Financial statements are reports that are prepared by an entity after every accounting period. Financial statements show an entity’s financial position at the end of the period. It also reflects its comprehensive incomes and respective cash flows. The main purpose of financial statements is to provide information to the various stakeholders so that they can make informed decisions. Entities may also use financial statements as a tool for measuring management’s performance. The international financial reporting standards (IFRSs) are the rules that managers follow when preparing financial statements. They include the generally accepted accounting principles and the assumptions used when preparing financial statements. The stewardship concepts paved way for the use of financial statements. The stewardship concept advocates for the separation of ownership and management in an entity (Kaplan and Cooper, 2009).
This concept, therefore, restricts the responsibility of the owners to the provision of resources. Management has the responsibility to manage these resources with the aim of increasing shareholders’ wealth. Consequently, at the end of each accounting period, management is required, at an annual general meeting, to give a full account of the entity’s performance to the owners. Managers do this through the preparation of financial statements. With this in mind, we can now move to identify the various financial statements that each entity is required to present at the end of each financial period (Mintzberg, 2010). The managers cannot exercise their own discretion in determining what to invest in because the company’s resources are all occupied elsewhere. This limits the ability of the managers to respond quickly to the emerging threats and opportunities in the industry. This characteristic of annual budgets limits many companies from competing effectively with others in the same industry.
The accounting standards, (IAS 1), recognize the following types of financial statements: first, there is the statement of financial position. This statement indicates the assets and liabilities of an organization after every accounting period. Secondly, the standards require a firm to prepare a statement of comprehensive income, which compares its revenues and expenses. A statement of cash flows showing both the operating and non-operating cash inflows and outflows is also mandatory. There are, however, other financial statements that mainly act as supporting information to the above-mentioned. These statements include a statement of changes in owner’s equity, disclosure notes, and comparative information. In some cases, the entity may be required to provide another statement of financial position as at the beginning of that respective period (Campbell, 1998).
Before we critically discuss the concept of fair representation, it is of utmost importance to note that, there are certain elements that make up financial statements. The first element is the assets. These resources belong to an entity, they yield future benefits. The second element is liabilities; they represent an entity’s obligations. The third element is equity; it represents the owner’s share of the entity. The fourth element is revenues and expenses; they represent the gains earned and the costs incurred by the firm respectively. The fifth element is cash flows; it represents the cash inflows and outflows of an entity. Lastly, we have the distributions and contributions to the owners. From the discussion above, it is clear that the ultimate rule in financial reporting is that, financial statements must always give a true and fair representation. This goal is only achievable if management follows the accounting policies to the latter (Elliot and Elliot, 2004).
Fundamental Accounting Assumptions and Their Implications on Financial Statements
International Accounting Standard 8 (IAS 8) provides that, for the financial statements to present a true and fair picture of the firm, they must be prepared according to the accounting principles and assumptions. Following is a discussion of these assumptions and their implications on the financial statements. The first assumption is the entity assumption. It assumes that the company is distinct from its owners and other industry operators of the same kind. Its implication, therefore, is that the financial statements prepared relate only to that specific entity and not its owners or other entities (Randall, 1999). The second assumption is the going concern assumption, which assumes that the firm will be in business indefinitely. The impact of this is that it allows for assets and liabilities to be categorized in accordance with their life spans. This is precisely the reason why we have current assets and liabilities and non-current assets and liabilities. If however, management suspects that an entity’s future is uncertain, the international financial reporting standards (IFRSs) require them to make full disclosure of the fact.
The third assumption is the periodicity assumption. This assumption assumes that, since an entity’s life is indefinite, then it should be broken down into smaller periods. In practice, this period is normally twelve months. The impact of this on the financial statements is that management might end up using more accounting estimates and assumptions. This is because, in reality, most transactions normally relate to a very long period. This means that the financial statements will not give a true and fair view and the number of inaccuracies will increase. On the other hand, the periodicity assumption ensures the timeliness of information in the financial statements (Elliot and Elliot, 2004).
The last assumption is the unit of measure assumption. This assumption assumes that money expresses and quantifies every transaction or event in the financial statements. The impact of this on the financial statements is that this assumption failed to recognize the effects of inflation. Inflation is the relentless increase in the general price levels of commodities in an economy. This means that the value of a transaction in a period where there is no inflation cannot be the same as its value in a period with inflation. This, therefore, restricts the stakeholders from making well-informed decisions (Elliot and Elliot, 2004).
Convectional budgets do not foster innovativeness in the management but promote adherence to the budget. It does not encourage continuous improvement. That is managers and workers strive to achieve the set standards to ensure they do not have an unfavorable evaluation. As a result, the quality of goods and services is compromised in the process. Compliance with the budget also results in wastage of resources since the management gives little attention to the need of developing better ways of production and utilization of resources. Operational managers will result in dysfunctional behaviors to ensure they earn their bonuses and that they do not get negative feedback from performance evaluation.
Generally Accepted Accounting Principles and their Implications on Financial Statements
International Accounting Standard 1 (IAS 1) lays down the principles or rules of financial reporting. Following these principles ensures fair representation of financial statements. Just like any other rule, these rules also have their own implications on financial statements. The first principle is the historical cost principle. This principle mainly affects the statement of financial position. The historical cost principle encourages managers to present transactions in terms of their fair values on the financial statements. That is the buying price of the asset and the amounts paid to obtain a liability. The implication of this is that the statement of financial position can only show items at their cost price without taking into account the effects of inflation.
The second principle is the matching principle. This principle provides a way of measuring profitability. The matching principle advocates for the comparison of revenues earned in a specific period with the costs of the same period. This principle mainly affects the statement of comprehensive income. It gives two alternatives for matching the revenues with the costs. The entity may choose to compare the specific revenue with the specific cost that led to that revenue. Alternatively, the entity may sum up all the costs and write them off in the statement of comprehensive income (Elliot and Elliot, 2004).
The other principle provided for by (IAS1.27) is the principle of revenue recognition better known as accounting on an accrual basis. This principle requires management to recognize revenues at the point where earning occurs and not the point where money is received. Similarly, managers should recognize costs at the point where they incur them and not when they pay out the money. However, there are certain guidelines that management needs to follow when applying this principle. There should be some kind of guarantee about the receipt of the money. The costs already incurred to generate the revenues must be of a significant proportion. Lastly, there must be irrefutable evidence that the entity earned that given amount of revenue. However, in some cases, these rules do not apply. An entity may recognize revenue after the receipt of cash, after production in a case where there is a ready market for the good, after cost recovery or during production (Carnal, 2007).
The fourth principle is the objectivity principle. Here, an entity is required to prepare financial statements that are unbiased. The financial statements should be fair to the extent that, any third party contracted to review them, should come up with the exact same information. The fifth principle is the consistency principle (IAS 1.39). This principle requires entities to treat similar transactions and events in the same way in every accounting period. This increases the usefulness of financial statements as it enhances comparability both internally and externally. It also makes it possible for the management to carry out trend analysis. Another principle is the full disclosure principle, which requires an entity to disclose all the relevant facts that may influence a stakeholder’s decision. This principle mainly stresses the importance of disclosing the different accounting policies adopted by the entity. Managers practice full disclosure through the financial statements or notes of disclosure.
It is important to note that there are other modified principles. They include the principle of materiality, the conservatism principle, and the industrial peculiarity principle. The principle of materiality requires managers to include the items that could affect a stakeholder’s decision only, in the financial statements. The other modified principle, the conservatism principle, provides guidelines to management in a case where the entity has to make a decision between two equally acceptable alternatives of different values. In such a situation, managers should take the alternative with the lesser value. This prevents the unnecessary overstatement of values in the financial statements. The last principle is the industrial peculiarity principle, which calls for the consideration of an industry’s uniqueness. Financial statements that are therefore prepared according to these principles and assumptions possess the quality of faithful representation. Consequently, they also possess the important qualities that ensure stakeholders have useful information for decision-making.
Qualitative Characteristics of Financial Statements
For financial statements to give a true and fair view, they must possess the most important qualitative characteristics. The International Financial Reporting Standards (IFRSs) clearly give the major characteristics that financial statements must possess for them to give a true and fair representation. It is important to note that an entity’s stakeholders include its customers, creditors, its owners, the government, and investors. Content-related characteristics and presentation-related characteristics form the two major categories of qualitative characteristics. Relevance and reliability make up the content-related characteristics. Relevance means that the given information shown on the financial statements should be good enough to influence a stakeholder’s decision. Relevance draws from the materiality principle (Maskell and Baggaley, 2003). It also means that the people involved should find it important to them. This includes stakeholders, managers, and the public who may have an interest in investing in the company.
Relevant financial information must have three components beneficial to a stakeholder: predictive value, timeliness, and feedback value. Predictive value means that the stakeholder should be able to use the given information to make decisions about the future. Timeliness on the other hand means that the stakeholder should have the required information when he or she most needs it and not earlier or later. Feedback value means that the information provided should be good enough such that the users are able to voice their opinions about that information (Millmore, 2007).
Reliability means that the information provided should be very precise such that it gives no room for misinformed decisions on the user’s part. In other words, it should be dependable. Reliability draws from the consistency principle. Reliable information must have some crucial aspects helpful to the stakeholders. This includes substance over form, completeness, and neutrality. The information must also be verifiable and maintain faithful representation. By faithful representation, we mean that the information provided should give the real picture of the organization. That is, the information given should relate to that specific organization and it should not be a form of misrepresentation designed to dupe the users (Jones, 2008).
Completeness means that the financial statements should be complete. All the items provided for by IAS 1 should be present. There should be no omission of information unless it is immaterial. Objective information is information that is free from any biased perspectives. Consequently, objective information is verifiable. This means that if a third party were to review the same financial statements given the same information, they would make the same conclusions. Substance over form means that the economic substance of a transaction should always take precedence over its legal form (Brimson, 2010).
Financial statements need to be comparable (IAS 1.38) and understandable for them to possess presentation related characteristics. Comparability draws from the consistency principle and the full disclosure principle. For the information presented by the financial statements to be comparable, managers have to make sure that for every financial period, they treat similar items in the financial statements in the same way. This is in line with the principle of consistency. This enhances the usefulness of financial statements. It gives managers the option of using the financial statements for internal trend analysis. In addition to this, it allows for comparisons with other entities in the same industry (Larson, 2004). Full disclosure requires managers to disclose all the relevant information either by way of disclosure notes or on the face of the financial statements. This is important because two entities comparing each other may not use the same accounting principles for example depreciation. Lack of full disclosure may therefore create the wrong picture, making an accounting entity too comfortable or too uneasy (Nokes, 2000).
For financial statements to be understandable, the accounting entity must consider many things. They must consider the target group, the users of their financial statements, and their respective abilities. In principle, entities assume that the people using the information from the financial statements possess some knowledge on the subject. However, managers should be aware that, for example, the knowledge possessed by a customer is not the same as that possessed by say an investor. Managers should tailor their financial statements accordingly in order to meet the expectation of all its users. The user should be able to obtain the relevant information that they need for their decision-making. The International Financial Reporting Standards (IFRSs) give the above qualities as the minimum requirements financial statements should have for the information provided to be true and fair (Horngren, Sundem, and Schatzberg, 2010).
The Concept of Creative Accounting
As mentioned above, the ground rule in financial reporting is that all financial statements should be prepared in a way that they give a faithful representation of the accounting entity. We further mentioned that, for this to be done, financial statements have to be prepared in accordance with the accounting standards. Creative accounting, as the name suggests, is an accounting technique where the managers alter the values of financial statements in accordance with the accounting standards. This whole concept depends on the loopholes that exist in the accounting standards. Therefore, while according to the accounting standards the information presented is correct, the information is not a true and fair representation of the entity (Armstrong and Kotler, 2011).
Managers normally use creative accounting to create the illusion that the entity is doing well or it is in a bad position. Managers may use creative accounting for various reasons but the main one is to influence the users’ decisions. Other reasons include personal gains or retaining the current market position. Managers achieve personal gains through bonuses or capital gains. However, we should note that, while the managers may overstate or understate the figures, the disclosure notes normally reveal the real figures. Creative accounting can take various forms. The first form is overstatement or understatement of revenues and consequently profits. Overstatement of profits and revenues has the effect of making the company seem like it is doing very well. This may lead to a rise in its stock price and managers may use this opportunity to make capital gains. Overstated profits also influence investors to invest in your company. In addition, overstatement allows managers to take home larger bonuses (Heuser, 2010).
On the other hand, managers understate revenues and profits to avoid paying high taxes to the government. Overstating may be due to understating of the costs incurred and understating may be due to overstating the costs. Creative accounting also takes shape where managers give wrong values for their liabilities and debt. They do this to dupe creditors into giving them more loans. Creative accounting also takes the form of large reserves and provisions. Managers do this to create the illusion that the entity is making a large number of profits. This illusion of high returns serves the purpose of luring investors (Friedlob et al. 1996).
Conclusion and Comments on the Discussed Issues
Through this discussion, it is evident that the manner in which managers prepare financial statements is very crucial to both the entity and the stakeholders. It is also evident that financial statements must possess certain characteristics. Due to the importance accredited to the financial statements by its various users, managers must ensure that they remain a faithful representation of the entity. The information provided in the financial statements must not be the cause of a user’s wrong decision. The international accounting body should never compromise on these qualities, as this could prove detrimental to stakeholders (Betzig, 2006).
The accounting body should put in place strict measures and policies to ensure quality remains the driving force in the accounting profession. To curb creative accounting, professional bodies should establish a system that allows for the constant review of the accounting standards. The accounting body should strictly punish managers found guilty of this crime. Managers should also take responsibility and shun the use of this accounting technique despite its allure. The use of sound accounting techniques will ensure that financial statements prepared by accounting entities give a true and fair view. Managers must always prepare financial statements with the stakeholders’ best interest at heart (Friedl et al. 2005).
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