The Nature and Purpose of Financial Statements - Essay Example

1. Explain the nature and purpose of financial ments The most useful reports that accountants and finance professionals use to analyze the financial performance of a company are the financial statements. The accounting staff of a corporation is responsible for the preparation of financial statements. The four major financial statements are the income statement, balance sheet, statement of retained earnings, and the statement of cash flow. The income statement shows how profitable a company has been during an accounting period. An accounting period typically is composed of one year in time. Within the income statement there is information regarding the revenues and expenses of a company. Sales or revenues are generated when a company sells a product or service. The revenue recognition principle dictates that revenue be recognized in the accounting period in which is earned (Accoutingtools, 2015). Two of the major expenses categories within the income statement are cost of goods sold and operating expenses. The figure at the bottom of the income statement is the net income or net loss of the company during an accounting period. The balance sheet is a statement that shows the financial position of a company at a specific point in time. The balance sheet follows the logic of the basic accounting equation. The basic accounting equation states that assets equal liabilities plus stockholders equity (Misscpa, 2011). The three major sections of the balance sheet are assets, liabilities, and equity. The preparation of the balance sheet must follow the historic cost principle. Historical cost is a measure of value used in accounting in which the price of an asset on the balance sheet is based on its nominal or original cost when acquired by the company (Investopedia, 2015). Assets in the balance sheet are subdivided into four subcategories: Current assets Long term investments Property, plant, and equipment Intangible assets Some examples of assets included in the balance sheet are cash, inventory, account receivables, short term investments, prepaid expenses, office equipment, and goodwill (Weygandt, Kieso, Kimmel, 2002). The liabilities section of the balance sheet is divided into current liabilities and long term liabilities. Current liabilities are liabilities that expire in less than one year. A few of the current liabilities included in the balance sheet are notes payables, account payable, current maturities of long-term obligations, unearned revenue, salaries and wages payable, taxes payable, and other current liabilities. A list of potential long-term liabilities are bank notes payable, mortgage payable, bonds payable, and other long term debt. The stockholder’s equity section shows how much capital the company has accumulated over time. The two main components of the stockholder’s equity section are common stocks and retained earnings. Some companies will also illustrate its preferred stocks within this section. The statement of retained earnings shows the changes in retained earnings that have occurred during a year. The preparation of financial statements occurs at the end of the accounting cycle. Companies provide information regarding its financial statements within the content of the annual report of the firm. Publicly traded companies often also release quarterly financial statements. Two accounting assumptions that accountants have to consider when preparing financial statements are monetary unit assumption and economic entity assumption. The monetary unit assumption requires that only transaction data that can be expressed in terms of money be included in the accounting records. Based on this accounting guideline the U.S. dollar is assumed to be constant or have no change in purchasing power over time (Averkamp, 2015). The economic entity assumption is another important accounting rule companies must follow. This accounting principle establishes a clear delineation between an economic entity and its stakeholders for the purpose of maintaining separate transactions records (Investorwords, 2015). In the process of preparing financial statements it is imperative for accountants to prepare them based on the generally accepted accounting principles (GAAP). 2. To what extend do the statement of financial position (or balance sheet) and the income statement provide useful information for an organization stakeholders. The information contained within the financial statements prepared by the accounting staff of a firm is used for both internal and external purposes. The stakeholders of a corporation are the users of the financial information prepared by companies. A stakeholder is a person, group or organization that has interest or concern in an organization (Businessdictionary, 2015). Some of the stakeholders groups of a corporation include its employees, unions, suppliers, governmental agencies, customers, investors, and the executive management team of an enterprise. Stakeholders utilize financial information for a variety of reasons. For example banks require companies to submit their latest financial statements whenever a company requests a loan or line of credit from the bank. The bank’s credit evaluation department analyzes the financial statements of companies to decipher if the firm has good profitability, efficiency, liquidity, and solvency. A technique that is often used to evaluate the information contained in the financial statements is ratio analysis. Ratio analysis uses financial basic financial formulas to create metrics that provide insight into the performance of a company. Some common financial ratios used to evaluate the financial performance of companies are the net ratio, return on assets (ROA), return on equity (ROE), current ratio, quick ratio, earnings per share, dividends per share, dividend payout ratio, debt ratio, working capital, inventory turnover ratio, average sale period. A stakeholder group that must follow the performance of a company is its employees. It is important for employees to know whether a company is doing good or bad financially. Companies that struggle financially often implement strategies that affect the employees such as downsizing. Some companies pay its employees with stock options or bonuses. Bonuses are often tied to the financial performance of the organization. Suppliers are another stakeholder group that has interest in the financial performance of a company. Based on the financial results of firm suppliers make decision of whether or not to extend credit to a firm. Employee unions closely follow the financial performance of an enterprise by analyzing financial statements. Unions pay close attention to the profitability of a firm in order to negotiate new collective bargaining agreements. If a company is doing well the union often asks for a raise for the employees. The government is another stakeholder that pays close attention to the financial performance of enterprises. Based on the net income displayed in the income statement the government taxes a company. Governments are also interested in the financial performance of private companies because there is a correlation between business success and job creation. The executive management of a firm which includes the CEO, president, and controller of a firm utilize the information contained within the financial statements to make business decisions. Based on the results of the financial statements business executives can make decisions such as expanding operations, closing down unprofitable business units, and investment decisions. The stakeholder group that probably pays most attention to the financial results of publicly traded companies is investors. Publicly traded companies are firm whose stocks are sold in the open market in marketplaces such as the New York Stock Exchange (NYSE). Some of the techniques used by investors to analyze financial statements are ratio analysis, horizontal analysis, and vertical analysis (Besley & Brigham, 2000). Customers also are interested in knowing the financial performance of companies. The use of financial statements is a great way to analyze the financial performance of enterprises, but despite its usefulness these reports also have its limitations. One limitation of financial statements is that it does not provide any qualitative information about the company. Important qualitative information such as the company’s expansion plans, size of the workforce, competitors, marketplace data, and future prospects of the industry are disregarded in the content of financial statements. A second limitation of financial statements is that its results are based on historical data. Financial statements do not provide forward looking information such as sales forecasts. Another limitation of financial statements is comparability of financial data between companies (Ahmed, 2014). The reason that often data between financial statements cannot be compared is due to differences in accounting methods used by different companies. A problem that exist regarding the information contained financial statements is that it does not consider industry trends, technological changes, changes in consumer tastes, changes in broad economic factors, and changes within the firm itself (Ahmed, 2014). Financial statements are a great resource that can be used to evaluate the financial performance of a firm. Companies that display poor financial performance are not good investment targets because bad financial performance is typically reflected in the price of the stock of the company. In contrast companies that perform well financially usually go up in price in the long run. The credibility of the accounting system is reinforced due to the use of the generally accepted accounting principles by accountants. It is important for business students to learn how to prepared and properly analyze financial statements. Knowledge about financial statements can help any professional or person because based on this knowledge people can make investments decisions in the stock market. References Accountingtools.com (2015). The Revenue Recognition Principle. Ahmed, S. (2014). Limitations of Financial Statement Analysis. Averkamp, H. (2015). Monetary unit Assumption. Besley, S., Brigham, E. (2000). Essentials of Managerial Finance (12th ed.). Forth Worth: The Dryden Press. Businessdictionary.com (2015). Stakeholder. Investopedia.com (2015). Historical Cost. Investorwords.com (2015). Economic Entity Assumption. Misscpa.com (2011). Basic Accounting Equation. Weygandt, J., Kieso, D., Kimmel, P. (2002). Accounting Principles (6th ed.). New York: John Wiley & Sons. Read More