The Essay Explores The Role, Objectives, And Limitations Of Published Annual Financial Statements.

Critically discuss the role, objectives and limitations of published Annual Financial Statements for companies. 

The Essay should focus on the challenges facing financial accountants when preparing financial statements. In discussing the objectives and limitations, you should also discuss the need for and sources of regulation. Accounting standards that refer to the measurement basis to be used should feature prominently in your work, as should academic and practical evidence to support or challenge the currently recommended approach. 

Role of Financial Statements

Annual Financial statements contain the summary of all the transactions and events that takes place in as particular year which provides the true picture of the financial position as well as the financial performance of the reporting entity. The process of preparation and presentation of financial statements is termed as the financial reporting function of an entity. Reporting entity is the firm that prepares and presents their financial statements and publishes them so that they can be used by the stakeholders of such companies in their decision making function in the areas in which they are associated with the reporting entity. The information contained in financial statements are communicated to the intended users by way of annual reports which is comprised of various statements such as income statement, statement of financial position, statement of cash flows along with the notes to accounts that provides details of the information contained in such statements.

A financial statement serves an important tool for the entity’s owners, investors and regulators in determining its true financial position. They provide necessary and relevant information to such parties to help them in undertaking sound and effective decision making (Schroeder, Clark & Cathey, 2001). The financial information in relation to an entity’s business is structured in the financial statements in such a way that the users can easily understand it. An entity’s financial statements must be prepared and presented in accordance with the Generally Accepted Accounting Principles (GAAP) or in accordance with the International Financial Reporting Standards (IFRS) (Callao, Jarne & Laínez, 2007). For each stakeholder group financial statements play different roles. For existing and potential shareholders and investors, these statements provide them insights about the profitability position of the company so that they can determine the level of returns they can earn by investing in such company. Only a profitable entity can offer sound returns to its investors and owners. For the banks and financial institutions, financial statements serve as the basic documents to assess the financial health of the company and its credit worthiness by evaluating its solvency position (Suh, 2017). The governmental regulators bodies refer to these statements to check as to whether the reporting entity complies with the regulatory requirements and for the determination of amount of taxation that they must collect as revenue from such entity. The employees of the company use its financial statements to determine the level of compensation they must receive from the company on the basis of its profitability and for the assessment of existing and future employment opportunities. Further, the owners and managers of the company uses such financial statements to evaluate their overall business performance so that required strategies and policies can be formulated for the subsequent periods in order to achieve the desired growth and success of business (Carraher & Van Auken, 2013).

Financial statements are prepared to meet certain important objectives of financial reporting. They are prepared to evaluate the true business performance of the business in financial terms so that necessary managerial decisions can be taken by the top management for the further period of the business (Zeff, 2013). These financial statements are published for their intended users i.e. the stakeholders of the company so that they can assess the financial health of the business from various aspects such as its profitability position, solvency position, liquidity position, market valuation and worthiness (Foster, 2004). As financial statements help the potential shareholders in determining company’s worth, it is important for them to compare the financial performance of such company with its competitors and other firms where investment can be made. Therefore, it is necessary that there must be uniformity in the rules of preparation and presentation of such financial statements. Hence, regulation of accounting function across the globe is quite essential. The use of accounting standards in framing the financial statements will not only promote uniformity but will also encourage the reporting entities to maintain transparency. The lack of appropriate regulation has made accounting function to lose its relevance which can be regained by way of regulating it stringently. Moreover, financial statements are prepared to anticipate the scope of growth of the business and to identify its financial strengths and weaknesses. Further, financial statements help in carrying out forecasting and budgetary processes for so as to project the future performance of the business. The financial projections are often used by the providers of finance such as banks and financial institutions for the purpose of sanctioning loan to the reporting entity. Also, financial statements are prepared and published in order to comply with various regulatory requirements as applicable on the entity. These statements facilitate managers in undertaking the decisions in regards to the allocation of scarce resources of their business and for to take up significant business matters such as assets replacement, mergers and acquisition and so on (Graham, Harvey & Rajgopal, 2005).

Objectives of Financial Reporting

According to the Barth (2006), the financial statements have numerous great importance and benefits of financial statements, there are certain limitations that hamper the effectiveness of the financial reporting function of a reporting entity. The biggest problem with the annual financial statements is that they merely cover the quantitative information i.e. the information about the financial performance of the company and not the qualitative information that tells about the performance of business in various other areas such as its social responsibility fulfillment, quality of its products and services, employees satisfaction, its sustainability practices and its loyalty towards the customers. All these areas are necessary to be covered while evaluating the overall financial statements. Unfortunately, the traditional financial reports do not contain such information and due to the lack of such important discussions, the annual reports do not serve their core purpose to the full extent. According to Efendi, Srivastava & Swanson (2007), the other problem with the financial statements is that they can easily be manipulated by the management of the company to mislead the stakeholders by revealing the falsified financial results of such company. This practice of manipulation is termed as window dressing or unethical earnings management practices which leads to incorrect decision making at shareholders and other stakeholder’s end. The cases of accounting scandals that took place in large corporations like ABC Learning, WorldCom, Enron etc. have made the financial reporting function lose its relevance in the eyes of general public. In all the cases, one thing that remained common was the heavy manipulation of accounting books to mislead the stakeholders of the entity by finding loopholes in laws and regulations related to accounting (Barth & Landsman, 2010). For instance, in case of Enron the financial statements were manipulated by reporting the expenses of 3.3 billion as the capital investments with the motive of achieving the desired profitability. The financial statements of different entities are prepared using the different accounting policies and procedures that creates the problem of non-uniformity which in turn creates difficulty in making comparisons of two different entities. Furthermore, financial statements are prepared on the basis of various professional judgments which are highly subjective in nature and vary from person to person. According to the Penman (2007), the financial statements are generally prepared using the historical cost accounting method where costs of the assets are incorporated in the statement of financial position. However, some of the entity’s assets are subject to changes in their market prices which are being ignored under historical accounting. All these limitations affect the effectiveness of financial statements of the entity.

It can now be concluded that financial statements plays vital role in assessing the financial health of the business. Therefore, these statements must be prepared with due diligence and with the highest degree of transparency in order to enable the stakeholders of the company to take informed economic decisions in relation to such company. However, due to certain limitations financial reports must not be completely relied upon by the stakeholders and they must seek for the more information about the business performance of the company in the form of integrated reports from the reporting entity.

References:

Barth, M.E. and Landsman, W.R., 2010. How did financial reporting contribute to the financial crisis?. European accounting review, 19(3), pp.399-423.

Barth, M.E., 2006. Including estimates of the future in today's financial statements. Accounting Horizons, 20(3), pp.271-285.

Callao, S., Jarne, J.I. and Laínez, J.A., 2007. Adoption of IFRS in Spain: Effect on the comparability and relevance of financial reporting. Journal of International Accounting, Auditing and Taxation, 16(2), pp.148-178.

Carraher, S. and Van Auken, H., 2013. The use of financial statements for decision making by small firms. Journal of Small Business & Entrepreneurship, 26(3), pp.323-336.

Efendi, J., Srivastava, A. and Swanson, E.P., 2007. Why do corporate managers misstate financial statements? The role of option compensation and other factors. Journal of financial economics, 85(3), pp.667-708.

Foster, G., 2004. Financial Statement Analysis, 2/e. Pearson Education India.

Graham, J.R., Harvey, C.R. and Rajgopal, S., 2005. The economic implications of corporate financial reporting. Journal of accounting and economics, 40(1-3), pp.3-73.

Money matters, 2018. Limitations of Financial Statements. [online] Available from: https://accountlearning.com/limitations-of-financial-statements/ [Accessed 12/12/18].

Penman, S.H., 2007. Financial reporting quality: is fair value a plus or a minus?. Accounting and business research, 37(sup1), pp.33-44.

Saylor. 2016. Understanding Financial Statements. [online] Available from: https://saylordotorg.github.io/text_exploring-business-v2.0/s16-02-understanding-financial-statem.html [Accessed 12/12/18].

Schroeder, R.G., Clark, M.W. and Cathey, J.M., 2001. Accounting: Theory and Analysis. John Wiley & Sons.

Suh, C., 2017. The Role of financial statement in the investment decisions of a micro finance institution (MFI): Bamenda Police Cooperative Credit Union Limited, Yaounde (BAPCCUL Yaounde).

Tran, M., 2002. WorldCom accounting scandal. Available at: https://www.theguardian.com/business/2002/aug/09/corporatefraud.worldcom2 Accessed on 09.12.2018.

Zeff, S.A., 2013. The objectives of financial reporting: a historical survey and analysis. Accounting and Business Research, 43(4), pp.262-327.