reflects owners’ equity. Second, share capital repaid or issued during a given financial period also shows changes in equity. Third, dividend payments are also other components of owners’ equity. Fourth, revaluation surpluses or losses realized in equity are also constituents of owners’ equity. Finally, changes in owners’ equity may also be realized due to impacts of changes in accounting policy.

Statement of Ratios

The statement of ratios can only be obtained after analysis of a company’s financial statements to reflect its condition after a specific financial period. Ratios are vital for making comparisons of different financial periods or comparisons with peers in the same industry (Illinois Small Business Development Center, n.d).

Information in Financial Statements for Various Stakeholders

The main objective of any financial statement is to offer financial information to any interested stakeholders. Information provided should clearly show the financial performance, position and changes in such position for a given fiscal period. In this regard, contents of financial statements are useful to “several users who require financial information to make informed decisions” (Interfluidity, 2010, p. 1).

Senior executives and managers need financial statements to run organizational affairs and make decisions. Managers can only make sound decisions when they evaluate and understand financial performance and position of their entities. For instance, income statements may provide information required by managers to make decisions on revenue generation.

Shareholders are interested in financial statements to evaluate their potential returns and risks associated with their investments in a given company or industry. Thus, statements that cover financial ratios are critical for making sound investment decisions for shareholders.

Potential investors are also interested in financial statement to allow them assess investment feasibility in a given company or industry. Prospective investors use financial information to forecast dividends by assessing net profits and margins shown in the financial statements (Illinois Small Business Development Center, n.d, p. 11). At the same time, they may also rely on the same information to predict potential risks associated with investments. For instance, variations could show instability and, therefore, significant risks to investors. Investors rely on ratios decide on their investment options.

Creditors and other lending organizations rely on financial statements to assess an entity’s performance and make a choice to advance a credit or a facility to an organization. In this case, the analysis would reveal financial health of an organization and show the chances of a bad loan. Thus, any decision to advance a facility to a business is based on sound asset and liquidity components.

Suppliers also require financial information to evaluate financial reliability of an entity and determine whether a business would be able to pay for goods and services supplied on credit. The ability of the company to repay its debt is vital for suppliers, and this information can be obtained from income statements and balance sheet to determine critical ratios for credit worthiness. Hence, the decision to advance credit is purely based on the company’s financial health.

In some instances, customers have often evaluated suppliers’ financial statement to ascertain their resource base for guaranteed future supplies. Firms that operate in specialized industries with specialized components tend to understand financial positions of their suppliers to ensure sustained supplies.

Employees also require financial statements to assess their performance and profitability, for instance, against competition. Specifically, some employees are interested in financial statements to understand their position and future compensation.

For competitors, financial statements act as basis for understanding their positions in the industry. Consequently, they can develop new strategies to enhance their competitive abilities.

The public may be focused on reports that accompany financial statements to understand how organizations impact the economy, the environment and local people.

Finally, tax-collecting agencies may also be interested in financial information to ascertain the accuracy of the filed returns. These data also assist governments to follow developments in the economy by analyzing various statements from a given industry.

Some of the discrepancies that can appear, be deliberately omitted in these statements

This section covers some discrepancies that have been noted in financial statements. The appearance or omission could be deliberate and, therefore, points to possible manipulation of financial statements. Components such as assets, market capitalization, and owners’ equity among others are prone to exclusion or inclusion. Although independent accounting firms normally audit financial statements to reassure users, it is imperative to review the numbers for any inclusion or exclusion that appears odd (Sageworks Institute, 2014). External auditors provide confidence to users that the statement may be “accurate and only ‘true and fair’ view of a firm’s financial position and performance is reflected” (Sageworks Institute, 2014, p. 1). An audit should detect and resolve any discrepancies noted and, therefore, provides assurance to users. While auditing can provide assurance, information contained in financial statements should not always be taken at face value because of possible intentional or not intentional inclusion and exclusion of certain figures. Analysis of the contents is therefore imperative for users of financial information.

Balance sheet provides a quick snapshot of what an entity owns, its liabilities and equity for a given fiscal period. However, one should go beyond the declared figures to get the actual picture because some common problems are often found in balance sheets (Lister, 2010). In 1997, for instance, organizations were allowed to “capitalize costs associated with internally developed software and amortize it over the useful life of up to five years to reflect development costs” (McGregor, n.d, p. 1). This provision opened a potential path for asset manipulation because these assets are known to be intangible and judgment is often subjective. Consequently, there are possibilities that a company may allocate more expenses to a given development to counter current operating expenses (McGregor, n.d).

Large year-end purchases have abilities to increase the inventory and accounts payable. Consequently, when creditors assess inventory and payable ratios and relate them to other past ratios, the figures may be questionable because they can present stale inventory and poor management of inventory. This situation points to unreliable collateral value (Lister, 2010). At the same time, large year-end sales may also increase the value of accounts receivable and send wrong signals to creditors.

Balance sheet manipulation was detected at Lehman in 2008 under the term ‘Repo 105’ (Corkery, 2010). Using an ordinary repo, Lehman raised cash through asset sales with the promise of purchasing them back later within days. In the balance sheet, they were seen as financings while the assets were never removed from the balance sheet. On the contrary, Repo 105 presented assets worth 105% and the transactions were regarded as sales and, therefore, assets were deleted from the balance, making the balance sheet to appear smaller by billions of dollars. Thus, the balance sheet did not present the actual financial position of the company in the fiscal year 2008. Repo 105 was considered as accounting gimmick and a lazy approach to balance sheet management. Lehman never met the actual quarterly balance sheet targets, but instead used Repo 105 to reduce the balance sheet size at the end of quarter fiscal year. For any rating agencies, the net leverage would not present the critical numbers required to make decisions.

Earnings are prone to manipulation. However, this may not be necessarily an intentional fraud. Rather, it reflects the extent of a wide range of aggressive approaches and interpretation of accounting rules in relation to operating activities. In the end, it is a serious misstatement of the financial performance and position of the company’s results promoted by individuals who were once regarded as honest and could not detect the effect of their accounting rule interpretation until they were analyzed (McGregor, n.d). Expenses have been wrongly capitalized. In this context, they appear as capital expenses and not cost on the cash flow statements. Consequently, it results into an asset that is amortized for the future. In this case, a keen investor should only concentrate on the free cash flow of an organization.

For managers, they have been known to manipulate the fiscal period of activities such that they only want the accounting system to include items in the fiscal year that is most favorable to them. In this case, the practice does not change the long-term aspects of the finance statements. Instead, it affects timing and, therefore, influences comparability of financial statements for a given fiscal period. For instance, an organization might decide to delay reporting in the month of December until April to report higher revenues, sales and profit for the first quarter. While the business would eventually declare sales and profits in the long-term, the approach has only served to increase sales in the near term, but has reduced the expected profits in the future.

In some instances, assets could be lower while liabilities are higher than initially shown (Marks, 2014). In this case, the unfavorable receivable assets are ‘reserved’ but not written off while other assets such as ‘prepaid insurance’ may be an asset, but it will never be an actual asset for the company. At the same time, inventory may not be worthy of the amounts spent on capital equipment repair while maintenance costs are not reflected in the statement. In other cases, the income statement may not capture the cash paid for prior and estimated taxes, unsolved inventory, loan payments, or purchase of machinery. These elements may reflect profitability while there is no actual cash in the bank account.

Businesses often focus on beating some earning projections provided by analysts and industry professionals. As a result, they would significantly grow the market capitalization and increase the value of the stock option. As such, the growth in market capitalization would appeal to investors. To achieve the projections, companies strive to surpass earning projections provided by analysts and the Wall Street. However, when they fail to achieve the targets, they intentionally manipulate earnings to meet the expectations (Rodriguez, 2014). This implies that an entity is most likely to report increased revenues, sales and profits.

Overstating or understating assets or liabilities could affect statement of owners’ equity. For instance, abundant assets depict the company as financially healthy and stable (McGregor, n.d, p. 1). The balance will be reflected in the balance sheet and, therefore, forms a part of the owners’ equity. In this regard, the company is depicted as owned by owners rather than owed. This outcome is achieved when an asset is misrepresented. The entity will not record an equivalent overstated or fictional debt for the fictional or overstated asset. Instead, the company records earnings. When earnings are overstated, then the net income of the company is also overstated, which in turn results in overstated owners’ equity. In this case, misstatement or fraudulent reporting is never reciprocally exclusive. While any asset can be overstated or misstated, inventory, accounts receivable and fixed assets are prone to misstatement or fraudulent reporting.

In these financial statements, the issues of omission and misstatement are critical because they address materiality in accounting information. Thus, any excluded or included information is evaluated based on materiality. That is, whether the information matter or not to users. In some instances, misstatements may be inevitable and preferred. For instance, users rely on income statements to make sound investment decision, management and assessment of performance. It is however noted that an income statement with too much detail could be difficult to comprehend within the larger organizational setup, cumbersome to prepare and could appear technical for users. At the same time, an income statement with too much information may risk exposing an entity’s secret or confidential data. Likewise, financial information is meant to support decision-making and enhance planning. Thus, non-essential information could distract users. Any misstatement or omission, on the contrary, would automatically defeat the purpose of financial statement.

In the US, for instance, the GAAP (Generally Accepted Accounting Principles) has been used to determine what matters in accounting information. Thus, the principle of materiality is necessary for entities when they draw financial statements. Any components that may affect individually or collectively the outcome of financial information and decisions of users are critical for inclusion. Hence, an omission or a misstatement of a component in financial statements should not be taken without due consideration in the surrounding situations because it can significantly influence the opinion of individuals who rely on such information for decision-making (McGregor, n.d).

In this case, industry professionals recommend that users of financial statement should rely on audited financial statements but with caution because of misstatement or omission. Generally, some of these omitted or misstated items could be attributed to abuse of the concept of materiality in accounting information. Consequently, they present serious legal repercussions to accounting firms and their clients. Thus, it is imperative to identify inclusion or exclusion of accounting information based on GAAP standards. Thus, any exclusion or inclusion should not be large enough to influence decision-making process. At the same time, questionable entries in the balance sheet, for instance, should not be too large to draw suspicions from auditors or other users of financial statements.

While inclusion and exclusion may occur during preparation of financial statements, it is imperative to determine factors behind the ‘errors’. Thus, it is necessary to determine the motivation behind inclusion or exclusion of certain items in the financial statement. In some cases, the intent may be to create artificially higher prices to grow market capitalization, inflate earnings or influence merger and acquisitions. These are abuse of accounting principles and the law, which are punishable offences. Hence, when a competitor follows such financial statements without deeper scrutiny, they are most likely to be misled.

The effect of accounting information user perception and judgment is also a point of consideration when evaluating inclusion or exclusion in financial statements. For instance, an indirect entry in labor expense may be openly entered into the direct cost of labor. In this instance, the misstatement may not be necessarily an abuse because it affects costs of operation, and gross profit and margin irrespective of its classification. On the contrary, when a financial statement presents an inclusion that is misrepresented in the gross profit with regard to operating expenses in the wrong line, then this would be seen as a fraudulent entry because the entry automatically increases the gross profits.

Given the limitations of financial statements, which could be intentional or otherwise, an appropriate reporting model should be adopted to minimize errors. According to Jacobs, accounting theoreticians and academics have only concentrated on forward-looking models and replacement-cost-based models with a greater focus on “addressing the limitations of the current model in its prohibition of asset write-ups” (Jacobs, 2000, p. 1). Notably, financial statements do not reflect a firm’s value based on the market capitalization. This is a critical issue because the GAAP value and market capitalization value of a firm may differ. It is known that market capitalization value is prone to rapid decline based on market and litigation conditions among other factors facing an entity. It is not clear whether the current accounting principles can address the issue (Jacobs, 2000).

The GAAP has often strived to resolve some issues in accounting that may lead to misstatement or omission. The decline in long-lived assets, for instance, is a critical issue that is rarely addressed in accounting information. Consequently, many users of accounting information fail to understand the relevance of financial statements, particularly when there are no auditors’ notes for explanation.

It could be difficult to estimate future undiscounted cash flows of a company because the process requires sound judgment. In this case, businesses are expected to make the most reliable estimate by ensuring that only sound and acceptable assumptions and projections are used throughout in a consistent manner. In addition, it is necessary to account for all available materials when developing financial estimates, and by consideration, the evidence presented should be corresponding with the extent to which facts can be evaluated objectively.

At the same time, any impairment losses and write-downs incurred should be declared in the assets based on the fair value of assets.

Financial statements should be useful for the intended users (Interfluidity, 2010). However, when bankers, for instance, find them irrelevant and do not heavily use them, then they fail to achieve the intended use and could show non-financial health of the company. In most circumstances, banks need financial statements from firms to understand specific details such as accounts receivable, monthly reports and accounts payable among others. They are most likely to evaluate statements and financial health of a company based on their criteria by selecting specific figures to provide information on key metrics such as debt to equity to ensure that the business would be able to service the loan. However, bankers have noted that it is difficult to find an issue in the financial statements and, therefore, they tend to focus on the most recent data and even conduct physical visits. This implies that creditors understand the limitations of financial statements, and they, therefore, seek for much information from other sources.

Benchmarking has been important tool for competitors that want to understand their positions. As such, a comparison of the margins against peers in the same industry has always assisted competitors to figure out their position and develop new competitive strategies (Biery, 2013). However, it can be said that the basic sources of information are financial statements. Wrong information is most likely to misled competition, as well as customers who may wish to know whether the business will still meet their demands in the future.

As such, users of financial statements are always encouraged to learn and obtain more information. They can meet accountants and read notes that accompany the statements. By focusing on major metrics presented in the financial statements, users can identify some critical information that may assist in management and decision-making. Besides, other professionals insist that it is necessary to focus on the trends because they provide up-to-date and historical information rather than concentrating on the company’s present position. However, this does not imply that the current position of the company is irrelevant. Instead, it shows that historical data are valuable for decision-making. The company’s management bears the greatest responsibilities for information contained in the financial statements.

Auditors rely on what the company’s management has provided, which is reasonable assurance to do the work. Hence, they believe that the statements are free of material omission or misstatement. This implies that users of financial statements must recognize the ‘reasonable basis’ that guides the entire opinion presented in financial statements. Most importantly for users, including management, customers and competitors, financial statements, including audited ones, do not always reflect the true financial health of an entity. Therefore, it is necessary to assess every single line of items critically and look for other relevant sources of information to understand both historical and current position of a firm.

References

Biery, M. E. (2013). What Are Your Financial Statements Telling You? Forbes. Web.

Corkery, M. (2010). How Lehman Allegedly Manipulated Its Balance Sheet. The Wall Street Journal. Web.

Illinois Small Business Development Center. (n.d). Understanding Where You Stand: A Simple Guide to Your Company’s Financial Statements. Springfield, Illinois: Illinois Department of Commerce and Economic Opportunity.

Interfluidity. (2010). Do Financial Statements Tell the Truth? Web.

Jacobs, A. M. (2000). Understanding Financial Statements What They Dont Tell You. ABI Journal. Web.

Lister, K. (2010). 12 Ways Your Financial Statements Tell Lenders the Wrong Story. Web.

Marks, G. (2014). 6 Things You Didn’t Know About Your Financial Statements. Entrepreneur. Web.

McGregor, S. (n.d). Earnings Management and Manipulation. Web.

Rodriguez, M. A. (2014). The Numbers Game: Manipulation of Financial Reporting by Corporations and Their Executives. University of Miami Business Law Review, 10(2), 451-482.

Sageworks Institute. (2014). Audited financial statements: What they do and don’t tell you. Web.