Definition of financial statements and what they seek to achieve
Financial statements are formal and original reports prepared to disclose the financial health of a business in terms of the profits, position and prospects on certain data. In essence, they summarize the overall performance of a business through logical and systematic collection of data (Thurkaram, E. 2003, 18). Another definition of financial statements would be documents presenting an organized collection of financial information and prepared in accordance with the accepted accounting and reporting norms. These statements are the end products of the accounting process and are prepared periodically from accounting information as the final accounts (Rachchh, M. 2011, 3). They come in handy in the decision making process for all stakeholders.
Thurkaram, E. (2003, 18) and Rutherford, B. A. (2000, 16-19) explain that financial statements seek to achieve the following objectives:
- To provide reliable information about economic resources i.e inflow and outflow of cash.
- To provide the net result profit or loss of an enterprise arising from its activities.
- To provide financial information that assist in earning capacity of the business.
- To provide other needed information about changes in economic resources or obligations such as change in working capital, fund flows etc
- To provide other information related financial statements to others who are in need of it.
Importance of companies publishing financial statements
According Fridson, M. & Alvarez, F. (2011, n.p) the primary function of financial statements is conveying the financial ability of a company in order to measure the profitability and the state of the company. In case the future seems bleak, the financial statements reveal where the managers need to make changes in the company. Therefore financial statements are the best way to see the future performance of a company (Kline, B. 2007, n.p)
The reports have to be publicized in order to provide information for decision making for the interested parties in the business enterprise such as the management, investors, prospective investors customers, creditors among others (Thukaram, E. 2003, 19). The financial reports need as much information as possible in order to meet the needs of every shareholder/stakeholder in the business.
Benefactors of financial statements
- The management: the information provided by financial statements enables managers to formulate their policies as well as discharge their day to day activities of the business. When a comparative study of the financial statements is done over a period of time, the managers are able to know the trends and modify the policies accordingly to avoid unfavorable situations.
- Shareholders: These are people who own the share capital of the company. They rely on the financial statements in guiding them to know the profitability and future prospects of the company.
- Creditors and suppliers: they provide loans to the companies and supply goods on credit therefore rely on the financial statements to know the liquidity position of the business and its ability to pay debts.
- Tax authorities: the calculation of the tax payable by the company is depends on the income given by the financial reports of the companies. Both the direct and indirect taxes are based on information provided by the financial reports.
- Employees and trade unions: the income statement as dispalayed in the financial reports show the organization’s profits thus determining the wage fixation policy and payment of bonus to employees.
- Customers: they basically depend on the price of products. The cost of production, profit margin, selling price as revealed by the income statement guides the customers in selecting the suppliers.
- Financial analyst : They use the information given by financial statements to give expert adv ice to their clients who are seeking to invest in particular companies
- Stock exchange: Financial statements are important to companies which seek to list their securities within the stock exchange. These reports are used by the stock exchange to quote the price of shares for the benefit of shareholders and other people.
- Regulatory Authority: based on the performance of companies, the regulatory authorities such as the Company Law Board, the Registrar of Joint Stock Companies amend the statues depending on the prevailing environment of the companies.
- Press: Financial reports give the basis of economic and commercial journals reporting on the performance, position and prospects of companies for the benefit of prospective investors.
- Trade Associations and Chamber of commerce: they use the financial statements of various companies to supply to their members.
- Government: they rely on financial statement to formulate policies relating to taxation, price, wage, income and national plans.
- The general public: they rely on the financial statements to know the extent of social responsibilities of business towards the society
Criticisms of financial statements
McLaney, E. & Atrill, (2010, 16) explains that over the past 25years the business environment has increasingly gotten turbulent and competitive bringing about challenges for managers and other users of accounting information. This has led to the changes in financial accounting and management accounting in order to address the needs of users thus the radical and complex review of the kind of information to include.
The increasing complexity and diversity of financial statements presents several challenges. Thukaram, E. (2003, 22) presents the following challenges of financial statements:
- Financial reports are basically interim reports but not the final report of the financial position of an organization / business. They reflect the progress of the business at intervals but the exact financial strength of a business can only be known w hen the business is either sold or liquidated.
- It only reveals quantitative information leaving out lots of qualitative information which are equally important to the company since they cannot be expressed in monetary value. Such information would include employer-employee relationship, reputation of the management and employee performance.
- Historical data: the information given by financial statements are based on past data. Future events are not included in the financial statements thus not very efficient in making future decisions. They offer limited insight on the future prospects of a company
- Financial statements are based on accounting concepts and conventions: some financial concepts such as the going-concern and the convention of conservatism are unrealistic. Some elements of finance are either included or left out such thus distorting the profit and loss accounts.
- Are biased and subjective: the accuracy of financial statements is determined by the personal judgment of an accountant. This would include the choice of method of depreciation, mode of amortization of fixed assets, treatment of deferred revenue, expenditure, the method of pricing material issues. This often distorts the true picture of the business.
- Window dressing: They are vulnerable to human interpretation and error and intentional manipulation by accountants or organizations to inflate their market performance. Sometimes organizations would want to conceal the accurate information concerning the organization in order to portray a good image about the organization to the public and especially its customer and investors. They would therefore window dress the organization and reveal a misleading picture for the public consequently this minimizes credibility and maximizes on the error of the financial statements.
- Different ways of accounting activities across time periods and across companies makes comparisons difficult. There are different accounting frameworks and policies due to diverse set of accounting policies thus making the preparation of financial statements difficult and hampers the comparability. Use of frameworks such as IFRS, US, GAAP in different geographical areas makes financial statements diverse. Some frameworks such as IFRS allow the preparer to use policies that reflect on the circumstances of their entities. (Accounting-Simplified.com, 2013, n.p)
- Use of estimates: Estimates are sometimes used in instances where the exact figures cannot be established. Such values are mostly subjective since they lack precision and cannot be verifiable thus reduce the reliability of the financial information.
- Verifiability: Auditing is conducted once financial statements are prepared but this does not really give an assurance of the absolute truth of financial statements. The inadequacy of auditing means that certain misstatements may still remain undetected.
Should company managers simply concentrate on keeping shareholders happy?
A shareholder is a person or entity who owns shares in an organisation or company. They are entitled to receiving dividends or any cash pertaining to an organisation when it is sold. On the other hand, a stakeholder is anyone who is interested in the success of the organisation or company. It may include shareholders but goes ahead to include creditors, customers, employees, the government and the public.
Companies are often found at cross roads on which category to satisfy most: whether to consider the stakeholder interest over shareholder interest or vice versa. From time immemorial, shareholders have been considered to be the most important people in the organization since they are the owners. However, this trend is gradually changing with organizations realizing that their success is dependent on the stakeholder satisfaction (Phillips, R. 2003, and v). An organisation would never succeed if it stood on its own. Several constituents of the organisations should be put in mind when making decisions as to what activities the company should engage in. Phillip, R. (2003, vi) further explains that businesses need to be based on fairness. All the elements of an organisation have to be attended to. Stake holder management consequently leads to improved shareholder value (Solomon, J. 26).
This means that the traditional wealth maximization objective of a business may become diluted over time, in favor of other initiatives more favorable to stakeholders (n.p). Creating value for stakeholders by focusing on maintaining value for local communities, employees and environmental impacts may be synonymous with creating value for the shareholders. Ignoring the needs of stakeholders can lead to lower financial performance of the shareholders and eventual corporate failure. Any company with poor stakeholder relations would be characterised by poor management and poor financial performance (Solomon, J. 29).
Having known this, an organisation has to focus on attaining its success through balancing the needs of different stakeholder which is often a problem (Solomon, J. 28). A consideration of both the shareholder and stakeholder theory comes in handy. The shareholder theory explains that the basic responsibility of a business generate maximum income. The management are hired on behalf of the owners and are therefore obliged to serve their interests. Stake holder theory is of the premise that a company is obliged to attend to the needs of the wider stakeholders and not necessarily on the needs of shareholders (Phillips, R. 2003. 3-4).
Neither of the theories can be adopted in isolation since every entity is equally important. First, it is important to note that the basic foundation of a business is to create profits. Therefore, profit maximisation of the shareholders should be key to any organisation. But this is not to say that the stakeholders are unimportant in an organisation but to certify the credibility of the shareholder theory. The stakeholder theory does not give the specific objective function of the organisation it only concentrates on distributing the organisations profits to the publics (Phillips, R. 2003. 25)
There are disadvantages of concentrating solely on the interests of the shareholders. The basic limitation is that managers would enrich themselves at the expense of the organization (Phillips, R. 2003, 19). The role of the employees cannot be dismissed against that of the creditors, suppliers or customers. An employee would want to be fairly paid considering the work done whereas the supplier would require payment for the goods and services rendered. Customers would require quality goods and services. The interests of all these groups are joint and that to create value, one most focus on how to create value for each and every individual (Freeman R. 9)
It is therefore selfish and delusional for an organisation to highly consider the needs of shareholders in any organisation at the expense of other stakeholders since all the components of the organisation are basic pillars that hold the organisation together. Riahi-Belkaoui, A. (2002, 20) explains that there are different objective functions of an organization. Both needs of the owners and stakeholders should be considered when carrying out its activities.
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