Essay: Financial Statements - Profits Vs Cash Flow, Limitations For Users.

Question 1: Presentation of Financial Statements
In evaluating a company should a User rely more on accounting profits or cash flow.

Question 2: Presentation of Financial Statements
The Financial Statements contained in published Annual Reports have been prepared to comply with GAAP, which provides limited information for some Users. Identify who these Users would be and discuss the limitations to Users of these financial statements?

Accounting Profit

The title of the report is Financial and Managerial decisions which itself suggestion the intention of the report for which it has been prepared. Information present in financial reports forms the basis for the decisions to be taken by the different stakeholders. If the information is not correctly presented or understand by the stakeholders inappropriately then the decisions taken not this information is not reliable. To understand the information present in the report in proper manner, this report has been prepared. The report has been prepared using different headings and sub headings. The main part of the report contains whether user should rely on accounting profits or cash flow for checking the returns of their investment. The next part of the report contains identification of users of financial statements and what are the limitations involved for users in getting the information which has been published in annual reports of the company. The report has been ended with proper conclusion and recommendation. The report has been prepared using the primary and secondary data available on internet. 

For evaluation of the any company, two important terms – accounting profits or cash flow plays a key role. The both terms helps in evaluation of financial health or profitability of the company.  Although the two terms helps the users of the accounting in the same manner, the primary different in two terms is different method/figures have been used to calculate both terms (Gibson, 2011). For understanding which term is more useful to different users of financial statements, first understanding of two terms in detail is required.

Accounting profit means the net income which has been calculated by deducting all expenses from the total revenue earned by the company.  It is the difference between the revenue and cost of running the business.  Accounting profits can be three types which are shown in statement of profit and loss account in the financial statements. Gross profit, Operating Profit & Net Profit which is different types of accounting profits which has been considered by the different users for their analysis. Each of the type of profits provides detailed information about the performance of the company in comparison of the company’s competitor and industry. Also, the accounting profits takes into account the non cash items like depreciation, taxes and interest while calculating the costs to company which in turn helps in correct analysis of the profitability. For example in case of Woolworths Limited, the accounting profits are $ 1593.4 million which has been shown in statement of profit and loss of the company for the year 2017. 

Cash flows mean the flows of cash which is calculated after considering outflow and inflow of the cash and cash equivalents. Cash flows calculation can be done by subtracting the opening cash and cash equivalents from closing cash and cash equivalents. The company should total their cash receipts and cash payments over a particular period of time. Cash flows of any company represents the liquid assets of that company which are required to pay of the outstanding debts, plough in back the extra funds, pay to investors and save for future contingencies. So, higher the cash flows higher the liquid assets. Cash flows are the necessarily required for daily business transactions and operations like purchases, tax payment, payment of salary etc. Cash flow is the indicator of overall financial wellbeing of the company. For example in case of Woolworths Limited, the net cash flows are -$ 38.7 million which has been shown in statement of cash flows of the company for the year 2017 (Woolworths, 2017). 

Cash Flow

The reliability of the two terms depends upon the need of the user seeking the information from these two terms about the company. There are several factors/ situation according to which determination of the more reliable term can be done. The following factors/ situations help in understanding the company’s performance:

• In case of High Assets held by the company- In this situation cash flow of the company is more reliable source for evaluating the performance of the company. For example, if the company is earning high profits by recognizing the credit sales, and the debtors are not paying to the company and this creates situation of fund shortage for payment of salary, then cash flow helps in better decision making for running business even though the profits of the company are very high.
• In case of substantial amount of debt- The accounting profits are more important. For example, if company has taken loan in April 2018 of $ 100000 @ 10% interest which has to be paid after a year, then the cash flows for April 2018 shows increase of $ 100000 which is misleading information for users as the interest component which is cost to company but the accounting profits will show the correct picture that profits in actual are decreasing for the month of April 2018.
• In case of Use of more accounting principles – Accounting profits will be considered in this case as better option because it show all the figures which can be calculating using accounting estimates and accounting assumptions. For example, in company A the management of the company assumes the life of air conditioner to be 3 years instead of 5 years, then the company’s cash flows will not change for the particular year but the profits will be different in both cases.
• For taking Financial Investment decisions – Cash flows are better tool in this situation as it considers the time value of the money. The profits will mislead the users in taking investment decisions as correct inflows can be judged on accrual basis (De Franco, Kothari, & Verdi, 2011).
• In cash of high value of non cash items – If the company has taken into account the high value of non cash item in calculation of accounting profits then accounting profits are more reliable for users in evaluation of company’s performance. Cash flows doesn’t take into consideration the huge amortization, impairment, depreciation etc which lacks the true and fair view requirement of users.
• In case of complexities – Cash flows are considered more reliable as there is only one method to calculate to check the validity of the cash flows calculated by company. On the other hands, accounting profits can be calculated using different complex methods which are sometimes difficult for users to understand.   
• In case of evaluation of company in terms of economic viability- Cash flows is better tools for user as it takes in account the future opportunities and deficiencies at the initial stage only which cannot depict from accounting profits. In evaluation of capital budgeting decision as tools for performance of company then cash flows are more appropriate (Dechow, 2014).

From the above it can be said that reliability of accounting profits or cash flow to totally depend on the company, its nature of business, business environment in which company and operates and circumstances for which the information is used in evaluation of the company.

Financial Statements are basis of the information which needs to be communicated to different stakeholders about the affairs of the business of the company. These statements are generally prepared using generally accepted accounting principles which governed the management of the company to show certain information in certain way or not to show some information (Fraser, Ormiston, & Fraser, 2010).

The basic objective of general purpose financial statements is to provide the information to different users of accounting information. The users of financial statements can be classified into two categories : External users of accounting and Internal users of accounting.

Internal Users Of Financial Statements

Internal users are also called Primary Users of financial statements which represents are persons who are internally working in the company. They are :

• Management of the company :-  They use the information which depicts performance and position of the company  to enhance the future results by taking necessary actions.
• Employees of the company :- They are more concerned with the information which shows profitability of the company as employees as users of financial statements mostly interested in their knowing the their remuneration growth aspect and job security in future years.
• Shareholders of the company :- They use the information to check the profitability and viability of the company's performance so that their goal of wealth maximization can be achieved. Also, they use the information to know what future actions are required from shareholders side so that loss to investment made by them cannot happen.

Internal users of financial statements uses the budgets, forecast, director's report, management accounts, financial accounts present in annual report of the company to have the information about the affairs of the company.

External Users Of Financial Statements

External users are also called Secondary Users of financial statements which represents are persons who are outside the company. They are :

• Suppliers and Creditors of the company : They are interest in knowing the credit worthiness of company by analyzing the financial statements. The conditions/terms of credit will decided only after having proper assessment of the financial information  in terms of financial health by the creditors about the company. Suppliers such as financial institutions or banks also does the same before advancing any money to the company.
• Investors :- They uses the information published in annual report for knowing the whether the company is in the position to provide reasonable return on the investment made by them. Investors generally check the feasibility of investment before providing any funds to the company.
• Tax authorities :- They uses the information to assess the genuineness of the tax liability disclosed by the company in their tax returns.
• Government Regulations:- Regulatory bodies uses the information to check whether the financial statements of company has been prepared in accordance with all the applicable laws, rules and regulations. They also ensure that information present corrected manner so that decisions made by the shareholders will be right.
• Customers :- They are persons from whom company earns its revenue. They uses the information to check stability of supply in future by the company and its operations.

All the information has been transferred and communicated to external users only in the form of financial statements. Financial statements should be prepared to fulfill the need of information of these diverse users (Asare & Wright, 2012). 

The users of financial statements uses the information present in information for forming better financial and managerial decisions. However, there are certain limitations because of which users of financial statements faced difficulties in analyzing the information. The limitations are :-

• Many accounting policies and different framework :- The financial statements are being prepared using the different set of accounting policies which are flexible in nature according to their nature, size and geographical conditions. For example, users like Government finds it difficult to compare the performance of different units of the company or different companies in the industry.
• Use of Accounting estimates:- Accounting estimates which has been used in preparation of financial statements depends on management forecasts which sometimes is not correct. For example, the management of company A has assumes the life o f air conditioner be 3 years but  the efficiency of air conditioner shows it should be 5 years instead of 3 years. So the estimate taken by management misleads the different users and financial statements looses their reliability to its users.
• Limitation of Audit : Audit is being conducted to checked the viability and correctness of financial statements. But due inherent limitations of auditing sometimes genuinity cannot be 100% judged by the auditor as a result wrong information can be communicated to users.
• Usage of Historical costs while presenting the assets of the company:- The users of financial statements finds difficulty in assessing the information related true value of assets held by company. Usage of historical costs create many problems to users as it ignore the change in price of assets over a period of time. It cause loss of relevancy in accounting information present in financial statements as the presented value of assets are more less than realizable value. It also does not take into account the opportunity costs which has involved in usage of asset by the company.
• Window dressing: Sometimes due to loop holes in laws and regulations which governed the preparation and presentation of the financial statements, the management of the company is able apply window dressing techniques to manipulate the profits of the company. This situation most of time cannot be identified by the different other stakeholders and they believe on misleading information present in financial statements which in actual fulfill all the requirement of GAAP but in actual are not correct. This is one of the major limitation to users that they sometimes even not able to check the validity of information presented to them (Gray, Turner, Coram & Mock, 2011).

Conclusion and Recommendation 

Financial statements are presented to achieve the basic objective of the accounting and financial reporting. The use of information by different users helps better financial and managerial decisions. To make the information presented more reliable the management of company should take all necessary actions so that information usage and decision making can happen at ease of the different stakeholders and as per law. To conclude the report, presentation of the financial statements should be done by using conceptual framework of accounting issued by different regulatory bodies and considering different aspects which make financial statement true and fair.

References

Asare, S. K., & Wright, A. M. (2012). Investors', auditors', and lenders' understanding of the message conveyed by the standard audit report on the financial statements. Accounting Horizons, 26(2), 193-217.

Dechow, P. M. (2014). Accounting earnings and cash flows as measures of firm performance: The role of accounting accruals. Journal of accounting and economics, 18(1), 3-42.

De Franco, G., Kothari, S. P., & Verdi, R. S. (2011). The benefits of financial statement comparability. Journal of Accounting Research, 49(4), 895-931.

Fraser, L. M., Ormiston, A., & Fraser, L. M. (2010). Understanding financial statements. Pearson.

Gibson, C. H. (2011). Financial reporting and analysis. South-Western Cengage Learning.

Gray, G. L., Turner, J. L., Coram, P. J., & Mock, T. J. (2011). Perceptions and misperceptions regarding the unqualified auditor's report by financial statement preparers, users, and auditors. Accounting Horizons, 25(4), 659-684.

Woolworths Limited, (2017), "Annual Report -2017" available at https://www.woolworthsgroup.com.au/page/investors/our-performance/reports/Reports accessed on 01-05-2018